Money Morning » Keith Fitz-Gerald

Fuzzy Math, Greater Fools and the Facebook IPO

Keith Fitz-Gerald — Fri, 10 Feb 2012 10:00:03 +0000

I have several friends who think the Facebook IPO is the next Microsoft.

I think it's more likely the next Research in Motion.

Or perhaps the next Sony, Kodak, or Eastern Airlines--all of which were once world-class brands that got sideswiped by hungry new competitors.

Facebook...you may as well buy a lottery ticket.

Don't get me wrong. In just a few short years, Facebook has accumulated an unprecedented 845 million users representing 12.07% of the world's population.

But does that merit an offering worth as much as $100 billion?

Maybe to a lot of people, but not to me.

Think about the numbers.

There are 7 billion people on the planet today, 5.15 billion of whom live on $10 or less a day. Of that group, roughly 3 billion people live on less than $2.50 a day.

That means if you remove those who live on less than $10 a day because theoretically they can't afford a computer or don't have enough disposable income to be monetized, that leaves roughly 1.85 billion potential Facebook users.

In a perfect world where a company could capture 100% of its target market, that would cap Facebook's potential user growth at 118.93%.

But we don't live in perfect world. As far as I know, no company has ever captured 100% of its target market. Not once.

There are always those who drop off, leave or simply don't buy no matter what the product is or how good the "offer."

That's not to say it couldn't happen, but unless Team Zuckerberg figures out new ways to monetize users or invents an entirely new class of customers, there is relatively little upside remaining in terms of the company's target market.

The Fuzzy Math Behind Facebook

And another thing, in my best Andy Rooney voice, according to Yahoo Finance, Microsoft's adjusted close on March 13, 1986 was $0.08. As of January 30, 2012, the stock was trading at $29.61, which means Microsoft stock has delivered a mouthwatering 36,913% return over the last 26 years.

For Facebook to deliver similar returns at its proposed $100 billion valuation, Facebook's market cap would have to increase to $36.21 trillion. That's roughly 57.47% of the entire world's GDP.

Possible? Sure. But there's a big difference between that and what's probable.

If Facebook is really worth $100 billion, that means the company would come out of the gate at roughly 27 times 2011 sales and nearly 100 times 2011 earnings. By comparison, Google trades at 5.22 times sales and carries a P/E ratio of 20.42 times earnings.

In other words, you'll have to wait 100 years to justify your Facebook investment versus a mere 20.42 years for Google. Dividends would obviously bring that figure down in a hurry, but to my knowledge the company has no such plans.

Google went public in 2004, raising $1.9 billion against a valuation of $23 billion - a record for the largest U.S. Internet IPO that has stood until now. At the time that worked out to 10 times sales, or less than half of Facebook's proposed initial valuation.

Even Apple, by a far more dynamic company backed by real products, trades at only 3.38 times sales. That's less than 20% of the estimates for Facebook's projected price to sales ratio. And Apple has a market cap of $460 billion.

Facebook's Greater Fools

At the end of the day, I realize that nothing I say can change your mind if you've decided to take the plunge, so I'll wrap up with one final thought.

Investors who fancy tech stocks often argue that the future matters more than current valuations, no matter how absurd they might be. That's why stocks like Facebook are "worth" the risk.

I have no comeback to that. I can't argue with how a technology might be used 10 years from now.

But I can point out that companies like Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG), and Microsoft (Nasdaq: MSFT) are fairly valued based on current earnings, cash flow and their respective cash stockpiles.

In other words, their stock prices reflect stuff that could realistically have a material effect on how each of these companies grows within the next 12 months - or not.

So where does that leave us?

If you're a day trader and you have money to burn, Facebook may make a superb opportunity. I think it could easily double on nothing more than the greater fool theory.

You know the one...that's where you plunk your money down on nothing more than a wing and a prayer (because you don't have earnings, sales or real products to back up your chosen investment).

And you hope a greater fool comes along at some point in the future willing to pay you more money than you spent to buy the stock in the first place. Just remember -- you're the greater fool who bought it in the first place.

But if you're an investor, I'd wait a year.

Let Facebook go public and bleed out the hype. Give it some time to build a public track record. Then, using that data, make a market-based determination as to whether or not you want to invest.

Of course, I suppose you could always break out the Magic 8-ball, too.

Just make sure you shake it hard enough to avoid another case of "MySpace."

Tags: facbook price, facebook 2012, Facebook IPO, facebook ipo date, facebook nasdaq, facebook public, facebook value

China's Economy: How to Beat the Coming Crash & Make a Bundle from China in 2012

Keith Fitz-Gerald — Fri, 03 Feb 2012 14:23:28 +0000

There's not a day goes by that I don't see some variation of the theme that China is going to crash, or that somehow that nation will blindside us, and that its markets may fall 60%.

This is like saying the U.S. markets were in for a hard landing in March of 2009 after they had fallen more than 50%. Folks who bit into this argument and bailed not only sold out at the worst possible moment. They then added agony to injury by sitting on the sidelines as the markets tore 95.68% higher over the next two years.

People forget that the U.S. stock market - as measured by the Dow Jones Industrial Average using weekly data - fell more than 89% from 1929 to 1932, more than 52% from 1937 to 1942, and more recently experienced a decline of more than 53% from 2008 to 2009 - and that doesn't even account for four 40+% declines beginning in 1901, 1906, 1916, and 1973.

Each was a great buying opportunity, and following those meltdowns, our markets rose more than 371% from 1929 to 1932, more than 222% from 1949 to 1956, more than 128% from 1937 to 1942, and more than 95.68% in just over two years starting in March 2009 - one of the fastest "melt-ups" in market history.

People forget that world markets dropped 40%-80% in 1987. And as legendary investor Jim Rogers noted earlier this month, that was not the end of the secular bull market in stocks, either.

People forget that our nation endured two world wars, a depression, multiple recessions, presidential assassinations, the near complete failure of our food belt, not to mention the deadliest terrorist attacks the world has ever seen, and more.

And guess what? It's still been the best place to invest for the last 100 years. (But that could be about to change. Take a look at the new U.S. dollar report from Money Morning to learn the insidious truth behind America's global depreciation.)

So what if China backs off or slows down?

The Asian currency markets blew up in 1997. Mexico's market fabulously went up in smoke during the great tequila crisis of 1994. And Argentina failed to the tune of a 76.9% crash starting in 1997 only to give way to a 1,724.56% rally from 2001 to 2011.

Gold rose by more than 600% in the 1970s, then fell by 50%, which terrified investors at the time. It subsequently rose by more than 850%, something else Mr. Rogers noted in recent interviews, as have I.

China is undoubtedly going to have several hard landings in our lifetime. Despite the fact that China is thousands of years old, modern China is a mere 40 years old, if you consider its opening following the historic Nixon-Kissinger visit in 1972.

And today's China has 1.3 billion people -- all of whom want to live the way you do.

It's growing by an average of 9% a year or more and has done so every year for the last 41 years straight. We've just poured an estimated $7.7 trillion into our economy and the best we can do is 2.5%. The European Union (EU) is on track for 0.2% growth in 2012 after trillions in euro backing there.

Make no mistake: China's government is well aware that it has a problem. Unlike our own government and those in the EU, it has raised bank reserve requirements repeatedly before loosening them a bit last month. Beijing hiked interest rates six times in the last two years.

They are deliberately tapping on the brakes. They actually want segments of their economy to fail so they can reboot parts of the system, including China's real estate market, which is a prime example of this.

The Reality of Real Estate

Real estate has been bid up to obscene levels in many parts of the country - not throughout the entire country, but in parts. And those are the places Beijing wants real estate developers to fail so that values can come back to more realistic levels while capital gets freed up for additional investment.

Take Beijing for example. There are plenty of writers at the moment who love to point out that it will take the average Beijing resident 36 years to pay for their house versus 18 years in Singapore, 12 in New York, and 5 in Frankfurt.

Well, Beijing is a first-tier metropolis so right away you know this number isn't an apples to apples comparison. Factor in second- and third-tier cities like outside Beijing, Shanghai, Shenzhen, Guangzhou and prices drop to 3,000-5,000 RMB/m2 and take 4-10 years to pay back, which is roughly in line with international standards.

Look at cities like Moscow, Zurich, or Tokyo and the argument falls apart further.

For example, in Tokyo and other cities across Japan, Japanese banks at one point offered 100-year mortgages. And property, once acquired, tends to stay in the family for generations. You can still get 50-year mortgages if you want, and you might need to because property values remain unthinkably high even after a 30-year collapse.

Here are some other things to think about:

Unlike the U.S. property bubble, which was nearly nationwide, Chinese borrowers must put 30% down for first-time purchases, 50% down on second purchases, and make full cash payments for third properties (where third properties are allowed). This means Chinese homeowners and banks can withstand a 30%-50% drawdown in prices before actually experiencing negative equity and stands in stark contrast to the United States, which is riding Occam's Razor in that regard.
Using Beijing as an example for the entire Chinese housing market is shortsighted. While prices in second- and third-tier cities have also experienced increases in value, they are far less (relatively) than first-tier cities. And it is in second- and third-tier cities that the majority of Chinese citizens live. Using Beijing (or Shanghai) as a gauge for the entire Chinese real estate market would be like using Las Vegas, Miami, or Phoenix as a gauge of the entire U.S. property market in 2007.
Chinese banks have not collateralized their mortgages into risky collateralized debt obligations (CDOs) and subsequently insured them with unregulated credit default swaps (CDS).
And lastly, when the U.S. property bubble burst our country had more than $12 trillion in debt. China, by contrast, is sitting on $3.2 trillion in reserves (which represents 54.5% of the country's entire GDP). While Beijing would obviously rather not do it, it could theoretically recapitalize its entire banking sector and have plenty of money to spare.

More Than Manufacturing

Another doomsday scenario people like to bandy about is the notion that China will collapse if exports fail or U.S. demand drops. That's a gross exaggeration and much of the pabulum that you hear is completely wrong.

For example, it's commonly cited that exports make up approximately 40% or more of China's GDP. In reality, the figure is between 10%-20% even after decades of explosive growth. The CIA estimate is 18%, and of those exports, the U.S. accounts for a mere 18% of the total.

Fully 75% of the GDP comes from domestic spending and domestic investment.

As for the notion of U.S. demand, what China bashers don't realize is that the United States is dangerously close to being completely irrelevant to the Chinese growth model. China will not live and die by U.S. demand.

There is always going to be an imbalance between the value-added content of what China imports and what the country exports. China's exports are becoming more and more upscale just as Japan's did, which is probably the same pattern for all developing nations.

This is sort of like the great days of the British Empire - you sell us iron ore and we will sell you nails, hammers and shovels. If the value of an economy goes up, it's only natural that the value of the products it deals with, sells, and consumes will, too.

Also, China's trade surplus is shrinking as a percentage of gross domestic product (GDP), from almost 11% in 2007 to 3%-4% in 2010 to 0.246% ($14.5 billion) of its $5.87 trillion GDP as of November 2011 - further reinforcing the notion that domestic consumption is becoming a bigger force in China's economy even with the slowdown.

Don't Miss Out

I'm not saying China is going to have smooth sailing - but then again, neither did the U.S. in the 20th century, and the DJI gained 24,000% over that 100-year period. China is merely going through the first uncomfortable growing pains of its adolescence.

Remember, in 1912 the United States still used child labor, had massive inequalities of wealth, and women still couldn't vote. So holding China to the same standards as the modern United States is inappropriate, considering the country has only been open to the rest of the world for 40 years.

You have to look at China appropriately. You can't arbitrarily force the 21st century U.S. lens onto other countries in a vain effort to judge them.

Additionally, other parts of the Chinese economy are doing very well. Most manufacturing, agriculture, pollution treatment, water treatment, power, and resource development are just a few of the areas undergoing tremendous growth.

The point is, many people look down upon China with the same sort of derision once reserved for post-war Japan. And if you grew up in the 1950s or 1960s and thought Japan was only for cheap tin toys and didn't invest there, you missed out in the same way investors who look down their noses at China will.

Keep in mind that China's economy is roughly one-third the size of the overall U.S. economy and growing fast. Together America and the EU are approximately 10 times the size of China.

So if it does suffer a major correction, it's not the end of the world - nor the financial markets. And if the markets fall by 60% in the next year as some people suggest, I know what I'll be doing...buying.

Four Ways to Safely Invest in China

In the meantime, it's best to look at China within the overall scheme of things. And here are the investments you might want to consider:

Buy yuan. It's still a blocked currency but you can legally get your hands on it using bank deposits, CDs, or exchange-traded funds (ETFs). The official story is that it's being held down. Bull. Since 2005 it's already risen by 23.29%, which is more than the U.S. government wants you to believe. If anything, the dollar is worth too much (But right now, Washington bureaucrats are on a campaign to devalue your dollars - by up to 90%! That would mean a $1 million retirement account would only hand you about $5,000 a year in income if you don't act quickly. This new report from Money Morning reveals Washington's secret plan.)
Buy commodities. When China's markets grow, so too does global demand for raw materials. The nation has no choice but to buy because it doesn't have many native resources.
Buy shares in Chinese companies on Chinese exchanges. One of the things that people miss in their rush to dismiss China is that they're tracking those shares of Chinese companies listed in the United States. That's a mistake. If the U.S. markets take a header, of course Chinese-listed companies on the NYSE and other U.S. exchanges will, too. Still, it's probably best to wait for the dust to settle before wading in.
If you're aggressive, you can even try a classic "short" then go reverse long once the markets gain their footing.

Five Ways to Make 2012 Your Best Year Ever

Keith Fitz-Gerald — Fri, 03 Feb 2012 10:00:36 +0000

I hear it everywhere I go. I'll start investing again...

...when the debt problem is fixed.

...when the markets pull back a little.

...when the EU crisis is over.

...when the elections are over.

Chances are you've said some of these same things to yourself.

Yet, waiting is exactly the wrong thing to do. Time is something you never get back.

And when it comes to consistent investment returns, time is the one thing you always have to capitalize on - without fail.

Besides, waiting makes it harder to get back in the game. Ask anybody who missed the S&P 500's 99.53% run up off March 2009 lows that carried things until April 2011.

Or the 87.26% run up through July 2007 following the low set in 2003. Or the 569.25% move from November 1987 (shortly after Black Monday) through January 2000.

No. The way I see it, the thing to do is to begin investing the moment you decide you want to. That way you pique your imagination, your motivation and your returns.

Five Ways to Get Better Results in 2012

Here are five tips to help you get started:

Have specific goals. Wall Street traders like to beat the S&P 500 or the Dow Jones Industrial Average and they pay themselves huge bonuses for having beat this index or that benchmark. But that's crap. Everybody I know invests to meet objectives like paying for college for their children or living the retirement of their dreams. Decide what you want and when. Then, figure out how you're going to get there. You might be surprised how manageable all of this actually is.
Know why you want what you want. Many investors spend more time analyzing a new washing machine than they do picking their next investment. Or, they count on Uncle Bertie and his sure things. Both are bad ideas. Ask yourself if that new hot stock or exchange-traded fund (ETF) fits the goals you've laid out for yourself. If so, great. Buy it. If not, pass. It's a waste of money to have something in your portfolio that doesn't help you meet your goals, not to mention it's more risky, too.
Be realistic. You'd be surprised how many of the investors I meet want to earn 5,000% by tomorrow at 8:00am and only use $100 to do it. Then again, maybe you wouldn't. It is possible, just not probable. There's a big difference. On the other hand, it's much easier to earn a consistent double-digit return from a choice like Kinder Morgan Energy Partners LP (NYSE: KMP) that yields a healthy 5.40%, or the quintessential "glocal" stock, McDonalds Corp. (NYSE: MCD), which yields 2.8%, was the best performing Dow component in 2011 and ended the year up 35.50%. Since 2000, KMP has returned 768.58% while MCD has tacked on 220.32% -- even with both the dot.bomb crash and the financial crisis. You probably don't need to be reminded, but I will do so anyway to make my point: The S&P 500 has turned in 10.87% over the same period -- including dividends.
Take action. The single biggest impediment to success stares back at you every morning in the mirror. Psychologists say we have built in saboteurs; common wisdom says we are our own worst enemies. Both are true. The "enemy" is standing in the mirror and is so persuasive we can talk ourselves out of anything, including success. That's why actually taking action can quiet the doubt and help minimize any backsliding. Besides, if you hit a few small winners, you'll have the confidence needed to take even stronger, more decisive actions down the road.
Don't stay down. My grandfather used to tell me that it was not how I handled getting knocked down that mattered but how I got up. That's why sticking to a disciplined plan is a lot better than making panicky decisions. If you're simply reacting by the seat of your pants, chances are you're going to get knocked down a lot. But if you get up, plan ahead and take steps to avoid the next stumbling block, chances are you'll begin to pull ahead. And stay there.

So what about the risks?

That's a fair question and an important one, especially now when there are so many fundamental problems to consider - Europe, China, our debt, the lack of adult supervision amongst the world's central bankers, and more.

That's what trailing stops are for.

If the fire gets too hot, trailing stops will get you out of the kitchen. The important part is to get back to cooking when things cool down.

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Tags: Debt, Dow Jones, EU crisis, Hot Stocks, Investing, personal finance, personal investing, S&P 500, Stock Market

Godzilla Will Come Out of Tokyo Bay Before Japan Rebounds

Keith Fitz-Gerald — Thu, 02 Feb 2012 11:17:06 +0000

Let's talk Japan.

Every year some analyst comes out with a variation of the story that Japan is about to rebound.

Usually the argument goes something like this: Japanese markets are impossibly cheap and the central bank will be there to prevent a catastrophe.

Or sometimes there is another variation of the Cinderella story.

Either way, don't hold your breath. Japan posted its first trade deficit since 1980 last year and the big trade surpluses needed to drive the Nikkei back to its glory days are over.

At best, Japan is going to see balanced trade figures or a small surplus in the years ahead. It won't be enough.

If you're not familiar with what a trade deficit is, here's what you need to know: Japan imported $32 billion worth of stuff more than it exported for the first time in 31 years.

Fighting the Demographic Tide

Critics say there are mitigating factors behind the figures and they're right.

Against the backdrop of one of the world's fastest aging populations, one of the lowest birth rates on the planet, a renewed reliance on foreign energy, and a yen that is so expensive that Japanese corporations are offshoring production, it won't be long before the country eventually plows through its savings.

So $32 billion is just the beginning...

In fact, we are more likely to see Godzilla walk out of Tokyo Bay than we are to witness a return to Japan's halcyon days.

Worse, I believe that within the next five years, Japan will long for the good old days when the trade deficit was merely $32 billion, instead of $100 billion, $200 billion or worse.

Not one of the things I've just mentioned - that the critics cite as short-term influences - are anything but continuations of much longer-term trends. Nearly all of them are being driven by Japan's declining population.

You may not know this, but Japan's population is projected to shrink by 30% by 2060. That means the total population will go from 128 million people today to only 87 million people in less than 50 years.

That's hard to imagine since Japan is one of the most densely populated countries on the planet. But the effects are already visible.

In my neighborhood in Kyoto, for example, we see abandoned houses that fall in on themselves after people die and there are no longer any other family members to live there. We see schools that are shut down in the region because there are no kids to attend them.

We're also seeing companies shuttered because there are no markets for their products, including my wife's family kimono business, which closed after 300 years in existence.

Simply put, you just can't grow a population or its stock markets without people.

Japan also has no immigration policy to speak of, so there is no means of replacing the "silvers," or senior workers, who are leaving their productive years behind them.

By 2060 the number of people who are 65 or older is going to double. At the same time, the number of people in the workforce between 15 and 65 is going to shrink to less than 50% of the total population.

By 2050, there will be 75 retirees for every 100 workers. By comparison, in the United States in 2050 there will be about 32 retirees per 100 workers.

Figure 1: Source: mtholyoke.edu

You'd think Japan could get "busy" and produce more children but even that's problematic. The country has one of the lowest birthrates on the planet. Many young Japanese simply don't want romance -- let alone children.

In fact, many Japanese don't even want sex.

As reported by CNBC, one AFPstudy reported that 36.1% of teenage boys between the ages of 16 and 19 have no interest in sex. That study in 2010 reflected results that were double the 17.5% reported only two years earlier. Girls are even worse, with more than 59% in the same age group reporting no interest.

Things are so bad according to one study I've seen, that at the current birth rate the last Japanese person will be born 953 years from now.

Game Over For Japan?

Critics challenge this assumption, arguing that somehow Japan's hyper-aged will reinvigorate the economy in an orgy of retirement spending and consumption.

That depends on generous pensions and an intact financial system - neither of which Japan has at the moment.

Japan's debt stands at 200% - 253% of GDP, depending on which studies you read, and is headed in the wrong direction. In fact, it looks like a ski jump that's three times our own debt burden.

Senior citizens I know are doing everything they can to hang onto their jobs for as long as they can.

As a result, there is literally nowhere for younger workers to go... except into low value "arubaito" or part-time work with no benefits, no promotions and very little economic value to contribute to Japan's recovery.

My nephew, for example, struggled for years in such a job before getting training and finding work as a mechanic for Mazda.

To be fair, Japanese citizens purchase approximately 95% of Japanese debt. That's why the country has been able to hang on and has not had its own Greek holiday.

By contrast, we borrow about 50% of our money as a nation from overseas, and we're dangerously close to our own version of Greece's meltdown.

But as the number of retirees rises and the number of workers falls, the Japanese government is going to have challenges maintaining this internal funding capacity.

At some point - either because there are not enough debt buyers or rates rise too high - they'll have to turn to external creditors and interest rates that could easily be double the 1.5% the Japanese government pays lenders now.

At that point, debt payments would consume more than half of all government revenue according to The Atlantic.

And then it's game over.

So what's an investor to do? Well for one thing, I sure as hell wouldn't invest in Japan on anything other than an extremely short-term basis.

Despite the fact that trade deficit numbers may ping-pong back into positive territory in the months ahead, there's no reversing the current long-term trend.

The notion that the Nikkei is somehow undervalued is naïve if you do not take the population and its effect on debt into account.

While it is true there may be short bursts of growth, there's no ignoring the fact that the bellwether index is trading at 8,802.51, or 77% below the high it achieved in 1990 and 12% below where it started in 1984.

With very few exceptions, money invested in Japan is going to get trapped there.

That's why, unless you've got money to burn, you can say "sayonara" to Japan.

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Tags: Global Markets, Japan trade deficit, Japan's debt, japanese economy, Japanese government debt, Japanese imports, Japanese markets, Japanese trade, Nikkei

Why Energy Investors Will Get Crushed If They Fail to Look Towards Dubai

Keith Fitz-Gerald — Thu, 26 Jan 2012 10:00:33 +0000

The way I see it, U.S. and European energy traders will be lucky if the door doesn't hit them in the backsides as everybody heads for the doors.

Like so many Western investors, they still have their blinders on.

They think that if demand in the U.S. and the European Union (EU) begins to slide that oil prices will fall into the toilet right along with it.

But what they don't see is that Asian oil demand is what actually "drives" the global oil market.
This is why today's investors need to adopt an energy investment strategy focused on what is happening on the other side of the Pacific.

Because what happens there is critical to higher prices and profits here.

Here's why.

First, consider Asian demand.

In the fourth quarter alone, Asian demand increased by 400,000 barrels per day even as consumption in the rest of the world fell by 700,000 barrels a day, according to the International Energy Agency (IEA).

Meanwhile, Chinese demand in particular is so strong that the Red Dragon is set to import more oil than the United States within two years, according to my projections.

And don't take my word for it. Goldman Sachs Group Inc. (NYSE: GS) thinks the U.S. will be overtaken by China this year, while the IEA believes it will happen in 2020.

I think that's splitting hairs frankly.

What matters is that Asian oil demand growth is likely to represent a staggering 70% of the world's total oil demand growth this year. Or more depending on which studies you believe.

As China Rises the World Shifts Toward Dubai

Second, consider the effect Asia has on how oil is priced.

U.S. investors have focused on U.S. and Brent oil prices for years, and with good reason. North American markets have been the largest in terms of both consumption and growth.

Now, however, Asia's demand growth of more than 720,000 barrels per day dwarfs our own.
By comparison, U.S. demand growth is only 310,000 barrels per day while Europe's demand growth is positively anemic at only 260,000 barrels per day, according to the IEA.

That means Dubai's Mercantile Exchange is rapidly becoming the new pricing standard -quickly displacing the traditional Brent.

That's where countries like China, Japan, Indonesia, Vietnam and others in the Asian Rim increasingly price their oil for delivery.

Sadly, most investors can't even find Dubai on a map, but they'd better learn in a hurry.

Today, the differential between Dubai crude and Brent crude is dropping quickly, and now stands at a 14-month low of $2.73 a barrel, according to the Financial Times. Last April the spread on the Dubai crude was 237% higher at $7.61 a barrel.

Critics note that this is because Dubai crude is of lower quality and the Libyan revolution left world markets without sweet crude.

True, but they're missing the point - Asian demand is shifting commodity pricing from London, New York and Chicago to Dubai, and even Shanghai, where traders believe it more accurately reflects regional pricing influences.

And as China's demand grows, prices head higher.

Emerging Markets: As Simple as Supply and Demand

Third, consider infrastructure development in the emerging markets.

China and India are both constructing new refineries estimated to have more than 1 million barrels a day of processing capacity between them.

Admittedly, bringing an additional 1 million barrels a day of production capacity on line doesn't sound like a lot in the scheme of things, especially when we've become numb to trillion-dollar deficits and bailouts. But think again.

The world consumes approximately 89.5 million barrels a day yet has production capacity of only 90 million barrels a day give or take.

This means the amount of production capacity being brought on line exceeds total current global excess production. It also means that the placement of that new capacity - in China and India - is likely to have a significant impact on global pricing.

Think about it. Supply and demand determines prices. It's one of the most basic of all economic principles.

If demand increases or there is a disruption in supply, there is upward pricing pressure. If demand falls relative to supply, prices drop.

By the same measure, if there is a limited supply and growing demand coupled with new capacity, pricing power shifts from markets where demand has dropped to markets where demand is rising.

You see this in your own neighborhood on a much smaller scale already.

If there are two service stations in town and a third one is built, customers start buying from the third station... particularly if it's closer to where they live, has more attractive prices, better gas, or is closer to the refineries servicing it.

Initially prices will drop in response to increased competition. But, over time, as the new entrant disrupts the existing supply and demand balance, prices actually tend to rise, particularly if the three service stations now have to fight over the same limited number of tankers serving the community.

Then there is the process of demand building to consider. New capacity arguably facilitates demand growth.

I think that's a battle that's already begun.

Take the Chinese government, for example. Beijing is likely to use its newly built refinery capacity to boost strategic reserves.

Many people believe this will be a function of China's growing military demand, but China's growing transport sector is far more important because it moves the goods needed by 1.3 billion people to market.

So they'll buy as much oil as it takes to prevent a revolution...even if it means we don't have any left to buy (except at exorbitantly high prices). This is why Chinese oil companies have been buying up oil assets anywhere they can get their hands them.

They know it's an issue of domestic survival rather than global domination, as the West prefers to think about their action.

At the same time, the so-called Arab Spring has interrupted the capital investments needed to maintain current oil production, shipping, and pricing levels.

This is significant because oil markets cannot function without constant capital improvement and investment, at least not at current prices.

Factor in the vulnerable oil transportation routes in the Gulf, the Malacca Straits and one can easily envision $150-$200 a barrel in risk premiums alone if things heat up...even without open hostilities.

More if the shooting starts.

How to Play the Global Shift from West to East

So now what?

No doubt the United States Oil Fund (NYSE: USO) and the United States Brent Oil Fund (NYSE: BNO), long the domain of both groups of traders will remain viable investments, but it's important to understand they're not the leaders they once were.

The same can be said for the big oil companies like Exxon Mobil (NYSE: XOM), Royal Dutch Shell PLC (NYSE ADR: RDS.A, RDS.B) and even the vilified BP PLC (NYSE ADR: BP).

I think the far more interesting and potentially profitable game lies directly in Chinese oil companies like Sinopec (NYSE ADR: SHI), PetroChina (NYSE ADR: PTR) and CNOOC Ltd. (NYSE ADR: CEO). Not only do these companies have the global reach needed to capitalize on the demand shift, but they've got the cash, too.

I also tend to favor companies like Halliburton Co. (NYSE: HAL), which provide plenty of services to foreign oil companies and oil service providers. Not only are they quite literally in the middle of everything, but many times services companies like Halliburton can work for several competitors at once, further expanding their coffers and their earnings.

And finally, I think the Middle East's markets are incredibly beaten down and, next to the Chinese markets, probably the most hated on the planet at the moment.

That potentially makes financial and property-heavy choices like the Market Vector Gulf States (NYSE: MES) appealing because all that oil money has to flow somewhere.

Eventually.

Either way, it's time for western oil investors to take the blinders off.

[Editor's Note: To get all of Keith's latest trades click here. Keith's Geiger Index advisory service has notched 58 winners out of 60 total trades over the past three years - a success rate of 97%.]

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The Markets or the Mattress: I Know Where My Money is Going

Keith Fitz-Gerald — Tue, 24 Jan 2012 10:00:59 +0000

The next 1,000 points on the Dow Jones Industrial Average in either direction are going to be determined by what happens in two cities thousands of miles from our own shores...
Athens and Berlin.

What's more, the risks associated with Europe's redemption, or its failure, are more concentrated now than they were before the crisis began.

There are two reasons: a) Europe won't help itself and b) Wall Street may still have $1 trillion or more in exposure to European problems.

What makes me crazy right now is that European chatter is what's driving the markets.

Every sound bite from Europe is critical these days. Not because there is anything relevant in the political babbling from financial ministers tasked with fixing this mess, but rather that there is a cascade of events that could take us in either direction.

Fix this mess and the markets will take off for a 1,000 point gain that will leave anybody who is on the sidelines hopelessly behind.

Fail and the markets could tank.

It certainly fits the pattern established in recent months. News leaks suggesting solutions have brought on rallies, while negative leaks have caused a ripple effect that has quickly dumped stocks into the hopper.

Yet, it's not really the numbers that matter at the moment - even with the Fed rumored to be considering another $1 trillion stimulus and reports that the European Central Bank (ECB) and International Monetary Fund (IMF) may be seeking as much as $600 billion each.

No. The market swings we are seeing are all about confidence or, more specifically, the near complete lack thereof.

The Mattress vs. The Markets

A recent report from TrimTabs shows that checking and savings accounts attracted eight-times the money that stock, bond and mutual funds did from January to November 2011.

That is a whopping $889 billion that went under "the mattresses" versus only $109 billion that went into the markets.

In fact, CNBC is reporting that the pace of money headed for plain-Jane savings and checking accounts from September to November accelerated to nearly 13-times the average monthly flow rate of the preceding nine months from September to November.

What's significant about this is that the money has headed for the sidelines when the markets have rallied. Usually it's the other way around. Normally money floods into the markets when they move higher.

The other notable thing here is that, generally speaking, up days this year have had thinner volume than down days. This means that most investors just can't handle the swings. In other words, every time the markets dip, they're packing it in.

Pessimism is the Breeding Ground of Opportunity

Bottom line: Investors are making a gigantic mistake - especially those with a longer-term perspective.

Periods of maximum pessimism - when everybody "knows" something - usually make for a variety of great buying opportunities.

For instance, do you remember the following quote?

"The economy is staggering under many "structural' burdens, as opposed to familiar problems.

The structural faults [...] will take years to work out. Among them the job drought; the debt hangover; the banking collapse; the real estate depression; the healthcare cost explosion and the runaway federal deficit."

I remember it like it was yesterday.

It's from TIME magazine in September 1992 - right before the markets took off on a breathtaking 16-year run.

To be clear here, I am not suggesting that the markets are about to go on a triple percentage point bender, only that investors would be foolish to ignore the possibility.

In fact, the very notion that Wall Street remains in denial about Europe and Europe itself still refuses to confront the seriousness of its situation bodes well for almost anybody willing to go against the grain.

That's been the case throughout history.

Take the Panic of 1873. It was the world's first truly international financial crisis and, by many measures, actually far worse than what we're dealing with now.

Things were so bad that more than 18,000 businesses closed, sending unemployment soaring to 14%. The NYSE even closed for ten days.

The depression that started in 1873 lasted until 1879 here in the United States and another 20 years in Britain -- where it's known as the "Long Depression" in history books.

Yet through it all, the market's dips, twists and turns turned out to be extraordinary buying opportunities. (You can learn more about a similar opportunity that I recently discovered in today's markets by clicking here.)

The same thing ultimately will be true today, especially if you're building long-term investment positions in "glocal" stocks with experienced management and fortress-like balance sheets that produce high dividends.

I feel the same way about energy, commodities and very specific microcap companies with promising inventions, medical technology or some other catalyst that can create game-changing returns.

It takes a lot of nerve, but that's how the markets work.

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Why Weak Earnings Today Could Turn the Bulls Loose Tomorrow

Keith Fitz-Gerald — Fri, 13 Jan 2012 10:00:39 +0000

Everybody is hoping for a swell earnings season on the assumption that it will help the markets move higher.

However, if history is any guide, weaker earnings may be just what the doctor ordered.

Here's why.

Obviously we don't want a disastrous set of numbers, but downbeat earnings and guidance actually creates the possibility of more positive surprises that will encourage money to move into the markets instead of away from them.

Think of it this way: When things shift from good to bad there's a distinct aversion to risk and assets flee like they did following the "dot.bomb" blowup in early 2000 and at the onset of the financial crisis in 2007.

But when they go from bad to less-bad, it's human nature to assume things are improving. And that sentiment brings out the bargain hunter in all of us while also drawing money into the markets. That was the case in mid-2002 and just after March 2009, when people were hoping for something - anything really - to get the juices flowing again.

Winning the Expectations Game

Wall Street understands this psychology better than you might imagine. That's why m anipulating earnings and analyst expectations is a science in and of itself.

Everybody denies it happens, but ask nearly any seasoned Wall Streeter and you'll get a sideways glance and a knowing smile.

The wall that supposedly separates the research, investment banking, brokerage and trading functions of any given firm is a plumber's worse nightmare, depending on your perspective.

Former analyst Stephen McClellan notes in his book "Full of Bull" that this is how the game is played.

He says that's why it's important to do what Wall Street does rather than what it says as a means of securing your personal profits.

I couldn't agree more.

Having spent more than 20 years closely involved with the markets, I've learned that Wall Street's blinders, miscues, set-ups and secrets are often more telling than the "telling" itself.

Consider what's happening right now.

According to Standard & Poor's, analysts have raised projections for 366 companies while lowering those associated with another 534 companies. In other words, lowered expectations out number rising expectations by almost 2:1. Bespoke Investment Group notes that all ten S&P sectors have had more negative revisions than positive.

That's in stark contrast to two years ago when analysts were positive at the onset of 2010 for roughly 80% of the market with the exception of healthcare and utilities. Both were viewed as little more than bastard children and cast as negative performers.

As you might expect, many investors bailed out of the latter while rushing into the former. But that turned out to be a mistake -- healthcare and utilities were the best performing sectors in 2011.

This doesn't always happen, but it's well documented that Wall Street often says one thing and does another. You'd think at this stage of the game things would be different, but they're not.

Take the Facebook IPO, which is widely believed to be imminent...

Last year, the firm made headlines with a quasi-private version of the offering with sales to private clients that imply a preposterous value of between $50 billion and $100 billion. And, right there in black and white, in the fine print it says that Goldman Sachs Group Inc. (NYSE: GS) may trade directly against its clients without warning and without recourse to the very investors they supposedly represent.

The lines are very clear here. Professionals know that supposedly independent research is often misleading at best and completely contradictory at worst. Notes McClellan, "transaction-oriented Wall Street, unfortunately, tends to discourage and even hinder proper investing."

A Chance to Outsmart Wall Street

So what does this earnings season suggest about the future?

I think Wall Street is trying to set the bar low, and even though valuations are not optimal, pullbacks represent buying opportunities - especially in areas that Wall Street dislikes such as energy, inflation resistant investments, and commodities.

I expect a lot of companies to set forth lowered guidance this year while trying to discourage gleeful thinking about the recovery. That way they can sweep back in with above-board surprises a quarter or two from now, having already built the gains that will occur then on the 19 consecutive weeks of outflows in equity funds happening now.

I also believe Wall Street is all too aware that 2011 was one of the worst years in recent memory. Nearly 60% of all hedge funds lost money, according to preliminary data from the HedgeFund Intelligence Database. Big or small, it didn't matter.

Noted billionaire hedge fund manager John Paulson - you know, the guy who reaped billions for his "Big Short" against the subprime markets - is reportedly down 51% in one of his biggest funds. You know that's gotta hurt and give him every motivation to get even.

Not surprisingly, bonuses, thanks to poor performance, were down significantly.

For example, a few years back, many senior Goldman partners reportedly took home $6 million or more. The payout last year was $3 million, according to CNBC.

I know...I know...cry me a river. I feel the same way.

But here's the interesting part. Overall compensation as a percentage of revenue is rising. This means that revenue also is falling.

Back to Goldman. In 2010, compensation as a percentage of firm revenue was 39.3%. According to CLSA (as reported by CNBC), this figure is now 44%. In other words, revenues have dropped, making the same payout a bigger piece of a smaller pie.

How much smaller? That remains to be seen, but in Goldman's case, firm revenues are expected to have declined by 22%, while profit may have dropped more than 7%. We'll know what the exact figures are on Jan. 18 when Goldman reports before the opening bell.

R eports also suggest that Morgan Stanley (NYSE: MS) employees may see bonus payout declines of 30-40%. Things are evidently so bad that Jefferies Group Inc. (NYSE: JEF) employees are threatening to quit if bonuses are not up to snuff.

This is very simple -- Wall Street is hurting ,which is why better-than-expected results a quarter from now may be precisely the prescription needed to get all that money back into the markets...again.

So view pullbacks with caution, but eye them for what lowered earnings suggest they may be - a chance to outsmart Wall Street at its own game and a chance to buy early.

When everybody else finally gets the message that things are "improving" and piles in, that will be the time to sell and repeat the cycle all over again.

You don't have to be whipsawed by the temporary swoon it would seem they want to create.

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Five Stocks to Avoid Like the Plague

Keith Fitz-Gerald — Tue, 10 Jan 2012 10:00:51 +0000

There's no better time to take a good hard look at your portfolio than the beginning of a new year.

I know this may not be your first rodeo and chances are you've already done at least a little thinking about how your investments came through 2011, and what you'd like to achieve in 2012.

If not, there's no time like the present.

Especially when it comes to something I call "Ditching the Dogs," which is a variant of the well-known and very popular "Dogs of the Dow." You've probably already guessed from the name that I'm talking about unloading those investments that have underperformed, or which are likely to hold my portfolio back in the next twelve months.

Obviously this is a highly personal process and every investor is different, but here are five stocks I'd avoid like the plague right now (and the reasons why):

1. Sears Holdings Corp. (Nasdaq: SHLD) - Long a bastion of American retailing success, I've been leery of the company for a long time. In fact, I've steered clear of it since hedge fund investor Eddie Lampert used more than a little financial wizardry to create Sears Holdings. At the time, his goal was to tap into the vast real estate empire underlying Sears and subsequently K-mart when that company emerged from bankruptcy and he snapped up shares. The stock hit $190 a share in early 2007 on the assumption that it would.

Now, though, it's a very different story. With real estate in the toilet and the value of his "collateralized" debt circling the drain, he plans to fire employees, cut more than 120 stores and sell property. Same store sales are down sharply as is profitability. Fitch Ratings Inc. has cut the company's bond to junk status, and it's likely to have hundreds of millions in writedowns ahead. I think the company is going to restructure, and net income is going to fall to the tune of billions when now-litigation conscious accountants have their day.

2. Research in Motion Ltd. (Nasdaq: RIMM) - Once the darling of connectivity and a status symbol for the cognoscenti, RIMM's share of the smartphone market continues to evaporate like fog on a hot morning. I recommended shorting the company a few years back but was early to the party on several occasions; somehow the stock seemed to fight back. The stock is down 89.52% from its peak of $144.56 in early 2008 and up a creek without a paddle...and you know which creek I am talking about.

Dual Chairmen and CEOs Mike Lazardis and Jim Balsillie, who are also co-founders by the way, couldn't fix things, and with iPhone and Android users on the rise, I don't believe they will. Long-term government contracts prized for their encryption and steady cash flow are falling by the wayside. Small businesses are dropping the company like hotcakes because of the constant updating, technical complexity and brain damage - mine included. We switched to Droids more than a year ago and have never looked back. The technology has simply had its day, and this is yet one more innovator that's about to head into the sunset. They'll be lucky to find a buyer.

3. Eastman Kodak Co. (NYSE: EK) - Speaking of sunset companies, it doesn't get any more painful than this. Having become nearly synonymous with the photographic industry itself, Kodak is truly on "death watch" having dropped to a mere $0.4001 and a total market cap of only $108.01 million as of Monday's close. Rumors are flying about bankruptcy filings. Three board members have hit the eject handle in the past two weeks. And earnings...well there aren't really any to speak of.

Hopelessly outclassed by the digital world, I think the brand belongs in a museum. The company has very little to pin its future on save the sale of more than 1,100 digital imaging patents and patent-related lawsuits aimed at harvesting earnings from those who - in Kodak's opinion - quite literally have stolen them including Apple Inc. (Nasdaq: AAPL) and Research in Motion. The former is understandable. The latter is itself on death watch, so this is like squeezing blood from a turnip.

The one shining star, if there is one to be had, is that the value of those patents may be $2 billion to $3 billion; however, that's a Pyrrhic victory in my opinion. The company doesn't appear to have the cash necessary to survive the judicial process. But, if you want a flyer, that's about how this one should be evaluated -- and then only with money you can afford to lose.

4. Microsoft Corp. (Nasdaq: MSFT) - It looks cheap, as usual. I remember growing up in Seattle when the company occupied just one tiny corner segment of an office park in Bellevue. And I recall the initial public offering (IPO) all too well - because I passed on it in one of the biggest mistakes of my investing life. I've owned Microsoft off and on over the years and have been pleased, but I wouldn't buy it again today.

The company is stuck in the $20 range, and has been since 1998 if you're not counting the dot.bomb years when it rallied to nearly $60 before flat-lining again. Over the past ten years, the company has returned little more than 10% versus the Standard & Poor's 500 Index, which has posted more than a 36% gain including dividends.

The problem, as I see it, is not that the company's core products don't work - they do. But they can't seem to figure out who they are, which seems more than a little futile to me given that Microsoft has outspent Apple 10:1 over the ten years. Still, it's been outclassed, outmaneuvered and out-innovated at every turn. An appealing 2.4% dividend just doesn't warrant trapping my money for years to come when the company is sitting on a $55.94 billion cash hoard, according to Yahoo! Finance.

5. Facebook Inc. (and almost any other social media company) - Many people think I'm a Luddite or some sort of curmudgeon for saying this. To be fair, I'm probably a little of both. But there is no way that a company like Facebook is worth the $50 billion-$100 billion being batted around. Well, not to anybody other than Goldman Sachs Group Inc. (NYSE: GS) and their private investment clients who invested via a highly anticipated "private" IPO last year, let alone the public IPO when it hits.

The company has the same old problem salesmen the world over have - monetizing eyeballs. Sure there's a tremendous amount of marketing data, and the biggest single voluntary collection of people in recorded history using it, but that doesn't necessarily translate into revenue -- nor does it equate to value. Tire kickers don't spend a lot of money.

Don't get me wrong. I like Facebook. It's innovative. It's created an entirely new form of communication that's quite literally revolutionary. And I can't help but admire the fact that the company has more than 800 million users, more than 50% of which log on in any given day. But when push comes to shove, Facebook will have to struggle to keep people interested in a never-ending race against "freemium" apathy.

Perhaps there's a MySpace posting about this somewhere...

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Tags: Facebook IPO, Stocks to avoid

Why China's "Blindside" Could Be A Great Buying Opportunity

Keith Fitz-Gerald — Fri, 06 Jan 2012 10:00:31 +0000

There's not a day goes by that I don't see some variation of the theme that China is going to crash, or that somehow that nation will blindside us, and that its markets may fall 60%.

This is like saying the U.S. markets were in for a hard landing in March of 2009 after they had fallen more than 50%. Folks who bit into this argument and bailed not only sold out at the worst possible moment, but then added agony to injury by sitting on the sidelines as the markets tore 95.68% higher over the next two years.

People forget that the U.S. stock market - as measured by the Dow Jones Industrial Average using weekly data - fell more than 89% from 1929 to 1932, more than 52% from 1937 to 1942, and more recently experienced a decline of more than 53% from 2008 to 2009 - and that doesn't even account for four 40+% declines beginning in 1901, 1906, 1916, and 1973.

Each was a great buying opportunity, and following those meltdowns, our markets rose more than 371% from 1929 to 1932, more than 222% from 1949 to 1956, more than 128% from 1937 to 1942, and more than 95.68% in just over two years starting in March 2009 - one of the fastest "melt-ups" in market history.

People forget that world markets dropped 40%-80% in 1987. And as legendary investor Jim Rogers noted earlier this month, that was not the end of the secular bull market in stocks, either.

People forget that our nation endured two world wars, a depression, multiple recessions, presidential assassinations, the near complete failure of our food belt, not to mention the deadliest terrorist attacks the world has ever seen, and more.

And guess what? It's still been the best place to invest for the last 100 years.

So what if China backs off or slows down?

The Asian currency markets blew up in 1997. Mexico's market fabulously went up in smoke during the great tequila crisis of 1994. And Argentina failed to the tune of a 76.9% crash starting in 1997 only to give way to a 1,724.56% rally from 2001 to 2011.

Gold rose by more than 600% in the 1970s, then fell by 50%, which terrified investors at the time. It subsequently rose by more than 850%, something else Mr. Rogers noted in recent interviews, as have I.

China is undoubtedly going to have several hard landings in our lifetime. Despite the fact that China is thousands of years old, modern China is a mere 40 years old, if you consider its opening following the historic Nixon-Kissinger visit in 1972.

And today's China has 1.3 billion people -- all of whom want to live the way you do.

It's growing by an average of 9% a year or more and has done so every year for the last 41 years straight. We've just poured an estimated $7.7 trillion into our economy and the best we can do is 2.5%. The European Union (EU) is on track for 0.2% growth in 2012 after trillions in euro backing there.

Make no mistake: China's government is well aware that it has a problem. Unlike our own government and those in the EU, it has raised bank reserve requirements repeatedly before loosening them a bit last month. Beijing hiked interest rates six times in the last two years.

They are deliberately tapping on the brakes. They actually want segments of their economy to fail so they can reboot parts of the system, including China's real estate market, which is a prime example of this.

The Reality of Real Estate

Real estate has been bid up to obscene levels in many parts of the country - not throughout the entire country, but in parts. And those are the places Beijing wants real estate developers to fail so that values can come back to more realistic levels while capital gets freed up for additional investment.

Take Beijing for example. There are plenty of writers at the moment who love to point out that it will take the average Beijing resident 36 years to pay for their house versus 18 years in Singapore, 12 in New York, and 5 in Frankfurt.

Well, Beijing is a first-tier metropolis so right away you know this number isn't an apples to apples comparison. Factor in second- and third-tier cities like outside Beijing, Shanghai, Shenzhen, Guanzhou and prices drop to 3,000-5,000 RMB/m2 and take 4-10 years to pay back, which is roughly in line with international standards.

Look at cities like Moscow, Zurich, or Tokyo and the argument falls apart further.

For example, in Tokyo and other cities across Japan, Japanese banks at one point offered 100-year mortgages. And property, once acquired, tends to stay in the family for generations. You can still get 50-year mortgages if you want, and you might need to because property values remain unthinkably high even after a 30-year collapse.

Here are some other things to think about:

Unlike the U.S. property bubble, which was nearly nationwide, Chinese borrowers must put 30% down for first-time purchases, 50% down on second purchases, and make full cash payments for third properties (where third properties are allowed). This means Chinese homeowners and banks can withstand a 30%-50% drawdown in prices before actually experiencing negative equity and stands in stark contrast to the United States, which is riding Occam's Razor in that regard.
Using Beijing as an example for the entire Chinese housing market is shortsighted. While prices in second- and third-tier cities have also experienced increases in value, they are far less (relatively) than first-tier cities. And it is in second- and third-tier cities that the majority of Chinese citizens live. Using Beijing (or Shanghai) as a gauge for the entire Chinese real estate market would be like using Las Vegas, Miami, or Phoenix as a gauge of the entire U.S. property market in 2007.
Chinese banks have not collateralized their mortgages into risky collateralized debt obligations (CDOs) and subsequently insured them with unregulated credit default swaps (CDS).
And lastly, when the U.S. property bubble burst our country had more than $12 trillion of debt. China, by contrast, is sitting on $3.2 trillion in reserves (which represents 54.5% of the country's entire GDP). While Beijing would obviously rather not do it, it could theoretically recapitalize its entire banking sector and have plenty of money to spare.

More Than Manufacturing

Don't Miss Out

I'm not saying China is going to have smooth sailing - but then again, neither did the U.S. in the 20th century, and the DJI gained 24,000% over that 100-year period. China is merely going through the first uncomfortable growing pains of its adolescence.

Remember, in 1912 the United States still used child labor, had massive inequalities of wealth, and women still couldn't vote. So holding China to the same standards as the modern United States is inappropriate, considering the country has only been open to the rest of the world for 40 years.

You have to look at China appropriately. You can't arbitrarily force the 21st century U.S. lens onto other countries in a vain effort to judge them.

Additionally, other parts of the Chinese economy are doing very well. Most manufacturing, agriculture, pollution treatment, water treatment, power, and resource development are just a few of the areas undergoing tremendous growth.

The point is, many people look down upon China with the same sort of derision once reserved for post-war Japan. And if you grew up in the 1950s or 1960s and thought Japan was only for cheap tin toys and didn't invest there, you missed out in the same way investors who look down their noses at China will.

Keep in mind that China's economy is roughly one-third the size of the overall U.S. economy and growing fast. Together America and the EU are approximately 10 times the size of China.

So if it does suffer a major correction, it's not the end of the world - nor the financial markets. And if the markets fall by 60% next year as some people suggest, I know what I'll be doing...buying.

Four Ways to Safely Invest in China

In the meantime, it's best to look at China within the overall scheme of things. And here are the investments you might want to consider:

Buy yuan. It's still a blocked currency but you can legally get your hands on it using bank deposits, CDs, or exchange-traded funds (ETFs). The official story is that it's being held down. Bull. Since 2005 it's already risen by 23.29%, which is more than the U.S. government wants you to believe. If anything, the dollar is worth too much.
Buy commodities. When China's markets grow, so too does global demand for raw materials. The nation has no choice but to buy because it doesn't have many native resources.
Buy shares in Chinese companies on Chinese exchanges. One of the things that people miss in their rush to dismiss China is that they're tracking those shares of Chinese companies listed in the United States. That's a mistake. If the U.S. markets take a header, of course Chinese-listed companies on the NYSE and other U.S. exchanges will, too. Still, it's probably best to wait for the dust to settle before wading in.
If you're aggressive, you can even try a classic "short" then go reverse long once the markets gain their footing.

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Tags: china's command economy, china's economic growth, China's Economy, china's economy problems, china's economy today, china's market economy, chinese economy, chinese economy facts, chinese economy overview, chinese economy today, current chinese economy, history of chinese economy, how big is the chinese economy, overview of chinese economy, rise of chinese economy, size of chinese economy

How Banks Are Using Your Money to Create the Next Crash

Keith Fitz-Gerald — Wed, 04 Jan 2012 10:00:43 +0000

In 2008, reckless credit default swaps nearly obliterated the global economy. Now comes the next crisis - rehypothecated assets.

It's a complicated, fancy term in the global banking complex. Yet it's one you need to know.

And if you understand it, you will get the scope of the risks we currently face - and it's way bigger than just Greece.

So follow with me on this one. I guarantee that you'll be outraged and amazed - and better educated. You'll also be in a better position to protect your assets at the end of this article, where I'll give you three important action steps to take. So follow along...

Their Profits on Your Money

Few people know this, but there's a process through which banks and trading houses are leveraging your money to increase their profits - just like they did in the run-up to the last financial crisis. Only this time, things may be worse, as hard as that is to imagine.

Consider: In 2007 the International Monetary Fund (IMF) estimated that this form of "leverage" accounted for more than half of the total activity in the "shadow" banking system , which equates to a potential problem that would put this insidious little practice on the order of $5 trillion to $10 trillion range. And this is in addition to the bailouts and money printing that's happened so far.

Wall Street would have you believe this figure has gone down in recent years as regulators and customers alike expressed outrage that their assets were being used in ways beyond regulation and completely off the balance sheet. But I have a hard time believing that.

Wall Street is addicted to leverage and, when given the opportunity to self-police, has rarely, if ever, taken actions that would threaten profits.

Further, what I am about to share with you is one of main the reasons why Europe is in such deep trouble and why our banking system will get hammered if the European Union (EU) goes down.

And w hat makes this so disgusting - take a deep breath - is that it's our money that's at stake. Regulators like the Securities and Exchange Commission (SEC) and their overseas equivalents are not only letting big banks get away with what I am about to describe, but have made it an integral part of the present banking system.

Worse, central bankers condone it.

As you might expect, the concept behind this malfeasance is complicated. But it's key to understanding the financial crisis and to avoiding a possible global recession in 2012 and beyond.

What we're talking about is something called "rehypothecation."

Most people have never heard the term, but trust me, you will shortly. Let me explain what this is, and why you need to know about it. Then, I'll offer three ideas to trade around it.

What Does Hypothecation Mean?

Hypothecation is what it's called when a borrower pledges collateral as a means of securing a debt. The borrower retains ownership of the collateral but it is hypothetically under the control of the creditor who can seize possession of the collateral if the borrower defaults.

If you own a house and have a mortgage, you have hypothecated it to your mortgage company, for example. This means that you still own it, but in the event of a default, your bank or your mortgage company (the creditor) can take ownership and do what it wishes.

"Re hypothecation" varies slightly when it is applied in the financial markets.

For example, if you put a buck in your checking account and the bank has to keep 10% of that in reserve, it can loan out $0.90. But then, if somebody else deposits $0.90, the bank can loan out $0.81 cents or 90% of the total assets on deposit. And so on, until literally all the money on deposit is effectively hypothecated to another entity. This is why banks are constantly seeking new depositors - to feed the hypothecation machine and their profits.

Obviously a buck is still a buck no matter which way you cut it, so cash does count for something. But at the end of the day, any banks can create a daisy chain of rehypothecated assets that results in as much as $10 in new checking accounts and rehypothecated assets against every $1 in actual deposits. Perhaps more.

If you're a brokerage house, the process is similar. Have equities, the collateral gets posted and used accordingly. Bonds, same thing. The brokers will reuse them by rehypothicating them at their discretion while making sure a fraction of the actual underlying value remains in reserve as collateral.

Typically, banks and investment houses have rehypothecated customer assets to back their own trades, their own borrowing, and their own operations.

Just like your house, which can be seized if you don't pay up, assets on deposit with a broker may be sold by the broker (hypothecated) if investors fail to keep up with margin payments or if the securities drop in value and the investors in question fail to respond to requests to boost their collateral - all at the broker's discretion depending on their margin and clearing requirements.

Now here's where it starts to get sticky.

Let the Leverage Games Begin

SEC Rule 15c3-3 allows broker dealers to rehypothecate assets equal to 140% of clients' liabilities to meet their financial obligations to customers and other creditors.

Here's an example.

If a client has $10,000 in securities on deposit and a debt deficit of $2,000, the net equity is $8,000. This means the broker-dealer could rehypothecate up to $2,800 of client assets to finance its own activities - often without notice.

Not only is this legal, it's common practice specified in the fine print of most brokerage agreements.

If you've ever traded on margin, chances are you're in the game whether you want to be or not because any common stock, cash, or other securities - even gold and Chinese yuan - can be used as collateral that the broker can hypothecate or rehypothecate.

And that's where the real games begin.

Remember our checking account example? It's the same thing here. Assets in brokerage accounts can be used and re-used in such a way the credit multiples far outweigh the actual assets in the accounts. In effect, rehypothecated assets become part of a daisy chain, for lack of a better term, wherein one company's liabilities become another's assets.

If there is a hiccup anywhere in the chain, the effect is one of instant collateral collapse as everybody in the chain is forced to buy back, or recall, their assets. The effect is not unlike a colossal global "short" on world markets.

Imagine what happens if something goes wrong and everybody wants their $10 back, but find that there is only $1 in actual cash.

I believe this is what Federal Reserve Chairman Ben Bernanke and his counterparts at the ECB are so concerned with and why they are obsessed with liquidity. Everybody knows that too much debt caused this mess, but what they don't realize is that it's the use of rehypothecated assets that make collateralizing it nearly impossible barring massive injections and printing.

Here's why. By their very definition, rehypothecated assets are those pledged as collateral against borrowings. That means they support not one, but two separate borrowing transactions - one of the originating firm's tally and one on the borrower's tally - perhaps even more if the broker in question takes its activities offshore to other jurisdictions not bound by the same rules.

Take the United Kingdom, for example, where there is no limit on the amount of client assets that can be rehypothecated. There, brokers have reportedly and routinely rehypothecated 100% of the value of client accounts, not just those assets pledged as collateral.

That's why firms like MF Global, Goldman Sachs Group Inc. (NYSE: GS), Canadian Imperial Bank of Commerce (NYSE: CM), the Royal Bank of Canada (NYSE: RY), Credit Suisse Group AG (NYSE ADR: CS), Wells Fargo & Co. (NYSE: WFC), and Morgan Stanley (NYSE: MS) more frequently establish U.K.-based investment pools and lateral assets from other jurisdictions like the U.S. into them.

Not only does this allow them to skirt the law and limits on their activities here, but it leads directly to the creation of even more leverage and, potentially, higher returns - which is why they do this.

Of course, it also potentially leads to catastrophic losses. But with government bailouts in their back pockets, and central bankers who have by their actions determined the big firms are worth saving at the expense of Main Street investors, the big financial firms don't seem the slightest bit troubled that they are playing with our money.

However, I find this deeply troubling on a lot of levels.

How to Protect Yourself - And Even Profit

You'd think that regulators would have a firm grip on this but they don't. Rehypothecated asset transactions are completely off balance sheet so it's exceedingly difficult to track what moved where and when. Worse, because of the lack of transparency, it's also very complicated to determine which firms - those stateside or those overseas in markets like the U.K. - hold the money.

Allegedly, MF Global couldn't live with the 140% SEC mandate so it began arbitraging differences between rehypothecation regulations in various markets and used off balance sheet entries to ratchet up leverage to obviously unsustainable levels. Now there may be an estimated $1.7 billion in customer money that can't be accounted for in that firm alone.

What makes this especially problematic is that it's tough enough to unwind rehypothecated assets in one country. Now, though, we are facing a situation where the regulators, lawyers and lawmakers may have to unwind rehypothecated assets that are effectively pledged as collateral in multiple transactions in multiple jurisdictions with multiple clearing firms. Absent balance sheet controls and forensic accounting, it's going to be very difficult to determine who really owns what.

As for why this is so serious, try this on for size.

There is conjecture that the actual asset backing for the sum-total of rehypothecated assets may be as little as 25% of the notional value at risk. In other words, a firm with $25 billion in rehypothecated assets may be at risk for $100 billion in instruments that are completely off balance sheet and for which there is nothing but thin air backing them up -- perhaps a whole lot more depending on how many times the actual assets have been rehypothecated and levered up.

According to Thompson Reuters, here's a partial list of firms and their rehypothecated assets in 2011:

Goldman Sachs Group Inc. ($28.17 billion).

Canadian Imperial Bank of Commerce ($72 billion).

Royal Bank of Canada (rehypothecated $53.8 billion of $126.7 billion available).

Oppenheimer ($15.3 billion).

Credit Suisse Group AG ($353 billion).

JPMorgan Chase & Co. (NYSE: JPM) ($546.2 billion).

Morgan Stanley ($410 billion).

That adds up to almost $1.5 trillion -- and that's just a partial list of what we know about.

Now queue up your best "Death Star approaches" music.

The mainstream press has reported that EU liquidity is drying up on default fears. But what if they know something else that they're not telling us?

I'm not into conspiracy theories, but I can very easily envision a scenario in which the underlying collateral has been rehypothecated between the various EU/US banks so many times that the actual value at risk may be more than four times the figures disclosed to the public to date.

This is one of the reasons that I have suggested -- since the beginning of the EU crisis -- that we're looking at several trillion euros before we can even think the EU situation is under control versus the "worst case" 200 billion-euro estimates floated at the time.

The other is far simpler. I believe Europe remains in denial, as do our own leaders. Much of the growth over the past 20 years was driven by excess leverage and speculation. Until that's gone, the markets will demonstrate the kind of reflexive pessimism we've seen recently that's characterized by short, sharp rallies and generally higher overall volatility.

To think that the EU will miraculously line up, that China will suddenly speed up again, and that the U.S. will suddenly rein in its exploding debt is pure folly.

So how can you trade this?

I can think of a couple of strategies:

Short specific banks or the broader financial sector as a whole. But be prepared for a bumpy ride. The world's entire central banking community is playing against you and will do everything it can to prevent a meltdown by sustaining the illusion granted to us by the rehypothecation process.

As the markets rise on the illusion of a fix or improving data or both, allocate a small portion of capital to put options or inverse funds. If nothing else, you'll sleep better knowing that these things will explode when the day of reckoning ultimately arrives.

Remain long with what you've already got, but continually ratchet up trailing stops to protect gains. Why the markets rally is not important, that you capture profits as they do is. It is absolutely possible to be a market bull and an economic bear.

News and Related Story Links:

Money Morning:
Should You Worry About Europe's Back Door Bank Run?
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Don't Buy Into Europe's Latest Rescue Effort - The Continent's Banks Are About to Go Bust
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Now's Not the Time to Buy Bank Stocks - Now's the Time to Short Them
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Tags: hypothecate, rehypothecate collateral, rehypothecate definition, rehypothecated securities, rehypothecation, rehypothecation of collateral, rehypothecation rights, rehypothecation risk

Why Mark Mobius is Betting Millions on this Acronym

Keith Fitz-Gerald — Tue, 20 Dec 2011 10:00:16 +0000

You may be surprised to learn that some of the world's best investors are buying heavily right now - not because they think we've hit a bottom, or even the bottom, but because they're setting themselves up for the next big run.

Take Mark Mobius, for example.

Long regarded an emerging markets pioneer, Mobius is in charge of more than $50 billion worth of assets on behalf of Franklin Templeton. Lately, he's snapping up Romanian real estate, Nigerian banks, Kazakhstani oil companies and more.

Why?

There are many reasons, but basically it comes down to this: Despite the fact that emerging markets returned almost 250% from 2001 to 2010, the old playbook no longer works.

And I have to be careful when I say that because many investors will blithely assume that emerging markets are dead. They're not - it's just time to redraw the map because the best opportunities are no longer where you'd expect.

It's no longer about the BRICs (Brazil, Russia, India, and China), for example. Sure these countries remain great places to stake your claims on the wealth of newly found purchasing power and consumerism, but it's the so-called MINTs (Mexico, Indonesia, Nigeria, and Turkey) that may offer a faster route to riches.

Or the Next 11, or N-11, as Jim O'Neill, the economist who coined the term "BRICs" a decade ago, calls them. The N-11 is basically the MINTs plus Bangladesh, the Philippines, and Pakistan plus a few more countries on the fringe of "civilized" thinking.

Then there's the VISTA (Vietnam, Indonesia, South Africa, Turkey, and Argentina) nations and the CIVETS (Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa).

Seriously?

Yes. For the first time in modern history, emerging markets are no longer completely dependent on Western economies nor demand, a point you've heard me make repeatedly in the past. At the risk of sounding like a broken record, this gives them an unprecedented range of options largely independent of the political, financial, and economic swamp the developed markets have become.

This is not the kind of thing you're going to pick up on in the mass media, but every single one of those nations is set for a runaway investment boom because they are advancing faster than almost everybody expects.

In fact, many of the big investing houses like Goldman Sachs Group Inc. (NYSE: GS), Fidelity, HSBC Holdings PLC (NYSE ADR: HBC) and others feel the same way I do - that the MINTs and N-11 have the potential to be every bit as profitable over the next 10 years as the BRICs were over the past 10 years.

But why not stick to the BRICS right now?

Every one of the BRICS has moved from raw capitalism, for example, to the more refined steady state that is accompanied by an entirely new class of investments in insurance, medical treatments, education, and even entertainment. This makes them steady growers to be sure, but also potentially slows them down a bit.

At the same time, rising wages and dramatic increases in the cost of living in BRIC countries means that profit margins are being squeezed, so it becomes harder to generate the same returns in years that used to take months.

Case in point, i n what is perhaps the ultimate irony, Chinese and Brazilian companies are beginning to offshore their own labor to markets like Vietnam and Colombia.

Consequently, many BRIC officials are more concerned with managing inflation and putting the brakes on at present . India has raised rates 12 times in the past 18 months while China has tacked on five rate hikes since last fall. Even so, the former is growing at 8% a year, while the latter is on track for 9% growth in 2011 -- more than six times the pace of the U.S. economy.

The MINT and N-11 markets may grow even faster.

Admittedly, the thought of investing in markets that Indiana Jones would find appealing is scary.

The risks and volatility remain quite high. Fraud, insider trading, manipulation and graft are all part of the experience -- and will be for some time to come.

But in the words of Jim O'Neill: "Just as we are getting downgrades in the developed world, we are getting upgrades in the developing world."

Believe it or not, private growth drivers in key sectors in each of these markets are actually accelerating. Energy, technology, agricultural resources, and defense contractors, in particular, are all bright areas as the world learns to do more with less - especially in economies that have never had much of anything to begin with.

That's why Mobius (and many savvy investors like him) aren't particularly alarmed by the potential for market chaos if the euro comes unglued. He knows, as we do, that any temporary crash would simply give him new opportunities to buy already battered emerging market stocks at even steeper discounts to where they are trading now.

Still can't stomach the thought?

Well, I hate to say it, but then investing isn't for you.

If you can't understand that whippy markets produce upside - especially when it comes to currently untapped, largely off- the- radar- screen markets - then you really haven't got a decent chance of getting ahead over the long run.

There is no easy money - just intelligent decisions to be made.

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Tags: Mark Mobius, mark mobius biography, mark mobius stocks, mark mobius templeton, templeton foundation, templeton funds, templeton global bond fund, templeton growth fund

Should You Worry About Europe's Back Door Bank Run?

Keith Fitz-Gerald — Fri, 16 Dec 2011 10:00:20 +0000

On Wednesday, Fitch Ratings Inc. downgraded its credit ratings on five of Europe's biggest banks, and while that decision made headlines, it's not the most important story to come out of Europe this week.

The real story, which the mainstream media is neglecting, is that there are signs of an underground run on Europe's banks.

Almost nobody's talking about it, but there are indications money is already moving out of the European Union (EU) faster than rats abandoning a sinking ship.

Not through the front door, mind you. There are no lines, no distraught customers and no teller windows being boarded up - not yet, anyway.

For now the run is through the back door, and there are four things that make me think so:

Italy's planned ban on cash transactions over 1,000 euros, or about $1,300.
French, Spanish, and Italian banks have run out of collateral and are now pledging real assets.
Swiss officials are preparing for the end of the euro with capital control measures.
Europe's CEOs are actively preparing for the end of the euro despite governmental reassurances.

Signs of a Run

Let's start with Italy and Prime Minister Mario Monti's plans to restrict cash transactions over 1,000 euros (down from the current limit of 2,500 euros, or about $3,200).

Ostensibly the move is about reducing tax evasion by prohibiting the movement of large sums of cash outside the official transactional system, but I think it speaks to something far more sinister - namely that the Italian government knows things are going to get far worse than they're publicly admitting.

Consider: Cash is a stored value mechanism. There's not a lot of it because at any given point in time, most of it is on deposit with banks in any country. That's as true in Italy as it is here in the United States when real interest rates are positive during "healthy" times.

But when real interest rates turn negative, people are likely to withdraw cash and stuff it quite literally under mattresses or in coffee tins. (Real interest rates are the official lending interest rates as adjusted for inflation.)

In such an environment, holding cash in a bank becomes nothing more than an imputed tax and a disincentive for deposits. It's also a significant thorn in the side of central bankers who want to control their country's money supply, because cash can operate outside the system and, specifically, logjam reform efforts.

The reason is really pretty simple. If you have negative real interest rates, and cash transactions are largely restricted or removed altogether, then the only way to effectively use cash is to withdraw it and spend it... immediately.

In other words, by limiting cash transactions to 1,000 euros or less, Italy is putting into place a punitive financial control fully intended to keep money moving in a system lest it become worthless or worse - hoarded and worthless.

Now let's move on to banks.

Banking Breakdown

Many investors have never thought about it before, but there are really only three sources of funding for a bank:

Money that's effectively "lent" to the bank by customers placing their assets on deposit;
Short-term money market funds;
And long-term bonds or securitized products based on long-term paper sold to bond investors.

Together, the three funding sources are like the legs on a stool - lose any one of them and the stool will topple over because it is no longer balanced. Cut the legs down and the stool collapses - that's what is happening now.

Individuals, pension funds and institutions alike are withdrawing funds from Italian, Spanish and French banks. Money has long since left Greece, Ireland, and Portugal.

Thing is, though, it's not just European money that's fleeing. Various reports from The Economist, Bloomberg, CNBC and others suggest that American financials may have pulled more than 40% of their funds from all European banks and nearly two-thirds of their total deposits away from French banks. This is drying up short-term lending capacity and driving up interbank lending costs.

At the same time, money managers the world over are selling their European bonds. This is driving prices lower and yields higher to the point where the cost of debt is now prohibitive (bond prices and yields move in opposite directions). As a result, new bank bond issuance may be down as much as 85% over the past two years, which further hobbles cash hungry European banks.

Finally, facing a near total loss of short-term financing alternatives and having run out of short-term liquidity needed to operate, a number of EU banks are reportedly having to pledge real assets as collateral for badly needed loans.

Normally, banks would use loans, leases or receivables to accomplish the same thing. The fact that they're now having to throw in real estate, their own property, and other assets into the mix signals extreme levels of financial stress that are far worse than what's been disclosed publicly.

Bracing for the Inevitable

Swiss Finance Minister Eveline Widmer-Schlumpf noted to the Swiss Parliament that she's got a working group examining capital controls and negative interest rates as a means of preventing an economy-crushing Swiss franc appreciation when the euro fails. That's not if the euro fails, but when the Euro fails.

This is an especially dire sign because capital control measures like those the Swiss officials are considering are inevitably the end of any failed monetary system.

European CEOs and their companies are taking matters into their own hands by actively preparing for the destruction of the euro.

Some, like German machinery maker GEA Group AG (PINK: GEAGY) are limiting the maximum funds on deposit with any single bank. Others, like Grupo Gowex, are moving cash and deposits to Germany away from Spanish banks (and Grupo Gowex is a Spanish company based in Madrid, so this is especially telling). BMW plans to cut production by 30% while also tapping into central bank reserves. According to Chief Financial Officer Friedrich Eichiner, the company is already reducing its leasing portfolio to cope with the potential decrease in car values that would impact its borrowing capacity.

As for what all this means for our money, that's pretty clear - think SAFETY FIRST. The return of your capital is far more important than the return on your capital at the moment.

Here's what I suggest.

Buy dollars - I know they're a bad long-term bet, but short-term, they're the best looking horse in the global glue factory as long as the euro is under pressure.
Stick with what you have in place now and manage risk with trailing stops. Confine new stock purchases to high-growth, low-debt emerging markets rather than low-growth, high-debt developed markets.
Short gold and oil in the short-term. Both are priced in dollars, which means both will fall as the dollar rises in conjunction with panic in the EU.
Purchase inverse funds that track the broader markets. If the euro fails, it will tank the broader markets. Then, once it becomes clear that the world will live on, the markets will disconnect from Europe and begin to rise again in earnest.
Run the other way if people tell you that banks are a great investment. They are speculative at best given the number of skeletons still in the closet.

News and Related Story Links:

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Tags: bank run in Europe, biggest european banks, committee of european bank supervisors, committee of european banking supervisors, european bank account, european bank etf, european bank failures, european bank index, european banks for sale, european banks in trouble, european banks in usa, european banks stress test results, european central bank exchange rates, largest european banks, top 10 european banks

Maverick Judge Jed Rakoff Stares Down The Street

Keith Fitz-Gerald — Mon, 05 Dec 2011 10:00:31 +0000

One of the biggest problems with Wall Street's malfeasance is how the ruling elite view legal settlements - as little more than an acceptable cost of doing business.

Well, no more.

Thanks to Judge Jed Rakoff we may see some real regulatory action leading to good old-fashioned investigations, perp walks, and even jail for the guilty.

I'm not talking just about the Bernie Madoffs or the Raj Rajaratnams either. I'm talking about potentially CEOs and even entire corporate boards.

Judge Rakoff recently rendered a 15-page decision rejecting the U.S. Securities and Exchange Commission's (SEC) $285 million settlement with Citigroup Inc. (NYSE: C) over toxic mortgages, calling it "neither reasonable, nor fair, nor adequate, nor in the public interest."

This is important because settlements like these have been a farce for years - little more than the financial equivalent of a parking ticket and having about as much impact.

In fact, in a world where banking secrecy is paramount and investment firms like Goldman Sachs Group Inc. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC) and others rule the roost, they're little more than obfuscations of the truth.

The investigations into these banks are toothless or highly secretive at best. Rarely does the public see anything even remotely resembling full disclosure.

Instead we're supposed to be placated by headlines insinuating that the SEC, the National Futures Association (NFA) and more than 20 other regulatory agencies are looking out for our best interests.

Who are they kidding?

A Drop in the Bucket

Remember the $550 million fine Goldman was forced to pay for its role in toxic credit default swaps (CDOs)? At the time it was the largest ever levied.

SEC officials couldn't stumble over themselves fast enough nor get enough sound bites. I recall lots of PR shots with earnest-looking people evidently proud of themselves for having made Goldman pony up at the time.

And the mainstream press loved it. But there was one tiny problem.

The firm booked $13.3 billion that year. Paying off the SEC in a settlement that neither admitted nor denied wrongdoing was an acceptable cost of doing business that amounted to a mere 4% of revenue.

The proposed Citi settlement was much the same. It would have required Citi to give up $160 million of alleged ill-gotten profits, $30 million of interest, and a $95 million kicker for negligence.

Bear in mind, Citi reported full-year net income of $10.6 billion on revenue of $60.5 billion in 2010 which means that, like the Goldman fine, the settlement is a drop in the bucket at a mere 1.50% of net income.

I think Judge Rakoff's ruling has been a long time coming. And I love the fact that he specifically called out the Citi settlement as too lenient - especially when it also potentially allows Citi to skate on reimbursing investors for the $700 million the firm lost as part of its toxic mortgage trading.

You may not realize this, but private investors cannot bring securities claims based on negligence. In my mind, they should be able to, but for now this is the way the law stands.

The way I see it, Rakoff's decision finally gets at the core of what caused the financial crisis: toothless regulators beholden to the very powerful elite they were supposed to keep in check.

I am all too glad to see him show the public the first glimpse of backbone we've seen yet.

Washington, are you watching and listening?

Sitting on the Bench, Swinging for the Fences

Judge Rakoff noted in his ruling that there is an "overriding public interest in knowing the truth."

Yes, there is.

And as Judge Rakoff put it, the SEC's core duty is to "see that the truth emerges." In the event that it doesn't as part of the settlement process, "courts must not, in the name of deference of convenience, grant judicial enforcement, to the agency's contrivances."

I did some checking and I learned that this is not the first time Rakoff has stuck it to the SEC.

Apparently, he's the one who made headlines when he initially rejected the BofA settlement related to that bank's shotgun takeover of Merrill Lynch & Co., a fact I'd forgotten.

At the time, Rakoff rejected the SEC's $33 million BofA settlement on the grounds that it punished shareholders. The SEC then came back with a much more realistic $150 million agreement.

Some think Rakoff has gone too far. They worry that judges have no business interfering in agreements ostensibly reached by private parties.

But I disagree. I believe the SEC is the public.

And the public has the right to know about any case where the transparency of the financial markets (or lack thereof) has so impacted the markets as to destroy the wealth of millions of hard working people and bring the global markets to the edge of oblivion.

Frankly, I'd love to shake Judge Rakoff's hand.

I hope what he's done encourages judges to finally stand up for the body of law they supposedly represent and the public that it's intended to protect.

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Tags: Judge Jed Rakoff

Why the Fed's Latest Rescue Effort is Doomed

Keith Fitz-Gerald — Thu, 01 Dec 2011 10:00:03 +0000

World markets got a nice tailwind yesterday (Wednesday) on news that the U.S. Federal Reserve is stepping into the fray along with other central banks to boost liquidity and support the global economy.

Of course it's nice to see stocks get a hefty boost, but to be honest I'd rather see them rising on real news.

Not that this isn't a good development in terms of stock values - but come on, guys. When things are so bad that the Fed has to step into global markets and bail out the other bankers in the world who can't wipe their own noses, we have serious problems.

Think about it.

The Fed is going to collaborate with the European Central Bank (ECB), the Bank of England (BOE), the Bank of Japan, the Swiss National Bank and the Bank of Canada (BOC) to lower interest rates on dollar liquidity swaps to make it cheaper for banks around the world to trade in dollars as a means of providing liquidity in their markets.

Put another way, now our government is directly involved in saving somebody else's bacon at a time when, arguably, we don't have our own house in order.

The Fed is cutting the amount that it charges for international access to dollars effectively in half from 100 basis points to 50 basis points over a basic rate.

The central bank says the move is designed to "ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credits to households and businesses and so help foster economic activity."

Who writes this stuff?

Businesses are flush with more cash than they've had in years. The banks are, too. But the problem is still putting that cash in motion -- just as it has been since this crisis began.

From Bad to Worse

I've have written about this many times in Money Morning. You can stimulate all you want with low rates, but if businesses cannot see a reason to spend money to turn a profit, they won't. And there's going to be little the government can do to encourage them to spend the estimated $2 trillion a Federal Reserve report estimates they're sitting on.

Similarly, if banks cannot see a reason to lend with reasonable security that loans will be repaid, they won't. And there's nothing the central bank can do about it, either. Neither low interest rates nor low-cost debt swaps will change the fact that companies and individuals are shedding debt as fast as they can despite the cost of borrowing being almost zero.

If anything, the Fed's newest harebrained scheme is going to make things worse. Absent profitable lending, many banks are already turning to bank fees and - like the airlines that are widely perceived to be nickel-and-diming passengers - this is understandably irking customers. Many are changing banks as a result, further fueling a negative feedback loop.

At the same time, ratings agencies are lowering credit ratings on banks worldwide. Standard & Poor's, in particular, just hammered 15 of the biggest banks in Europe and the United States as part of a dramatic overhaul of its ratings criteria. Good move guys, but you are literally days late and trillions of dollars short.

The problem is that by hammering the likes of JPMorgan Chase & Co. (NYSE: JPM), Bank of America Corp. (NYSE: BAC), Well Fargo & Co. (NYSE: WFC), Goldman Sachs Group Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), Barclays PLC (NYSE ADR: BCS), HSBC PLC (NYSE: HBC) and UBS AG (NYSE: UBS), among others, the ratings agencies have also just baked worse performance into the cake.

The reason is that for every ratings drop, banks need to have additional credit facilities and collateral on hand. That's why the compliance departments for big banks have been in overdrive recently. They can't refresh their disclaimers fast enough. The new ratings will trigger automatic changes in existing derivatives contracts, funding commitments, and borrowing arrangements.

Collateral Damage

Take American International Group Inc. (NYSE: AIG), for example.

Regulations allow firms with the highest credit ratings to enter swaps and other exotic derivatives contracts without depositing collateral with their counter-parties (those on the opposite side of the trade). When AIG was downgraded, the firm was instantly required to post collateral to the potential tune of $85 billion -- collateral it didn't have. That meant the U.S. government - i.e. taxpayers - had to create a special secured credit facility of the same amount. Whether you view that as a backstop or bailout is a matter of perspective.

That wasn't enough, though. As AIG's stock continued to weaken, and ratings were dropped further as the company's financial strength deteriorated, the government had to create additional facilities against which AIG ultimately drew $90.3 billion against a total of $122.8 billion as of Oct. 24, 2008.

Or, consider BofA. Downgrades impact BofA's derivatives contracts and will require the bank to put up more collateral in much the same way. At the same time, the downgrades could trigger termination provisions in the contracts that result in losses and ultimately further damage the already-struggling behemoth's liquidity.

As for how that affects your wallet, it's really pretty simple. Bank of America reported a third-quarter profit of $6.2 billion profit that was mostly accounting gains. A ratings cut could easily wipe that out as well as any future gains in the months ahead, depending on the extent of the resulting damage it triggers.

And that's part of the problem. Exactly how much damage lurks? There are more than $600 trillion in derivatives contracts that we know about. And there are potentially trillions more in collateral requirements that we still don't know about. These things are entirely unregulated -- and that's a huge part of the problem, even now.

Nobody knows what the impact will be, but we undoubtedly will find out. My guess is that it will be in the hundreds of billions, and that money has to come from somewhere.

Perhaps that's the real reason the Fed acted. Now that S&P has blasted the 15 biggest banks, the central bank is worried about the new updated ratings on the other 750 banks that S&P covers.

The bottom line: Don't misinterpret this rally as anything other than what it is at face value - a complete farce and nothing more than a globalform of QE3 even though it's not being called that.

A Look Ahead

Here are the things to watch:

The dollar is going to rally if the primary liquidity mechanism used remains dollar swaps. Gold will likely fall over the same time period. Oil will slip. And Treasuries will rise as traders come to terms with the real risks.

Then the real games will begin.

In the meantime, don't look a gift horse in the mouth. Be nimble. Harbor no illusions about what is happening. Capture profits as they're created and ratchet up your trailing stops if the rally gains legs.

The Fed has merely saved the day, not the system (and I'm echoing the legendary Jim Rogers here, who originally made similar comments directed at the ECB's actions during a CNBC interview on Oct. 17, 2011.).

The more drugs you inject into an addict, the more dependent he becomes on them. The Fed's actions are not a solution on anything more than a short-term basis.

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Why Warren Buffett Is Buying – And You Should Be Too

Keith Fitz-Gerald — Fri, 18 Nov 2011 10:00:56 +0000

Legendary investor Warren Buffett recently made news with his purchase of International Business Machines Corp. (NYSE: IBM), though I can't say I'm surprised.

Despite criticism that he's buying into a top-heavy market, that IBM is at a premium, and that he's losing his touch, chances are Buffett knows exactly what he's doing.

And guess what, it's exactly what I've been counseling investors to do since this crisis began - bolster defenses by putting money to work in companies that are backed by trillions of dollars in tailwinds, and have solid defensible businesses (Buffett calls these "moats").

According to a Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B) filing made Monday but dated Sept. 30, 2011, Buffett also waded into General Dynamics Corp. (NYSE: GD), DirecTV (Nasdaq: DTV), CVS Caremark Corp. (NYSE: CVS), Intel Corp. (Nasdaq: INTC) and Visa Inc. (NYSE: V).

In the third quarter, Buffett funneled $10 billion into Berkshire's IBM stake, which now stands at 5.5%. Of course, Berkshire maintains a $13.5 billion stake in The Coca-Cola Co. (NYSE: KO) that remains the firm's largest.

Buffett Pulls the Trigger

As a long time Buffett watcher, I am somewhat surprised that he picked up Intel and IBM, if only because the Oracle of Omaha has a well-documented aversion to tech.

Still, I can see the logic. Both companies are global giants poised to profit from the whirlwind of growth set to take place thousands of miles from our shores in the decades ahead.

There are technical similarities, too.

For instance, IBM's price has risen more than 29% this year. As a result, at least five analysts have removed their buy recommendations because they believe the stock may have run its course, according to Bloomberg News and YahooFinance . At the moment, less than 50% of the analysts who cover IBM recommend buying the stock.

Back in 1988, it was much the same situation. Coke had more than doubled in size and analysts had much the same reaction when it came to doubts about further growth. Many openly bashed the stock's prospects and completely ignored the global growth potential that today is Coke's mainstay.

Coke is up tenfold since then. Enough said.

Here's what I think Buffett sees:

IBM has shed its personal computer businesses and returned to its roots as a century-old technology company. I believe Buffett sees this as an opportunity to capitalize on further budget cutting and the need to do more with less. So-called "right sizing," or making technology work harder, has long been a strength for IBM.
Big cash flows. IBM has enjoyed 25 straight quarters of per share profit increases -thanks largely to former-CEO Sam Palmisano, who gutted the place and who rebuilt IBM's core computer services businesses. The company's first female CEO, Virginia "Ginni" Rometty took over last month and is expected to provide strong leadership, so I expect this trend to continue.
Increased per-client revenues. In downturns, it's easier to do business with companies you already have on board than it is to acquire new customers. IBM has a long history and deep client relationships that can likely be "farmed" to be worth far more than the changes to new technology providers would cost.

Unfortunately, these three things also tell me that - despite his very public pronouncements that things are on the mend - Buffett is girding for more turmoil.

They also suggest to me that Buffett really doesn't care. He's making investments that are devoid of concerns for volatility and short-term market fluctuations because he knows that value never goes out of style.

Buffett also knows that by properly concentrating his wealth, he's better off playing defense in this environment. He noted as much in last year's annual Berkshire shareholder letter.

So if you think that timing the markets is a good idea, yet you aspire to the kinds of returns that have made Buffett one of the all-time investing greats, think again.

The ability to find and buy distressed investments is becoming more difficult by the minute in today's markets, so you have to concentrate on growth if you want to get ahead - even if the payoff is not immediate.

[Special Announcement: Money Morning Chief Investment Strategist Keith Fitz-Gerald is always chasing down leads on potential profit plays - and he just dug up a big one. So on Monday, Nov. 21 he's going to share it with any Money Morning subscriber who tunes in to his free video briefing. We don't usually do this, but Fitz-Gerald firmly believes he's locked on to a game changer. And all you have to do to get in on it is register by clicking here.]

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Tags: Warren Buffett

European Bond Traders Are Going For the Jugular

Keith Fitz-Gerald — Thu, 17 Nov 2011 10:00:13 +0000

If you look at the crisis in Europe, the key questions to ask are clear: Will this crisis continue to spread? And will the United States get singed by the fallout?

In both cases, the answer is a very clear "Yes."

Whereas traders once were content to play around the edges by trashing Greece, Ireland and Portugal, now they're going for Europe's jugular vein. What I mean is that traders now are dumping the debt associated with so-called "core" European Union (EU) nations.

French and Austrian bonds, for example, sank to near record lows Tuesday, as yield premiums over German debt rose to 192 basis points and 184 basis points respectively according to Bloomberg.

Yields and prices run in opposite directions. If yields are rising, that means prices are falling and vice versa.

At the same time, Italian yields again sliced through 7%, the level at which debt is regarded as unsustainable. That's the second time in a week that's happened.

Meanwhile, the Spanish premium over German debt hit 482 points, which is above the 450 point spread at which both Ireland and Portuguese banks were forced into bailout status.

As measured by a combination of credit default swaps, correlation, and systemic risk, things are now worse than they were in 2008 at the depths of the financial crisis.

The way I see it, the EU debt market has become a two-way street, much the way our financial markets have become addicted to U.S. Federal Reserve funds. If the European Central Bank (ECB) is buying debt as part of a bailout, the markets rally. If the ECB is not, the markets fall.

There are no real EU debt buyers.

There are four reasons why this matters to us:

When it was created in 1999, nobody ever envisioned that the euro would fail. That means there has never been a plan to step back from the brink if required. That's one heck of an oversight in my opinion, so it's no wonder that the majority of EU ministers are clueless right now.
If the euro fails, every bank that holds euro-denominated bonds is going to lose money. European banks that can't fend for themselves likely will default on monies owed to the U.S. institutions that have lent to them.
Europe is the world's largest trading bloc, and purchases huge amounts of American goods. A European failure will cause purchases to drop, and the corresponding drag on sales, earnings, and jobs here will be felt very quickly. At that point, both Europe and the United States will fall into another recession in 2012. This will effectively nullify the weak dollar policies to which the Fed has adhered on the assumption that American goods need a weak dollar to stimulate growth.
European investors are the single largest source of foreign investment in the United States. A recession and capital drain in Europe will cause European companies that would otherwise invest here to keep their money at home.

What to Do When Europe's Crisis Hits U.S. Shores

The only way out is for individual nations in the EU to print money now - which obviously raises the stakes significantly.

If the Eurozone breaks up or is substantially restructured, German taxpayers, for example, may be required to make good on French debt loaned to Greek homeowners. Or Spanish businesses may have to kick in extra taxes to pay for Italian municipal failures underwritten by French banks.

The permutations are endless and very complicated.

There's something else, too.

Like citizens around the world, traders are tired of being lied to by politicians who lie to each other. And, most of all, they're tired of not being able to adequately assess risk to the point where they can do their jobs.

So they're taking matters into their own hands.

This is what I mentioned was Wall Street's worst nightmare a while back - that traders finally get fed up enough that they overwhelm central bankers and force interest rates higher, much the way the so-called bond vigilantes did in the early 1990s.

By hook or by crook, it doesn't matter why. That they have now centered their attention on core European countries does.

So now what?

I believe that the world's governments and central bankers think they're smarter than the rest of us and that they can manage the world's economy better through central planning than capitalism can through private enterprise.

I also believe they're dead wrong. They've been wrong since this crisis began and they're still wrong.

Here's how investors need to respond:

Hold hard assets as a means of hedging the value of your investments and protecting your purchasing power.
Include energy in your portfolio because it's driven by demand, compared to debt, which is driven by clueless politicians throwing good money after bad.
Bet on growth in the form of "glocal" stocks - global companies with a big presence in developing markets.
Protect yourself with inverse funds that appreciate when the broader markets head south.
Understand that it's not "buy and hold" that matters any longer. Instead it's more like "buy and hold your nose."

Yes, the risks are great, but the risks of getting left behind are greater -- even if the payoffs are not immediate.

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Three Psychological Stumbling Blocks That Kill Profits

Keith Fitz-Gerald — Wed, 16 Nov 2011 10:00:39 +0000

Face it, the past 12 years have been horrible for most investors.

This is not necessarily because the markets have been rocky, but rather because the vast majority of investors are hardwired to do three things that kill returns.

You can blame Washington, the European Union, debt, high unemployment, or half a dozen other factors if you want to, but ultimately, the person responsible is the same one staring back at you from your bathroom mirror in the morning.

That's why understanding the bad habits you didn't know you had can be one of the quickest ways to improve your financial wealth.

Here's what I mean.

Dalbar, a Boston-based market research firm, produces annual research that compares the returns of stock and bond markets with those of individual investors. The latest, covering the 20-year period ended last year, shows that the Standard & Poor's 500 Index returned an annualized gain of 9.1%. That stands in sharp contrast with the measly 3.8% gain individual investors averaged over the same timeframe.

Fixed income investors didn't do any better. According to the Dalbar data, t hey gained a mere 1% a year versus an annualized return of 6.9% for the Barclay's Aggregate Bond Index.

In other words, investors' self-defeating decisions contributed to an underperformance that was 58% below what it could have been for stocks and 85.5% below what it could have been for bonds.

Why?

Three reasons: recency bias, herd behavior, and fear.

It's All About Perspective

Recency bias is what happens when short-term focus trumps long-term planning and execution.
It's what happens when somebody yells "fire" and everybody runs for the same exit at once despite having entered through any of half a dozen doors in the auditorium. Simply put, recency is recent knowledge that overrides longer-term thinking and memory.

This is why momentum trading works, for example, or the news channels seem to cover the same stocks at nearly the same time - because a huge number of people are focused on exactly the same companies simultaneously. Logically, they then become the subject of increased attention and tend to move more strongly or consistently.

The question of why is the subject of much debate among human behaviorists, but I chalk it up to the fact that human memories tend to focus on recent events more emotionally than they do longer-term plans that are put together with almost clinical detachment.

And the more extreme the events or the news, the sharper our short-term focus becomes.

That's why, according to "Mood Matters," a book by Dr. John Casti, one of the world's leading thinkers on the science of complexity, "bombshell events are assimilated almost immediately into the prevailing [social] mood" where as longer-term cycles bear almost no witness to gradual change.

If that doesn't make sense, think about what happened on 9/11. Most of the world's major markets bottomed within minutes of each other on short-term panic and emotion. Then, when trading resumed days later, they began to climb almost in sync as highly localized events once again faded into the longer-term fabric of our world.

And that brings me to herding.

The Herd Mentality

We'd rather be wrong in a group than right individually so the vast majority of investors tend to make decisions, and mistakes, together en masse.

You can see that in market data suggesting we have a fine tradition of doing exactly the right thing at precisely the wrong time. Instead of buying low and selling high, most investors tend to sell low and buy high, further damning themselves to subpar returns.

A lot of studies suggest this is the case, but none is as interesting as that by Philip Z. Maymin, an assistant professor of finance and risk engineering at Polytechnic Institute of New York University.

Maymin scrutinized records kept by the inv estment firm Gerstein Fisher from 1993 to mid-2010. Professor Maymin's work included analysis on more than 1.5 million interactions between the firm and its clients and made a staggering finding . The value of investment advisors is not so much in picking stocks but in keeping clients from impulsively trading at the wrong time. Maymin found that aggressive orders cost clients about 4% a year.

In other words, investors act against their own best economic interests with alarming regularity and cost themselves huge amounts of wealth in the process.

Dr. Casti says this is because society tends to form social groups based on affinity rather than simply becoming a collection of isolated individuals. That's why investors tend to magnify the importance of information you see in the herd around you rather than breaking from it before it goes over the cliff.

When it comes to money, we see this in a phenomenon known as "chasing returns" or following the hot money. This is why annual performance issues like those published in Forbes, Money Magazine or Kiplinger's, for example, are so irresistible. And so dangerous.

That brings me to fear.

The Only Thing We Have to Fear...

Right now millions of investors are sitting on the sidelines completely paralyzed by plain old-fashioned fear. And who can blame them? These markets have been some of the most vicious in recorded history.

Yet, I would argue that fear actually contributes to both recency and herding because it causes people to sit on cash that should be invested or keep money in the game when it should be taken to the sidelines.

Studies show that this comes down to pain. Losses hurt. They hurt financially and they hurt emotionally. Nobody likes them.

That's why people are more likely to let a losing position go against them than they are to take profits - because they can't take the "pain" of being wrong. The fact that they are unprofitable becomes almost irrelevant.

I can attest to that, having helped hundreds of thousands of investors over the years through my columns, presentations, and seminars worldwide.

That's why I do everything I can to enforce the discipline of taking profits and minimizing losses in careful concert with an overall plan.

By breaking the recency factor and eliminating the herding mentality that went with it, I find that many times fear is no longer an issue.

So how do you break the habits that you didn't know you had?

Here are three simple options:

Have a plan. The proprietary 50-40-10 structure allocation model I pioneered in our sister publication, the Money Map Report. That way you can sleep well at night knowing that even if the markets pitch a hissy fit, your money is properly concentrated in a safety-first structure that's high on income, stability, and growth.

Take a measured approach. Dollar cost average into positions over time by splitting your money into chunks instead of investing it all at once. That way you're investing a little at a time and can overcome the recency bias associated with big down days or bad news that rocks the markets. People usually look for patterns they can bet on and averaging in removes this self-defeating tendency very deliberately and effectively.

Use trailing stops. Conventional wisdom tells you to sell your losers and let your winners run. I think that's backwards. Nobody ever made money by selling losers. You have to periodically sell your winners without interference and trailing stops let you do that. Of course, you've got to trim your losses, too, so don't get me wrong here. Most brokerage firms have online trading platforms that can do this automatically. If yours doesn't, consider a simple, inexpensive service like www.tradestops.com.

In closing, there's no denying that what happens tomorrow is a function of what happened to us yesterday. The question is how we harvest what we learn in the meantime.

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How Much Cash Should You Hold?

Keith Fitz-Gerald — Fri, 11 Nov 2011 10:00:17 +0000

As you might imagine, I receive a lot of questions from readers around the world and right now the question I'm being asked most frequently is, "How much cash should I be holding?"

There's no right answer, but given the extraordinary times we're living in, I think the more interesting thing to consider is "what to do with it?"

But first things first. Let's talk about how much cash may be appropriate, then address what to do with it.

Traditional Wall Street thinking holds that cash is a drag that actually holds you back. The argument, particularly in a low interest rate environment, is that cash actually produces a negative real return because it really isn't "earning" anything while it burns a hole in your pocket and gradually loses ground to inflation.

I have a problem with this argument in that it's based primarily on the assumption that there's nothing better down the road.

I believe cash is key when it comes to providing the flexibility needed to safeguard wealth or capitalize on new opportunities - even now.

Not to make light of the current situation in Europe or our woes here in the United States, but the way I see things you can either ignore the problems and hope they go away in which case your cash is a dead asset, or you can learn how to deal with the uncertainty and profit from it in which case your cash is an asset.

If you're retired, holding something on the order of two to five years of living expenses is prudent. That way you can plan for regular expenses like insurance, medical bills, a mortgage if you've got one, and investing. Especially investing.

Now, if you're still working and have a regular paycheck, you can take some risks and hold less cash on the assumption that future income will offset the risks associated with a lower cash "buffer" on hand. A generally accepted rule is six months, but I think given today's economy 12-months worth of expenses is more appropriate.

Either way, the goal is the same - to have enough cash on hand that you don't have to spend money you don't want to at an inopportune time nor sell something when you don't want to.

For somebody in my situation, I think having about 20% of my investable assets in cash is about right.

If that strikes you as low in today's markets with all the risks they harbor, bear in mind I also use trailing stops religiously and I'm prepared to go to cash if things roll over. If you aren't disciplined or aren't prepared to be as nimble as the markets require, perhaps a more conservative 40% to 60% is appropriate. Maybe more.

Once you've decided what level of cash is appropriate for your particular situation, you can get to the bigger question of what to actually do with it.

This is where things get really interesting because even cash can be tweaked for better performance.

Bonds can be a Cash Alternative (For Now)

As long as interest rates remain low, core bond funds may make more appropriate "bank" accounts. At the very least, they can make good complements to the usual savings, checking and money market funds most Americans have already established.

Now, I can already sense the snarky e-mails heading this way telling me I have lost my mind or don't understand the risks associated with rising rates.

I haven't. Rising rates will make bonds tumble, and bond funds - with very few exceptions - will lose money.

But consider this: The chronic state of economic misery that we live in now may be with us a while. That's going to help keep interest rates low because the government believes - wrongly I might add - in stimulative economics that don't work and have never worked in recorded history.

More to the point, the U.S. Federal Reserve, for example, has announced that it's going to keep rates near zero through 2013. To me this is a near picture perfect repeat of the "Lost Decade" in Japan, which now is actually entering its third lost decade. We're on the same path.

The uncertainty could drive investors to bonds and actually make rates fall still lower from here, as hard as that is to imagine.

Consider starting with the TCW Core Fixed Income Fund (MUTF: TGFNX), or something similar. The Core Fund has returned 11% annualized over the past three years, according to Kiplinger's Personal Finance Magazine. That's handily beaten the benchmark Barclay's U.S. Aggregate Bond Fund by 3.5%. Dividends are paid monthly and the fund's yield currently stands at 3.59%.

Or, if you're bothered by the concept of holding bonds right now, try the American Century Capital Preservation Fund (MUTF: CPFXX). Started in 1972, CPFXX is one of the most senior and established Treasury-only money market funds in the investment industry. As such, it's an ideal place to stash your cash while waiting for new investment opportunities. It's also worth noting that CPFXX is exempt from state income tax, too.

There are two keys to watch here. First, if the benchmark yield on 10-year Treasuries begins to rise above 2.20% or ratings agencies downgrade U.S. debt, you could reduce your exposure and transfer cash back to a traditional bank account.

Broadening Your Horizons

Something else you may wish to consider is creating a multicurrency basket of cash. This is a common practice in areas outside of the United States. And, it's as much about opportunity as it is about hedging risk.

Something like the EverBank foreign currency CDs or WorldCurrency Access Deposit Accounts may be a great way to start if you don't travel internationally or are not "Swiss" worthy*.

The former offers a mix of currencies in a single CD that helps diversify the risks associated with cash itself. The latter allows you to transfer money between currencies in a single, global deposit account. Both are insured by the Federal Deposit Insurance Corp. (FDIC).

Structurally Sound

Finally, you could elect to buy "structured" products.

These are being marketed aggressively right now and come with their own set of wrinkles, so take the time to understand what you are getting into.

In a nutshell, structured products are essentially annual income generators designed as substitutes for low yielding traditional bank accounts. The yield is usually pegged to underlying stocks or in some cases bonds.

If the underlying portfolio rises, the investor receives a coupon payout equal to that amount. And if the underlying portfolio stays flat or falls, the investor is out a fee of 1% to 3% depending on the individual product.

If held to maturity, many structured products guarantee principal which is a good thing if stocks are headed higher. But if they're not, investors may have to recover their losses before any principal coupons are paid.

Be careful though, all investments involve risk...even cash.

*Special Note of Disclosure: Money Map Press has a promotional relationship with Everbank.

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Inverse Funds: How To Profit From Inverse Funds – Without Losing Your Shirt

Keith Fitz-Gerald — Fri, 28 Oct 2011 17:25:59 +0000

So-called "inverse funds" are widely misunderstood and can be tricky to use, but these specialized investments have a place in most portfolios.

In fact, with U.S. stocks having zoomed more than 80% off their market lows, now could be the ideal time to add inverse exchange-traded funds to your portfolio.

But there's definitely a right way and a wrong way to use them.

So it's worth taking a closer look.

The Lowdown on Inverse ETFs

If you're not familiar with inverse exchange-traded funds (ETFs) - or haven't used them, yet - don't worry. You're not alone. Despite the fact that they've been around a few years, I've found that many investors either aren't aware of them, or don't quite understand how they can be used.

Others who are familiar with inverse ETFs view them solely as a hedging instrument - and don't realize that their strategic use can lead to higher, more-consistent returns over time.

That's ironic, because they've proven their worth, time and again - such as during the run-up in oil prices in 2008, and, before that, during the financial crisis that got its start in late 2007. (And it isn't over, yet. Take a look at my updated report to learn the latest fallout from the financial crisis. This one is hitting regular investors like you and me. And it could reduce your retirement account by as much as 90%. Learn how to fight this new financial threat right here.)

As their name implies, an inverse ETF is a specialized investment vehicle that moves opposite to whatever security or index it's designed to track.

Inverse ETFs trade just like stocks on regular exchanges, which means that investors who want to use them don't have to have special accounts or approval from their brokers. And because they are priced in "real time" - just like regular stocks (and as opposed to conventional mutual funds) - investors who want to really fine tune their approach can literally monitor their exposure down to the minute or the tick if they wish.

Inverse funds can utilize a variety or combination of financial instruments - including options and futures - to achieve their objectives. And yet, their operation is almost completely invisible to the investor. That makes ETFs ideal for counter-balancing long positions in a diversified portfolio without having to worry about the intricacies of short selling, put options, liquidity, taxes or margin management.

Inverse funds also remove the element of market timing from the equation. And that's a very good thing, since the vast majority of investors - individual and professional alike - fail to keep pace with the market averages. In fact, in any given year, about three-quarters of all professional managers lag the performance of the Standard & Poor's 500 Index.

Rydex/SGI created one of the first inverse funds: The Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX). In professional trading circles, it was known as the Rydex URSA, or simply "ursa," which is Latin for "bear."

Today, as part of a $1 trillion industry segment, there are more than 100 inverse funds tracking the S&P 500, the Nasdaq Composite Index, the Dow Jones Industrial Average, as well as all sorts of other indices ranging from domestic small caps to foreign choices like the iShares FTSE/Xinhua China 25 Index (NYSE: FXI).

There are even so-called "ultra" inverse funds, which offer double or triple the inverse results - if you want to be more aggressive. These come with their own unique wrinkles because they use leverage to achieve their objectives. But don't necessarily believe all the bad press they've received in recent years. If used properly, they're hardly the "return killers" pundits would have you believe.

I like to use inverse funds in two ways:

As an "income stabilizer."
And as an "absolute-return producer."

Let's take a look at both.

Inverse Funds as an Income Stabilizer...

If you've ever been sailing and hit rough water, you might be familiar with something called a "storm anchor." It's something that's thrown overboard in an effort to stabilize the boat.

That's a great analogy. Because inverse funds are truly non-correlated assets, they serve the same purpose as a storm anchor. So if you're dependent on income, using inverse funds can stabilize the principal value of your holdings, while allowing you to concentrate on preserving your income.

This is more of a "set-it-and-forget-it" approach to income investing. And research studies underscore that having 5% to 10% of your overall assets in such holdings is just about right.

... And as an Absolute-Return Producer

If you're more aggressive, you can use inverse funds to achieve absolute returns (a.k.a. profits) during rough market stretches in which everyone else around you is fretting about the losses they're incurring.

Investors who travel this route typically allocate more than 5% to 10% of their portfolios in inverse-type investments - depending upon what it is that they're trying to hedge.
Investors in this group also tend to rebalance their inverse funds regularly - sometimes even daily - to accommodate the market's inevitable ebbs and flows.

Consider, for example, a $10,000 investment that outperforms the markets by 5%. An investor who uses inverse funds to hedge that investment would now want to add an additional $500 to an appropriate inverse fund to rebalance the incremental return (or "alpha," as it's referred to by professional investors).

Similarly, if a hedged investment has fallen by 5%, that same investor would want to sell $500 worth of inverse funds to reduce the net exposure to zero ($0.00).

A Worthwhile Sacrifice

In investing, as in physics, there is no "free lunch." In other words, in order to get the security that these inverse funds provide, you have to give up something.

Because inverse funds move in the opposite direction to the underlying indices they track, they'll take a little off the top when markets are rising.

However, in a world characterized by out-of-control government spending and markets that are exposed to the risks created by seriously out-of-control financial institutions, that's an acceptable trade-off. Especially when it comes to the peace of mind I get by using them.

Actions to Take

Although they are specialized investments, I believe "inverse funds" have a place in most portfolios.

Here are a few of my favorite choices to help you get started.

If you're partial to U.S. stocks, consider the aforementioned Rydex Inverse S&P 500 Strategy Inverse Fund (RYURX). It moves opposite the S&P 500 Index.

If you've got heavy U.S. Treasury exposure - particularly at the longer end of the spectrum as many investors do right now - consider the Rydex Inverse Government Long Bond Strategy Inverse Fund (RYJUX) or even the iPath U.S. Treasury Long Bond Bear ETN (DLBS). Although the latter is technically an exchange-traded note (ETN), the purpose and function are similar.

If you're an investor who favors high tech, or who is big into energy, there's the ProShares Short QQQ ETF (NYSE: PSQ) or the United States Short Oil Fund (NYSE: DNO).

If you find that you share one of my major worries, and are concerned that the U.S. dollar may fall even further (Take a look at my latest research to learn where the dollar is headed and why it could be dragging your investments down with it.), or if you have the majority of your portfolio in dollar-denominated investments, you will find that the PowerShares DB U.S. Dollar Index Bearish (NYSE: UDN) will provide the security that eases those fears.

Finally, if you share my view that China represents the greatest long-term investment potential on the planet - but you still wish to "smooth out" some of the interim volatility that's certain to come - consider the Ultrashort FTSE/Xinhua China Proshares ETF (NYSE: FXP). This is the yin to the yang of the aforementioned iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI).

The Market's Next 1,000-Point Move

Keith Fitz-Gerald — Tue, 25 Oct 2011 12:23:55 +0000

Stuart Varney, host of the aptly named and very highly rated "Varney & Co." program on Fox Business, put the following question to me in his usual direct style: "Will we have an agreement on Wednesday out of Europe and what will that mean for the markets?"

Yes, I began, we probably will - but for all the wrong reasons, and it will never last.

There are three reasons why:

for

something

The bottom line: This is not over by a long shot. In fact, I expect it to drag on well into next year.

Still, in the short-term, the next 1,000 points the market moves in either direction are going to be the direct result of whatever "solution" comes out of Europe tomorrow (Wednesday).

The better we understand this situation as a nation and as investors, the better off we'll be.

A Misguided Mission

At issue is the very nature of the "recapitalization." The fact is Europe's debt has gotten to the point that it can no longer be sustained.

Much like our own debt situation here in the United States, there are many causes, including completely incompetent government, irresponsible decision-making, feckless leadership and paltry economic growth.

Citizens on both sides of the Atlantic understandably have had enough.

But the problem is that the policies that led Europe to this point were decades in the making. So it's unreasonable to expect them to go away any time soon even if the EU announces a solution on Wednesday.

Furthermore, the use of comparatively healthy public balance sheets to shore up irresponsible banks and speculative trading houses is a big mistake that removes the free hand of risk that is a required element of capitalism.

Now, this could come to a quick resolution - if the politicians would stop their meddling. Yes, companies would fail, banks would fail, and the markets would take the brunt of it on the chin.

But - like Iceland, which fabulously ignored international advice and undertook a complete reboot - the sooner we take our medicine, the sooner we can begin healing.

It's not too late, but whether it becomes too late is a question for the world's central bankers and policymakers who have yet to become serious enough about what's needed.

The Downward Spiral

Barring any sort of massive economic growth, neither the EU nor the U.S. can make a dent in the debt cycle and the stuff eventually will hit the fan.

When it does, there are four ways out:

Default.

Austerity.

Repression.

PIMCO

Growth through redistribution.

failed government investments like Solyndra

Which course we end up taking is yet to be seen. But I do know this: Whatever comes out of Europe tomorrow will directly affect the markets to the tune of 1,000 points in either direction.

As investors, our most prudent course of action is to shield ourselves from the fallout.

Staying Ahead of the Game

So here are some things to think about.

This is a time to buy resources that will help preserve value and wealth - and not just metals, either. Jim Rogers and George Soros, two of the most famous investors of all time, are reportedly buying farmland.

This is a time when cash and bond equivalents, including the U.S. dollar, may be the best looking horses in the glue factory.

It's also the time to do some serious bargain hunting.

So what if we are not at a bottom, let alone the bottom. Stocks usually offer the greatest returns to those who buy them when everybody else is terrified to invest.

Companies like Caterpillar Inc. (NYSE: CAT) and Apple Inc. (Nasdaq: AAPL) prove that you can still knock the stuffing out of the ball even if the global economy is circling the drain.

Dividends are king when you can get them. On "sale" is even better, especially when it involves companies like the dividend royalty, which have increased payouts for at least 25 consecutive years.

Take issue with this if you want, but companies that are providing the stuff that people "have" to have still lead the way. Many actually have stronger balance sheets, lower debt ratios and report higher productivity than before the financial crisis.

T he only people who have made money over the past 15 years are those who invested through 2001-2004 and during the crash of 2008-09. That's why you must stay in the game if at all possible and even if it hurts like hell.

And don't forget the specialized inverse funds that I've mentioned so often in Money Morning that I feel like a broken record. If you're following along and use trailing stops as a means of selling into strength, you'll have plenty of cash available. So you might as well invest in something that profits even if stocks take their own "Greek Holiday" (again).

News and Related Story Links:

Money Morning:
Four Moves to Make Before Greece Defaults

Money Morning:
Deutsche Bank AG (NYSE: DB) Will Be Crushed Under the Weight of Europe's Debt

Money Morning:
One of These Banks is Europe's Lehman Bros. – And We're Going to Profit From Its Collapse

Money Morning:
Don't Buy Into Europe's Latest Rescue Effort - The Continent's Banks Are About to Go Bust

Money Morning:
IMF Growth Forecast: U.S. and Europe Will Ignore Warnings, Despite Slashed Estimates

Money Morning:
As Greek Debt Default Nears, Investors Need to Take Cover

Money Morning:
The Only Way to Solve the European Sovereign Debt Crisis

Money Morning:
European Union Debt Crisis Stings France, Putting U.S. Banks at Risk

Money Morning:
Special Report: What is the Greek Debt Crisis, and What Does it Mean for Investors?

Tags: market, Open Market

Don't Buy Into Europe's Latest Rescue Effort – The Continent's Banks Are About to Go Bust

Keith Fitz-Gerald — Mon, 17 Oct 2011 13:16:03 +0000

The latest plan to preserve the European Union (EU) and save the global banking sector is to force European banks to increase their equity capital.

The goal, of course, is to restore confidence and stability. But if that's the case, then why are so many analysts and savvy investors still nervous?

To put it bluntly, because they know it won't work.

As it stands, the capital shortage is about 200 billion euros ($277 billion) according to the International Monetary Fund (IMF). I think it's more like 1 trillion euros ($1.4 trillion) by the time you factor in all the cross holdings and the daisy chain of exposure that makes the entire banking system there look like Swiss cheese.

Why Recapitalization Won't Work

There are three things that are especially problematic to me:

European Union (EU) ministers apparently are going to put capital into the system without knowing how much it needs or exactly where to put it. Hard to believe, but thanks to the opaque nature of the derivatives markets, nobody can be sure exactly how much exposure any one bank or financial institution has.
Healthy banks that do not need an infusion will get one anyway. Rainer Skierka, who is a stock analyst at Bank Sarasin & Cie AG, shares my belief that this will lead to massive dilution for shareholders.
Any bank that is undercapitalized will effectively be the recipient of capital that has been diverted away from healthy banks and into its toxic financials. Unfortunately, this money will be placed at higher risk in an effort to earn the incremental income needed to backstop bad bets that already are on the books. That means shareholders who are led to believe things are improving will actually find their money at an even higher risk than before.

As I have noted repeatedly since this crisis began, regulators are fighting the wrong battle and have been since 2008. They are worried about liquidity when they should be worried about solvency.

Sure, a bank recapitalization can repair the banking system when it comes to keeping money moving in terms of short-term credit - but no amount of money can prepare European banks for a sovereign default or credit freeze because there literally isn't enough money on the planet to recapitalize the banking system unless you remove the risks that plague it.

The "system" is still at incredible risk.

The total worldwide notional derivatives exposure is more than $600 trillion dollars according to the Bank for International Settlements (BIS). And that's against a gross market value of merely $21.1 trillion.

In other words, banks have invested in instruments valued at $21 trillion but with a total exposure that's 28.4-times that -- or $600 trillion dollars.

This is why rogue traders are such a problem; they can take disproportionately large risks with not a lot of capital, which often leads to catastrophe.

Take Nick Leeson, the former derivatives broker who worked for Barings Bank. His leveraged trading losses eventually reached $1.4 billion, or twice Baring's available trading capital. Barings went under as a result.

More recently, Kweku Adoboli, who served as director of exchange traded funds (ETFs) at UBS AG (NYSE: UBS), blew a $2 billion hole in UBS' balance sheet.

Part of the problem is that n obody knows exactly how much cash banks spend to amass such investments because derivatives and sovereign debt trading instruments are still largely unregulated and "self policed" within the industry.

So what's this have to do with our money?

Everything.

Looming Liquidation

If there are additional downgrades of European or American banks ahead, or if the cost of credit default swaps (CDS) continue to rise, thus making new financing prohibitively expensive, the banks trading derivatives will have to post additional marginable collateral.

In plain English, this means the firms trading in derivatives will have to come up with huge amounts of cash they don't have. So they will sell everything but the kitchen sink as a means of raising it.

Consider what happened last time around.

Merrill Lynch said in a quarterly report in 2008 that a one-notch downgrade of its credit rating would require the firm to post an additional $3.2 billion of collateral on over-the-counter derivative trades. Around that same time, Morgan Stanley (NYSE: MS) estimated in a regulatory filing that a single-level downgrade would mean posting an extra $973 million. And Lehman Bros, before it collapsed, said a one-level downgrade would require about $200 million of additional collateral.

This is what was behind the massive drops in gold, silver, and the broader markets in late 2008. Credit locked up, the cost of capital rose and margin calls ensued. So banks and trading houses sold everything they could as quickly as they could to raise the necessary capital. The selling began in the metals markets because they are most liquid. Then it moved rapidly into the broader equity markets, causing a downdraft that most investors would like to forget.

We experienced a similar thing earlier this summer as a result of more downgrades and prohibitive CDS costs. Not surprisingly, the Standard & Poor's 500 Index fell 18% and gold tumbled 15% as the banks' trading arms raised capital to cover their bets.

And it will happen again when the latest plan fails.

If you're tempted to believe that the likes of BNP Paribas SA (PINK: BNPQY), JPMorgan Chase & Co. (NYSE: JPM), Goldman Sachs Group Inc. (NYSE: GS), and others care about anything other than their own hides when the downdraft starts, think again.

Not only will institutions like these begin selling at the first hint of a margin call or more ratings downgrades, but they will actively use their own proprietary funds to book more gains in the process - even if it means trading directly against their own clients.

Four Ways to Protect Yourself

So enjoy the rally while it lasts and do these four things in the meantime:

Sell into strength using trailing stops. That way you can capture the rally if it continues and move your money to the sidelines if it doesn't. Nobody knows how long the fairy tale will last so you might as well let the markets show you the way instead of trying to second guess them and risk being wrong.
Buy commodities. Holding energy and agricultural commodities as well as precious metals like gold and silver will help you preserve your wealth. Even after large pullbacks that may result from capital raising activities, the long-term direction for these is up. To minimize risks, buy in chunks or dollar cost average in over several months.
Go Global. Put new money to work in "glocal" stocks . These are companies with fortress-like balance sheets, globally diversified revenue and experienced management. Average in here, too. Things may get rocky but over time, but dividends are the best defensive measure available.
Short financials. If you're an aggressive trader, you can short individual banks or the entire financial sector. After all, "they" took us for a ride -- why not get even when the tables eventually turn?

News and Related Story Links:

Money Morning:
One of These Banks is Europe's Lehman Bros. - And We're Going to Profit From Its Collapse
Money Morning:
The Looming Bear Market: What You Can do That Washington Can't and Wall Street Won't

Tags: best european banks, biggest european banks, committee of european bank supervisors, committee of european banking supervisors, european bank, european bank account, european bank etf, european bank failures, european bank index, european bank stress test, european banking, european banking news, European banks, european banks for sale, european banks in trouble, european banks in usa, european banks list, european banks stress test results, european central bank exchange rates, european investment banks, european system of central banks, largest european banks, list of european banks, major european banks, top 10 european banks, top european banks

Derivatives: The $600 Trillion Time Bomb That's Set to Explode

Keith Fitz-Gerald — Wed, 12 Oct 2011 10:00:08 +0000

Do you want to know the real reason banks aren't lending and the PIIGS have control of the barnyard in Europe?

It's because risk in the $600 trillion derivatives market isn't evening out. To the contrary, it's growing increasingly concentrated among a select few banks, especially here in the United States.

In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller.

The four banks in question: JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS).

Derivatives played a crucial role in bringing down the global economy, so you would think that the world's top policymakers would have reined these things in by now - but they haven't.

Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market.

Think I'm exaggerating?

The notional value of the world's derivatives actually is estimated at more than $600 trillion. Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments.

The world's gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.

Compounding the problem is the fact that nobody even knows if the $600 trillion figure is accurate, because specialized derivatives vehicles like the credit default swaps that are now roiling Europe remain largely unregulated and unaccounted for.

Tick...Tick...Tick

To be fair, the Bank for International Settlements (BIS) estimated the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money and well beyond the billions being talked about in Europe.

Imagine the fallout from a $600 trillion explosion if several banks went down at once. It would eclipse the collapse of Lehman Brothers in no uncertain terms.

A governmental default would panic already anxious investors, causing a run on several major European banks in an effort to recover their deposits. That would, in turn, cause several banks to literally run out of money and declare bankruptcy.

Short-term borrowing costs would skyrocket and liquidity would evaporate. That would cause a ricochet across the Atlantic as the institutions themselves then panic and try to recover their own capital by withdrawing liquidity by any means possible.

And that's why banks are hoarding cash instead of lending it.

The major banks know there is no way they can collateralize the potential daisy chain failure that Greece represents. So they're doing everything they can to stockpile cash and keep their trading under wraps and away from public scrutiny.

What really scares me, though, is that the banks

think this is an acceptable risk because the odds of a default are allegedly smaller than one in 10,000.

But haven't we heard that before?

Although American banks have limited their exposure to Greece, they have loaned hundreds of billions of dollars to European banks and European governments that may not be capable of paying them back.

According to the Bank of International Settlements, U.S. banks have loaned only $60.5 billion to banks in Greece, Ireland, Portugal, Spain and Italy - the countries most at risk of default. But they've lent $275.8 billion to French and German banks.

And undoubtedly bet trillions on the same debt.

There are three key takeaways here:

There is not enough capital on hand to cover the possible losses associated with the default of a single counterparty - JPMorgan Chase & Co. (NYSE: JPM), BNP Paribas SA (PINK: BNPQY) or the National Bank of Greece (NYSE ADR: NBG) for example - let alone multiple failures.
That means banks with large derivatives exposure have to risk even more money to generate the incremental returns needed to cover the bets they've already made.
And the fact that Wall Street believes it has the risks under control practically guarantees that it doesn't.

Seems to me that the world's central bankers and politicians should be less concerned about stimulating "demand" and more concerned about fixing derivatives before this $600 trillion time bomb goes off.

News and Related Story Links:

Money Morning:
Don't Get Duped by Derivatives
Money Morning:
Deutsche Boerse/NYSE Mega-Merger More About Derivatives Than Stocks
Money Morning:
The Next Banking Crisis Starts Here
Money Morning:
Death Derivatives: Wall Street's Latest Ill-Advised Maneuver
Money Morning:
Credit Default Swaps: Why Washington Ignored Our Warning
Money Morning:
Avoid Financials: Bank Earnings Are Set to Slide

Tags: define derivatives, definition of derivatives, Derivatives, derivatives definition, derivatives explained, derivatives for dummies, derivatives market, equity derivatives, equity derivatives trading, examples of derivatives, financial derivatives, financial derivatives definition, foreign exchange, foreign exchange derivatives, history of derivatives, rules of derivatives, stock derivatives explained, stock market derivatives, types of derivatives, warren buffett derivatives, what are derivatives

One of These Banks is Europe's Lehman Bros. – And We're Going to Profit From Its Collapse

Keith Fitz-Gerald — Mon, 10 Oct 2011 10:00:04 +0000

Back in July, I warned you that Europe probably had its own Lehman Bros. - an unstable financial institution on the brink of a collapse.

At the time, I didn't know exactly which institutions were most at risk.

Now I have a pretty good idea and want to share that with you.

One big firm, the Brussels-based Dexia SA, is already set to be dismantled.

And based on an analysis of 50 European banks with a combined $129 billion (92 billion euros) tied up in Greek sovereign debt, I've identified two other suspect institutions: BNP Paribas SA, and Societe Generale SA (PINK: SCGLY).

These banks have a high level of exposure to Greek sovereign debt and once they're forced to acknowledge the precariousness of their situation investors will stampede for the exits. That will have negative effects for both European and U.S. banks, as well as the overall markets. But there is a way to not only protect yourself, but turn a serious profit.

I will explain that to you shortly, but first, let me give you an idea of what it is we're dealing with.

Europe's Lehman Bros.

Basically, there are two ways to judge which banks are most at risk. You can look at how expensive the credit default swaps on these banks are compared to their peer group. And you can look at how quickly those credit default swaps have climbed.

Credit default swaps, in case you are not familiar with them, were originally created as "insurance" that protected the lender in case of a default. When they are purchased, the loan is turned into an "asset" and is then "swappable" for cash if the borrower defaults.

Generally speaking, the more expensive a credit default swap is and the faster its price has increased, the greater the risk there is associated with it.

As of Oct. 4 , the senior debt of the top 25 global banks with tradable CDS instruments was at 289 basis points. (A basis point is equal to 1/100 of a percentage point . They are commonly used to denote a rate change or, in this case, the difference or spread between two interest rates.)

However, the five-year senior credit default swaps for Societe Generale and BNP Paribas are considerably out of line with that figure - or at least they were as of Oct . 6. They've recovered since rumors of another rescue surfaced, but they're still dangerously high. Five-year senior credit default swaps were recently valued at about 386 points for Societe Generale and 287 basis points for BNP Paribas.

As for how fast the cost of insuring that debt has risen, the data is even more incriminating. Since 2009 Societe General's credit default swaps are up 294.17% and BNP Paribas credit default swaps have risen 199.60%.

This suggests two possibilities: 1) Traders are betting that the banks are substantially undercapitalized - meaning they may not have enough money to meet potential losses; or 2) They've got way too much exposure to Greek debt to withstand the country's failure.

This is no coincidence. BNP and Societe Generale are among the top foreign holders of Greek government bonds, according to the European Central Bank (ECB) and the Institute of International Finance (IIF).

Why regulators and central bankers cannot put two and two together is beyond me. To hear them tell it, BNP and Societe Generale have already written their Greek debt down 21%, so this shouldn't be an issue.

But other European banks wrote their Greek debt down by 51% on average. That means BNP and Societe may still have another 30% in write-downs that they don't want to pull from the closet like the skeleton everybody hopes isn't really there.

An additional 30% in write-downs for these suspect banks could result in more than $2 billion in extra losses, or roughly triple what's already been booked.

In BNP's case, the hit would be another $2.3 billion (1.7 billion euros). The bank calls that manageable, but I have my reservations. And Societe Generale would have to take an additional net loss of $135 million to $200 million (100 million to 150 million euros), according to Laetitia Maurel, a spokeswoman for the firm.

The Two Moves to Make

The word is that Europe is going to "handle it" (again).

Well call me crazy, but I don't believe it.

Aside from the fact that this is the seventh or eighth attempt at subduing this crisis, I simply don't believe that it can be done based on my experience in Japan over the past 20 years.

I lived through the financial crisis in that country and I recall very vividly what happened when Japanese banks were forced to take write-downs on bad debt. Many went bust and those that shorted the entire Japanese financial sector made a fortune.

That's what I see happening here.

So here's how you might play this if you're an aggressive trader.

Bear in mind, though, that what I am about to suggest will require some finesse - if only because the world's central bankers still believe they can save Europe's banking system.

That they will try I have little doubt. That they will ultimately fail, I have no doubt.

The key to this trade is sentiment. Stocks rose sharply towards the end of last week, lifted by the hope that the European authorities will succeed.

Good. The longer the illusion is maintained, the higher prices will be before we short them.

The timing signal I'm looking for is very simple: When Greece misses its first bond payment or news of break up talks hits the wires. That's going to cause a cascade of sales, forcing the value of all Greek bonds to immediately drop as traders make a mad dash for the exits. The three banks we're targeting will get hit the hardest, but U.S. banks will be adversely affected as well.

I don't think it would be out of line to get in the game a little early, but recognize that the trades may go against you before they ultimately perform as expected.

So here's what to do:

Short the banks I've mentioned - BNP Paribas SA, and Societe Generale SA. Be careful, though. These may rise dramatically in the short term before falling again in 2012 when the write-downs and declining earnings really come home to roost. Proper risk management is critical.
Buy long-dated put options on the individual banks, as well the broader Standard & Poor's 500 Index. Ideally, you want these to be dated 2012 or even 2013 when they become available. While your risk is limited to the amount of money you use to buy them, these puts will be volatile so only use capital you can afford to lose entirely.

News and Related Story Links:

Money Morning:
Special Report: What is the Greek Debt Crisis, and What Does it Mean for Investors?
Money Morning:
Three Ways to Slash Your Risk Despite the Negative Investing Outlook
Money Morning:
European Banks Wait in Fear Over Consequences of Unresolved Greek Debt Crisis
Money Morning:
The Future of the Euro: Why Europe's Key Currency is Doomed

Tags: economic crisis in the usa, Europe's Lehman Bros., financial crisis in the usa, lehman borthers, Lehman Bros, lehman bros bank, lehman bros bankruptcy, lehman bros bonds, lehman bros collapse, lehman bros hldgs inc, lehman brother bankruptcy, lehman brother collapse, lehman brother crisis, lehman collapse, lehman investment banking, lehman lawsuit, shearson lehman bros

Four Ways to Play the Bond Market Bubble

Keith Fitz-Gerald — Fri, 30 Sep 2011 10:00:44 +0000

To hear the "bond bubbleistas" tell it, the bond market is poised to collapse the second interest rates start to rise.

But if you're thinking about dumping all of your bonds, you should think again.

Yes, rates will rise - but not as fast as many analysts are forecasting. What's more, even if rates do increase, the price risk is not as bad as you might think.

That's why the more appropriate strategy is to simply reorient your bond portfolio, rather than pull out all together.

Don't get me wrong. I'm not trying to make light of the global financial crisis or our current situation, but people have been calling for an "end" to bond markets, in one form or another, for quite a long time.

Failed Forecasts

PIMCO cofounder and fund manager Bill Gross has actually done so twice, most recently dumping all government bonds in early 2011. He's since admitted he was wrong and piled back in. Granted, his business is bonds so he had to, but the point is moot.

PIMCO investors paid through the nose in lost performance, though. The PIMCO Total Return Fund was up just 3.2% as of August, trailing more than 70% of its peers and lagging the 5.6% return of its benchmark index, according to Bloomberg.

Meredith Whitney famously called for the $3 trillion muni-market Armageddon in November 2010. Her clock is about up and she's mentioning nothing about her prediction in recent appearances despite turning the bond markets upside down for months.

Even economist Nouriel Roubini has eaten crow when it comes to bonds. He called for the complete meltdown of everything we knew to be true in 2004, 2005, 2006, and 2007. And while he's since become a media darling, his predictive record is less than stunning. Journalist Charles Gasparino, who investigated Roubini's track record, noted that he couldn't find a "single investor who regularly uses his research."

My point is not that any of these incredibly smart people were wrong - everybody is wrong from time to time - just that investors risk a lot by not "risking" anything.

Let me explain.

No Substitute for Stability

Fueled by banking blunders and the European banking crisis, U.S. Treasuries have not only risen this year, they've rocketed so high that in August the benchmark 10-year yield dropped below 2% for the first time since 1950 and traded at around 1.96% yesterday (Thursday).

That means investors who hung in there despite the risks and the hype have enjoyed a nice return from bond appreciation even as they continued to reap the benefits of the yield those bonds kicked off. Those who bailed out did so prematurely and got left behind.

So what's going to happen to the bond market when rates rise?

When rates do eventually start to rise, bonds will decline - but not at the pace many fear.

How do we know that? Because there is precedent.

Consider the period from 1993-94, for example. During that time, interest rates on 10-year Treasuries rose 50% from 5.3% to 8% in a mere 13 months. Yet the Barclays Capital Aggregate Bond Index fell just 3.5% over that period because income shielded the principal value.

Sure, individual bonds tumbled, but funds generally held a steadier, controlled hand on the tiller. Over longer time periods, this is a significant buffer.

People forget that interest payouts, while they can be small when rates are low, really do offer a cushion against falling prices - even if it's just a small one.

They also tend to forget that if fund managers hold bonds to maturity, the drop in bond prices is not actually offset because there is no realized "loss" to contend with. The reason is that bond prices move back to par as the bonds approach maturity. This is true whether you hold them individually or as part of an investment in an exchange-traded fund (ETF) or bond fund.

So, even though our country is functionally bankrupt, and the bond market is at frothy levels, I still believe investors would be foolish to dump bonds entirely. Limit your exposure and hedge your downside risk - but don't dump them.

Because for all their risks, bonds have been and will continue to be an important stabilizing force in your portfolio - bubble or not.

Four Ways to Beat the Bond Bubble

That said, there are four things you can do to limit your exposure to the bond market - and its downside risks - without pulling out entirely.

Keep durations short. Duration is the measure of a bond's sensitivity to interest rate changes. Basically, it works like this: For every year of duration, a fund or an individual bond will gain or lose value that's directly related to interest rate moves. A five-year duration, for example, will roughly equate to a 5% fall in face value for every 1% increase in interest rates. That's why I believe investors should keep duration under five years and preferably under three if they can. This will help minimize losses if rates rise, and it will give you much needed stability. You'll also have the opportunity to continually buy new bonds at higher rates.
Pick up Treasury Inflation Protected Securities, or TIPS. These specialized securities are linked to the consumer price index (CPI) so they're not going to move quickly as long as the government remains in denial with regard to inflation. However, they will move eventually and no amount of creative accounting will be able to hold the CPI down once the inflation we all know is here begins to move through the system in earnest.
If you're aggressive and want to profit from the looming shift in capital that will eventually accompany our profligate spending rather than simply defend against it, consider shorting long government bonds using an inverse fund like the Rydex Inverse Government Long Bond Strategy Fund (MUTF: RYJUX). It's down 26.82% year to date and that means mainstream investors are still looking the other way. Just as we are using short duration to our advantage as a defensive measure, this fund actually capitalizes on those who maintain a long duration. That means you can play offense.

[Editor's Note: There's one more idea about how to brace for bond market turmoil, but it's only available to Money Morning Private Briefingsubscribers. If you're already a subscriber you can read about it in today's briefing. If you're not, then you can sign up by clicking here.]

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The Looming Bear Market: What You Can do That Washington Can't and Wall Street Won't

Keith Fitz-Gerald — Mon, 19 Sep 2011 10:00:48 +0000

I just finished a battery of media appearances on Fox Business, Bloomberg, BNN and CNBC Asia, and without exception I was asked about two things: President Barack Obama's jobs bill and the U.S. Federal Reserve's "QE3."

The first thing investors and analysts alike want to know is whether or not the president's jobs bill will work. The answer to that question is "no" - not as it stands, anyway.

The second question is whether or not Fed Chairman Ben S. Bernanke will further extend the central bank to help the economy. Well, I do think the Fed will intervene, but I don't believe for a second that the central bank's intervention will help the U.S. economy.

As a result, we're likely to see stocks enter into a bear market and retest their March 2009 lows.

I know that's a terrifying thought. But to be perfectly honest, there's nothing President Obama or Bernanke can do at this point. If companies don't want to spend the $2 trillion worth of cash they're hoarding, there's very little the government can do to encourage them to loosen their purse-strings.

That said, I want to give you five specific steps to take to protect yourself from the looming bear market, preserve your sanity - and even profit.

But before I get to that, you need to understand the dangers that are fast approaching.

A Roadblock to Recovery

President Obama and Chairman Bernanke can toss all the money they want at the economy. But no amount of spending can change the fact that we need the following three things to get our market moving again. They are:

Sustained demand.
A solution to the European sovereign debt crisis.
And a bottom in housing prices.

As it currently stands, the U.S. economy will be lucky to log 1% growth this year, which is even lower than the anemic 1.5% I predicted in my annual forecast in January.

That's pathetic for a nation that spent more than $1.4 trillion of borrowed money on "stimulus." This lackluster growth is also evidence that the Obama administration's $800 billion stimulus plan - and the Fed's two rounds of quantitative easing - did absolutely nothing to salvage our economy.

Citizens are scared silly. Businesses are uncertain. They're uncertain of regulatory changes, uncertain of taxes, and uncertain about their overall economic environment. So they're doing what rational people do when confronted with the unknown: They're hunkering down.

And with good reason.

The typical U.S. family got poorer during the past 10 years due to a decade-long income decline. Median household income fell to $49,995 last year, and is now 7% below where it was in 2000. The number of people living in poverty has risen to 15.1%, the highest level since the U.S. Census began tracking this information in 1959.

It should also be noted that a large portion of that decline is directly attributable to inflation, which the Fed continues to assert is "transitory."

Out of the Fire...

You may be holding out hope that the president's jobs plan will help turn things around - but it won't.

Jobs exist because they create value. You can't just assume businesses will hire for the sake of hiring, which is essentially what the Obama administration's plan does. There has to be demand. All the employees in the world won't do any good if business owners can't grow their customer base and their revenue.

This is true for infrastructure as well. Infrastructure should be built as a means of increasing productivity - not just to put bodies in motion. That's something the "bridges and tunnels" crowd doesn't seem to understand.

That's why we have to consider the president's plan for what it is - yet another government-sponsored diversion of capital and resources.

As such, there are the usual questions about how President Obama wants to pay for this. And that's assuming the plan even manages to get through Congress, which I don't believe it will.

I think the jobs bill is dead in the water, and that the fight over some of its elements will create more uncertainty than jobs. That will be bad for the economy and even worse for the stock market, which will react negatively to the bickering and yet more indecisiveness.

Enter the Fed.

A Five-Step Plan for Dealing with the Looming Bear Market

When the president's jobs bill fails - just as his previous attempts to jumpstart the economy with deficit spending failed - and unemployment rises a year from now if not sooner, Bernanke will undoubtedly step in with QE3.

Of course, it may not be called QE3. It will likely be called "Operation Twist," or some derivation thereof.

But here's the real rub. Quantitative easing, no matter what it's called, is a euphemism for printing money. It is an attempt to bring down longer-term rates and twist the interest rate curve in such a way that companies have no choice but to spend money, and investors have no choice but to take on more risk.

But how low can you go when rates on the short end of the curve are already near zero? Not very.

I saw this firsthand in Japan. The Japanese government took rates all the way down to zero - and nobody wanted the money! Japanese companies wouldn't spend their cash then any more than U.S. companies will spend the $2 trillion they're sitting on now.

Instead, the government will be "forced" to spend even more.

So while Bernanke and President Obama are trying to dig their way out of this mess, they're really only digging our economy into a deeper hole.

That's why stocks are destined to retest the market lows of 2009. I don't know exactly when but I intend to help investors safeguard their assets and profit by preparing for it now - before it actually happens.

Here's five steps to get you started:

Sell Strategically: Sell into strength and capture profits using trailing stops that are gradually ratcheted up as the bounce begins. This will help you raise cash (that can be used to buy into the rebound when it eventually happens)
Hedge Your Bets: Use specialized inverse funds to hedge downside risk that will accompany the rollover to the downside and rack up significant gains at the same time.
Consider Alternatives: Buy commodities - most notably gold and oil - on pullbacks. These alternative assets will help preserve the value of your portfolio as the markets roll over. Their value will accelerate dramatically when the world economy recovers - as it eventually will.
Think Globally: Put new money to work in so-called "glocal" stocks with fortress-like balance sheets, diversified revenue and experienced management. Not only will they help hedge the value of your portfolio, but by concentrating your focus on them you are building in upside potential even if we haven't hit a bottom. Those offering big dividends are best because that will help you keep pace with the inflation the government debt will ultimately induce.
Stay in the game: I know it's tempting to bail out given my prognosis for more downside, but attempting to time the markets is a fool's errand - and never works. You just wind up getting skinned twice - once on the way down and again because you were standing on the sidelines and got left behind when the markets ultimately reverse - which they will.

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