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What Might Get The Market Moving Higher Again

The Bad News

The Kelly Letter is Buying

Back On Track

Here's Your Chance, Latecomers

Getting Killed By Leverage

Now They Say We're
Climbing The Wall Of Worry


Too Many End-Of-Year Bulls?

Stock Experts In Typical Disagreement

Still Bullish After All These Gains

Don't Miss Any More Of This Bull Market

Do Not Miss This Market

Thoughts From The Non-Disaffected

The End Is (Not) Near

Fight The Fear And Invest

Van Knapp On The End Of The Credit Crunch

Did You Miss The Rising Market?

Highlights From Fortune's "Crisis Counsel"

The Cold Facts

Van Knapp on Sub-Prime Risk and Reward

Stratfor on Sub-Prime

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What Might Get The Market Moving Higher Again
November 26, 2007

I'm optimistic for a rise in the market.

I wrote last summer that oil would rise higher before falling lower for a while, then continuing another leg higher. That forecast is unfolding.

Lower oil prices are probably not far away. There's no economic reason for oil prices to be this high. Peak oil theorists aside, we're nowhere near the end of oil. Production is actually increasing and is ahead of current demand and projected demand for at least another ten or 15 years.

Some economists say the main reason oil prices are high is that they're denominated in dollars, and the value of the dollar is sinking. Some economists say the opposite is true: the dollar is falling against the euro because oil prices are rising and Middle Eastern nations sell dollars they receive for oil as soon as they receive them.

Either way, there's more to rising oil prices than just a falling dollar. In the past five years, oil prices are up more than three-fold while the dollar has lost less than one-third of its value. Not exactly a hand-in-glove moment that would make O.J. proud.

As with the chicken and the egg, we're not sure whether high oil prices or high euro values come first, but we're sure they come together. What also looks increasingly likely is that both are getting set to reverse course.

As week after week goes by with no economic fallout from the weak dollar, the headline will lose impact. Even now, smart foreigners are taking advantage of lower real estate prices in some parts of the U.S. combined with stronger foreign currencies to buy property at 25% off. That could turn the low dollar into a real estate support asset, which would help the economy, which would help to boost the value of the dollar again.

Another factor shaping up to get the dollar standing tall is the unpegging of Asian currencies from it. India has been letting its rupee rise, South Korea has been letting the won rise, Singapore has hinted at a similar policy, and even China is grumbling about the high price of gas and food and thinking that maybe a rising renminbi would be a quick fix.

If the world goes closer to a free float, the higher return on capital in the U.S. economy should one day get the dollar back on top, or at least closer to the top than the bottom.

Currencies are very complicated, actually, and no matter how much we talk about what influences them, what might happen, what happened in the past, and so on, there may be a much simpler way to get a handle on the odds.

Here it is: think in cycles. Markets tend to move in cycles. The euro weakened against the dollar for the first two years of its existence. Then, for the last seven years it's strengthened. If you know nothing else about why or when, don't you think it looks about time for the worm to turn for a while?

Barron's reported over the weekend that GaveKal, a top research firm, thinks so. It expects that worm to turn down hard, in fact, to where the euro will fetch only $1.05 or $1.10 within two years, down from its current level of nearly $1.50.

So, let's say the dollar strengthens, the price of oil drops, and we get those Fed rate cuts everybody is sure are on the way.

Then, say the consumer keeps on shopping -- as happened over the weekend. That will bring retail profits in higher than expected, because nobody expects much of anything at the moment.

As the above come to pass, financial companies wind down their one-time loss announcements and will have successfully set the stage for rosy backward comparisons in future quarters. How hard is it to do better than losing $11 billion, after all? Not very.

Finally, to cap it all off, GDP keeps coming in positive and recession is officially avoided.

While that may not be a recipe for a rip-roaring stock market, it sure seems like a recipe for a higher one than we have today.

Let's not give up on a rosy medium term just yet.

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The Bad News
November 16, 2007

Greg writes:
Don't you think people are too optimistic for a year-end rally to make it actually happen? You know what they say: when everybody's in agreement, everybody's wrong.
I'm not sure what optimism Greg's referring to in his note. I find an abundance of negativity around me.

John McClure at ProfitScore just emailed me this:
The reason that recessions are so devastating is that few see them coming. We are still in a pre-election year which has historically been the best time to be in the market and, for this reason, many have remained steadfastly bullish. But this factor would be more than offset by the bursting of one or more of the bubbles that exist today so that when it comes, it will cause assets to get rapidly re-priced. Based on the data we are now seeing, if this time has not come, it looks like it's just around the corner.
With all the talk of recession, it's sometimes hard to remember that we're not in one, nor are incoming data showing one on the way. The latest was well presented yesterday morning by Dick Green at Briefing.com:
New claims for unemployment for the week ended November 10 rose to 339,000 from 319,000 the week before but remain at levels well below recessionary trends.

The NY Empire State index of manufacturing conditions for November was stronger than expected at 27.4, but down a bit from 28.8 in October. This is just a regional survey but is seen as an early read on November conditions. It is good news.
Then, there's Enzio von Pfeil who wrote on Monday:
We have just now asked the Bank to sell all individual stock positions, the view being that this is the beginning of the end. That is because markets not only swing from buy to sell, but they also start discounting news. So, as we put forth recently, we thought that that by selling in mid-December we would beat the rush to the door. Today, we have fast-forwarded this and sold out completely. . . . We have taken the sales proceeds and will be going into a "short" ETF on the S&P.
Regular readers will recall Mr. Von Pfeil from my disagreement with him about October. He went on "red alert" for October, saying that many of the market's crashes have happened in that month. I said that you should not fear. Indeed, the S&P 500 gained 1.4% in October while the Nasdaq gained 5.8%.

Other dire forecasts include Outstanding Investments editor Byron King calling for $150 oil by December, Bank of England Governor Mervyn King saying that stocks are headed for a severe fall, and the estimable Economist writing that "the United States may well be heading for recession" and expounding:
Dearer oil is set to squeeze households further (this week's drop in crude prices notwithstanding). Consumer confidence has already fallen sharply. It cannot be long before consumer spending stumbles, which in turn would hurt companies' profits and investment. The weak dollar will boost exports, but at only 12% of GDP, exports are too small to make up for a weakening of consumer spending, which accounts for 70%.
I'd say there's plenty of negativity to go around, and that the minority viewpoint would be one looking for higher share prices, not lower.

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The Kelly Letter is Buying
November 02, 2007

We're buying into one of the bargains created by yesterday's sell-off around sub-prime. The Kelly Letter watches and waits for sometimes months before a stock reaches its target price. Yesterday, we went well below our target price and are jumping on the chance.

Do not be afraid of this market. The experts called for an awful October. I responded that it would be fine, and it was. More on that soon.

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Back On Track
October 28, 2007

My continued bullish stance last weekend following a drop in the market was correct.

Last week, despite weak home sales data and high oil prices, stocks rose dramatically:

Dow ................ 13,807 +2.1%
Nasdaq ............. 2,804 +2.9%
Nasdaq 100 ......... 2,195 +3.0%
S&P 500 ............ 1,535 +2.3%
S&P Midcap 400 ..... 895 +1.9%
S&P Smallcap 600 ... 428 +3.0%

People are too worried about the market. Everybody is afraid of getting in at the top of the Dow. They're concerned that sky-high oil prices will sink stocks. They're convinced that housing is doomed and will take down the economy. We'll soon be in a recession.

We've seen these same fears before. Usually, when they're high, the market is poised for gains.

Right now, they're high. Get ready for more gains.

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Here's Your Chance, Latecomers
October 21, 2007

Friday was the crowning moment of a bad week. Caterpillar came in with weak earnings and fell 5%. Such a stalwart collapsing was enough to fold weak hands on the anniversary of Black Monday 20 years prior. Forecasters of gloom raised their arms in victory as the Dow shed 2.6% for the day.

I wrote last month that we would not see another Black Monday, and we haven't. Some disingenuous pundits are using Friday's sell-off to claim prescience in warning us of an impending repeat of 1987. Please. Twenty years ago, the drop was 23% in a day. Friday's 2.6% drop is fairly routine. Anybody in this business knows that and should not exploit the coincidental timing to capitalize on fears.

Another idea I wrote last month was that any weakness this month would be the opportunity for latecomers to finally join the rally underway. I still feel that way. We have weakness, so now's the time to get into the market if you haven't already.

Look carefully at the reasons behind last week's drop: sub-prime, high oil prices, declining dollar, economic uncertainty, accusations of a befuddled Fed. Do you see anything new there? No. It's the same bear list we've seen for a long time. New fears -- unforeseen -- would be greater cause for concern because big drops are usually surprises. Last week was just a normal amount of market shakiness. It's weakness that should be bought. It'll probably persist a little longer, but is nothing cataclysmic.

Keep your perspective here. The market stepped down three rungs on a tall ladder that's gone almost vertical for two months. The dizzying heights have been reduced, but the ladder is still in place and the climbing will resume.

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Getting Killed By Leverage
October 17, 2007

Yesterday's article on leverage sparked conversation. It's the conversation that's always sparked by leverage because you invariably have to say that "it works both ways." Andrew Tobias pointed that out in his inestimable The Only Investment Guide You'll Ever Need.

Wade asked:
If the index falls 50% and you are leveraged 100%, don't you lose everything?
With most investments, yes. With leveraged mutual funds and ETFs, however, no. The reason is that they maintain constant leverage by daily rebalancing of equity and debt, whereby they buy shares when the market rises and sell when it falls. Even though they are selling shares by the boatload as the market plummets, they'll always have some shares leftover.

The main point, though, is whether you can be severely damaged by a leveraged index investment in the event of a big bear market and the answer is: absolutely. This is their downside.

However, can't we say the same about any investment? If you bough Sharper Image for $13 last June, you'd be in bad shape now. It closed at $1.81 yesterday.

Tom wrote:
If we start looking at your example from another date, the results would be very different. Let's say I had invested $10,000 on April 1998, at the start of a short bearish period:

04/98 to 08/98: -50%
08/98 to 08/00: +186%
08/00 to 03/03: -59%
03/03 to 04/06: +220%
04/06 to 07/06: -23%
07/06 to 10/07: +55%

This gives me a return of only 8.86% per year for the past 9.5 years, well below many actively managed funds. Am I calculating this right?
Yes, Tom is calculating right. The unfortunate person who started their investment program in April 1998 is still waiting to see much success.

Is it really the fault of leverage, though?

The total return of the leverage in the period Tom specified was 124%. During that same period, the total return of the Dow was 53% and the Nasdaq 45%. That gives them respective average annual returns of 4.6% and 4.0%.

As for how 8.86% per year since April 1998 stacks up against mutual funds, according to Morningstar, it makes the top quartile. That's pretty good considering that Tom deliberately chose one of the worst times to have begun the investment program.

Both Wade and Tom make valid points. Any leveraging strategy has the downside of magnifying losses. It's possible to time it just wrong and do lousy. Any measure that can be taken to reduce the steep losses helps immensely. We can't count on that skill, however, so I leave it out of my calculations and always include full losses with full gains.

My own ability to time the market has proven to be pretty good, which is why I'll be launching a timing service around these leveraging strategies next year. My hope is to add value by reducing the impact of down markets by being in cash during a portion of them.

A simpler approach is to only use this leverage after the market has corrected at least 20%, or to double your regular contributions to the portfolio during such corrections. Setting a concrete percentage on the decline required to use leverage removes the need for intuition, which is unreliable.

I'll show the benefit of using set percentage levels to change your contribution in a future article.

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Now They Say We're
Climbing The Wall Of Worry

October 14, 2007

Inflexibility makes for bad forecasting. The best forecasters possess an ability to change their minds on a dime, the moment it looks like they've made a mistake, and to re-formulate their assumptions. The worst forecasters maintain their initial forecast even as its reasons disappear, thinking that the market should have done what they predicted and that, therefore, it will get in step any day now.

Five weeks ago, I changed from cautious to bullish. It was a controversial move, attacked on several fronts for its "carelessness" and "ignorance of systemic issues." I was told personally that I had no "regard for the hard-earned savings" of my subscribers. One person told me to "wake up."

As one week of solid returns became two, then four, and now five, the tone of criticism has changed. Instead of re-visiting the initial call, some competing forecasters are just re-forecasting from now as if we're starting fresh, slate clean, forget about what happened five weeks ago. "What's going to happen from here?" they ask, and then re-state their market fears as though they hadn't been wrong for more than month, or more than several years in some cases. It's a clever change of subject and comprises the modus operandi of most in the forecasting business for a simple reason: they're usually wrong.

Typical is the weekend note sent by EquiTrend's John McClure, which always ends with the sign-off "Working for your wealth." Last weekend, it was titled "We Are Climbing The Wall Of Worry" and contained these excerpts:
It was back to a bad news, good action week for the most part as investors chose to look at the data through rose-colored glasses. . . . Dow Theory states that for a trend to be confirmed, both the Dow Transports and Dow Industrials must be trending in the same direction. Although the Industrials have recovered all the territory lost since the July melt, the Transports have struggled. This week the Transports lost ground while the Industrials ended slightly higher. Until they both are heading in the same direction, the trend is in question.

And after falling since September 14, the Market Volatility Index (VIX) jumped this week to 17.73 from 16.91 last week as volatility (and fear) crept back into the market. . .

There are clouds growing on the horizon.

Given that a number of indexes are at or above their 2 standard-deviation trend channel top lines, the next correction could come at any time. Volumes also remain low and there has yet to be the flood of new buyers entering the market that normally accompanies -- and confirms -- a sustained rally.
Mr. McClure is hardly alone when it comes to this type of forecasting. Those who look for sustained rallies are by definition leaving themselves out of the early parts of the rally. That makes their eventual bullish calls risky because they come closer to the day of reckoning, when the market reverses course and heads lower. Then, such forecasters keep their readers invested as the market goes down, down, down until they can confirm that it's a "sustained" bear market.

I wrote about Marc Faber and Enzio von Pfeil on September 25. Mr. Faber said that the U.S. economy is heading toward recession and that the bull market will end. Mr. Von Pfeil wrote, "We are now on 'red alert' for the current month of October."

Mr. Faber has been bearish this entire year. He told Barron's in January, "This economy is in the greatest bubble ever." He then outlined various reasons that the bubble would burst.

In his Oct. 10 article, Mr. Von Pfeil wrote:
Here are some more market chillers protruding from Wall Street:
  • This year, 10,000 guys lose their jobs on Wall Street.
  • Industrial production rose by an annual 6% last September; this August, it rose by 1.7%, i.e. by less than one third. Adieu, turnover.
  • Retail sales peaked at an annual growth rate of 9.2% in 5/06; by this August, they were limping along at 3.9% , i.e. by less than half. Adieu, turnover.
  • Unit labour costs rose by an annual 2.4% in March, 2005; by this July, they were rising by 5.1% -- or by over twice that rate. Goodbye margins.
  • Profits, unsurprisingly, are cooling. Having risen by an annual 6.6% in 1Q05, by 2Q07 they were sputtering at 4.7%, which represents a slow down of nearly 30%.
So how can profits rise if The Economic Time is worsening? We keep sensing that stagflation is on the way.
It's not hard to see the wall of worry. It's also not hard to see who builds it brick by brick.

Nevertheless, the Dow is up 13% this year. Portfolios from The Kelly Letter are up much more than that, as usual:
  • +42% The Dow One
  • +24% Double The Dow
  • +22% Maximum Midcap
The cover of last weekend's Barron's read "Black Monday" and made comparisons with October 19, 1987 when the Dow lost 23% in a day. I already wrote about that in the October issue of The Kelly Letter, from which this is taken:
Where 1987 and today differ is in the valuation of the market. Heading into October 1987, the S&P 500 had a P/E of 22. Today it's just 18.

More damning for 1987, though, were performances. In August 1987, the S&P 500 was up 45% year-to-date and Treasury yields went from 7% to 9%. Those were major warning flags. This year, the S&P 500 topped out at a gain of 10% and Treasury yields never moved beyond 5%. The market is not wildly overvalued.

Don't fear a calamity in October. If we get a sell-off, it'll be a good time for late-comers to join the party that will see stocks higher in the medium term.

That's all it will be.
The solid returns of the past five weeks have not dulled my enthusiasm for stocks. I expect 3Q earnings growth and forecasts of good 4Q earnings to keep this rally going.

We have yet to see strong individual investor participation, which is usually what brings the blow-off top to a bull market. That top is where lots of gains are made. You need to be in ahead of it, not after it's gone on for a while and there's reason to believe it's sustainable.

The market will decline again someday. We can all agree on that. For the time being, though, it's better to own stocks than avoid them.

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Too Many End-Of-Year Bulls?
October 11, 2007

John wrote:
I've been following the debate on whether the pessimists are correct or not, and so far the market is going our way after your bullish call [one month ago]. I have no idea what will happen next. However, my one comment is that I worry about the "sure thing." It is "common knowledge" that the market runs up at the end of the year. It "always happens."

It may well happen again, as it usually does. It's just that when we count on something to "always" happen, the market has a habit of doing what it likes, and sometimes the sure thing evaporates.

I get worried when everyone agrees.
I do, too, but there's nothing near a bullish consensus now. In fact, the switch from cautious to bullish here was met with heavy resistance, even insults.

We're one month into solid returns, but frustrated bears are only nibbling at the idea that the market might rise after all. Read forecasts carefully and you'll see a lot of reference to downside risks remaining high, the October surprise lurking in the shadows, and such. We've decided to charge ahead in full bull regalia despite those fears -- which are always present, by the way -- and so far we've been right.

Even the Fed is hedging, though:
St. Louis Fed President William Poole said Tuesday that the Labor Department's recent employment report implies the economy is not in as much danger as was feared, but conditions remain delicate. On the same day, San Francisco Fed President Janet Yellen said she is uncertain whether further rate cuts will be required to stabilize the economy. "Financial markets appear to be stabilizing, but they have not returned to normal and are still fragile," said Poole. He cautioned that housing will likely remain weak for several more quarters. Yellen believes the rate cut helped to contain downside risk, but she said it is too early to tell whether the economy "dodged a bullet." "I have a totally open mind about what, if anything, is going to be needed from here on in," she said. [Full Article]
While it's true that there's a seasonality to the market, saying everybody is on to it overstates the case. In fact, that "everybody" is generally the Stock Trader's Almanac, which advocates a mechanical strategy that looks to be getting into the market about now for what it dubs the "best six months." I criticized the Almanac yesterday for its rough conclusions about the presidential election cycle, and its best six months strategy deserves equal disdain.

Creating skepticism around the strategy doesn't even take financial analysis. Just think about it. Don't you suppose that if winning in the market were as easy as putting your money in every fall and taking it out every spring, we'd all just create an automatic timer with our brokerage accounts? Sure we would.

Unfortunately, the strategy isn't all it's cracked up to be.

From 1995 to 2005, the Almanac's prized strategy of combining its "best six months" approach with MACD timing to get better seasonal entries and exits returned a cumulative 225%. Just owning the Nasdaq 100 returned 332%, and that's including the dot com crash. How much investment acumen does it take to just put your money in a Nasdaq 100 index fund or ETF? Not much, yet it was far better than the Almanac's seasonal timing strategy.

If you really want to see the lack of research going on at the Almanac, compare its performance to my permanent portfolios. My Maximum Midcap strategy returned 526% just as a lump sum. The extreme volatility of the strategy combined with regular monthly investments did far better, still. In fact, it's that pairing of extreme volatility with assured recovery that makes the strategy so perfect for the way most people invest: by sending additional funds each month or quarter.

One weakness of the Almanac is that its strategies are based and proven with data going back to 1950. That sounds good in theory because they're tried and true. Unfortunately, they appear to be a bit old and stodgy. They certainly don't stand up to the "what have you done for me lately?" rule that most investors employ, whether consciously or not.

For example, the Almanac is proud that its "best six months" with MACD has not had a losing year since 1983. Nice soundbite, but it doesn't mean much when looking at the bottom line. Volatility is your friend when it eventually moves upward. From 2000 to 2005, the Almanac generated these annual returns: +5%, +16%, +6%, +8%, +2%, +8%. Not a losing year, true, but not much in the way of winnings, either. Maximum Midcap speaks for itself.

So, I wouldn't worry about the impression that everybody is on board for an end-of-year recovery. First, they're not. Second, that impression is mostly from the Almanac's touting of such seasonality, which has not proven to be the most profitable approach to stocks.

This comes up every year, we get through it every year, and I'm sticking with my forecast of a strong medium term -- for reasons that have nothing to do with the Almanac's strategy.

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Stock Experts In Typical Disagreement
October 09, 2007

The following exclusive report is from Dave Van Knapp of Sensible Stocks, a frequent contributor to this site:
It's not unusual for "the experts" to disagree on where the market is headed, but the mid-summer credit crunch seems to have sparked a special debate. Here are three expert points of view culled from last Friday's news (October 5, 2007).

From "Daily Trader's Alert" by Sam Collins and his accompanying article at ChangeWave:
At times like these, the sentiment indicators are often referenced in order to give some idea as to where the "smart money" (i.e., hedge funds, institutional traders) is going and whether it is heading in the opposite direction of the "dumb money." (The latter is generally considered to be the investment advisers and the public.)

Recent reports from Investors Intelligence (which tracks the advisers) and the American Association of Individual Investors (AAII) (which follows the public) show that both advisers and the public are now strongly bullish -- and that's not good.

In fact, in July -- just three days after the failed market breakout -- both were at the most bullish levels in months. And in August, again just three days following the market low, both were very bearish.

Now, both are very bullish. And so, you may be wise to continue to hold some cash rather than taking a flyer on the latest tip from your barber.
So Collins is bearish.

But consider John Waggoner's Friday column in USA Today.

Experts point to the fact that investors pulled more money from stock mutual funds in August than in any month since June 2006 as evidence that mutual fund investors (dumb money) have remarkably bad timing at pinpointing market bottoms.

Mr. Waggoner wrote: "Over the years, Wall Streeters have found different ways to watch what the smart money is doing. In theory. . .you'll make good money doing the opposite of what the public [dumb money] is doing. . . . Mutual fund flows are a classic contrary sentiment indicator, under the classic Wall Street belief that the public tends to buy high and sell low."

Stock funds had a net outflow this August (the last month for which data are available). The last time funds had a net outflow (June 2006), the S&P 500 gained 14% in the next 12 months. In August 1998, there was a net outflow, and the market gained 26% for the next 12 months.

Mr. Waggoner concludes, "Buying when most of the public is selling is usually a pretty profitable move. . . . In short, it's better to run to your fund than away from it when other investors are fleeing."

So, looking at virtually the same data as Collins (smart money versus dumb money), Waggoner reaches the opposite conclusion and is bullish.

Waggoner also points out that TrimTabs, which tracks flows of money into and out of the market, is bullish for a different reason: stock supply is shrinking because of all the buyback programs. "We have never seen a contraction like this," said Conrad Gann, TrimTabs's president.

By my count, that's one expert (Collins) who is bearish, one (Waggoner) who is bullish based on the same data, and one (TrimTabs) that is bullish for an unrelated reason.

Jason Kelly and I "put in the call" to enter the market at the end of August and in early September. Of course, we don't know what the next few months have in store, but so far, here are the results of my own stock purchases beginning in late August:
  • Apple - purchased 8/27 - up 20%
  • Bank of America - purchased 8/20 - up 2%
  • Berkshire Hathaway - purchased 8/31 - up 1%
  • Chevron - purchased 9/20 - down 2%
  • Cummins - purchased 8/27 - up 21%
  • Diageo - purchased 8/31 - up 7%
  • Diana Shipping - purchased 9/27 - up 8%
  • GE - purchased 9/25 - up 3%
  • Goldman Sachs - purchased 9/21 - up 10%
  • Johnson & Johnson - purchased 8/20 - up 7%
  • McDonald's - purchased 9/17 - up 2%
  • Noble Corporation - purchased 9/24 - down 6%
  • Pepsico - purchased 8/31 - up 8%
  • Powershares QQQ Trust - purchased 9/21 - up 5%
  • Raytheon - purchased 8/31 and 10/1 - up 1% (averaged)
  • Spider BRIC (Brazil, Russia, India, China) ETF - purchased 9/20 - up 12%
  • Synchronoss Technologies - purchased 9/25 - up 5%
  • United Health - purchased 8/20 - down 5%
  • Zoltek Companies - purchased 8/27 - up 11%
You can see that there are a variety of conservative and aggressive investments, large and small caps, and so on. The simple average of those purchases is up 6.4% in an average of about 4 weeks. Sixteen of the 19 positions are up, and their average gain is 7.7%.

Don't be deceived by the large number of purchases. I am not a short-term trader. (Several of these purchases were additions to positions I already held.) But I had some money to put to work, and when the time seemed right (and my evaluations of the companies and their valuations were encouraging), I put it to work. I am essentially "fully invested," as they say.

So far, the main bases of my bullish call -- the rate cuts, money infusions, and verbal signals of the Fed -- remain in place. I continue to believe the market will be higher in February (six months after the call) than it was in August.

Things are off to a great start.
Indeed things are off to a great start in the past month. As I pointed out over the weekend, The Kelly Letter's permanent portfolios rose an astounding 29%, 14%, and 14% since I changed our stance from medium-term cautious to medium-term bullish.

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Still Bullish After All These Gains
October 07, 2007

Sung to the tune of Paul Simon's "Still Crazy After All These Years," I am still bullish after all these gains.

Stephen writes:
You reported over the weekend that your permanent portfolios are up 29%, 14%, and 14% since your bullish call a month ago (wow!). My question is, Am I too late to the rally?
I'm afraid he's too late for the excellent start to the rally but, no, the market is not done yet.

If you're determined to get in a little cheaper than the levels we saw last Friday, then wait for a slight pullback, but not too much of one. If you wait for doubts to dissipate entirely, you'll wait forever.

For instance, I found this on The Capital Spectator:
The Fed cut rates because it perceives the odds have risen for an economic slowdown, if not worse. If that's good for stocks, how does one explain the past few years, when the Fed raised interest rates in the face of a strengthening economy? . . . Some trouble makers are starting to use the phrase "sucker's rally" to describe the action of late. . . . If now's not a good time to cut back on equities, particularly U.S. equities, when might such a moment come? Call us crazy, but selling high and buying low is still the only game in town. Beyond that generalized view of money management, the devil remains firmly entrenched in the details.
What a lot of folks missed, and won't admit, is that the time to have bought low was a month ago. The time to have sold high was early in summer, when I advised caution over the medium term.

I've analyzed my reasons for being medium-term bullish in recent articles and in The Kelly Letter. In this short installment, I'll just say that the reasons still apply, that you should ignore the bears, and that this is a time to be getting in -- not out -- of the market.

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Don't Miss Any More Of This Bull Market
October 06, 2007

Are you missing out on the bull market?

Bespoke Investment Group wrote on Thursday:
The current bull market is different than any other on record because there has actually been a large contraction in p/e ratios. At the start of this bull in October 2002, the p/e of the S&P stood at 29.06. It is currently at 17.84. There have only been two other bulls that saw contractions, but they were very small. This data bodes well for those arguing that this bull still has legs.
Then, on Friday, "Today's run to new highs in the S&P 500 officially erases all the declines we saw during the summer credit crisis."

As expected here in The Kelly Letter, the credit implosion story has lost its fear factor. The market rose strongly last week against a backdrop of bad news from the credit and housing sectors, because the economy remains strong.

Warnings from financial companies came as a relief since they clarified the extent of losses from sub-prime. Citigroup, for instance, warned of a 60% drop in 3Q earnings because of a one-time write-down. One time. The problem won't last forever and had little effect on anybody except those in high finance. Few waste tears on their paper losses.

Those fearing a recession missed out on a big part of this fall's rally. There are still some calling for a crash of epic proportions this month. The market appears to not share those concerns yet.

It's now been one month since we changed from our medium-term cautious stance to a medium-term bullish stance. I am proud of that courageous call, and subscribers should be proud to have followed it.

In the past month since we went bullish, amid forecasts of recession, a global credit crisis, and a housing meltdown:

> The Dow gained 7.3% and the Nasdaq gained 9.8%

> Our Dow One strategy gained 29.3%

> Our Double The Dow strategy gained 14.4%

> Our Maximum Midcap strategy gained 14.0%

Less than two weeks ago, a reader named Brent attacked my bullish call. He pointed out warnings from Marc Faber and Enzio von Pfeil, the latter having just gone on "red alert" for the month of October. Brent told me to "wake up."

I concluded my response:
While I welcome all viewpoints around here, the most important remains my own and I continue to believe that we're not entering a recession, that the housing "meltdown" just means a great time to be buying a housing stock, and that any weakness in October is another chance for those slow on the uptake to get their money into the market.
You can see the article here.

The fact is we've been right, and that's making people who sat on the sidelines angry. They're looking for ways we got lucky, why the odds were against the market rising and how it was foolhardy for us to have bought in.

Don't pay attention. The best times to buy almost always look the way they did a month ago: scary, lots of emotion, a lengthening list of reasons the market couldn't possibly go up, threat of recession, inevitable systemic collapse, and so on.

Such times are often shrill with the warnings of eminent commentators, people with impeccable credentials who are nonetheless proven wrong.

We haven't seen the end of volatility. I'm sure any whisper to the downside will blare trumpets of "I told you so" from the cowering crowd, but you'll know the truth.

When it was time to buy, they didn't. My subscribers did, and they're richer for it. That makes them investors.

If you'd like to join the ranks of the knowing and have a penny to spare, try the letter's one-month trial. If you like it and continue, it'll only run you five bucks a month -- and you can stop that at any time, too. Odds are you won't, though. A full 85% of those who try the letter keep receiving it forever.

It's easy to see why. We're good.

Our permanent portfolios destroy almost every other service and are the very picture of relaxed investing. Just look at their performance since inception in 2002, and consider that as of last Friday they're up 27%, 23%, and 23% so far this year. They're so good that they're the subject of an upcoming book.

But the permanent portfolios are just part of the letter. Each weekly missive includes market commentary that cuts through the media fog that misleads people, as it did in the past month. It also includes our portfolio of individual positions that gooses performance beyond the core portfolios. We do well there, too.

If you join us today, you'll get the straight skinny on the housing market. We've been watching it for months now for a good entry point on beaten down homebuilder shares. Last week, Citigroup sent the whole sector flying nearly 20% higher as it called the bottom. We don't buy it for a second, partly because Citigroup issued the same call for a bottom last December -- and then watched the stocks lose another 60%. Be careful who you listen to.

Start by listening to me. I'll send you this weekend's note tonight, which includes the scoop on housing, a peek at Yahoo's pending recovery, and a look at whether gold is a good hedge against inflation.

As I mentioned, it's only a penny, you can cancel at any time, and you just might finally join the ranks of those who beat the market, without all the silly fretting that goes on elsewhere.

See you soon! Click here now to join.

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Do Not Miss This Market
September 30, 2007

We've now passed the third higher week since The Kelly Letter changed from a medium-term bearish to a medium-term bullish stance. The validity of that change is still doubted by many and angers many, as evidenced by the volume and tone of hate mail I've received. It comes mostly from people who are not invested, naturally.

The letter's take that the overall market will move higher while housing moves lower, has been spot-on.

Housing continued taking a beating last week. In August, existing home sales fell 4.3% and new home sales fell 8.3%. Prices in 20 of the biggest cities fell by 3.9% in the year to July, according to the S&P/Case-Shiller home-price index.

Also, the most important statistic regarding home builders is, of course, the one that went unnoticed last week. There's a new record of supply on hand, now at 10 months, meaning there's no impetus to ramp up construction soon. In fact, builders need to cut back on construction and consider dropping prices. No growth in construction means no growth in earnings, which means there's no near-term catalyst for stock price improvement.

Fannie Mae CEO Daniel Mudd put the end of the housing crisis a year away still, and said that even from that distant point it will take time "to work its way back." Prior to that, we should see companies with the weakest balance sheets declare bankruptcy. That's always a good sign before bottom fishing a dropping sector.

Consumer confidence hit a two-year low of 99.8 in September, sounding alarm bells to those who don't know any better. There is no correlation whatsoever between consumer confidence and stock market performance. None. Write it down somewhere near your desk for future reference.

That didn't stop CNBC from trotting out its market morticians to predict that this year's holiday sales will produce more coal than carols. Yep, it's that time of year again. The forecasts will be for a weak holiday season and the consumer will, yet again, surprise on the upside.

Your own research is useful in this area. Are you or is anybody you know planning to cut back on Christmas spending because of sub-prime headlines? Probably not, and you're not alone.

The media is making a comparison between conditions at this time of year in 1987 and now. I wrote Tuesday about a forecaster named Enzio von Pfeil who is on "red alert" for October and expecting the onset of stagflation to cause an epic crash.

I do not share these concerns.

Monday, October 19, 1987 is known as Black Monday because on that day the Dow fell 22%, its second-largest one-day drop in history. It's coming again, some say.

There are some interesting similarities. The dollar was dropping back in 1987 and is doing so now. Both years are the second-to-last of a Republican administration. Both years are the fifth in a bull market.

In 1987, the stock market began the year strong, sold off over the summer, and began a nice recovery into October. That's the same pattern we've seen so far this year.

These comparisons are fun for Trivial Pursuit buffs, but don't pack a lot of analytical power for our purposes. There are a lot of years in market history that look similar, but their similarities provided little predictive power even to those who called the patterns early on. Why? Because the patterns generally showed the market to be likely to move higher, hardly a breakthrough because the market moves higher 66% of the time.

If in doubt, bet on a rise, as we do in our permanent portfolios, which are up 15%, 20%, and 22% so far this year.

Where 1987 and today differ is in the valuation of the market. Heading into October 1987, the S&P 500 had a P/E of 22. Today it's just 18.

More damning for 1987, though, were performances. In August 1987, the S&P 500 was up 45% year-to-date and Treasury yields went from 7% to 9%. Those were major warning flags. This year, the S&P 500 topped out at a gain of 10% and Treasury yields never moved beyond 5%. The market is not wildly overvalued.

Don't fear a calamity in October. If we get a sell-off, it'll be a good time for late-comers to join the party that will see stocks higher in the medium term.

That's all it will be.

Last week, the bulk of what we own rose and all of what we're watching fell dramatically. That's the second week in a row we've seen such perfect conditions.

This is a time to be invested. Show what you're made of. Put your money to work against a backdrop of worries, a legion of angry people who swear this market must fall, and a frothy-mouthed media that sees calamity behind every statistic.

We're making money. Are you?

To see what we're up to -- and why we always come out ahead -- please click here.

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Thoughts From The Non-Disaffected
September 26, 2007

Occasionally, it's good to know that not everybody reading my views thinks I'm nuts.

In response to yesterday's article, John writes:
You have to be thick skinned to be in your profession.

Over my 40 years of investing I've observed that about 75% of newsletters have a negative slant most of the time. It seems that only about 5%-10% of newsletters actually give reasonable forecasts in up and down markets.

I have also observed that the more dour the consensus of newsletters, the more the market seems to climb (the wall of worry). I normally subscribe to or read both types of forecasts as at any time you can find both points of view.

Then, based on information from the newsletters and my personal observations, I make my own investment decisions. I usually find myself on the other side of the consensus. I'm not sure that makes me a contrarian, but it has made me a successful investor.

On the basis of my subscription to your letter for the last year, I put you in that 5%-10% of better investment newsletters.
Thank you for that, John. I agree that the majority of letter editors are bearish, and even touch on that point in my stock book. It's always safer to call for trouble and then leave everybody pleasantly surprised when it doesn't come -- people are happier than they expected and nobody complains.

I also agree that a letter is a starting point on the road to better investing. It's a good place to get new ideas and guidance, but a lousy place to turn of the brain and blindly follow.

Chris agrees, too:
I pay a very reasonable price to a smart and successful investor to hear his best ideas for buying individual stocks.

Buying individual stocks is exactly what an intelligent investor should do in a bear market. Stocks go up. Stocks go down. But there's always a bull market somewhere. All of the macro stuff is interesting and not without importance, but much of it is simply noise.

I have investigated a lot of investing services and passed on all except for two. I feel I have more than enough bang for my buck with your newsletter and my Motley Fool Hidden Gems subscription. Thanks for your newsletter as I approach my first year with you.
You're most welcome, Chris.

Finally, Dave Van Knapp of Sensible Stocks has this to add:
Not all predictions are correct (by definition), and yours may not be either. Alan Greenspan just the other day put the chance of a recession at about 33%. I would put it lower, but it is not zero. So your detractors are not 100% sure to be wrong, any more than you are 100% sure to be right.

But my belief is that the market will be higher six months from now, and that the chance of a recession is low. I have been greatly swayed by the Fed's actions a couple weeks ago and its rate cut last week -- that's the main reason I don't think there'll be a recession near-term: the Fed is going to try to stop it, and I think they acted in time.

The only thing I know about the clock theory is that even a stopped clock is right twice a day.
To those who think Brent's comments yesterday were out of line, just remember that maintaining the poise that the market requires for success is not easy for anybody, much less somebody just starting out. It's natural to be buffeted by greed and fear, more the latter these days.

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The End Is (Not) Near
September 25, 2007

Hate mail from the bears keeps coming. Brent writes:
I don't know how you snuck into the top ranks of market forecasters, but your latest call to buy stocks here is nuts. Don't you read anything? Look at Faber, a guru much more experienced than you. Look at that economic clock guy. He's also been at this a lot longer than you -- and his clock is ticking down to one of the great crashes in history. Wake up.
The abundance of fear is what's still providing us with chances to buy select stocks on the cheap. Specifically, I've targeted the beleaguered housing sector where the stock we want to buy plunged 9% yesterday, and we're still waiting.

Marc Faber is indeed a guru who has been investing longer than I. He told ABC TV's Inside Business yesterday that the U.S. economy is heading toward recession and that the bull market will end. He also worried that the Fed would print money to escape the immediate crisis, thereby causing inflation. He believes that housing stocks have farther to fall, a point with which I agree, as mentioned above. Finally, he suggests owning precious metals as a hedge against inflation caused by an excessive printing of paper money.

While Mr. Faber is well respected and indeed more experienced than I, market forecasting and investing has been my job for the past 15 years. In that time, I've learned that the U.S. economy is the world's most resilient, that fearful times are the best for buying stocks, that somebody is calling for a recession nearly every year, but that the market nonetheless rises two-thirds of the time. That means the bears are usually wrong, and I think this moment is no exception.

As for "that economic clock guy," I assume Brent means Enzio von Pfeil, the Hong Kong based creator of Enzio's Clock, an investment cycle timing service.

Mr. Von Pfeil wrote yesterday:
We are now on "red alert" for the current month of October. Many of the bigger market crashes have occurred in October, but nobody knows why. So we are just going to accept the reality of this perception.

Another long-held belief of ours: stagflation is returning. Those of us who survived the oil shocks of the seventies and eighties know this scenario: growth stops and inflation rises.
He cites four reasons that stagflation will return:
  • A strengthening Chinese currency leading to more expensive Chinese products in America, thus inflationary pressure.
  • The weakening of the dollar and his belief that it, like all superpower currencies, must collapse.
  • Rising commodity prices.
  • Slower productivity growth, as evidenced by unit labor costs rising 6x faster than when they bottomed.
With all due respect to my elders in the business, I don't see much rigorous analysis here.

My research into market history shows that currency markets and stock markets are different animals. A direction in one does not say much of anything about the direction of the other.

A "weak" dollar sounds bad, but it's not if you're a Dow investor. Every member of the Dow Jones Industrial Average is a multinational corporation based in the United States. A weak dollar means that when they bring foreign currencies home, they get more dollars of profit. Despite my being still wet around the ears in the eyes of some, I know that more profit is good for stocks. You probably know that, too.

While I welcome all viewpoints around here, the most important remains my own and I continue to believe that we're not entering a recession, that the housing "meltdown" just means a great time to be buying a housing stock, and that any weakness in October is another chance for those slow on the uptake to get their money into the market.

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Fight The Fear And Invest
September 23, 2007

Two weeks ago, The Kelly Letter changed from a medium-term bearish stance to a medium-term bullish stance. Since then, the market has done well:
  • Dow +5.4%
  • S&P 500 +5.0%
  • Nasdaq +4.1%
The letter's permanent portfolios have done even better:
  • The Dow One +18.2%
  • Double The Dow +10.6%
  • Maximum Midcap +6.3%
Now, people are wondering if they've missed their chance to get in the bull market. This note from Hank is typical:
Your change from cautious to bullish in the middle of the housing collapse and sub-prime debacle looked reckless to me. Then the market rose that first week and I thought I'd wait for a correction to get in, but last week was the best in 2007 so far.

But I'm still queasy. Jon Markman -- who is a proven market genius -- wrote on Friday that we're on the verge of a bear market of epic proportions. Housing data came in bad again last week. Oil is at a record high price. And on and on.

You need to be careful, Jason. This isn't a game. It's people's money on the line and you shouldn't tell them it's OK until there's no reason to fear.

With all that in mind, when do you think will be a better time to start?
I've never in my career seen a market free of fear. Never. People who've been in the business longer than I will tell you the same thing. There's always a reason to gripe, worry, and fret, yet the market has risen through most of its history and we have every reason to believe it will continue doing so.

More importantly right now, I just plain disagree with the prevailing view that the sub-prime mess, housing sector downturn, and credit crunch are dangerous. I've written that all along, even last summer when the market was falling and our bearish view in the medium term served us well. Even as I knew that the market would overreact on the downside, I also knew that there was nothing to fear in the headlines then scaring the market. I still feel that way.

In his Friday article, Mr. Markman passed along the views of a credit derivatives expert named Satyajit Das. Mr. Das believes that we're on the verge of a bear market of epic proportions because:
Massive levels of debt underlying the world economic system are about to unwind in a profound and persistent way.

He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.

Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen -- mostly banks and hedge funds that pay him consulting fees -- that the jig is up.
There are problems with this approach to forecasting.

First of all, long-term forecasting -- other than to say that the market will rise in the long run -- is an exercise in coin flipping. The only honest thing to say about the market's course over the next five, 10, 15, and 25 years is that we haven't the foggiest idea.

Second, "the jig" in credit markets was supposedly up two years ago, then last year, then at the beginning of this year, then last spring, then in August, and now yet again. Notice that all we've seen reported are near failures in the system, never actual failures. There's a reason for that. Central banks, hedge funds, investment banks, institutional managers and others have been on top of this credit problem for a while now. It's not inconsequential, but it's not a systemic shutdown and certainly not worthy of the label "epic proportions."

Third, companies are doing well. Did you see Oracle's strong report last Friday? How about Nike's? Apparently they've managed to keep the register ringing during this end-of-the-world moment.

Finally, I am careful and do realize that this is not a game, that it involves real money earned by real people. That's why I work very hard to try to understand what's really happening in the market, not what's being reported. To keep money growing at its maximum velocity requires boldness based on sound research.

It was bold for us to charge back into the market two weeks ago, but it was not reckless. I wrote then that the medium term would be strong in the market, and I still believe that. I also believe that if you haven't put your money to work yet, you should fight the fear and invest.

If you're waiting for a green light and a market that presents no reasons to fear, you'll be waiting forever and your money will stagnate.

Be bold. Join us. Profit when others panic and see the news in a whole new light.

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Van Knapp On The End Of The Credit Crunch
September 20, 2007

Contributor Dave Van Knapp of Sensible Stock Investing updated his thesis on the credit crisis yesterday, and sent it to me last night. I'm pleased to share it with you:
I believe that the credit crisis of 2007 is over, at least insofar as it is likely to impact the stock market. To be frank, it ended somewhat sooner than I expected.

A few weeks ago, I published a thesis about the credit mess. In a nutshell:

1. The credit crunch, begun by sub-prime mortgage lending in the USA, had spread into all areas of the credit markets. Ill-advised loans, over-reaching by unqualified borrowers, and over-leveraged purchases of loan packages had led to spreading defaults, the failure of some hedge funds, and the tightening or withdrawal of credit availability not only in the USA but around the world.

2. Investor sentiment had been badly shaken and would continue to yo-yo. Investors would fret over the credit situation, possible effects on the economy, and the ability of the Fed and central banks around the world to contain damage. They would have hair-trigger reactions to any signs, positive or negative. Therefore, severe market volatility was inevitable. Up and down days would exceed 200-300 points repeatedly, with an overall downward trend until the situation clarified. At the time of the article, stocks had already dropped 6% to 7% from their high on July 19.

3. The Fed and other national banks had begun to respond by injecting massive amounts of money into the financial systems to stave off panic, illiquidity, and recession. It was not at all clear whether such moves would stave off a true economic crisis. However, the initial moves did suggest that the central banks recognized the gravity of the situation and would try to head off grave damage.

4. Investors were likely, but not guaranteed, to recognize that in the overall scheme of things, the credit crisis was limited in size and was unlikely to drag the economy into recession. Pullbacks from the market had driven many stocks down to attractive valuations, and investors were more likely than not to see these as entry points if they could regain confidence that the economy was not going down the tubes. While investor sentiment would swing wildly, on balance it would tilt positive, and the markets were likely to be higher than lower six months hence.

5. Therefore, I recommended that investors (a) look for excellent companies with strong balance sheets; (b) loosen or eliminate sell stops to allow for the likely market volatility over the next few weeks or months; but (c) limit their stock investments to 1/2 or 2/3 of available "stock money" as a hedge against the thesis being wrong.

That thesis has proved quite prophetic. The markets, while extremely volatile, did start to bottom out and trend upward again. It did become more clear that the credit crisis was unlikely to topple the economy into recession.

Now, with Tuesday's slashing of the federal funds rate by 0.5%, and an equal lowering of the discount rate (the amount the Fed charges banks for loans from the government), along with similar moves by central banks around the world, I believe we can declare that the credit panic of 2007 is over.

This does not mean that there won't be more bad news. Some over-leveraged hedge funds and investors may still go belly-up. More borrowers will default, especially as adjustable-rate mortgages reset. Credit will be harder to obtain generally (which is a good thing).

But I now believe it is clear that the Fed and other central banks will contain the damage from the credit crisis. Stock investors can return to more "normal" strategies. Using appropriate caution, they can take advantage of good valuations to purchase shares in excellent companies. If they use sell-stops, they can return them to more normal levels. And they can become fully invested again. There is now a very high probability that the market will continue on an upward trend, and move toward more normal volatility ranges, over the next few months.

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Did You Miss The Rising Market?
September 19, 2007

Alan writes:
Could you have timed your switch from bearish to bullish any better? That was brilliant. I'm kicking myself for not moving money into the market two weeks ago, when you first said to get back in, and then last weekend when you reiterated the call.

My wife said the market looks scary with all the credit trouble, and she worried that banking problems like England's run on Northern Rock might come to the U.S. She said, "People are lining up at banks and you're gonna put money in the stock market?" That scared me a little, so I stayed away. Now, your Dow strategy is up 10% in the last two weeks or something, and I'm frustrated that I let her talk me out of investing.

Do you think I missed the boat?
No, I don't.

Since I changed from medium-term bearish to medium-term bullish on Sept. 10, here's how our permanent portfolios have done:
  • Dow One: +22%
  • Double The Dow: +9%
  • Maximum Midcap: +8%
Keep in mind that a good portion of those returns came just yesterday, courtesy of the Fed's 0.5% rate cut, which sent Double the Dow up 5% and Maximum Midcap up 6% in just a single day. The Fed doesn't cut rates every day and the predictable pop after its doing so may not last, so I wouldn't get overly excited about that.

What I would understand as quickly as possible, however, is that the market is poised for a solid performance in the medium term. If you're still stuck on last month's headlines about sub-prime and shaky credit markets, you're looking in the wrong direction on your calendar. Flip forward, not back. It won't be long until this silly little correction isn't even talked about, and it won't rate anywhere near the top of the issues successfully faced down by the stock market.

Here at The Kelly Letter, we were never afraid of sub-prime. We never thought the "state of the market these days" was scary. We watched all of the action with amusement, and watched for bargain prices, but not for even a minute did we think systemic failure was imminent.

If you did, take this opportunity to look into yourself and ask if you have what it takes to be an investor. I'm not joking. What happened over the summer is not unusual in the stock market. If it rattled you, this business may not be up your alley. If you pay attention to fear-mongering headlines in even the most august of publications, this business is definitely not for you. If your first reaction when hearing how bad things are is to think about what to sell when you should be thinking about what to buy, you need to hang it up while you still have some capital left.

Now, the market won't keep going higher at this pace, of course. Last week was great and this week is off to a heck of a start, but even in a strong medium-term environment, the market won't just rise.

You'll know you've reached a professional stance when your approach to stocks is the same no matter what's in the newspaper. When they say the world is ending, you look for bargains. When they say it's a new world economy and that stocks won't ever go down again, you still look for bargains. The media is a sideshow, folks, and the sooner you realize that, the better.

Directly to Alan's question: No, I do not think it's too late to get in this market. The beauty of my permanent portfolios is that it's never too late, hence their name. What Alan really wants to know, though, is whether he missed the opportunity to get money in for the end-of-year run-up I wrote about.

Obviously, he missed some of the performance, but not all. The end of the year is quite a ways out there still, and the people who think the market is scary will take more convincing to realize that it's not -- and will pile on just about the time the bargains are all gone. That will send prices higher, so there's still upside in this market.

As ever, be smart. Don't put your money in at the highs following the Fed's rate cut. Wait for another scary headline and a price drop. It'll happen along the path higher, which is still intact.

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Highlights From Fortune's "Crisis Counsel"
August 22, 2007

Last week, Fortune ran an article called "Crisis Counsel" that began, "Will the sub-prime lending meltdown and credit crunch send us into a financial free fall? We asked the sharpest minds in business to share their reactions to the downturn, and their insights on the road ahead."

I think you'll find remarkable similarities between their comments and others you've read on this site. The following are highlights from the article.

Warren Buffett, Chairman and CEO, Berkshire Hathaway:
Because many institutions are highly leveraged, the difference between "model" and "market" could deliver a huge whack to shareholders' equity. Indeed, for a few institutions, the difference in valuations is the difference between what purports to be robust health and insolvency. For these institutions, pinning down market values would not be difficult: They should simply sell 5% of all the large positions they hold. That kind of sale would establish a true value, though one still higher, no doubt, than would be realized for 100% of an oversized and illiquid holding.

In one way, I'm sympathetic to the institutional reluctance to face the music. I'd give a lot to mark my weight to "model" rather than to "market."
Wilbur Ross, Chairman and CEO, W.L. Ross & Co:
Liquidity is not about physical cash; it is mainly a psychological state. Subprime problems have consumed only trivial amounts of global cash but already have burst bubbles by shocking lenders. Clever financial engineering effectively had convinced lenders to ignore risk, and not just in subprime. A major hedge fund participated in a loan to one of our companies, but sent no one to a due diligence meeting. So I called the senior partner to thank him and tell him about the non-attendance. He responded, "I know. For a $10 million commitment, it wasn't worth going to a meeting."

The present $200 billion of delinquencies will grow to $400 billion or $500 billion next year because $570 billion more low, teaser-rate mortgages will reset to market and consume more than 50% of the borrowers' income. Therefore most of the loans will be foreclosed or restructured. Probably 1.5 million to two million families will lose their homes. Meanwhile, few lenders will put mortgages on the foreclosed houses, so the prices will plummet. Despite these tragedies, total losses will probably be less than 1% of household wealth and only 2% to 3% of one year's GDP, so this is not Armageddon. However, even prime jumbo mortgages will be more expensive and more difficult to obtain.
John Mack, Chairman and CEO, Morgan Stanley:
I was around in 1987, and that crisis was more disruptive and much more alarming than this is. So was the 1998 foreign-debt crisis. It's not all bad news now. There's still liquidity in the markets. There's plenty of investor money in China, Russia, the Middle East, as well as the U.S.‚ÄČ The rest of the world has developed to the point that, if the U.S. goes into a recession, I don't think we'll have a global recession. I don't think a recession is going to happen, but it's what our central banks have to worry about.
Bill Miller, Chairman and chief investment officer, Legg Mason Capital Management:
These sorts of things are what's known to the academics as "endogenous to the system"--that is to say, they're normal. They happen usually every three to five years. So we had a freezing up of the market for corporate credit in the summer of '02. We had an equity bubble just before that. In '98 we had Long-Term Capital. In '94 we had a mortgage collapse like we're having right now. In 1990 we had an S&L collapse. In '87 we had a stock market collapse. These things flow through the system, and they're part of the system. I saw one quant quoted over the weekend saying, "Stuff that's not supposed to happen once in 10,000 years happened three days in a row in August." Well, I would think that you would learn in Quant 101 that the market is not what's known as normally distributed. I'm not sure where he was when all these things happened every three or five years. I think these quant models are structurally flawed and tend to exacerbate this stuff.

But these events represent opportunities. When markets get locked up like this, it's virtually always the case that you'll have opportunities if you have liquidity. Instead of worrying how bad it's going to get, I think people should be thinking about where the opportunities might be.

The NYSE financial index is probably the best barometer of what's to come. The financials tend to be a very good indicator of where the market's going. They tend to lead the market because they're the lubrication for the economy. So I think the financial index will tell you if this thing is over, and so far it's telling you it's not over. It's still falling. But just as financials lead on the downside, they will lead on the upside.
Jim Rogers, Founder of the Rogers Raw Materials Index:
Historically, when an industry goes through a retrenchment like this, you have two or three big companies going bankrupt and most of the companies in the industry losing money for a year or two or three. Well, we haven't gotten anywhere near that in the homebuilding business, so I think that bottom is a long way off. As far as the credit bubble, we have another several months, if not more, of mortgages that are going to reset and people who are going to find themselves with even higher monthly payments. There are many, many more losses to come, most of which we won't know about for weeks or months.

Normally you have markets go down 10% or so every couple of years. We haven't had a 10% correction in the stock market in nearly five years. I don't know if this is the beginning of it, but we've got a lot of corrections coming. It wouldn't surprise me to see a little bounce--say if a central bank cuts rates. But that will just lead to the markets falling further late this year or next year. It would be better for the market, it would be better for investors, and it would be better for the world if we went ahead and cleaned out the system. If they do cut rates in the U.S., it would be pure madness. Because the market's down 7% or 8% from an all-time high? My gosh, what's that going to say about the dollar? What's that going to say to foreign creditors? What's that going to say about inflation? The Federal Reserve was not founded to bail out Bear Stearns or a few hedge funds. It was founded to keep a stable currency and maintain its value.

I have been and continue to be short the investment banks and the commercial banks. If they bounce up, I'll probably short more. I'm certainly not buying anything. The market's only down 8%. I don't consider that a buying opportunity. The things that I'm short, some people probably think are buying opportunities, but I don't. I've been short the banks for close to a year, and for a while it was not fun. But I added to my positions, and now it's a lot of fun.
Jeremy Grantham, Chairman, GMO:
There is a lot of pain still to be had in the equity markets, particularly aimed at the risky end of the spectrum. We think the fair value on the market is about a third lower in the U.S and EAFE from today and about a quarter less in emerging markets.

Most of that is not because P/E's are high. The great weakness in equities is that profit margins are off the scale globally. They're off the scale for the same reason that the risk premium got so low--that we've had wonderful global conditions, wonderful global growth, wonderful global liquidity, wonderfully low inflation. That will do it every time, without fail. So the profit margins went steadily up under a constant series of pleasant surprises: Global growth was always a little better than expected, consumption in the U.S. was always a little stronger than expected.

Pleasant surprises are the key to profit margins. If you can put together three years of constant pleasant surprises, you will have fabulous profit margins. It isn't to do with productivity, it isn't to do with China or India. It's to do with pleasant surprises. And of course, the longer the pleasant surprises, the higher the hurdle. The hurdle is now desperately high. It is virtually impossible to pleasantly surprise the world now. And profit margins will of course drift or drop down to normal and below. That's the pressure on the markets. That is what causes the market value to be a third less than it is today.

And people don't get that. People always look at P/E and take great comfort. Often it's perfectly fine to do that. But today it's horribly misleading because the main pain is in profit margins.

In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.

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The Cold Facts
August 21, 2007

In my article last Wednesday, Why I'm Not Worried About Sub-Prime, I wrote:
Next, ask yourself how much of the U.S. economy housing represents. By the tenor of the news these days, you'd think half of the U.S. gross domestic product comes from the housing market. It doesn't. Housing accounts for a mere 5% of the economy. Even if housing slipped by 50%, the overall economy would suffer only a 2.5% loss. That's not nothing, but it's not the stuff of The Big One. Besides, housing is nowhere near falling 50%, so we're actually looking at a hit to the overall economy of maybe 1%.

Folks, this is no disaster. The stock market is not finished. We're not seeing the front edge of a storm that will demolish all we've built over the years.
In response to that article, L. Morelli from Colorado Springs wrote:
Your comments on the fraction of GDP are quite correct, but what do they have to do with perception in the market?

When the dot-com bubble burst, the whole market fell 30%. Why? Did people stop buying soap, toothpaste, or food? Did IBM add a dot to its name? Were the dot-com companies 30% of the US economy? Hardly!

So, why are you giving the cold facts? They are just confusing the issue. The market had been going up for a very long time without a correction, and the sub-prime issue is a fine excuse to have one.

Is the economy in bad shape? Not at all. Is the job market collapsing? With 4.6% unemployment, it isn't even close. Have companies stopped turning a profit? No, but the rate of increase has slowed down and will presumably stop at some time. If Americans weren't so bad at math, they would realize that any growth rate of 30% has to stop way before it reaches the size of the national budget. House prices increasing at 20% to 30% per year is unsustainable even in the not-so-long run.

But, then, I am making your mistake, using facts to justify my arguments.

A much better issue is why a family with an income of $145K/year buys a house for $900K with $0 down. Income of $145K/year is not chicken feed, but is not enough to pay a mortgage more than six times its value, unless the residents live a life of pork and beans, Goodwill shopping, a 20-year-old jalopy, etc. That's hardly what one expects from people buying a $900K home. And, guess what? They lost the house.

So, is there an explanation for this situation? I can think of three: greed, stupidity, and bad math, none of which is fixable, especially the second. Cases like these are nationwide and it will take a while before we see all the consequences.

In the meantime, the market will gyrate and hopefully offer some real bargains as in the post-dot-com collapse.
I give the cold facts because to the non-stupid out there -- among whom I count most of my readers by virtue of their choosing my material from a sea of alternatives -- understanding the relatively low threat level of the scare-of-the-moment provides confidence needed to buy when prices are low. Keeping the facts handy when emotions run wild is a good way to see if those runaway emotions are providing an opportunity that the more rational can exploit.

Mr. Morelli is right to flag emotions as a key part of market analysis. The only reason price-to-earnings ratios change is that emotions surrounding the stock or index in question change. We could all agree, for instance, that it never makes sense to pay more than 10x earnings for a stock. If we did so, anybody with a calculator could tell you what a stock will trade for at a future date if its earnings estimates are met.

It never goes that smoothly, though. Emotions magnify the distance traveled in both directions. When the news surrounding a company is bad in conjunction with its earnings falling, people sour on it. "It's dead money," they say. "All past and no future. Move on."

The stock might have sported a P/E of 20 prior to the storm, but suffers both a drop in earnings and a drop in sentiment to drive its price lower than is reasonable. If the earnings fell 10% in a rational world where the P/E never changed, the stock price would also fall 10%. In the real world, though, it falls that much and more as the multiple people are willing to pay also drops.

Look at an example.

Say a home building company named T.R. Norton earns $2 per share and has a P/E of 20. Let's prove to Mr. Morelli that not all Americans are bad at math by grasping immediately that $2 earnings times a P/E of 20 gives us a share price of $40. In reverse, a $40 price (the "P") divided by $2 in earnings (the "E") gets us back to a P/E of 20. All clear on the how the numbers relate?

Suddenly, T.R. Norton hits a rough patch in the housing market and its earnings drop a sickening 40%. Improving the image of Americans yet again, we nimbly subtract 80 cents from $2 to get a new earnings-per-share of $1.20. OK all you American math whizzes, if the P/E remained constant, what would the new share price be? That's right: $24. I know you Americans know this, but for any math-challenged foreigners, I'll explain. The new $1.20 earnings times the P/E of 20 gives us $24. The earnings dropped 40%, so the share price dropped an equal 40%.

That's not how it really goes, though, and here's where our keen math skills reach their limit in the stock market. If all it took were math, professors would be the richest among us. They're not.

What would actually happen is that headlines would report that T.R. Norton is facing the worst business environment it's ever seen, that some analyst somewhere thinks the housing market may never recover, and that the company president recently sold a bunch of shares.

Now, we've got a company that nobody wants. Out go the calculators, in come the animal spirits and bar room commentary until nobody's willing to pay 20x earnings anymore. Are you kidding? For such an out-of-luck, no-future, dead-in-the-water piece of junk as T.R. Norton?

So the multiple drops. Instead of paying 20x earnings, investors are willing to pay just 12x. Take $1.20 earnings-per-share times a P/E of 12 and you get a new share price of $14.40. The earnings shortfall brought the share price down 40%, and emotions brought it down another 40%. Understanding emotions, something even the best calculator won't help you do, was just as critical to analyzing this situation.

When the turnaround arrives, it all happens the same way in reverse. The earnings improve, the news brightens, the image of the company turns up, some analyst somewhere thinks housing looks great for the next five quarters, the president invests a million dollars in the depressed stock, the bar room talk turns in favor of ownership, the multiple expands back to 20, and you get a raging climb in the share price. That's the cheery consensus Warren Buffett talks about being absent among low prices.

Keep the facts in mind because they'll help you see the good news waiting to happen down the road. Once you know the facts, watch how current emotions are ignoring them and take advantage of the discrepancy.

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Van Knapp on Sub-Prime Risk and Reward
August 20, 2007

Frequent contributor Dave Van Knapp of Sensible Stock Investing sent to me over the weekend an excellent report on the current situation. I read it with the intent to excerpt, but decided instead to provide it to you in its entirety, as it contains nothing irrelevant and is consistent with the view I've presented in outline form on this free site and in depth to Kelly Letter subscribers.

Subscribers and I remain firmly in bargain hunting mode, not rashly buying anything that drops, but setting and adjusting price targets as waves of sentiment roil the market. As Dave points out, there's a chance to get extremely low valuations on excellent companies.

Here, then, is Dave Van Knapp on sub-prime risk and reward:
The past four weeks have provided a great example of stock volatility within a downward trend. No sooner did the Dow set an all-time record on July 19 by breaking 14,000 than the markets went into a volatile tailspin: Up-days and down-days have several times exceeded 200-300 points, but overall the market is down about 6%-7% since July 19.

This provides a terrific real-time opportunity to think about market volatility, corrections, and downdrafts -- and then to act in accordance with your conclusions. In short, what's the best thing to do right now?

Let's set out a few facts:
  • The current tailspin was begun by sub-prime mortgage lending in the USA. Defaults on such loans have caused the mortgage market to partially seize up, meaning that less money is available, and only under more stringent conditions, than before the situation developed. It is fair to say that the mortgage market went into a bubble, and that the bubble is now deflating or collapsing.
  • The sub-prime mortgage mess began a chain reaction that has spread through the credit markets and out into the stock market. Important links in the chain include:
    • Sub-prime mortgages were bundled into packages ("securitized") and sold to hedge funds, banks, and other investors.
    • Hedge funds (in particular) not only purchased these securities, but did so with high leverage: As much as 70% or more with borrowed money.
    • As mortgagors have defaulted on loans, the collateral supporting the mortgage-backed securities has collapsed.
    • Thousands of variable-rate mortgages will reset to higher interest rates over the next few years. We can expect that as they reset, some owners will default, unable to make their new higher monthly payments.
    • The difficulties in mortgages have spread to other credit markets. For example, the loans banks made to hedge funds were themselves sub-prime, although nobody called them that. In other words, because of the risk inherent in the hedge funds' investments in securities based on sub-prime mortgages, hedge funds have run into debt crises of their own. A few have already collapsed, and others can be expected to follow.
    • The country's largest mortgage lender, Countrywide Financial, has veered near the edge of bankruptcy, nearly running out of money to continue normal operations, until it borrowed a massive amount of money last week to be able to continue. Smaller lenders have already failed. Some others can be expected to fail, including possibly Countrywide itself.
    • The problem has spilled over into the stock market via several paths. One is that margin calls have gone out, predominantly to hedge funds who own highly leveraged stocks. Forced to raise cash, the hedge funds have been forced to sell stocks, contributing to the market's overall decline. A second is that hedge funds (and others) have been selling stocks that they "own short," because those positions have turned badly against them (i.e., they are in what is known as a short squeeze). Beyond that, many investors have panicked, particularly about financial stocks (banks, mortgage lenders, etc.), sending their prices into a disproportionate tailspin. Yet further, private equity deals are grinding to a halt, as the money to finance them becomes unavailable (private buy-outs are usually highly leveraged). Many market-watchers agree that private buy-outs helped fuel the market run-up earlier in the year. That propulsion is over, at least for a while.
  • National banks around the world, fearing a liquidity crisis, have been injecting massive amounts of money into the financial system to stave off panic and illiquidity. The Fed has done so several times over the past week or two, sometimes quietly, other times with fanfare and press releases.
  • On Friday, the Fed surprised by lowering its discount rate (for direct loans to banks) by 0.5% to 5.75%, which is another way of adding money to the economy.
  • But so far, the Fed has not lowered the more important Federal Funds Rate, the one that impacts most other interest rates and serves as a benchmark for millions of consumer and business loans. The Fed has kept that rate at the same 5.25% level it has maintained for over a year. The Fed's next scheduled meeting is in September, although the Fed can act at any time. Many economists are expecting the Fed to lower the Federal Funds rate to further ease the economy. But the Fed, by its own statements, has been reluctant to touch that rate, because it is trying to keep inflation to about 2% or less. (Lower interest rates tend to encourage inflation.) Besides, overall the economy is considered to be in good shape.
  • Pundits, economists, and investors are split about the big-picture importance of the credit crunch. Some maintain a "not too worried" stance, pointing out that the mortgage market is a tiny fraction of GDP, and that even in a worst-case scenario of massive defaults, the economic impact will be small -- much less than the impact of the savings-and-loan crisis of the 1980's. They feel that the markets will work the problems out on their own, and some believe that the government has already gone too far in "bailing out" lenders and borrowers who participated in ill-advised loans. At the other end, some experts feel that the crisis is going to get much worse, last much longer, and affect a wide swath of the economy. Supporting this "very worried" position, they say that we don't yet know the depth of the crisis, how many huge sub-prime loans banks may have in their portfolios, how tight credit may really get as lenders pull in their horns, nor how consumer and investor confidence -- and ultimately the entire economy -- are going to be affected.
  • Many stocks, because of the downturn, are at very low valuations, and many pundits believe that we have reached a once-a-decade buying opportunity despite potential short-terms risks.
  • Economic and company-specific fundamentals are fine. The just-ending earnings season showed strong results. Many excellent companies are doing well, are growing in a healthy fashion, depend little on debt, and have no weaknesses on their balance sheets.
  • Warren Buffett, Hall of Fame investor, has said, "The first rule is not to lose. The second rule is not to forget the first rule." Most stocks have lost quite a bit in the past few weeks; investors would have been better off in cash rather than stocks, although that (of course) is old news now. Buffett has also said, "...Attempt...to be greedy only when others are fearful." Obviously, there is some tension between these two principles. Those investors who are fearful are fearful because their stocks have been losing money and they cannot see a clear end to that.
What does this all mean to the average individual investor? Is it time to be greedy or fearful? Is it time to protect against further losses (by selling stocks), or is it time to purchase first-class companies at rock-bottom prices? Are the past few weeks the beginning of a bear market, or just a "correction" that will reverse itself as the credit mess unwinds and as investors regain confidence in the fundamentals? Will the Fed ride to the rescue, on the one hand, or on the other hand (1) limit their intervention and allow the markets to penalize stupid investors or (2) focus too much on fighting inflation to the detriment of the economy and the stock market? What is investor sentiment likely to be, short-term, medium-term, and long-term?

What would Warren do?

The subject is risk management. That means taking actions to safeguard your money from the possibility that any investment decision is wrong -- including decisions not to invest (which can cost you money you would have made had you invested) as well as decisions to hold onto investments or to invest even more.

If the subject is risk management, what are the risks right now? I'd say these are the top three:
  • The credit problem, already something of a crisis, will turn into a catastrophe. There are probably many dangerous loan situations out there that we don't know about yet, and the trend will be for the credit markets to seize up for many months to come. That will continue to spill over and negatively affect the economy and the stock market.
  • The economy will tip into recession. That will also negatively impact the stock market. Companies will fall not only in stock price, but in actual performance. Rather than get conservative, some companies will throw risky Hail Mary passes and lose.
  • The Fed will make the wrong moves (which could be inaction or over-reaction), or it will wait too long to make the right moves.
Risks usually have counterparts: potential rewards. What are the possible opportunities given what we know now? My top three:
  • The worst of the credit crunch is already over. The credit machinery of the economy will emerge stronger, as lenders and borrowers learn from their mistakes and reinstitute old-fashioned sound lending standards, to the long-run benefit of all.
  • The Fed will make the right moves at the right times. The economy will continue growing, and no recession will result from this situation.
  • Many stocks are extreme bargains right now, and investors should consider this a buying opportunity -- but be willing to withstand some short-term volatility (i.e., paper losses) for a month or three while the market settles down. It is a good time to purchase the stocks of companies that are sure to weather this storm, not to sell out. In a few months or a year, the market will return the prices of excellent companies that are now in the bargain bin to more rational levels. Today's buyer will be tomorrow's winner, not those who flee.
Prediction: The second list -- the list of opportunities -- is more likely to occur than the first list, although that is certainly not a slam dunk. Reasons for thinking this:
  • Investors are likely to recognize that the credit crisis is limited in size even as they cannot be sure about its duration nor about exactly where it is going to continue to pop up in the coming weeks.
  • The low valuations on many excellent companies are likely to prevail over the fear that the credit crisis will ruin the economy.
  • By its injections of money into the economy over the past week and by its rate-lowering action Friday, the Fed has signaled recognition of the importance of maintaining not only actual liquidity, but also the appearance of liquidity, in the economy and the markets.
  • The strength of practically all economic and company fundamentals -- other than the credit crunch itself -- is likely to prove persuasive on investor sentiment over the impact of the credit crunch.
  • The credit crunch -- whether the worst is over or not -- is already reversing, what with the Fed's action Friday, the shuttering of some hedge funds with the worst difficulties, the reinstitution by banks of more traditional and conservative lending standards, and so on.
Conclusion: What is likely to happen over the next six months:
  • There will continue to be revelations of serious credit problems in various areas, both in the mortgage markets and in other credit markets.
  • More hedge funds will collapse. Some banks and financial institutions will be revealed to have more exposure to "worthless" credit assets than previously thought. The stocks of these companies will fare poorly even if the market as a whole rises.
  • Lending standards will become tighter for mortgages, commercial loans, loans to hedge funds, and the like. Cash-rich companies (who have no need for credit) will benefit in comparison to companies which need a high debt load to operate.
  • Investor sentiment will yo-yo as different revelations come to light. As a result, the stock market will remain very volatile for a while longer. Up and down days of 200+ points on the Dow will be fairly common.
  • The Fed may abandon (for a while) its tunnel-vision focus on keeping inflation to 2% if that proves necessary to head off a recession. They may or may not lower the Federal Funds rate, depending on conditions as they unfold. They will continue to take other actions to insure liquidity in the economy.
  • Investors will be all over the map on whether this is a time to be fearful or greedy, but on balance, the tilt will be towards seeing this as a buying opportunity. This "blended sentiment" will be based on the extremely low valuations (bargain status) of many excellent companies.
  • As a result of overall willingness to buy, the stock market will be higher in six months than it is now, perhaps back to its July 19 level if not higher.
Action steps:
  • To the extent you have cash to invest (either new cash or the proceeds of stocks you have recently sold), look for excellent companies with strong balance sheets to invest in.
  • If you use sell stops to protect on the downside, either set them wider than normal, or don't set them at all, putting your faith instead in the foregoing analysis. The wider sell-stops are to allow room for the likely market volatility over the next few weeks or months.
  • Because the conclusions above are not slam dunks, limit your stock investments to 1/2 or 2/3 of your available "stock money." Neither be fully invested nor flee the market.

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Stratfor on Sub-Prime
August 16, 2007

I wrote yesterday that the sub-prime mess doesn't worry me because it doesn't affect a large enough portion of the economy to bring on disaster.

Stratfor Founder and Chief Executive Officer George Friedman agrees. From his August 13 Geopolitical Intelligence Report:
Stratfor views the world through the prism of geopolitics. Not all events have geopolitical significance. To rise to a level of significance, an event -- economic, political or military -- must result in a decisive change in the international system, or at least a fundamental change in the behavior of a nation. The Japanese banking crisis of the early 1990s was a geopolitically significant event. Japan, the second-largest economy in the world, changed its behavior in important ways, leaving room for another power -- China -- to move into the niche Japan had previously owned as the world's export dynamo. The dot-com meltdown was not geopolitically significant. The U.S. economy had been expanding for about nine years -- a remarkably long time -- and was due for a recession. Inefficiencies had become rampant in the system, nowhere more so than in the dot-com bubble. The sector was demolished and life went on. Lives might have been shattered, but geopolitics is unsentimental about such matters.

The measure of geopolitical significance is whether an event changes the global balance of power or the behavior of a major international power. Looking at the subprime crisis from a geopolitical perspective, this is the fundamental question. That a great many people are losing a great deal of money is obvious. Whether this matters in the long run -- which is what geopolitics is all about -- is another matter entirely.

When the subprime defaults started to hit, the banks that had loaned money against the mortgage portfolios re-evaluated the loans. They called some, they stopped rollovers of others and they raised interest rates. Basically, the banks started reducing the valuation of the underlying assets -- subprime mortgages -- and the internal financial positions of some hedge funds started to unravel. In some cases, the hedge funds could not repay the loans because they were unable to resell their subprime mortgages. This started causing a liquidity crisis in the global banking system, and the U.S. Federal Reserve and the European Central Bank began pumping money into the system.

Told this way, this is a story of how excess emerges in a business cycle. But it is not really a very interesting story because the business cycle always ends in excess.

There currently are three possibilities. One is that the subprime crisis is an overblown event that will not even represent the culmination of a business cycle. The second is that we are about to enter a normal cyclical recession. The third, and the one that interests us, is that this crisis could result in a fundamental shift in how the U.S. or the international system works.

We try to measure the magnitude of the problem from the size of the asset class at risk. But we work from the assumption that proved true in the S&L crisis [of the 1980s]: Financial instruments collateralized against real estate, in the long run, limit losses dramatically, although the impact on individual investors and homeowners can be devastating.

The S&L crisis involved assets of between 8% and 10% of GDP. The final losses incurred amounted to about 3% of GDP, incurred over time.

The size of the total subprime market is estimated by Reuters to be about $500 billion. This is the total asset pool, not nonperforming loans. The GDP of the United States today is about $14 trillion. That means this crisis represents about 3.5% of GDP, compared to between 9% and 10% of GDP in the S&L crisis. If history repeats itself -- which it won't precisely -- for the subprime crisis to equal the S&L crisis, the entire asset base would have to be written off, and that is unlikely. That would require a collapse in the private home market substantially greater than the collapse in the commercial real estate market in the 1980s -- and that was quite a terrific collapse.

Unlike commercial real estate, in which price declines force more properties on the market, home real estate has the opposite tendency when prices decline -- inventory contracts. So, unless this crisis can pyramid to forced sales in excess of the subprime market, we do not see this rising to geopolitical significance.

From this, two conclusions emerge: First, this is far from being a geopolitically significant event. Second, it is not clear whether this is large enough to represent the culminating event in this business cycle. It could advance to that, but it is not there yet. We cannot preclude the possibility, though it seems more likely to be a stress point in an ongoing business cycle.
I reiterate a point I made yesterday on this free site and have made repeatedly to subscribers: smart investors are looking for chances to buy in this downturn.

That doesn't necessarily mean piling into what fell the most yesterday. It means knowing in advance of the sale what you think could be unjustly marked down in the likely mood ahead. Watching the list of such targets in a market-wide scare, waiting for them to get to prices that seemed impossible just weeks before, and then buying at a significant discount to profit when -- yet again -- the crisis passes, is the way to wealth.

I'm pleased to note that the home builder we're watching to buy fell another 16% yesterday. That stock, as just one example, is now selling at an 81% discount to its September 2005 price. Insiders bought recently, an encouraging sign. I wrote to subscribers over the weekend about this stock: "My initial buy target is $17, which is 16% below Friday's close." We already got there, but we haven't bought yet. This sale isn't over.

Watching and waiting is the key to this business and this is the time, folks! Crises that look frightening to the general public but are non-events to those who live in the market are manna from heaven.

When others look back in six months or a year and say, "Darn, I should have bought something," smart investors will smile and say, "I'm glad I did."

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