Defend & Advance

March 10, 2008


The Bulls are still hoping that Fed rate cuts will turn stocks around. They need to get with it! In July 1997, we entered a period of excessive currency devaluation initiated by the collapse of Asian financial paper, which resulted in 35%-85% declines in emerging market stock markets from 1997 to 1998. The response by global monetary authorities was to cut rates, which was coordinated with government fiscal stimulus—all of which led to excessive credit creation that developed into an induced business and investment cycle, the likes of which we have not seen since the 1920s and 1930s. This was the last time the Fed Funds Rate was positively correlated to stock prices (bond prices were very negatively correlated) for more than a decade.

We will continue to report on Figures 11 and 12 to see when inflation risk once again overrides default risk. Crude and commodity prices are telling us that the reassertion of this risk, which dominated the markets from 1968 through July 1997, will most likely be returning soon. The Fed sure hopes it does soon!

We did not part with emerging market shorts because they hedge recession risk. We expect to cover some near $124.

We first introduced Figure 15 in our March 2007 installment, Yen Rising, Dollars Setting, which made the case for employing a long yen (FSY) to hedge equity declines. In April 2007 and November 2007, we also initiated additional currency hedges. We added long Swiss franc exposure (FXF) and we shorted the carry-trade via selling short the shares of DBV.

A steep yield curve is bad for stocks and the U.S. dollar. It is great for inflation hedges (GLD, GDX) and short-term Treasuries (SHY). The red line in Figure 16 tracks the difference between 10-year T-Note and 2-year T-Note yields, which has widened dramatically since November 2006 in response to Fed rate cuts and greater inflation fears. Mr. Market hedges risk.

Hedges can be very volatile consequently; they need close monitoring. Portfolio A is overweight gold and gold stocks with a 15% allocation to GLD plus 15% to GDX. Figure 17 compares Hecla Mining Co. (HL) gross profits with price changes in the primary metals mined. Overweight positions are justified by strong top-down economic fundamentals (Figure 16) and by bottom-up, company-specific (and/or sector-specific) support. HL is one of many mining stocks tracked to justify our positions.

How Do You Value The Unknowable?

Chris Whalen, founder of, emailed me the quote below in reference to MBIA, one of the troubled monoline bond insurers that have rocked our world in 2008.

"Why did the investing public turn its attention from dividends, from asset values, and from earnings, to transfer it almost exclusively to the earnings trend, i.e., to the changes in earnings expected in the future? The answer was, first, that the records of the past were proving an undependable guide to investment; and secondly, that the rewards offered by the future had become irresistibly alluring. The new era concepts had their roots first of all in the obsolescence of the old-established standards. During the last generation the tempo of economic change has been speeded up to such a degree that the fact of being long established has ceased to be, as it once was, a warranty of stability."

"The New Era Theory"
Security Analysis
Benjamin Graham & David Dodd (1934)
MBIA’s (MBI) stock price is pure speculation. In the January 31, 2008, press release included in the 8-K dropped on that date, MBI speculates that its reported losses from collateralized debt obligations (CDOs) WILL MOST LIKELY IMPROVE. Many value investors took heart from the company’s statement to substantiate their recent purchases of deep-value MBI shares.

Marty Whitman of Third Avenue Value Fund (TAVFX) has contributed much to our profession and he has an enviable track record. However, I cannot understand how Mr. Whitman (and other value investors) bought much of their MBI stock near $30 per share during 2008 Q4. Perhaps they should read (again) Chapter XXVII of Graham & Dodd, from which the quotation above was excerpted.

Mr. Whitman also bought mortgage insurer Radian Group (RDN) in October 2007 after the company announced heavy losses related to investments in the subprime mortgage market. In addition, in early September he grabbed rival MGIC Investment (MTG), the country's largest mortgage insurer. He most likely purchased RDN and MTG near $17 and $30.

Here is the opening line in "3 Bargain Stocks," an article by Yuval Rosenberg of Fortune published October 23, 2007:

Marty Whitman, the dean of deep-value investors, identifies stocks he considers 'safe and cheap.' His picks will surprise you.

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