The Spin Stops Here

THE PRICING OF OIL: It never ceases to amaze me how little is known and understood by all the talking heads that we see and hear on TV pontificating on the topic de jour: Today’s being the price of oil. From our Know Nothing politicians all the way through to our oil traders, none of them seem to understand how the price is determined in either the Futures or Spot markets. ECONOMICS 501: There are two primary concepts, apart from supply and demand, both acting in concert that determine price. # 1 is Expectations and #2 is Marginal demand and supply (a very difficult concept to grasp). It is the price of the last barrel that determines the price of all the others. Price is based on the resolution of the sum total of the expectations of both suppliers and consumers as to where they think price will be in conjunction with the bidding between the buyer and seller for the last barrel. That is why a company like Amazon can sell for $400 per share even though they had emphasized that they wouldn’t have any earnings for 5 years or how a Google can sell for 500 times earnings. The only reason is expectations, in these cases, of future profits. If the US Congress announced tomorrow that ANWAR and off-shore FL and CA. were now open to full exploration, the price of Oil would drop $50/barrel within 5 minutes of the announcement, even though there would not be a single change in either the supply or demand for oil that day or for the near future: But the EXPECTATIONS picture would now be a lot different. Once the producers of oil expected that prices would drop, they would be out there producing and selling every drop of oil they possibly could in an effort to beat the price drop. Then we would find out just how large production capacity really is. At the same time, consumers would only bid for their immediate needs less what they already had in storage (which they would now be losing money on) and individuals would no longer be topping off their tanks. There would then be a whole new dynamic in place of real immediate demand bidding for real immediate supply. When you have a bunch of politicians, none of whom understand how a free market works, the best thing that they can do is get out of the way and lets the free markets work. What chance is there of that happening?

ARE WE IN RECESSION?

U.S. households lost $1.7 trillion in Q1, with personal net worth falling at a striking annual rate of 11.3%. New debt growth was only 3.5%, the slowest in 15 years. Do we really have to wait for Bernanke to tell us that we are in Recession? The evidence of slower growth is now visible in the rather startling contraction in gas consumption. Just as the heavily traveled Memorial Day long weekend began, MasterCard reported that gas consumption, based on credit card charges, had fallen by more than 6% over the last four weeks. During the seven days of the Memorial Day weekend, Americans bought 28.8% less gas, a huge drop! Clearly, soaring prices are finally beginning to have their impact as per the Laws of Supply and Demand. For this reason and the obvious parabolic nature of the crude oil chart, I believe oil prices are now being propelled strictly by Johnny come lately speculators (they always get killed) as demand has clearly peaked and if not yet, will very shortly to be followed by a huge correction in price, maybe to as low as $80 per barrel?

Like I warned you back in December 2007 in my letter, “DENIAL is not just a river in Africa”, Just because we were saved from what would have happened that Monday if Bear Stearns had gone under, doesn’t mean we were saved from all the forces that conspired to get Bear Stearns to the brink in the first place. The worst is yet to come as the sub-prime mess spreads, first to Alt-A, then to Prime and finally to commercial mortgages and real estate. Also, let’s not forget about the entire student, consumer and car loans that are out there on the books of all banks and that have also been collateralized. They too, should be considered as the equivalent to the Sub-prime mess.

The inevitable derivative fiasco, of which I have also been warning about for the last several years, have admitted to their first losses totaling over $382 billion. This forced financial firms to raise $270 billion in new capital, resulting in a shortfall of at least $112 billion for the purposes of issuing new credit. Using a typical (reduced) ratio for leverage of roughly 14:1, we see that there is now $1.5 trillion ($112B X 14) less credit available. Given that, it now takes an estimated $5 of credit to create $1 of expansion GDP. Everyone’s friend, Big Ben, will have to get back into the money creating business in a big way, just to stay where we are. (Whoops, there goes the dollar.) THE BIG QUESTION IS: Is there a limit as to how much money can be created without destroying the dollar?

The amount of municipal bonds that have defaulted thus far this year is already more than triple the $226 million that it was for all of 2007 and there is more bad news to come. Ambac and MBIA, both of which are technically bankrupt but are too dumb to lay down, are staring at more nails in their coffins as Municipal Bonds start to default in a big way, like we saw in Vallejo, Ca. In turn, Muni’s and their ratings are also about to change in a major way. There is no possibility that the Monolines will be able to survive such an onslaught. The record year was 1991, when almost $5 billion went bust. That's still small potatoes compared with what will happen over in the corporate bond market, where $36.6 billion blew up in 2006 and almost $240 billion in 2007.

OPTIMISM

The only optimism lies in Wall Street where the fraud originated and continues on to this day. The key question no one seems to ask is where will all the money come from to offset all these losses. The U.S. banks have only $130 billion in reserves with an estimated $800 billion or more in losses lying there just over the horizon, waiting to be written off.

LEHMAN & CITY: WHAT HAS HAPPENED TO COMMON SENSE?

Any time there is only a 15% to 18% conversion premium on a convertible, you have a no risk, can’t lose convertible hedge; where you buy the convertible and short the common and if they will pay you 9% dividends, who in their right mind would buy the common? Secondly, with a discount rate at 3.5%, why would Lehman or Citi willingly pay 9% and 11.5% dividends that are not tax deductible? This means it’s costing them 12% and 15% respectively. Even junk bonds don’t have to pay that much and they are not convertible. Standard & Poors announced in late May that it has cut or might cut debt ratings on $34 billion of securities tied to Alt-A mortgages, whose type issued in 2007 already have a default rate of 6.64%.

Large S&P downgrades might soon force Wall Street firms to move up to $5,000 billion ($5 trillion) of assets from off-balance sheet locations back onto their books. The Federal Deposit Insurance Corp (FDIC) has declared 76 banks as officially ‘Troubled,’ a rise from the 50 at the end of 2006. The worst still lies directly ahead for banks and their stated losses. Panic might set in within a few months time. Structured Investment Vehicles (SIV) and now Variable Interest Entities (VIE) constitute the shell game for insolvent giant banks avoiding honest balance sheet reporting. It is estimated that impaired mortgage related assets of up to $784 billion remaining in VIEs are scattered across major Wall Street and Money Center Banks as an avalanche of bank write-offs looms in the not too distant future.

New Muni Bond underwritings are virtually dead! Delays by banks on credit asset portfolio write-downs create risks perhaps greater in the United States today than they were in Japan in the 1990s. Lehman Brothers stock has massive open option puts, especially at strikes that would only pay off if LEH completely imploded, with some even that expire in June. This looks like an identical situation to Bear Stearns just three months ago. Lehman Brothers is in serious trouble, no matter what management claims. The Credit Default Swap for Lehman Brothers corporate bonds has jumped from 130BP at end April to 240 at end May and to 275 in early June. In 1Q 2008, Lehman admitted to a mere $200 million in losses from the oversized $6.5 billion portfolio of sub-prime securities on its balance sheet. I, for one, would certainly not want to own any Lehman securities.

Countrywide is in danger as Bank of America could quickly force its bankruptcy. The implication is that the credit market will realize that the financial storm is nowhere near an end. They originated almost 20% of the US mortgages in recent years. Countrywide could end up as the largest bank bankruptcy in US history. Ripple effects would be enormous and cause contagion across the banking industry. The National Association of Realtors reported that the 1Q 2008 showed single family home prices to be 14.1% lower than Q1 of last year. Home values provide the collateral basis for the majority of bank assets. Did I hear anyone say buy Gold?Without a sizable improvement in the financial sector (representing 40% of the S&P), I cannot envision a sustainable rally in the US stock market. CNBC’s latest headlines stating that – following two consecutive months of gains on all major stock indices, the worst for the economy is over – sounds to me like nothing more than the usual Wall St. cheerleading and or is it just whistling past the grave yard?

The present day mortgage (real estate) crisis is eerily similar to the savings and loan crisis. Although we manage to fix it, we seem to have learned NOTHING from it because Congress could or would not blame itself so it spent all its time, just as they are doing today, looking for scapegoats. The creation of a new Resolution Trust Co. (RTC) is an absolute must, but probably won’t take place until after the elections. That event will create systemic conditions very favorable to gold, silver, and their mining stocks. Until then, banks are just playing shell games, shifting bonds among themselves as inflation marches steadily upward with the government no longer able to mask inflations rise.

NOTE: NOTHING MOVES IN A STRAIGHT LINE: So don’t let bounces trap you into believing happy days are back again. I have been short BAC, C and LEH since the day they announced how they raised their capital and fully intend to stay that way.

LIQUIDITY, LIQUIDITY, LIQUIDITY

Standard & Poor’s placed Wachovia on Credit Watch as part of a broader review of investment banks. S&P also lowered its ratings on Lehman, Merrill Lynch and Morgan Stanley. S&P also revised downward its outlooks on Bank of America Corp. and JP Morgan. The negative actions taken basically by insiders, in my opinion, reflect prospects of continued weakness in the investment banking business and the potential for more write-offs, some possibly larger in magnitude than those of the past few quarters. If you are afraid to short them, at least don’t get caught trying to catch a falling knife.

HEDGE FUNDS

Hedge and are supposedly in the opposite end of the spectrum. But they are as leveraged and vulnerable as you can get, especially since they don’t seem to appreciate the concept of the role of LIQUIDITY. The term 'Hedge Fund' so egregiously misapplied is exactly like another venerable and previously inaccurate term of the early 1980’s: Portfolio Insurance. In the mid 1990’s, the media invented the term 'market timer' for people who cheated the market by back-stamping the times of their trades. Market timers and hedge funds used to be considered practitioners of decent professions. Now the terms are used for people who run—or are perceived as running—scams. The ticket back-daters should be called frauds, and today’s so-called hedge funds should be called HIGH RISK, leveraged, gunslinger funds. Investors in these funds also seem to believe that their managers will buy and sell as necessary in anticipating market conditions, as if they are smart traders. But they are not traders. They are buyers on leverage. There is hardly a trader among them. Traders go long and short and sometimes they go to cash, depending on their market outlook. But buyers just buy. Does this not sound familiar? It should, because the spec-fund phenomenon since 2003 has been nothing but a beefed-up, more-leveraged version of the equally erroneously named 'day-trader' phenomenon of 1999-2000. Back then, mild corrections in the stock market in 1999 and 2000 decimated these so-called traders who were really just buy and holders. Think back to 1987 when these very same recent graduate geniuses invented Portfolio Insurance so that when they got caught in a down draft, they ended up causing the largest one day drop in history and the second largest market crash since 1929. Be careful that you don’t get caught as “History Repeats.” The words “trader” and “hedger” are used as if it meant someone ultra smart rather than just a “buyer.” A buyer is not a shrewd trader or hedger, they don’t even know what hedging means. Stocks like Bear Stearns, America Online, Lehman and others that move down 29%, 60% or 82% should be a bane for day traders. Those are huge moves; their direction is irrelevant. An actual trader should be able to make money from them, but a buyer cannot. 'A former can’t-lose day trader' in this context means a former couldn’t-lose bull. The very idea that there are legions of novice, knowledgeable, money managers coming straight out of Harvard and Yale, without any experience, becoming expert derivative, stock and commodity traders is ludicrous. Have you never heard of the BELL CURVE? It applies to everyone and everything. It is impossible that there are 25,000 smart money managers out there in the USA alone. They are predominantly all bullish maniacs who have never seen a Bear Market, but are managing unbelievable amounts of money that has ever been seen in history and all are caught up in the leverage mania. They too, never heard of Liquidity. They turn 2% to 5% profits leveraged up 25 to 40 times and report 50% to 200% profits as a sign of their brilliance. The proof is that a measly 5% to 10% correction can ruin them. They will soon find out what a 20% correction in both the Bond and Stock Markets will do. And what will a Bond Market Top followed by a 15% -20% sell-off do to the $90 trillion worth of Derivatives that those, leveraged to the hilt, hot shot money managers will soon face, with absolutely no ability of getting out or even reducing their massive positions. Those markets will soon teach them about Liquidity and remind them that TANSTAAFL. [There ain't no such thing as a free lunch.]

Richmond Fed President Jeffrey Lacker unleashed a striking insider's critique of the Fed's recent moves to expand its lending to brokers-dealers and back JP Morgan's rape of Bear Stearns. He worries that the move could encourage further excessive risk-taking, leading to more frequent crises and creating a direct path leading to the Fed's door. To convince the markets it won't continue to support troubled firms, the FED will have to let some institutions fail.

Is it just a coincidence that it is always the banks that get left “holding the bag” at every major speculative peak and then the taxpayers have to bail them out. This also sets the stage for the banks to make a killing on the recovery; again on the backs of the taxpayer as interest rate spreads are widened much more than they need to be.

WHERE TO NOW

Bottom Line: In my last letter, I speculated that the Bear Market Rally was over as the Maximum 61.8 % correction was reached and only a high Bullish Sentiment figure was missing from me giving a Major Bear Market Sell signal. Up until this week, the three major indexes, rather than being in agreement have been presenting confusingly different pictures. The DJIA and SPX presented similar pictures, the DJII was negative but the SPY was still slightly positive. The NDX, on the other hand, was strongly positive. Will it be able lead the rest of the market higher? I think not - the tail does not wag the dog, or does it? The problem the market faced at this time is that although the rally from the March lows had TOPPED OUT, I had no major sell signal. So I recommended the buying of puts on the Financials and Home Builders, two groups that I felt strongly would go down no matter what happened to the general market: Nobody promised it would be easy. For a little over a week, the markets backed and filled but drifted lower and I was short the right Groups until 2 days ago when finally all three indices fell into place on the down side, with the Lehman underwriting plan clinching the down draft. You can never have a strong up market without the participation of the Financials and for now their direction is down. THEY ARE STILL IN DENIAL. I’ll be staying short and increasing my short positions into any 1 to 3 day rallies.

INTERET RATES

Interest rate increases on the long term treasuries (10-yr & 30-yr) and relentless tightening of the lending standards is killing what is left of the barely breathing mortgage sector. Last week, it was announced that the value of residential housing in America had decreased in value by some 14.3 % over the past year. Applying that figure to the official total ($23 trillion) value of the U.S. housing stock, gives a dollar value of some $3.3 trillion or 23% of the $14 trillion U.S. economy. In other words, Americans have seen a paper reduction in their aggregate wealth equal to almost a quarter of U.S. gross domestic economic production! Yet we are expected to believe that we are not in Recession. As the FED continues to create more and more money and credit out of thin air, that constitutes a mammoth monetary inflation. To date, all new money creation has been hogged by the money center and investment banks on Wall Street. However, the US Congress is a pack of cowards. They will refuse to make the tough decisions on a new RTC until after the November presidential elections. Until then, housing and Financials will decline further. Households will retrench as they endure hard times. Bank mortgage bonds and portfolios will continue to crumble. They will retrench until they seize up and then fail. Until then, there will be an ongoing battle between money creation and credit (money) destruction. They might (?) enjoy a nostalgic orgy first, but it will be a false suck-in rally. In the meantime, they will eventually drive up all the precious metals. We are witnessing the formation of a foundation built for Gold.

We might also be witnessing a calculated plan to subjugate the middle class and centralize power in the hands of the state in a historical manner similar to FDR’s New Deal (don’t say I haven’t been warning you) as the Socialists take complete control of Government without anyone left to utter even a single word of dissent. The USA, the greatest country ever to grace this world, built on a foundation of Individual FREEDOM and Free Market Capitalism and who has spread God’s word, freedom and prosperity, all over the world has finally become the single most anti-capitalist country as all the former Communist and Socialist countries like China, Russia, India and even Vietnam have turned to capitalism in order to reverse a 100 years of stagnation and depression. How could that happen you may ask? Simple my friends, it is a Great Left Wing Conspiracy and all you have to do is just take God out of the Public Square.

Warren Buffett and Ahmadinejad

Question: What do America’s premier investor, Warren Buffett, and Iran’s toxic President, Mahmoud Ahmadinejad, have in common? Answer: They’ve both made a bet about Israel’s future. “Ahmadinejad declared on Monday that Israel “has reached its final phase and will soon be wiped out from the geographic scene.” By coincidence, I heard the Iranian leader’s statement on Israel Radio just as I was leaving the headquarters of Iscar, Israel’s famous precision tool company, headquartered in the Western Galilee, near the Lebanon border. Iscar is known for many things, most of all for being the first enterprise that Buffett bought overseas for his holding company, Berkshire Hathaway. Buffett paid $4 billion for 80% of Iscar and the deal just happened to close a few days before Hezbollah, a key part of Iran’s holding company, attacked Israel in July 2006 triggering a month long war. I asked Iscar’s Chairman, Eitan Wertheimer, what was Buffett’s reaction when he found out that he had just paid $4 billion for an Israeli company and a few days later Hezbollah rockets were landing outside its parking lot. Buffett just brushed it off with a wave, recalled Wertheimer: He said, “I’m not interested in the next quarter. I’m interested in the next 20 years.” Wertheimer repaid that confidence by telling half his employees to stay home during the war and using the other half to keep the factory from not missing a day of work and setting a production record for the month. It helps when many of your “employees” are robots that move around the buildings, beeping humans out of the way. So who would you put your money on? Buffett or Ahmadinejad? I’d short Ahmadinejad and go long Warren Buffett. Why? From outside, Israel looks as if it’s in turmoil, largely because the entire political leadership seems to be under investigation. But Israel is a weak state with a strong civil society. The economy is exploding from the bottom up. Israel’s currency, the shekel, has appreciated nearly 30 percent against the dollar since the start of 2007. The reason? Israel is a country that is hard-wired to compete in a flat world. It has a population drawn from 100 different countries, speaking 100 different languages, with a business culture that strongly encourages individual imagination and adaptation and where being a nonconformist is the norm. While you were sleeping, Israel has gone from oranges to software, or as they say around here, from Jaffa to Java. The day I visited the Iscar campus, one of its theaters was filled with industrialists from the Czech Republic, who were getting a lecture — in Czech — from Iscar experts. The Czechs came all the way to the Israel-Lebanon border region to learn about the latest innovations in precision tool-making. Wertheimer is famous for staying close to his customers and the latest technologies. “If you sleep on the floor,” he likes to say, “You never have to worry about falling out of bed.” That kind of hunger explains why, in the first quarter of 2008, the top four economies after America in attracting venture capital for start-ups were: Europe $1.53 billion, China $719 million, Israel $572 million and India $99 million, according to Dow Jones VentureSource. Israel, with 7 million people, attracted almost as much as China, with 1.3 billion. Boaz Golany, who heads engineering at the Techneon, Israel’s M.I.T., told me: “In the last eight months, we have had delegations from IBM, General Motors, Procter & Gamble and Walmart visiting our campus. They are all looking to develop R & D centers in Israel.” Ahmadinejad professes not to care about such things. He was — to put it in American baseball terms — born on third base and thinks he hit a triple. Because oil prices have gone up to nearly $140 a barrel, he feels relaxed predicting that Israel will disappear while Iran maintains a welfare state — with more than 10% unemployment. Iran has invented nothing of importance since the Islamic Revolution, which is a shame.

Historically, Iranians have been a dynamic and inventive people — one only need look at the richness of Persian civilization to see that. But the Islamic regime there today does not trust its people and will not empower them as individuals. Of course, oil wealth can buy all the software and nuclear technology you want or can’t develop yourself. This is not an argument that we shouldn’t worry about Ahmadinejad, we should, although.Iran’s economic and military clout today is largely dependent on extracting oil from the ground. Israel’s economic and military power today is entirely dependent on extracting intelligence from its people. Israel’s economic power is endlessly renewable. Iran’s is a dwindling resource based on fossil fuels made from dead dinosaurs. So who will be here in 20 years? I’m with Buffett: I’ll bet on the people who bet on their people — not the people who bet on dead dinosaurs.” By THOMAS L. FRIEDMAN Published: June 8, 2008

It’s about time we Americans went back to betting on our people instead of relying on government.

GOLD

On Tuesday I went to my bank and withdrew all the money that I received from my subscribers and drove directly to my coin dealer and bought Canadian 100% Pure Gold Maple Leafs at $898.00 per coin. Do I have to tell you any more than that about what I think of Gold?

Major bullish signals are generated when the monthly XAU Price Relative to Gold ratio gives a bullish signal, which was triggered yesterday. So even though the market may waffle around for another week or so, I am expecting a strong advance to begin no later than July. I am now bullish on the XAU.

GOOD LUCK AND GOD BLESS

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Aubie Baltin CFA, CTA, CFP, PhD. June 11, 2008

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