Make Money Like it's 2002 All Over Again

Lately, it looks like the markets are merely treading water, waiting for the circling sharks to make their move. NASDAQ and S&P are in the worst shape they’ve been in years. But according to Greg Guenthner, there is something that can put your fears to rest, despite this current market downswing…or maybe because of it.

The past few weeks have tested investors’ resolve – especially those invested in smaller stocks. November is quickly coming to a close. With only a couple of trading days left, this month is shaping up to be the worst the NASDAQ has seen since December 2002. There’s blood in the water; investors are panicking. The sharks are circling…

Some talking heads have recommended an escape to larger stocks. But those waters are far from calm. The S&P 500 is also having a rough go of it. It’s on track to have its worst year since 2002.

Don’t panic. Times like these test your resolve. And while others are fleeing the carnage, there are shares of plenty of small, ignored companies that are begging to be bought. The market is offering you massive opportunities right now. Many stocks are testing 52-week lows. Naturally, some of these companies are being unfairly punished.

It’s partly tech stocks that have infused a healthy dose of fear into the NASDAQ. The establishment is convinced that slowing growth will take its toll on the likes of tech leaders Google (NASDAQ:GOOG) and Apple (NASDAQ:AAPL).

As these names – and many others – were hit, smaller stocks felt the reverberations. When the NASDAQ took a beating this earnings season, it seemed like it was almost impossible to win. No news seemed good enough, and earnings reports, no matter how positive, were met with flat or falling share prices.

It is through this volatility that we are able to find some of our best opportunities. After all, wide price swings make people money, and create massive buying opportunities. Looking beyond positions, the market has offered you a variety of options. Many stocks are testing 52-week lows. Naturally, some of these companies are being unfairly punished. That’s where we’re looking for the majority of our penny stock opportunities right now.

This small biotech’s share price was completely slammed last month after management warned shareholders on its full-year revenue. And its lead product has endured months of medical and media scrutiny. Right now, investors are avoiding this company like the plague. Almost every single day, its share price slides perilously closer to its 52-week low of $3.85.

That’s the performance of the Russell 2000 – the benchmark small-cap index – between November 20, 2002 and the end of 2003.

From its lowest point in early 2003, the Russell rose 60% in a little less than 10 months. We’re not saying 2008 will provide the same results. But it is clear that when small-caps bounce back, they do it in a big way. The S&P 500 only squeaked out a little more than 30% over that same timeframe.

Finding the bottom-bouncers now will set you up for the big returns when things begin to turn around. You’ll be in while everyone else is getting out.  And you’ll be rewarded while everyone else watches the one that got away.

Now that’s a position you want to be in.

Regards,

Greg Guenthner
for The Daily Reckoning
November 29, 2007

"There go my men. I must follow them. For I am their leader."

– Attributed to an Italian general

Yesterday, Don Kohn, number two man at the Fed, told the world that America’s central bank would be "flexible and pragmatic."

People knew what that meant. The Fed is prepared to cut rates next month.

So encouraged by this were investors that they set about buying every stock in sight. The Dow rose 331 points. That brings the total to 546 points gained in the last two days. Not bad.

But what does it mean? Less than investors think.

We have opined that the great flood of cash and credit, enjoyed by investors for lo these many years, is now ebbing away. Yesterday’s backwash seemed to contradict us. And we’ve been doing this for far too long to imagine that we know God’s Own Plan for the U.S. economy. Anything can happen – and usually does!

But let us look at what is happening. The Fed funds rate is 4.5%. Investors now imagine that a 50 basis point cut is coming. That will take the signal rate down to 4%. But in this instance, the Fed will not be leading…it will be following. The 10-year note already yields less than 4%. Bonds have been falling since June. They are just another of the many signs of deflation – of a draining away of credit, cash – liquidity – from the markets.

In other words, now the Fed is no longer driving inflation

…it is trailing along behind deflation, trying to keep up with it.

We indented that last sentence, because we didn’t want you to miss it; we are so proud of it. Remember it. Quote it to your friends. To put it another way…the Fed is no longer pulling on the string…it is pushing on it. In offering money at 4% (just a hypothesis) it will only be catching up to what investors have already been doing.

Now, it’s private lenders who are doing the pulling. They’re reluctant to lend into the open market; because they fear they won’t get their money back. But they’re happy to lend to the U.S. government. Spreads are widening – always a sign of a tightening credit market.

For example, Citibank got itself into subprime trouble and needs big money, fast. So, it turned to Abu Dhabi. But the Arabs wanted a lot more than the T-note rate. They wanted a pound of flesh – forcing one of America’s leading financial institutions to pay a rate normally associated with third world hellholes and first world shysters – 11%.

Behind the subprime problem is a problem in the U.S. housing market…and in U.S. economy…and in the whole world economy.

Houses are selling at their slowest rate in eight years, Bloomberg reports. In California, sales are down 40% from a year ago.

And here’s more from Bloomberg:

"The worst U.S. housing recession in 16 years will drive down property values by $1.2 trillion next year and slash tax revenue by more than $6.6 billion, according to a report by the U.S. Conference of Mayors… ‘The real estate crisis of 2007 and 2008 will go down in the record books… The wave of foreclosures that has rippled across the U.S. has already battered some of our largest financial institutions, created ghost towns of once vibrant neighborhoods – and it’s not over yet.’"

No, it’s not over yet. In some ways, it has barely begun…because the knee-bone of consumer spending is still connected to the thigh-bone of house prices, which is still connected to the hip-bone of mortgage credit. And if one of these bones breaks, the economy stops walking forward and falls on its face.

That is what we think is happening.

There’s a greater than 50% probability that the financial system "will come to a grinding halt because of losses from mortgages said Gregory Peters, Head of Credit Strategy at Morgan Stanley (NYSE:MS).

"Lenders’ belt tightening stifles growth in economy," says the NY Times.

"Mortgage crisis is a drag on Atlanta economy," says the Atlanta Journal-Constitution.

Well…yes…the ankle bone is connected to the shin bone. That’s the way it works. You can’t take $1.2 trillion out of the consumer economy, without consumers feeling it.

And now the Fed is rushing to try to put the money back in. Alas, it is not that easy. Japan’s central bank tried it for 17 years.

And America is in a much tighter spot than Japan. With a very positive trade balance, and abundant savings, the Japanese had room to maneuver. Not so the United States. Investors have already shown what they could do to the dollar. Let the Fed cut rates more and there could be a bloodbath in the currency markets…forcing spreads even wider, and pushing the U.S. economy into an even deeper crisis.

*** No milestones reached this week. At least, that’s the way it looks so far. Oil has not gone over $100. Instead, it dropped to $90. The euro (EUR) did not go over $1.50. Instead, it has held steady at $1.48. And gold did not rise above $850. Instead, it fell back to towards $800.

But we think these milestones will be reached – even though we think the dominant trend of the market is in the other direction, towards deflation, not inflation.

Have we confused you yet?

Tomorrow, we will clarify. There are two, apparently contradictory trends underway. Both will be fully expressed – eventually. Inflation is unstoppable. Deflation is unmovable. How and when they collide is the story we are following.

And what an exciting story it is!

Our guess is that investors will be smacked by deflation. And then they’ll be walloped by inflation. What can they do?

We’re still buying gold – on dips. The price is back to a record set in 1980. But if you look at a chart of gold and compare it to one of gold in the ’70s, you see a different pattern. Back then, gold rose slowly…and then took off in ’78…soaring in a big spike to $850. So far this century, we’ve seen nothing like that. Gold has steadily gained ground. But there has been no spike.

That spike stage is typically the final stage of a bull market – when taxi drivers start talking about which gold stocks to buy…and TV presenters ask whether the price will go to $5,000 an ounce. We’ve seen none of that. Just steady price appreciation. The real excitement is still ahead.

*** We mentioned a few days ago that popular attitudes to free trade are changing. Americans have come to believe that they are on the short end of the stick…that they gain less from free trade than they lose to it.

In a theoretical sense, they are surely wrong. Free trade is good for everyone. But it is better for some than for others.

If protective tariffs and trade barriers really made any sense, Indiana could improve its lot in life by prohibiting goods coming in from Ohio. California could benefit by excluding Wisconsin cheese. Pennsylvania could protect itself from Virginia hams. West Virginia could develop a thriving auto industry by prohibiting imports from Japan…or Michigan.

Adam Smith and the laissez faire economists demonstrated long ago that free trade improves standards of living for everyone, by allowing people to do what they do best. No convincing evidence to the contrary has ever been presented.

But just because it is stupid doesn’t mean it won’t be popular. If this were not so, television wouldn’t be nearly as successful as it is…and no recent candidate for president of the United States would have been elected.

Here too…there go the voters. Our leaders must follow. Expect a shift in political rhetoric…a shift against free trade.

*** Another thing you can expect is more government meddling in the credit markets. The feds can’t really permit millions of homeowners to lose their houses, says colleague Dan Denning:

"This sounds like a job for a new federal agency to buy the debt from the bankers at an agreed upon discount, say 50 cents on the dollar. The agency then becomes the landlord of the ARM borrowers…and is free…on behalf of the government of the United States and the American people…to re-set the loan at a fixed rate for a different maturity.

"The financial markets get transparency and the risk is moved off bank balance sheets on to the Fed or the Federal Home Loan Banks. Stocks rally!

"Borrowers get a reprieve from the hangman’s noose. Stocks rally!

"The Fed gets order back in the credit markets and some measure of control of the situation. Stocks rally!

"I’m not saying the dollar would respond well to this massive socialization of housing losses.

"But…we live in the 21st century. All financial losses are socialized. The only question right now is how this one will be managed.

"We have some clue with the fact that the Atlanta Federal Home Loan Bank has loaned – get this – $51 billion to Countrywide Financial… (NYSE:CFC) since September 30th. I’m not kidding. California is not in Atlanta, in case you were wondering.

"I would have suggested Fannie (NYSE:FNM) and Freddie (NYSE:FRE) as the preferred bail out vehicles. But they need bailing out themselves, faced with write-downs in the value of their own mortgage portfolios and a regulatory inability to purchase mortgages. Congress could simply change the limits on the size of the GSE portfolios…and the Fed could loan them the money to purchase the toxic stuff from other lenders. But it’s likely these two have been sullied too much to be saviors.

"Or the Fed could just load up the garbage on its balance sheet and extend the term of its loans…trading cash for trash for as long as the trade takes. Come to think of it, the Fed’s been turning cash into trash for years, so this is probably the least exotic option.

"…But I’d say the trade of the decade is still a good one: sell the dollar, buy gold. In fact, I think you’re going to see the liquidation of all sorts of higher-risk assets…bonds, emerging market stocks, and high-yield currencies….to maybe buy call options on 90-day t-bills. Or precious metals.

"Either way, I’d expect something big, but low-key. The action of the Atlanta FHLB was very low profile…lest taxpayers realize it was back-door bailout of Countrywide. But you know, this seems like the kind of bailout everyone can get behind…unless you own a lot of dollars and are counting on them to retain their value.

"If you’re one of those people, you know, a saver…well sorry. Good behavior should be its own reward. But don’t expect to get paid for it.

"Meanwhile, I expect the formation of a pseudo-public ARM/CDO slush fund, like the Resolution Trust Coporation. Banks might even capitalize this entity a little, to make it less obvious bad loans are being transferred from the private sector the public balance sheet.

"Heck, they might even sell shares in the thing. Why not an IPO and let people buy shares in the recovery of the housing market. Pay a dividend (those IO loans need to keep performing), and make it tax deductible. Don’t just socialize the risk, make it investable!"

Until tomorrow,

Bill Bonner
The Daily Reckoning