The Smart Money Strategy

A shrinking dollar, growing federal debt, the housing bubble, rising oil prices…they all add up to financial vulnerability. But, as Addison Wiggin explains, there are steps investors can take to avoid loss – and profit…

The U.S. economy is vulnerable on so many fronts. Social emphasis is being placed on protecting ourselves against terrorists and the threats of nuclear and chemical attack. But perhaps an equally serious peril is being ignored: our dependence on Middle East oil, for example.

We face a shrinking dollar, growing federal debt, increasing trade gap, record-high consumer debt, mortgage bubble, rising oil prices, inflation, flat productivity, falling wages-all part of the same trend translating to financial vulnerability, of course. But this economic sword of Damocles points the way to how everyone can change their investing mode, not only to avoid loss but also to maximize their investment profits.

If you accept the suggestion that big changes are going to be coming in these arenas, how can you reposition assets without also increasing market risks? Most investors are not going to sell their equity positions and go short on stocks, sell options, or sell futures. It simply isn’t within their profile to do so. The trick is to find ways to take advantage of the coming changes in smart ways, and there are several. The way you choose to change strategies should depend on your investing experience and knowledge, risk tolerance, and personal preferences. In seeking ways to reposition your portfolio, there are three major markets to keep in mind as places where you will want to either avoid long positions or seek ways to work against the trends: mortgage pools, oil, and gold.

Mortgage Pools: Mortgage Pools

A few years ago, mortgage pools seemed like no-brainers. Fannie Mae and Ginnie Mae, among others, were formed to buy up mortgages from primary lenders, package them into pools, and sell shares to investors. Because these pools consisted of secured debt in owner-occupied homes, they were described as low-risk. Not any more. Fannie Mae, caught tinkering with the books, has already dropped off its high price levels. In 2004, the stock fell from over $77 per share down to $64 by September and there is more turbulence to come.

Investors who understand the options market would be wise to look critically at mortgage pools and think about buying long-term puts. (These options rise as the underlying stock’s price falls, so the long-term put would be a good position for future price declines.) Fannie Mae has more than $1 trillion in assets, and it may prove out that its accounting problems will be the first blip on the mortgage crisis radar. Why? Think about what happens to mortgage pools when the mortgage bubble bursts.

Many of those owner-occupied homes, financed with variablerate mortgages, may prove both overpriced and overfinanced once the bubble bursts. Continual refinancing motivated by lower and lower interest rates may have created widespread exaggeration in appraised values. Is this possible? Of course. Lenders, always looking for profits from new loans and from refinancing, hire appraisers to look at properties. If the lender wants to write the loan, you can be sure the appraisal will come out at the level the bank wants, unless claimed value is simply so out of line that the appraiser can’t force the numbers.

But appraisers who are paid by lenders understand the game. If banks want to aggressively write mortgages, appraisers will play along. The lenders churn those loans. They make their profit short term and then sell the debt to Fannie Mae and other mortgage pools. These pools, potentially with growing numbers of loans granted based on inflated or exaggerated values, are packaged and shares are sold to investors. As interest rates begin creeping upward, the monthly payments follow suit and many homeowners, only marginally qualified to begin with, will find themselves unable to keep up. If the market value bubble also bursts, many borrowers will find themselves with zero equity and even negative equity in their homes. The simple thing to do in that case is to just walk away. The consequence of this will be higher levels of foreclosures. Those properties, going on the market at discount, will further drag down housing values. While these outcomes will affect regional markets and not necessarily national averages, if the problems are widespread they could spell disaster in the housing market and in the mortgage pool industry.

Mortgage Pools: Oil

The price of oil went over $50 per barrel more than once in 2004, and by 2005 it seemed inevitable that the price was going to continue upward. Remember, only three years before, barrel prices were down at the $20 range. The rise in prices was not as surprising as how quickly it occurred. The problem is not just the Organization of Petroleum Exporting Countries (OPEC)’s holding back on production, although that certainly plays a part in the big picture. A civil war in Nigeria, the fifth-largest U.S. supplier, has directly affected U.S. imports as well. Add to that the four hurricanes in 2004, which cut back about 11.3 million barrels of production in the Gulf of Mexico.

We are also facing growing demand for oil from China. Its oil imports were up 40 percent in 2004, and that growing demand is also driving up prices paid in the United States. Chinese industry demand for oil is experiencing the highest growth curve in the world today. The Chinese population adds to the problem in that the automobile has become desirable and affordable. During a two month period in the summer of 2003, for example, private automobile ownership in Beijing rose by 200,000 cars. Chinese demand has been climbing steadily over the past 14 years.

When oil consumption in China is projected forward only a few years, it is apparent that consumption is going to outpace any hopes of production’s keeping up. We can safely assume based on the trend in both industrial and consumer use that China is going to be the major oil consumer in coming years. So there is no logical reason to expect oil prices to drop. Rising prices affect one-third of all U.S. companies in some way. They create a double whammy on corporate profits. First, they drive up operating costs, and second, higher prices lead to reduced consumer spending. So it isn’t just oil; it’s the whole economy and any industry using petrochemicals.

These include construction, manufacturing, clothing, carpeting, and a vast number of other industries. Increased demand affects oil prices as much as weather patterns, political problems, and of course the threat of terrorism. And there is little the United States can do to fix the problem. In 2005, Congress approved oil drilling in the Arctic National Wildlife Refuge (ANWR) in Alaska. But even this won’t produce a drop of oil for at least 10 years. Additional drilling is not going to address the deeper problem. At current consumption rates, there is only enough oil remaining to meet current need levels for another 30 years. The relationship between oil discovery and production also looks quite dismal. What can investors do to position their portfolios?

Stocks in companies involved in oil drilling and exploration, as well as those supplying drilling ventures, will continue to be solid investment opportunities in the future. New demand for oil rigs and drilling will push profits and stock prices higher.With OPEC already producing at 95 percent capacity, it is hollow to blame their policies for shortages.

The truth is, reserves are dwindling as demand grows. Evaluate the oil production and drilling industry. Look for stocks that will benefit as oil prices rise. For mutual fund investors, seek out energy and commodity funds. For the more advanced investor who is comfortable with options, consider buying long-term calls in oil-related sectors with the greatest growth potential. Consider the four major subsectors within the larger energy sector of the market: coal, oil and gas (integrated), oil and gas operations, and oil well services and equipment.

Of course, looking for energy-related mutual funds and ETFs is also a wise move. With prices rising, oil and gas companies and their products will become more in demand in the future.

Mortgage Pools: Gold

The ultimate dollar hedge investment will always be gold. Investing in gold through ownership of the metal itself, mutual funds, or gold mining stock provides the most direct counter to the dollar. As the dollar falls, gold will inevitably rise.

In a moment, we’ll provide you with many ways for positioning your portfolio to profit from a bull market in gold. For now, we emphasize the high probability of gold’s future. The real potential for profits in the coming years and decades is not going to be found in the traditional American blue chip industry. That is a financial dinosaur that can no longer compete in the world market. The future growth is going to be seen in gold. The world economy may remain off the gold standard, but ultimately the tangible value of gold as the basis for real value-whether acknowledged by central banks or not-will never change. Historically, this has always been the case, and it always will be. In other words, we are on a "gold standard" in spite of the popularity of fiat monetary systems.

Besides knowing where to position your capital to maximize returns when the dollar falls, also think about strategies that sell the dollar to produce profits.


Addison Wiggin
The Daily Reckoning

September 01, 2005

Addison Wiggin is the editorial director and publisher of The Daily Reckoning. Mr. Wiggin is also the author, with Bill Bonner, of the international bestseller Financial Reckoning Day and the upcoming thriller Empire of Debt. Mr. Wiggin is frequent guest on national radio and television programs.

The above essay was taken from Mr. Wiggin’s newly-released book, The Demise of the Dollar…and Why It’s Great for Your Investments. The book has not only spent weeks on, Barnes and Noble and the Wall Street Journal bestseller list – this week it is on the most prestigious of all bestseller lists…

Today, we are closing up the house. It is time to get back to work. So, the summer chairs must be folded and stored. Shutters must be fastened. Bicycles, toys, tools – everything has to be put away.

It is melancholy work, for it marks the end of a period in our lives…

The weather changed last night too…the clear, sunny days have given way – suddenly – to rainy autumn weather. This must be nature’s way of making it easier to leave, like bidding adieu to an old person who has lost his mind; we don’t like to see him go but we can still say to ourselves, ‘it is time he went.’

We watched a documentary about Robert McNamara, former U.S. Secretary of Defense, last night. "It was a great time for the whole family," said McNamara of his time in Washington. It must have been the summer of his life. By dumb luck, he says, he and the Kennedy team avoided a nuclear war during the Cuban missile crisis. Then by dumbness alone, his team at the Defense Department got the nation into an imperial war that ended badly.

After summer comes the fall. After Mr. McNamara and his friends in the Johnson administration had made a mess of Vietnam, he moved on to the World Bank, where he continued to make a mess of things with his customary energy and intelligence.

The problem with the Vietnam War was that our opponents didn’t fight fair and square. The French had already been through it. DeGaulle told Kennedy he was crazy to get involved in that "rotten country." But the United States went in…and paid a high price to learn what the French had already told them for free. America was used to European-style wars, where you confront the enemy and try to beat him. The Vietcong were following a different program; they were fighting in the Asian fashion.

Robert McNamara and his whiz kids were toting up the costs of war, figuring that if they could make the war dear enough to the enemy he would give up. But Ho Chi Minh and his followers didn’t seem to care how expensive it was. They couldn’t seem to count. The Asian model didn’t include statistical analysis. More than 3 million Vietnamese were dead before the wars for independence finally came to an end when the last American helicopter finally left the embassy roof.

And so, it was the United States that gave up; because McNamara could count. And after a while, he figured out that the costs of the war far exceeded anything that might be gotten from it. He resigned.

More news, from our team at The Rude Awakening…


Chris Mayer, reporting from Gaithersburg, Maryland

"Every contrarian investor pledges allegiance to the following creed: Shun whatever the masses love; love whatever the masses shun."


Bill Bonner, back in Ouzilly…

*** Still reeling from the aftermath of Hurricane Katrina, oil and gas prices continue its rise – gas jumped 50 cents a gallon in some states on Wednesday.

Some Americans may be changing their plans this Labor Day weekend, as "out of gas" signs are starting to pop up all over the country.
Long gas lines, not unlike those during the 70’s gas shortage, have been occurring in places close to the hurricane’s path.

"Gasoline is shooting higher not just due to fear, but also actual interruption," explains our energy expert, Kevin Kerr.

"The blow to Louisiana is like striking at the heart of the gasoline production. $5 and $6 gas are certainly possible, if not probable. While there are cases of profiteering and gouging, I think little of this price reflects that. Fuel trucks can simply not get through, refineries are shut, infrastructure is shattered, and worst of all, nobody is estimating how long before it may be brought back on line.

"And one final grim note, more tropical storms are brewing – the season is far from over."

*** Now the United States is engaged in another imperial war – in Iraq. It is an imperial war because it has nothing to do with the security of the U.S.; instead it is merely an extension of Wilson’s messianic imperial claptrap: to make the world safe for democracy. Once again, we face an enemy who doesn’t seem to understand our Western way of war and doesn’t seem to care about "costs." Instead, he seems to want to raise the costs as high as possible – to destabilize his own country.

America attacked the regime of its former client, Saddam Hussein. Having disposed of his government, it found it had created a new enemy. Not knowing who these people were, the military and press came up with an all-purpose term to describe anyone who resists the imperial power – "insurgents." Reading press reports, our centurions seem to have the same formula for dealing with these new insurgents as the McNamara bunch had for dealing with the Vietcong: raise the costs. More troops. More money. More firepower. More protection. Stay longer. Work harder. Spend more time and money.

We wonder if the insurgents can count. But we’re sure Americans can count. Sooner or later, we guess they will get tired of counting the bodies and dollars spent on the imperial frontier in Mesopotamia.

Sooner or later, we guess, we will have to close the shutters in Baghdad too…pack up…and beat it.

But the nice thing about having an empire is that you don’t have to win wars…you just have to fight them. In a real war, a loss would be disastrous. The enemy would burn our cities, rape our women, and steal our Warhol prints. But there was never any danger that the Vietcong would invade California. Nor do we expect to see ‘insurgent’ bombers over Washington…any time soon.

That will come…but not for a long time. It took more than 3 centuries after Rome hit its peak for the barbarians to finally sack the city. We still have some time…

And maybe even an Indian summer…

*** Only one day and counting until we find out what Addison and his merry-but-mum band of analysts have up their sleeve.

Word on the street is that tomorrow will be the most monumental day in the financial community since Martha Stewart was released from her horrific four-star jail suite this past March.

After the announcement is made, entire families stand to benefit for generations and generations. Tens of thousands of dollars will be saved. And you’ll be invited to make as much money as you wish.

But here’s the kicker…

Addison wasn’t even joking. He is dead serious about this historic event. More to come tomorrow…

*** What we are going to miss most is our library. The kids wanted a swimming pool. Elizabeth wanted a tennis court. Instead, your editor built a library.

There was an old, brick octagonal building on the property. We couldn’t figure out what to do with it. It was cold in winter and warm in summer. But it sits in the middle of the garden with lovely views in every direction. So, we turned it into a library…with a gas fireplace to take the chill off in winter.

We sit in it now. Out one window we see cows grazing. Another window looks out over a flowerbed. Another allows us to watch the comings and goings of the farmhands. Never was a man more favored or spoiled; he can barely keep his eyes on his computer…or his mind on his thoughts.

There are so many books he would like to read. He picks at least one up every day. A history of the French resistance in WWII. Families and How to Survive Them, by former Monty Python star John Cleese. Michelet’s history of Rome. Settling down to read, he stretches out. Before he knows it, the book is flat up his chest. What a marvelous way to sleep!

The Daily Reckoning