September 13, 2008 – The Brilliant Boys, and Why I’m Starting to Buy

by JDH on September 13, 2008

Wow.

To quote Comic Book Guy from The Simpson’s: “Worst stock market year ever.” My portfolio is down almost 40% this year, and apparently I’m not the only one.

Our friends over at Casey Research, in this week’s The Room publication, admitted that “We certainly didn’t foresee the depth of the pullback in the juniors.”

Eric Sprott, probably Canada’s leading and most successful hedge fund manager, was quoted in the Globe & Mail this week as apologizing for costing his investors so much money. Here’s the quote:

“Mr. Sprott didn’t see those declines coming, especially in gold, in large part because he never expected regulators to act so aggressively to bail out the financial system.

“We apologize for that,” he said on a conference call yesterday after telling investors “we thought we were well positioned because we thought that gold would rally.”

The problem has been the stream of government-backed salvage plans for financial companies such as Fannie Mae and Bear Stearns Cos. Inc. These are keeping bank stocks artificially inflated and taking the wind out of a rally in commodities, he said – a complaint shared by other commodity bulls. Mr. Sprott expects that the U.S. government will rush to help should Lehman Brothers Holdings Inc. and Washington Mutual Inc. need aid.

“The Treasury and the Fed are breaking all the normal rules of engagement,” Mr. Sprott said.”

Yup. Unfortunately shares in Sprott are down 50%, the Sprott Canadian Equity mutual fund is down almost 30 per cent this year, and Sprott Hedge LP fund is down 11 per cent so far in September, erasing almost all the year’s gains.

Even our old friend Mr. Dines said in his IWB on Friday that:

As one of the original pioneers of Visual Analysis (Technical Analysis) we can report to you that it is simply not working, exemplified by the fact that the Oversold conditions normally preceding rallies have dropped into record Oversold lows with no rally yet. We ascribe this to the intensity of the desperation of the sellers to raise cash.

He goes on to say that:

What we did not anticipate was that the uranium-mining stocks, all of them, would plunge along with the rest of the market. Ditto for gold ….

Sure, if we had known that the uraniums would have had this deep a Correction we would have led you out at the Top, but that would be the Low State of 20:20 Hindsight, a form of the Low State of Pastloitering…

Hmmm. I think the reason we subscribe to newsletters is because we want to be lead in at the bottom, and out at the Top. PNP.TO – Pinetree Capital Ltd. hit $14.98 on April 13, 2007. It is now exactly 17 months later, and Pinetree had a great day on Friday, up 14.5% in one day! Unfortunately, even with that big uptick, it is still only trading at $1.34, and amazing 91% drop from the peak. And, for most of that time, Mr. Dines rated it as a conservative buy.

(It was only this week that Dines issued an IWB saying there would be problems ahead, and all of his stocks are now a “Hold”. Well, better late than never. What would it take for this guy to put out a sell recommendation? Perhaps his “hold” is actually a buy signal).

My point here is not to trash Casey, Sprott or Dines. They have all been wrong. As have I.

The depth of the crash is much greater than any of us imagined. Had we expected this, we would have all been short, and we would all now be rich.

I accept the explanation that market players were so leveraged that when they had to raise cash, they sold anything they owned, so everything has gone down. More specifically:

Everyone knew that the U.S. financial system was in big trouble. The hedge funds had made tons of money shorting the financials, and going long the commodities, including gold, accounting for the run up in gold and the tanking of the financials. The boys in charge, Paulson and Bernanke, new that the collapse of the financial system, including Fannie and Freddie, would usher in a great depression, not to mention some serious problems from places like China that had invested heavily in the U.S. dollar.

They needed to save the system by boosting the financials and tanking the commodities. But how, and when?

Exactly two months ago today, on July 13, a Sunday, with the North American and U.S. markets closed, but just as the Asian markets were opening for the week, so that the number of players was few, they launched their rescue program. And, for good measure, the SEC made it more difficult to short the financials.

We had a perfect storm. Like Ike, everyone panicked. The short sellers had to cover their shorts, which they did by raising capital from wherever they could get it. They sold everything, including gold, silver, uranium, and any other type of stock they owned. Of course, with only the Asian markets open, it was hard to find buyers for what they were selling, which started the snowball rolling down hill, fast.

Bank stocks soared, which was the goal, to allow them to raise new equity. As their prices increased, the shorts got squeezed. The dollar rose as foreigners bought bank stocks, which of course meant that the hedge funds that were short the dollar had even more covering to worry about.

The next day marked the peak for gold:

Gold Three Month Chart

Gold Three Month Chart

Since then, gold has fallen from $975 to below $750, so congratulations are in order for a job well done to Paulson, Bernanke, and Chris Cox (from the SEC for changing the rules on shorting). With the collapse in commodities prices, no-one is talking about inflation, so now there is no pressure to raise interest rates to contain inflation.

It’s brilliant, really. The Gang of Three knew that the hedge funds were highly levered, so it only take a slight push to force them to sell, and therefore take the pressure off the equally highly levered financial players, like the banks and Fannie and Freddie.

Brilliant.

Freakin’ brilliant.

Commodities are down, the banks are saved, gold is a barbarous relic, and all is well with the world.

Except that’s not true.

July 13 was not the end of the world. The banking system was not saved. A crisis was only temporarily avoided. The smart money did not decide to plow more capital into the likes of Fannie and Freddie.

And so, on yet another Sunday with the markets closed, this time September 6, the Boys decided to nationalize Fannie and Freddie. That’s right, the good ole USA, bastion of capitalism, decided to borrow a play from the best communist’s playbook, and nationalized the U.S. mortgage industry.

So perhaps all is not right with the world.

Why do commodity prices increase?

First, because of supply and demand. We may be in a recession that is depressing prices, but ultimately as half the world’s population in China and India continue to consume, prices must rise again.

Second, the intervention of the Big Boys works both ways. They got their wish by driving down commodity prices to save the financial system, but what goes down most often also comes back up. And the harder they fall, the faster and powerfully they rise, just like a spring.

Global real interest rates are negative. Foreign money managers exiting Fannie and Freddie may temporarily have parked their money in the U.S. dollar, but that won’t last for long with negative returns. They will want to put it somewhere, and with commodities very cheap at the moment, it won’t take them long to realize where their money should be.

So what does all of this mean?

First, I don’t believe that the events of the last two months mean that the financials are out of the woods. There will be more problems, more failures, more defaults. The government can’t buy up every financial stock, they can’t nationalize everything (can they)? As the financials come back to earth, commodities will rise again.

Second, I don’t know how long this unwinding will take. I don’t think gold will be $1,000 tomorrow, or next month, but I strongly believe that a year from now, or two years from now, we will look back on September 13, 2008 and say “I should have loaded up, big time.”

So, to play that, I have started to put in stink bids. It’s time to deploy any unused cash, but it pays to be patient. Pick an entry point below market levels, and on the down days, buy.

Since this strategy may take time to unfold, I’ll be doing it with cash, not with margin. I have no desire to get wiped out in a margin call if the Feds decided to nationalize more stuff. It’s not worth the risk.

I’ll be patient. Gold, silver, and uranium will rise again, and I will be positioned, ready, and patient.

Agree or disagree, your comments are always welcome on the Buy High Sell Higher Forum; see you next week.

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