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Markets: Spinning Out of Control?
New York: August 20, 2007
By John R. Stephenson

Lately, we have been witnessing the unwinding of the greatest bait and switch of all time as the subprime mortgage fiasco plays out in markets around the globe. Investors everywhere have been duped into believing that debt, no matter what the origin and rated AAA by the major rating agencies was safe. How wrong they were.

Increasingly the stock market has been preoccupied with an impending credit crunch as buyers for risky mortgage paper have been scarce. Investors globally have all of sudden started to realize just how risky investing in the debt of US subprime lenders really is.

Most of what has been wreaking havoc on the markets lately has been the huge amounts of collateralized debt obligations ("CDOs") that have ended up on the books of mainly Asian and European financial institutions. These CDOs are 10-20 times leveraged securities that are comprised of the riskiest tranches or slices of pools of less than stellar mortgages. The problem? No one knows what this stuff is really worth. Literally, trillions of dollars of these so-called derivatives are out in the global financial system and it will be some time before the dust on this matter settles.

To package and sell these CDOs to unwitting buyers in Asia and Europe, shrewd investment bankers needed help. They got that help from the major rating agencies. In 2006, some $850 million or 44% of Moody's Investor Service revenue came from the rating of these structured products. This was up from a paltry $50 million in 1995. Rating agencies were making huge amounts of money from investment banks for rating these structured products and proclaiming to prospective investors that these investments represented little (a AAA rating) risk.

The problem was that the basis of these ratings was the mathematical modeling of default rates on the underlying pools of U.S. mortgages that the value of these securities depended upon. The models turned out to be wrong and the values of these securities are nowhere near what was predicted by the soothsayers on Wall Street who took highly risky pools of mortgages and sliced and diced them into products that they could flog globally.

And then the music stopped. In the last few weeks, thousands of portions of subprime debt have had their investment ratings slashed by the rating agencies. On August 9 th , BNP Paribas, a French bank, suspended withdrawals from three funds invested in securities backed by U.S. mortgages, citing "the complete evaporation of liquidity in certain market segments." The same story has been playing out in New York and Frankfurt, as financial institution after financial institution has hinted that some of the "assets" they hold may not be worth what they thought they were.

To meet redemption requests and to de-lever their balance sheets, asset managers and financial institutions have been selling and liquidating their investment portfolios. Already we have witnessed a correction in the equity markets of more than 10 percent and it is likely to get worse before it gets better. This is a financial crisis unlike anything we have witnessed before with literally trillions of dollars of paper floating around out there that aren't priced by the market, don't trade in the market and are of increasingly dubious value.

Figure 1: The U.S. Dollar is Weak and Likely to Get Weaker!

In past financial crises, the pattern was similar to what we are currently witnessing. First, financial stocks start to weaken, then the broad stock market falls, next the deep cyclical stocks wither and the U.S. dollar falls. The cycle ends with central banks stepping in to try and stabilize the situation and then finally the U.S. dollar gets revalued downward. Gold and the stocks of gold producing companies are the place to be as this is starting to occur.

Gold, like many of the other commodities, has been going sideways for some time but is poised to move higher dragging with it the underperforming gold stocks. That's because gold is considered a store of value. In times of crisis, particularly crises that involve the financial system gold outperforms.

Figure 2: Gold (GLD an ETF) is Set to Outperform

In bull markets, it is the income statement of companies that drive the charge to higher and higher stock market valuations. In bear markets, it is the balance sheet of companies and concerns over the amount of both financial leverage and asset quality that tends to lead the market lower. Today, we have the classic makings of a major bear market as many of the financial institutions globally have balance sheets that are of dubious strength since many of their so-called "assets" are really some low credit quality U.S. mortgages. Look for a major financial institution to bite the dust before all is said and done.

If the stock market continues to weaken with the financial stocks leading the way down, a bull market in gold and gold stocks is likely the next phase for savvy investors to capitalize on. If the greenback breaks through 79 on the DXY dollar index (figure 1) it will take out a low established in 1992 with a very strong likelihood that gold will rally, hitting $700 or more an ounce taking gold exchange traded funds (such as the GLD) higher as well as the stocks of companies that explore for and mine gold.

Increasingly, the best investment ideas will reside in gold and in markets outside of the United States. The investment world will likely start to decouple from the U.S. as concerns over weak economic growth, fraudulent investment ratings, a depreciating currency and financial inventions used to export risk grow.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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