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Markets: Tightrope!
New York: December 24, 2007
By John R. Stephenson

What a year it's been! When all is said and done, 2007 will go down as a pretty dismal year for investors. Who would think a bunch of Gucci-wearing guys in Connecticut could cause more damage to the world economic system than the terrorists did on 9/11 — but that's the case. Central banks around the world have pumped a tremendous amount of capital into the system, in an attempt to re-liquefy the global economy. With money being pumped, rather than trickled into the system, the stock market is more likely to end with a roar, rather than a whimper.

The amount of money that has been pumped into the global economy is both staggering and unprecedented. The reason for such dramatic action is straightforward — the solvency of the global financial system is at stake. But in spite of the impending credit crunch, the stock market powers higher, as pundits call the bottom and massive injections of capital from central bankers, help spike the punch bowl at the year-end holiday party. The market will likely trend higher, at least for now.

But the situation is not a good one. Bank after bank has announced massive write-downs of their portfolios of asset backed commercial paper. Each new announcement seems to be more ominous than earlier admissions. Where it will stop, is anyone's guess.

UBS, a global financial services powerhouse, just announced a $10 billion dollar write-down. At Morgan Stanley, the write-down was $9.4 billion and in Canada the Canadian Imperial Bank of Commerce (CIBC) announced a write-down of $2 billion and counting.

For both UBS and Morgan Stanley, the shortfall needed to be covered by someone. The answer to their prayers was found in either a sovereign wealth fund, or a quasi-governmental investor from a foreign land. Never before has the first world been bailed out of a homemade crisis by massive investments from the third world. What we are witnessing is the beginning of a major transformation of the global financial system.

Sovereign wealth funds are institutions that manage part, or all, of the national savings of sovereign nations and their impact is just beginning to be felt. For Morgan Stanley, salvation came from the China Investment Corp. (CIC), that country's sovereign wealth fund. For the cash infusion of $5 billion into Morgan Stanley, CIC receives the option to convert its investment into a 9.9% equity stake in the firm in 2010. According to Yin Zhongli, a researcher with the Financial Research Institute of the Chinese Academy of Social Sciences, "the credit crunch induced by the subprime crisis in the US could help buyers get a real bargain."

Figure 1: Sovereign Wealth Funds Rule!

Source: Globe and Mai

With cash to burn and bargains to be had, sovereign wealth funds seem like the logical buyer of distressed financial services firms. It will take massive infusions of both debt and equity capital which will result in massive dilution of the stocks of financial services firms, before the bottom is reached.

But it isn't just the banks that are in trouble, it is also the bond insurers and hedge funds that are feeling the pain. In return for a premium, specialist bond insurers guarantee repayment of interest on a wide variety of debt securities in case of default. With the banks and hedge funds in trouble, these guarantees are being called upon. This has forced many of these firms to fight for their survival. The two largest firms are MBIA and Ambac and they are in trouble. Some analysts have predicted that the losses for these two firms alone could top $18.7 billion, a figure that easily dwarfs their combined equity capital of $12 billion.

In spite of a spate of truly horrific news, the stock market appears ignorant of just how dire a situation we appear to be in. The S&P 500 is trading at a forward earnings multiple of 27 times, implying that growth and good times are just around the corner. Hopefully the market is right — but don't bet on it. Pundit after pundit is claiming that with yet another write-down behind us, now is the time to step back into the stock market. Perhaps. But if a patient lay dying in hospital and test result after test result showed a worse prognosis, I doubt many of us would be overly optimistic. To my mind, further announcements of bad news seem like a poor justification of a buying opportunity .

But a bottom will eventually occur where a significant buying opportunity will emerge. When, it will be is anyone's guess. For my money, it will be some time yet and it will probably be preceded by the failure of one of the major money center banks.

With some tough sledding ahead in the markets, we continue to recommend gold and the stocks of gold companies as a great safe haven for investors. Gold is the only asset that is nobody's liability, where the supply is finite and knowable and that has done well in times of crisis. Amen.

Figure 2: Monsanto Has Been on a Tear!


Food is the other great investment class that investors should focus on in 2008. Since the spring, prices for wheat have doubled whereas the prices for milk, maize and oilseeds are near an all-time peak in nominal terms. Agflation is a direct outgrowth of long-running changes in diet as the third world continues to industrialize. In 1985, the average Chinese consumer ate 44 pounds of meat a year but today that number has risen to 220 pounds. When you consider that it takes 8 pounds of grain to produce 1 pound of beef you can see why agflation is on the rise.

The way to play agflation is by investing in the companies that produce the fertilizer (fertilized food grows twice as fast as unfertilized food) and the tractors and equipment that the farmer needs. With the US economy walking a tightrope between recession and growth, investors should concentrate on investments that are levered to global, not US growth. l

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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