Go for the Gold

This past couple of weeks have felt like an eternity when it comes to noteworthy occurrences in financial markets. We’ve marked out 10th (IndyMac) and 11th FDIC bank rescue. As a result of the escalating number of troubled banks and diminishing value of the assets that these banks hold, the FDIC has been forced to go to the U.S. Treasury for a credit line.

The recent jobless claims and ADP figures have unemployment at a multi-year high, while inflation has quietly ticked over 6% officially. Consumer spending continues to dry up while shoes continue to drop in the credit market. All in all economic indicators continue to tell us that stagflation is in our not so distant future.

Last, but most definitely not least, is the recent bailout of Fannie Mae (FNM) and Freddie Mac (FRE). This marks the greatest bailout by size in our nation’s history. The aftermath has yet to shake out and find the main stream media, but signs of financial strife as a result of this market manipulation are beginning to show.

All in all, it has not been a pretty picture, but I have reason to believe that the outlook for the next 6-12 months is even more pessimistic. Fortunately for us, when there’s blood on the street, there’s opportunity to make money, and I think we are entering a period of truly fantastic profit potential. First, let’s take a look at why I carry such a pessimistic view for the near and intermediate terms.

Blood on the Street

To truly understand credit markets, we must understand one very important notion. Credit markets aren’t frozen because there is a lack of money to go around. They are frozen because there is a lack of lenders willing to lend at current rates. It is for this exact reason that regardless of monetary policy, the long term trend for interest rates is higher. Please look at this chart of the following institutions and the price they are being forced to pay for lent money:

• Lehman Brothers (LEH)--11-13%
• Merrill Lynch (MER)--11-12%
• Morgan Stanley (MS)--9-10%
• Citigroup (C)--9 ½-10 ½%
• Keycorp (KEY)--11-13%
• National City (NCC)--13-15%
• Wachovia (WB)--10-12%
• Zions Bancorp (ZION)--13-15%
• GM/GMAC (GM)--not possible
• Washington Mutual (WM)--not possible
• Ford (F)--not possible

The real scary thing is that the companies on this list have approximately one trillion dollars worth of short term debt to roll over by next summer. Of that trillion, $300 billion will mature before December. Do you think these companies can run a profitable practice with such massive debt on their balance sheets, continuing diminishing asset values (not just tier 3 either), and double digit interest rates staring them in the eye? Neither do I. There are only three options left for these guys: massive liquidity injection (private), bankruptcy, or government bailout.

Just a quick note of interest: it seems liquidity injections by the private sector are drying up. Recently the Korean Development Bank ended discussions for a potential capital infusion in Lehman Brothers. I’m sure KDB has been spending time looking through Lehman’s balance books only to find out that things were less rosy than expected. As long as were discussing Lehman, the New York based bank is also the largest holder of commercial real estate backed securities. I believe that the commercial real estate sector will probably be the next major shoe to drop in the credit sector (short position should be considered).

I’m sure you’re also wondering about the bottom three companies on the list. Take that for what it is. These guys literally can’t find financing, or should I say, they can’t find public financing. It’s ironic that I decided to discuss this today, because the House of Representatives is currently meeting to discuss a potential $25 billion federal credit line for the big three (Ford, GM, and Chrysler). Unfortunately for the auto makers, it looks like they won’t receive the $50 billion they were asking for. It’s this sort of last resort socialistic tendencies that are necessary when these companies are no longer solvent

As for the fate of GM/GMAC, Ford and Washington Mutual, it’s not looking good. With Federal money, Ford and GM might be able to pull through, but with the inability to finance debt at ANY price, WaMu is facing sure bankruptcy or bailout (a WaMu short position should definitely be considered as well). It is just a matter of time now. As for the auto makers, this credit line doesn’t mean they are out of the woods yet. Only time will tell.

All Signs Point to Inflation

As shoes continue to drop in the credit market and asset prices continue to fall, we are looking at a massive contraction in liquidity. Dear reader, that’s how free markets work. After decades of excess money and credit growth, markets eventually revert to the mean. Unfortunately our ‘mean’ is so far below the current level of monetary base that if allowed to revert; we would be looking at a deflationary cycle that would dwarf the great depression.

As a reaction to this contraction of liquidity, monetary authorities around the world will enter the race to inflate. I don’t care what the rhetoric is now by Trichet or anyone else claiming a hawkish stance on monetary policy. I mean, that’s how Bernanke got the nickname Helicopter Ben in the first place.

Essentially what I’m getting at is that the health of our credit market carries an inverse relationship with growth in the money supply. Think of it like this as a giant bucket that’s half filled with water. As each shoe drops in the credit market, a new leak is sprung in the bucket. Growth in the money supply is like a hose feeding the bucket. The Fed wants to keep the water level constant, but as new leaks are sprung, the Fed has to turn up the pressure on the hose.

Golden Profit Potential

As readers of mine, you know that my favorite indicator of increased hose pressure is gold. Whether it’s irony or stupidity, the gold market has continued to contract through the Fannie and Freddie bailout and the rest of the credit woes.

Some claim the contraction to be the end of a bull run; obviously I couldn’t disagree more. Others claim the bull market is intact and it is simply following the correction in oil markets. Then there are others who claim there is just a robust demand for dollars during a time of such illiquid markets.

What do I think? I think many analysts, myself included at times, are guilty of over analyzing the issues at hand. I like to call it what it is, a market that just overheated to the upside and was in need for a correction. Gold has consolidated, and in the process built itself a base sturdy enough for another strong move to the upside.

Listen, what I will do is let you in on a little secret as to how I’m playing this trend. I believe that the far out of the money spring call options are extremely undervalued at current prices.

That’s all I’m going to say for now.

Note: The author and publisher do not hold positions in the securities mentioned.

Comments

[YOU MUST BE...:]

Way to go, SEEKING ALPHA!!!
Go ahead and recommend shorting stock trading at $2.73 (down about 95+ %) and way out of the money call options...
That's what I call prudent & way-ahead-of-the-crowd investing mentality...
UNBELIEVABLE...
And I thought nobody could be worse than CRAMER...
THANKS FOR LETTING ME KNOW WHO YOU TRULY ARE!!!

2008 Sep 14 05:27 AM

[ron martin:]

Finally, a guy that does not end his article with a recommendation to buy while the market is down. Few realize that what is happening is not the peaks, valleys or "adjustments" in the markets. This is a seachange and it is global and it is serious. It is probably the end of our comfortable life as only we Americans know it. We have lived through the best of times and will now see the worst of times. I am selling all my stocks, keeping my precious metals and own physical assets that I hope will see my family through this crisis.

2008 Sep 14 07:17 AM

[oldgoldbug:]

User 244150 - Thank you. I wondered when somebody would speak up about all the bulls who apparently have been able to endure this onslaught with such aplomb. "Don't worry, buy more". WITH WHAT? Who recommended selling at anywhere near the top to be able to put money in this market now? No one. What happened to GRMN at 124? Oops, its 33 now. Probably a stock to consider almost 100 points lower.
It still bothers me that the long Government market is at 4%+/-. It may be that market is the only one able to contain the amount of money coming out of long liquidation of institutional portfolio therefore it is unusually strong in the face of high inflation or is it saying "deflation, deflation, deflation." I guess we will find out soon enough.

2008 Sep 14 08:09 AM

[User 201843:]

Sad you dont want to talk about the "spring call options " more!

Take a look at HMY on Friday..... buy and lets talk in a few weeks.
The Govt is so far behind the curve ....and scared !

2008 Sep 14 08:53 AM

[Emerald:]

If its more deflation than inflation, gold call options will go nowhere. Otherwise, the correction in gold is a good entry point for possible inflation ahead. My bet: Long GLD.

2008 Sep 14 01:18 PM

[nyka:]

Your "writing style" needs dramatic improvement, starting with a strengthening vocabulary. Start by eliminating the dead expressions starting with there -- "there is," "there are," etc., and by beginning sentences with nouns, not the lifeless, vague "it."

2008 Sep 14 05:11 PM

[Kinabalu:]

"Not possible"

Well WaMu got some of my money at 5% last week. I think you don't realize that it's a lot easier for the banks on your list to get funds than the other companies.

2008 Sep 14 06:16 PM

[dlaw:]

This is a FANTASTIC opportunity to short gold.

I wish I had the money to do it.

For obvious reasons, gold will follow oil lower because gold is a commodity. The spike in gold and the euro were excellent opportunities to get short again.

Folks, you have to stop listening to the conventional wisdom on this stuff, because it has been wrong all along.

2008 Sep 15 10:16 AM

[Paul Killinger:]

What you're seeing is global DEFLATION, not inflation, my friend. And the time to invest will be when EVERYONE wants to sell, which is rapidly approaching as we speak. Just as it always is!

2008 Sep 15 10:47 AM