The Daily Reckoning | Monday, May 3, 2010
Joel Bowman 
Eric Roseman 
Bill Bonner
Tuesday 4 May 2010
Shorting Eurozone Banks and the
Chinese Boom
How to protect yourself against future Black Swan events
Reporting from Taipei, Taiwan...
We woke with a fright. It sounded as if someone, or something, was scampering around downstairs. The bookcases shook and the bedside lamp vibrated violently. "We're being robbed!" was our first, half-asleep thought.
Your editor leapt out of bed, grabbed the heaviest thing he could find (a half-read novel by a dead Frenchman) and crept slowly, stealthily down the stairs. Alas, the pen is no more use than the sword when it comes to combating a foe of this variety. Luckily for us, the action was over by the time we reached the first floor landing.
So went your not-so-brave editor's first earthquake experience. The 6.9 magnitude "shake" reverberated a few hundred miles off the Taiwan coast last week. We're told they are relatively common in this part of the world. Apparently, this one was just a baby.
Near death experiences aside, it was the earliest your editor had been out of bed - without having a plane to catch - in quite some time. We decided to grab a McDonald's breakfast to celebrate the occasion.
"It was a sideways shake, which aren't as bad as the vertical ones," a local friend, Michael, explained to us later that day. "But you live in a new building, so you are probably safe either way. Except if a really big one comes. Then...well...I don't know..."
The problem with Black Swan events - epic natural disasters, market crashes, best-selling books called The Black Swan, etc. - is that they are entirely unpredictable. What's more is that, after the fact, it's hard to imagine the world without them. Imagine for a second, living in a world without Google...or Harry Potter...or The Daily Reckoning. You're right. It's impossible!
Now, how can we possibly prepare for the unknown, you ask? Good question. The short answer is, we can't. Fortunately, not everything is as unknown as it appears. Black Swan events are hard to predict because they are unprecedented (until they happen, of course). But there's nothing unprecedented about a currency implosion...or a sovereign debt default...or, indeed, the collapse of an entire empire. It would be unprecedented if these things did NOT occur periodically. In fact, the only thing that ought to surprise you about the somewhat regular repetition of these events is that people are actually surprised when they invariably come to pass.
This morning we read that protestors have taken to the streets in Greece, where a new round of government austerity measures is working its way through the political process.
"This is going to be the biggest story in financial markets this year," Rob Parenteau, chairman of The Richebächer Society, told Addison in an interview last week.
"When the Greek government cuts expenditures and raise taxes, it will suck cash flow out of the private sector. Houses and firms will not have as much cash flow. That means the existing debt load to the private sector will be harder to service. So we're not going to see just public debt distress - which investors understand now - but private debt distress as well. Some of these countries, like Spain, have very highly leveraged private sectors - even more leveraged than their governments.
"What this means, is that banks that have exposures in terms of private loans to households and in the Eurozone periphery are going to find their loan losses going up. And then investors are going to start asking questions about their capital adequacy. And then, how can they raise capital in such an environment?
"I think many of the Eurozone banks could be wonderful shorts."
The situation in Sparta - and across Europe - is a powder keg, no doubt about it. But what would come as a greater shock: That a single currency experiment involving dozens of countries and hundreds of languages spread across deeply entrenched lines of cultural and political tension, should simply last forever? That ratings agencies of questionable motivation and deplorable track records would, although characteristically late on the scene, somehow manage to get it all right in the end? That governments would overspend their kitty, only to find a magic money beanstalk in the backyard?
OR, that a bone-headed central planning committee botched the job, ripped off the masses and guaranteed a painful, embarrassing economic demise for the entire continent?
Hmmn...
We read also that China, engine room of the world's great economic recovery, may be sputtering, breaking down even. The "people's" government banned loans for third homes and raised mortgage rates and down-payment requirements for second-home purchases over the weekend in an effort to cool the runaway mortgage market there. According to Bloomberg, "Prices rose 11.7 percent across 70 cities in March from a year earlier, the most since data began in 2005."
Marc Faber, Gloom, Boom & Doom Report mastermind and perennialAgora Financial Investment Symposium favorite, reckons the Middle Kingdom's economy could crash within a year. Jim Chanos says they're "on a treadmill to hell."
Many find such comments shocking. But again, what would be more likely - that an economy of a billion-plus impoverished people would slingshot from utter destitution to world-beating financial prowess under the stewardship of a communist brain trust within a couple of generations? Or that a few trillion yuan worth of centrally planned bubble blowing had gone astray? It wouldn't be the first time a foaming gaggle of speculative investors had been duped by a slew of politically-greased handouts and freebies.
Of course, we could be wrong about the embattled euro and the bubblicious, Chinese miracle. Maybe Europe will defy the critics...and maybe the Chinese stock market will go to the moon without a hitch or a hiccup along the way. In any case, it is probably wiser to insureagainst the odd Black Swan than it is to place all your money on them.
The Daily Reckoning Presents
The Best Natural Gas Stock
Natural gas is almost a dirty word. After hitting an all-time high almost five years ago north of $15 per MMbtu or (million British Thermal Units), natural gas prices have been confined to bear market territory. At just $3.92 per MMbtu now, many producers will either go bankrupt, become buyout targets or struggle to earn a decent profit for the next several years...unless prices rally soon.
Almost no one likes natural gas. Supplies are abundant, companies' profit margins have atrophied, if not disappeared altogether, and most analysts think gas prices will remain low for a very long time. The advent of Canadian and American shale gas production has put another big dent in prices...and bullish sentiment.
But one company dominates profitability in North America. Not only is this company generating piles of free-cash from shrewd forward hedging, it is also entering potentially lucrative joint-ventures to boost production. Despite these virtues, this company's stock trades 30% below its all-time high, and only slightly above book value. The company I'm talking about is Canada's EnCana Corporation(NYSE:ECA).
But before delving into the bull case for EnCana, let's explore why natural gas prices have remained so depressed and what developments might lead to a reversal of fortune.
There's no denying that there are good reasons for the slumping price of natural gas. Supplies are ample. Storage facilities across North America are still swelling amid rising supplies. Winter 2010 ranked among the warmest in history with March temperatures alone hitting the record books - March was the warmest in the Northeast since 1946. Unseasonal temperatures don't help gas prices. If temperatures are above-average in any given winter then households and businesses consume less natural gas.
Ironically, if above average temperatures continue into that summer months, that would be bullish for natural gas. The hotter the weather, the greater the use of air conditioning - a factor that increases electricity usage and therefore, natural gas usage. Also, the Gulf of Mexico, a major hurricane corridor, has been unusually calm since Hurricane Katrina in 2005. That might change this year.
Oil has been a far more consistent performer in the energy sector than natural gas. While crude oil has more than doubled off its post-credit- crisis lows, natural gas prices remain depressed. Despite their recovery off ultra-low levels last summer, natural gas prices are still more than 70% below their record highs.
But the bear market in natural gas will end, simply because very few producers can produce a profit at current prices. Many producers are suffering large losses. But this condition will not last forever. In fact, it may be changing already. Several factors suggest gas prices will rise back above $6, possibly $7 over the next 12-18 months.
For starters, the crude oil-to-natural gas ratio hit a multi-decade high last summer, and remains near that level. In other words, natural gas is extremely cheap relative to oil. This ratio is signaling we are at extreme lows in natural gas prices - a solid "buy" signal.
Another bullish indicator is Exxon-Mobil's (NYSE:XOM) recent takeover of natural gas producer, XTO Energy (NYSE:XTO) for $41 billion dollars. Exxon-Mobil is the world's largest company by stock market- capitalization and easily the biggest in the energy sector. Exxon knows something more than nothing about natural gas. Obviously, Exxon-Mobil would not write a $41 billion check for a natural gas company if it believed natural gas prices would be languishing for the next several years. Clearly, Exxon-Mobil believes natural gas prices are at an extreme low.
Finally, natural gas is the cleanest-burning fossil fuel, unlike oil or coal. As the United States, China and other countries look to shrink their environmental impact, gas has the edge over oil and coal because of its cleaner-burning properties. And coal, which remains highly popular and generates 50% of electricity in the United States, is also the culprit responsible for 81% of the carbon emissions spewing into the atmosphere. Natural gas is by far the cleanest burning fossil fuel, while also emitting half the carbon dioxide of coal. These facts alone are powerful drivers of natural gas consumption and they won't change.
As natural gas prices eventually form a secular bottom in this cycle, the ensuing bull market promises to be lengthy and robust. EnCana offers a great way to participate. Based in Calgary, Alberta, EnCana is North America's largest and most profitable natural gas concern. Management is superb. President and CEO, Randy Eresman, has been the driving force behind the company with 25 years of experience at EnCana and has a first-class executive team and board to steer the gas giant.
In 2009, the company spun-off its oil sands business as Cenovus Energy went public, generating about $3.5 billion dollars for EnCana. Following the spin-off, EnCana is now a pure natural gas story. The company's shale gas properties are the muscle behind EnCana's goal to become the world's dominant player. The company is actively developing these reserves, both independently and through various joint ventures.
EnCana was an early pioneer in the shales. And today, the company's core business is unconventional natural gas with its main holdings in the Haynesville shale, Deep Bossier, the Rockies, Horn River Basin and the Montney shale. EnCana produced daily production volumes of approximately 3 billion cubic feet of natural gas equivalent in 2009 with 95% weighted to natural gas.
The company's balance-sheet strength is considerable. Long-term debt is now being reduced, following the cash proceeds from the Cenovus spin- off. Even before the spin-off, EnCana held relatively little debt. Another plus for EnCana shareholders is that - unlike many other energy companies that continue to struggle with a decline in long-term production - EnCana has no major resource play currently on terminal decline. In fact, the company has several great properties with high revenue potential.
EnCana continues to generate positive earnings in a tough environment, sports a healthy dividend of 2.5% and trades just above book value. So why not buy now and wait for the inevitable turnaround in gas prices?
Eric Roseman
for The Daily Reckoning
Joel's Note: Eric Roseman is the investment director for The Sovereign Society, an independent research group dedicated to helping individual investors protect their capital in this era of increasingly onerous interference from Big Brother. In his latest report, Eric shows members of his Commodity Trend Alert how to buy "scratch and dent" silver at a 25.3% discount.
Daily Reckoning readers may like to give his research a risk-free test drive right here.
Bill Bonner
An Even Better Trade of the Decade
"Hot Babes! Call 800-234-3512"
This ad was on the side of a rolling billboard. In Las Vegas, they put billboards on the back of trucks and move them around town. It must pay; we saw several of them.
What do you get when you call the number? Home delivery? We don't know...
But what a town! We stayed in the Four Seasons. Nice hotel, right? At 4AM the phone rang:
"Could you send up some condoms to room 10211?"
"What?"
"Who is this? Isn't this the front desk?"
"I'm sorry, but I think you've misdialed."
"Sorry..."
Later, in a taxicab, we saw a different Las Vegas:
"This town is dead. Just look around. It's nothing like it was a few years ago.
"We got hit hard by this recession. Lots of cab drivers lost their homes. What are you going to do when prices go down 50% at the same time your income goes down 50%? People don't come to Las Vegas. So cab drivers spend their time at the airport waiting for a fare. So they can't make their mortgage payments.
"Just look how quiet it is. I'm glad I'm retiring. I've been driving this cab for 17 years. That's enough. Before that, I was in the army. My wife and I both were in the army.
"We both grew up in the same orphanage in Brooklyn. Then we got married at 16 years old. We had to change some documents from the orphanage and drive down to Elkton, Maryland. Apparently, they don't care how old you are in Elkton. So, we got married at 16...
"Then, we stayed together for the next 48 years. We were getting ready to celebrate our golden wedding anniversary. And then she got pancreatic cancer. Boy I miss her.
"But we had some great times together. We have 11 children. Only 2 are our natural children. We adopted the others. We grew up in an orphanage. Both of us. So we knew how important it is for kids to have a home. We gave them the best home we could.
"And I'm proud of them all. They're doctors, lawyers...all of them turned out well.
"But it's time for me to retire. There's no traffic. And besides I'm not retiring completely. I got offered a job, part-time as a traffic controller...an office job. A lot easier than driving a cab."
And more thoughts...
Here is the speech we gave in Las Vegas on Saturday, edited and improved:
An Even Better Trade of the Decade
On my recent trip to India, the financial press was very eager to hear what I had to say.
They invited me on to their television shows. They interviewed me for magazines and newspapers. The local paper ran a full-page interview and sent out an artist to do a sketch of me.
I thought they might have had me mixed up with someone else. I'm not used to people taking me so seriously.
"Noted Western Economist Gloomy on World Recovery," was the headline in the paper.
In all these interviews I had more or less the same message. I told them that there was no recovery...none at all...and that very soon it would be obvious that we were in a period of correction - the Great Correction, I called it.
Stock prices would fall, I said. The property market in the US and the UK would sink further. There would be some spectacular bankruptcies...including some bankruptcies by whole nations.
Whether the next move to the downside has begun or not, I don't know. The Dow fell 158 points on Friday, after taking a jolt earlier in the week. Gold rose over 1,180.
The one thing that Indian investors seemed most interested in...and I assume you are interested in too...was my Trade of the Decade. But I'm not going to give you a typical investment analysis or a target for GDP growth or for the Dow this year. Instead, I'm going to talk to you about history and philosophy. I hope that's okay.
I had great luck with my last trade of the decade. Ten years ago I suggested selling US stocks and buying gold. It worked out very well on both sides. So people wanted to know what my trade would be for the next decade. I gave it some thought and came up with something. I think this one will work out too... but I'll give you an even better Trade of the Decade.
But first, let me explain how it works. Behind the Trade of the Decade is just a simple observation: that things that are very out-of-whack tend to get back into whack. Over a 10-year period you have a fair chance that they'll return to normal.
This is another way of describing the phenomenon known as regression to the mean. One of the surest phenomena in the natural world is that things that are extraordinary will eventually become less extraordinary. And over a 10-year period, you have a decent chance that that's what will happen.
So, what's my Trade of the Decade now?
Right now, the US Treasury market is out of whack. It's been going up since 1983. And now investors lend money to the world's biggest debtor at what are historically very low interest rates. And they do this at a time when that debtor has begun the biggest borrowing and spending spree in history. This is not normal. It's downright weird.
Sometime within the next 10 years, I figure that the Treasury market will get whacked hard. So on one side of the trade...I'm short US Treasuries.
On the other side of the trade I had more trouble. Because I was looking for something to buy. And nothing is really cheap. Even gold...which seems to be in a bull market...and which I expect to go up much higher...is not cheap. As near as I can tell, an ounce of gold buys about as much - in terms of consumer products - as it did 700 years ago...and maybe even as much as it bought 2,000 years ago.
Gold has already reverted to the mean, after being seriously undervalued in 1999. Now, most likely, it will become over-valued when the current monetary system begins to break up...but that's a different phenomenon. It's not reversion to the mean, at least, not for gold. It's a reversion to the mean of the monetary system... I'll get to that in a moment.
What I needed for the buy side of the trade was something that was historically undervalued. And the best I could come up with was Japanese small cap stocks, which have been going down since 1989. There are some that sell for less than the amount of net cash and current assets that they have in their own company accounts. That is extraordinary. Of course, it could become even more extraordinary. But that's the risk we take. And over 10 years, we hope that that risk - such as it is - comes and goes.
So, that's the new Trade of the Decade. Sell US Treasuries. Buy Japanese small caps.
But I'm going to give you an even better Trade of the Decade. The problem for non-Japanese investors is that the small caps may actually go up...but if the yen goes down you might lose your gains.
So, how about this? Instead of selling US Treasury bonds, sell Japanese government bonds. Japanese bonds are probably even more over-valued than US bonds. And with the Japanese borrowing more than ever...while the Japanese savings rate declines...it seems a fair bet that Japanese government debt will go down at least as much as US debt. Maybe more.
By buying Japanese small caps while selling Japanese bonds you take out the currency risk. You have an even better Trade of the Decade. The Japanese small caps stocks are extraordinarily under-appreciated. The Japanese government debt, on the other hand, is extraordinarily over- appreciated.
But the first point I want to make is that this is just an idea. It's not a substitute for a serious investment strategy.
The second point I want to make is that you can only have a serious investment strategy if you're willing and able to think deeply about ideas. And if you do think about them enough, you'll have a decent chance of doing well...simply because most people - including most serious investment professionals - don't think about them very much. That's what I mean about philosophy...you have to think long and hard about how the world actually works. And history is about the only tool we have to work with.
I'm going to give you 2 examples of what I mean right away.
First, we celebrated an important anniversary in April. It was 2 years ago, in April 2008, that Countrywide Financial went broke. Countrywide was the second biggest subprime lender in the US. When it went down it set in motion a whole series of domino-like bankruptcies that eventually wiped out half the world's capital.
But when Countrywide collapsed, reporters asked Henry Paulson what would happen next. Paulson would seem to be a good person to ask. He was Secretary of the Treasury and formerly the top man at Goldman Sachs. Nobody had more or better information than Paulson. So what did Paulson say?
He said that he could imagine 'no scenario' in which the taxpayer would be called upon to bail out the financial industry.
That was 2008. By the end of 2009, according to Bloomberg's calculation, the federal government had committed more than $8 trillion in taxpayer support, supposedly to prevent the end of the world.
It must have worked. Here we are 2 years later, and the world still exists.
But there's a gap of 8,000 billion numbers between Paulson's estimate and the eventual federal commitment. Which, at the very least, makes you wonder about the people at the top of America's financial intelligentsia...and the methods they use to figure out what is going on.
What does it mean when the best informed, most sophisticated, most knowledgeable financial authorities in the country are completely wrong about what is going on?
Continued tomorrow...
Regards,
Bill Bonner,
for The Daily Reckoning
-------------------------------------------------------
And one final word from Joel, in Taipei...
If you're one of the more than 3,000 people who took our precious metal coin survey last week, you'll be as interested in the results as we were. You can grab a few bullet points here but, truth be told, it was the comments and questions in the "open ended" section that we found most valuable.
We boiled down some of your most frequent queries about coin investing and, next Tuesday, Addison will put them to First Federal's CEO Nick Bruyer and a couple of reps from the two major, independent coin grading companies - NGC and PCGS.
If you're interested in hearing what these guys have to say, you can sign up for the free, web-based follow-up interview right here. We'll let you know the moment it goes live.
Again, thanks for your interest in the survey and for helping us drill down into the questions you and your fellow reckoners really want answered. We trust you'll find the interview valuable.
Cheers,
Joel Bowman
Managing Editor for The Daily Reckoning
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