Small Cap Stocks

On the subject of the continuing bailout saga, I offer the following quick thought: Ignore the Drama. It will soon pass, once the robbery of key financial assets, by connected billionaires, is complete. What’s happening now in the US, used to happen routinely in third-world countries, like Brazil. As such, the history of the financial markets during government induced panics in those countries, should provide a good framework for developing a profitable investment strategy during the current US panic.

The way to make money off of Paulson’s Panic and Plan, is simply not to panic and stick with companies with strong balance sheets and good growth prospects. Let the billionaires battle it out for who will ultimately gain control of the massive US hedge fund.

As I’ve stated in previous posts, any thinking person can clearly see that the events of this month and the current bailout scheme, led by Paulson and Bernanke duo (and now famed investor, Warren Buffett), represent one of the greatest financial frauds of all time.

I offer these two additional insights for thinking investors:

1. Everything Paulson’s plan is seeking to save hardly existed in the economy 10 to 15 years ago and more importantly does not need to exist for an economy to function properly and grow. Specifically, there is absolutely no need for complicated mortgage-backed securities in order for any real estate market to function and flourish. Actually, you don’t even need mortgages to support a healthy real estate market. There is also no need whatsoever for complicated credit default swaps, which have brought down AIG. As such, if these assets completely disappeared from the financial world, as they should, there would be absolutely no long-term fallout or depression in the US or the world. Yes, there may be a slowdown for a few quarters in the US and world economy, as traditional banks rebuild their capital, but over time, the economy would pick up again, as it always does.

2. But what about banks failing, you may ask? A simple mathematical analysis would prove that traditional banks, taken as a whole, do not need to be bailed out, even if they suffer $1 trillion in cumulative losses. Non-traditional or shadow banks, such as hedge funds, are another story, but then again these institutions contribute nothing to the real economy and hence can disappear with no long term effects (though again there will surely be short-term effects as the economy adjusts to what was previously a normal economy, as opposed to a ponzi scheme economy).

The reason why most traditional banks do not need to be bailed out is simply because they can lend off of their deposit base. So to the extent that most people in the US continue to work providing needed products and services, the economy will grow over time, and the deposit base of banks will also grow. As deposit bases are rebuilt, in due time lending will also pick up steam. Yes, many banks may have to curtail lending significantly for some time, as balance sheets are strengthened and the deposit base is allowed to build back up, but again that is merely a timing issue of at most a year or so ($1 trillion dollars is only 10% or so of US GDP, so it’s not a big number when you take into consideration the entire working population of the US). Over time, banks would rebuild their capital, and the economy would pick up again, as it always does.

So, although we cannot avert a recession as banks balance sheets are rebuilt, there is obviously no need for a bailout. So why the Paulson Panic and Plan? It’s a simple way for Paulson, Goldman and others to seize a huge amounts of financial assets which will generate astronomical income fees and profits for years to come. In addition, Paulson is looking to save the giant financial Ponzi scheme which he helped to develop over the last decade or so.

The only people who need to panic in the current market are those Wall Street billionaires who have for one reason or another somehow personally slighted Paulson in the past. Clearly, Paulson disliked Fuld and Greenberg, and hence bankrupted LEH and sent AIG reeling.

Goldman, of course, survived, and Buffett’s investment in Goldman is probably simply a case of Buffett trying to get into good graces with Paulson, before the $700 billion in spoils is divided following the bailout. What’s interesting about Buffett is that it’s simply amazing how he survived this whole crisis without any damage to his reputation, despite the fact that he owns big stakes in the rating agencies which were key players in precipitating the financial crisis. It’s also interesting to ponder the ties of Buffett to AIG and Greenberg (i.e. isn’t Buffett a competitor of AIG and Greenberg).

What was said for Buffett applies to Bill Gross of Pimco, as well. Check out his ludicrous rationalizations for the bailout here: http://biz.yahoo.com/rb/080924/business_us_financial_bailout_pimcobiz.html . Bill Gross is also angling for a piece of the bailout spoils, so it’s understandable that he is in favor of the bailout.

Apparently, Paulson misses his days at Goldman and Bernanke is jealous of other sovereign wealth funds, so together they have both created the largest US hedge fund, with potential assets of over $700 billion. Incredibly, Paulson will have unprecedented powers to use the nearly $1 trillion as he sees fit, with little or no oversight. You can read the details here.

About, the only thing missing from the government hedge fund is the authority to buy stocks and commodity futures. But, I’m sure these asset classes will be added once the “private asset managers” who are supposed to manage the government hedge fund gain control. On the subject of private asset managers: This seems like the business opportunity of a lifetime, and one wonders who is going to get that job.

All kidding aside, the more one thinks about this bailout plan, the more one realizes that it is simply ludicrous, comical, and has potential fraud written all over it. Giving one or two people authority over what will become a fund worth over $1 trillion of other people’s (i.e. US taxpayers) money, is simply a travesty. Is it any wonder that Paulson is pressuring everyone to get this deal done as soon as possible?

The root of the current crisis is: Too Much Leverage by consumers, businesses, and financial institutions.

The way out of this crisis is simply: Reduce Leverage, no matter how painful that will be and how long it will take.

Highly leveraged financial institutions and hedge funds investing in toxic assets have nearly brought the US financial system to ruin. Will setting up a giant hedge fund to buy the assets that many sophisticated investors have already concluded are not worth buying, somehow save the US and world financial system?

Instead of investing $700 billion in worthless assets, why not put $700 billion into developing products and services that society really needs? How about investing $700 billion into implementing alternative energy plans so that we can reduce our reliance on foreign oil and help the environment in the process? Surely, this will do more to help the economy long-term, than setting up a hedge fund.

How to personally profit from the Paulson scheme? For various reasons, I still think commodities, energy/alt. energy, and emerging market shares will continue to soar on this bailout news. Stay away from dollars and US companies with no significant export business. Though I’m biased to a certain extent, I still think Brazil is a long-term winner as this crisis subsides. The country is in great fiscal shape, is politically stable, is energy independent, and has the largest commodity economy in the world. One negative about Brazil is the corruption in politics. But surely, after witnessing what Paulson has done in the last few weeks, Brazil’s corruption seems quite tame relative to what is currently happening in the US. EWZ provides the widest exposure to Brazil, but it is a highly volatile equity (Disclosure: I am long EWZ).

If you need a prime example of the height of insanity that our financial markets have reached, look no further than the KBW Regional Banking Index (KRE).

This index, which represents regional banks in the US, fell to a low of about $22 back in July when significant pessimism surrounding US financial institutions, especially FNM and FRE, really began to take hold. Amazingly, today on the heels of the Fed rescue plan, this index opened at $51 and climbed to $60, a multi-year high. If you were long this ETF and were able to take profits: congratulations!

In essence, in less than two months, during what was supposedly the worst financial crisis in decades, an index, which represents many companies supposedly facing a crisis, nearly tripled in value and reached prices from back in 2006 before this financial crisis even started. So, presumably holders of the KRE can naively and confidently reply, as the President of Brazil Lula did just the other day when asked about the financial meltdown: “Financial Crisis? What Financial Crisis?”

What a game!

Today’s development in the continuing US financial saga, proves again the ultimate fragility of our entire financial system, but alas it’s good news for those who enjoy playing the investment game (unfortunately, most can’t even play today since all the online brokers sites have crashed).

From what I’ve read, the Fed will seemingly set up an entity which will spend hundreds of billions buying up worthless paper from US banks. Despite the obvious implication for the long-term value of the dollar (i.e. very negative, but positive for energy) this is good news, since it essentially allows banks, over time, to recapitalize and for the financial game to resume as usual in due time. As such, we should be back, at least momentarily, to the regular features of the stock market game: analyzing and making bets on future profit potential and subsequent changes in valuation.

It’s unclear why the government couldn’t have implemented this solution a few weeks ago or a year ago, but perhaps the government needs to give the impression that the financial system is not a house of cards. Or perhaps many in the government really do believe in the reality of our paper-based, or now bit-based, financial system. Clearly, if too many people believed in the Keynesian view that the financial markets are merely “a game of musical chairs”, it becomes difficult to motivate people to work and save, since human psychology doesn’t deal well with irrationality and randomness. So in some sense it is important to scare the living daylights out of market participants once in awhile in order to at least provide a semblance of reality to the financial game. Finally, and most likely, the government, aka Paulson, needed time to orchestrate one of the greatest financial frauds of all time (refer to this post).

However, if you’ve been following the events of the last few weeks closely, surely you would now agree that the financial system is and has always been a casino (i.e. Casino Capitalism), which rests entirely on emotional sentiment, confidence among the players, and continued cash infusions from the government to function.

In a sense it is a massive ponzi scheme, with one crucial difference: The ponzi scheme should never, and will never be allowed to, collapse completely since there is always an entity, i.e. the government, that can, and must out of necessity, infuse money into the system to keep the ponzi game going. There is, of course, nothing wrong or cynical about this state of affairs, since these are simply the rules of the game. Most of the time they function very well, but in certain instances, when confidence is low, the government must step in to get the system running again.

Investment implications of the bailout: As I mentioned in the past, I believe you should continue stick to energy, alternative energy and emerging market (e.g. Brazil) stocks, since printing another $500 billion will surely devalue the dollar over time and force up commodity prices.

The UK bans short selling, major US pension funds refuse to lend shares to short, naked shorting rules in the US are implemented… and stocks skyrocket? Coincidence?

Did short selling of financial stocks greatly exacerbate this panic? If so, Paulson and his cronies bankrupted Lehman (LEH), Fannie (FNM), Freddie (FRE), and took over AIG because of short-term pressure on stocks from illegal shorting? How else can the strange events of the last two weeks be understood. Some entities obviously profited big from the overnight demise of these financial companies. At the same time, long-term shareholders got completely wiped out. Was saving long-term shareholders, most of whom were employees of the companies, really a moral hazard, if wiping them out simply rewarded short sellers? The irony, of course, is that the same investment firms which facilitated illegal short sales are now being brought their knees by illegal short sales.

Unfortunately, it’s doubtful we will ever find out the truth of what transpired during this unusual month. However, it seems clear that the stock market casino, has apparently caused major political and economic upheavals. It should now be interesting to see which Wall Street firms win the business of managing the government’s new financial businesses (i.e. FNM, FRE, AIG). Goldman anyone?

What the government is essentially doing in its current “bailout” schemes, in my opinion, is simply stealing companies from US shareholders. This sort of thing used to happen in third-world countries, like Brazil, where for example during the reign of their President Fernando Collor de Mello, citizens bank accounts were essentially confiscated overnight and replaced with less money the next morning.

In the same vein, Paulson and the rest of the US Government, are simply taking advantage of short-term liquidity issues to confiscate US companies, and wipe out shareholders in the process overnight. Yes, they haven’t actually gone into citizens bank accounts yet, but is there really a difference? And could we expect anything different when we hired a Treasury Secretary, whose former job was running Goldman Sachs?

Some may argue that the stocks are really worth $0 and hence the Government is doing the right thing. This of course is too complicated a subject to get into at the present time, but suffice to say, there are other more rational options to the current crisis and it is quite obvious that these companies are not worthless. And are regular shareholders really to blame for the current crisis? By what measure are creditors of these companies more worthy than the equity shareholders, especially since it’s the creditors who have created all these derivative schemes?

For instance, most people I’m sure realize that AIG’s fall had to do with the need to post collateral for credit default swaps. There is absolutely nothing wrong with AIG’s other insurance businesses. Why on earth AIG really feels the need to honor these collateral requests is beyond me, especially since most of the company’s counterparties are seemingly themselves facing a similar crash crunch. Couldn’t the level of collateral required been renegotiated or paid out over time when things settle down? And who exactly are the counterparties that are forcing AIG to post collateral immediately? Why should AIG bow to their demands?

The key question to ask, therefore, is who is getting wealthy off of these US “bailouts”? In the Lat Am countries, like Brazil, it was clear that President Collor and his friends and family made fortunes off of the bank raids. But, who is making money off of the US Government’s Robbery of US companies? Hedge funds that are shorting on inside information? Foreign governments?

Bottom line, the current bailout scheme is simply unprecedented in the US and is akin to government robbery of US business to benefit a few insiders. Time will tell how this plays out. In the meantime, if Brazil’s past provides any clue as to the ultimate endgame, it is this: At some point the robbery will end, business will get back to normal, and investor’s confidence will return.

It may take 1 year, 2 years or 5 years, but things will get back to normal, as there is not much left for the government to steal, unless of course they opt to pay for the next “bailout” by raiding US citizens regular day-to-day bank accounts. Perhaps, then US citizens can dip into Paulson’s and Bernanke’s bank accounts to pay our day to day bills?

Investment Opinion: Stick with commodities, related commodity/energy equities, such as alternative energy, and invest in companies with business overseas. After this crisis passes, the US dollar will plummet again, as no sane person could possibly believe the US currency is worth much, after all this. When the dollar once again begins its descent, oil and other commodities/energy will soar, along with the stocks in emerging markets, many of which are more stable the US, which has quite literally become now become a third world market.

Quick Follow-Up:
I listened to an interesting interview with Donald Trump yesterday who said that Paulson probably made a great deal with AIG. However, the flaw in this argument is that the government should not be in the business of “making great deals.” They are not a business, they are a government and a lender of last resort. As such, trying to negotiate a takeover of AIG, taking equity etc. is completely senseless and the wrong approach for government (as the Markets have already decided). Paulson, given his background, probably can’t help himself from acting like a businessman/shark in this environment, while what the financial system really needs is simply a government that supplies cash (“lender of last resort”) and restores confidence.

A second interesting debate, centers around the fact the government is getting equity in these failed institutions, and that ultimately these investments may become quite profitable, benefiting tax payers. But does anyone seriously believe this nonsense? In what way will taxpayers ever see the profits (if there are any) from these equity positions? Will the government lower taxes in years ahead or send out dividend checks to everyone, if these equity positions become profitable? I’m sure nobody believes either option is possible, and ultimately it’s not clear who benefits, if in fact the government’s equity in these failed institutions increases in value. The truth is probably that there are no financial benefits that will accrue to any taxpayers, and this is why the government forcing companies into bankruptcy, and taking equity stakes, instead of just supplying cash, is utter foolishness, in my opinion.

One of the issues in this crisis, probably centers around the fact that many in the government actually believe in the “reality” of the financial system. However, any rational person recognizes that the financial system is merely a ponzi scheme and can only sustain itself with constant cash infusions from the government. There is nothing wrong with that. That’s the game and it’s usually a fun game for everyone. But the government needs to recognize the game and keep it going by supplying huge amounts of cash, and not busy itself by negotiating to buy troubled businesses.

First there was Bear. Then Fannie and Freddie. Now possibly Lehman will fail. But the key question, I keep asking myself, is: So What?

Has the economy really been damaged by the failure of any of these firms. The answer is: No. Will the economy be damaged by more failures. The answer, again, despite the marketing by biased financial institutions and the Fed is, I believe: No. In fact, these firms should be allowed to fail as quickly as possible, so the economy can get back to creating, producing and selling products/services that are actually needed by society.

The major US financial institutions have long ago ceased to provide any product/service that is actually in demand or needed in society. Even simple mortgages, and especially mortgage-backed securities, are not essential to a fully functioning real estate market (see below for a brief explanation).

Of course, there is a need for basic banking services in an economy, but major US financial institutions, and especially the investment banks, hedge funds etc. have not really been focused on “true” banking business, for quite some time. Instead, they are in the business of selling, marketing, and trading what amounts to worthless paper. Society does not really need what they sell. As such, should these firms completely disappear the US and world economy would be no worse off. Quite a few paper billionaires, make become mere millionaires, but should that really concern society?

I’d be more worried, if a company, like Microsoft or Google, was on the brink of failure, since they produce products that are needed and demanded by society. Then again, even if they failed, it would not be much of a worry, since there are plenty of smart entrepreneurs who could fill the void and recreate the products.

Basically, as long as there are companies, and most importantly hard-working people, in an economy, which create and supply products/services that are needed and in demand, an economy can continue to grow and flourish. Naturally, without major banks peddling worthless securities, many companies would fail, since due to the paper ponzi scheme developed by Wall Street, many businesses are not run to produce profit, but rather to sell securities. However, there are millions of businesses that are run for profit, and that sell needed products/services and these companies would continue to flourish.

Getting to investment strategy: as long as the companies you invest in provide needed products/services and do not need continued financing, you should not be worried by the current sell off (assuming of course you do not buy on margin and are diversified). The values of these companies, even considering major fluctuations, will be mostly retained over time, since they sell something that is needed and, presumably, can do so at a profit.

On the Mortgage Market: Quick Take
Interestingly, if the mortgage market completely disappeared, society would still function and people would still buy real estate. Need proof of that: Consider traveling to other countries, like Brazil, where the vast majority of real estate transactions are and have always been conducted in cash. Of course, without a mortgage market, real estate prices would plummet further, since few can afford current prices in cash. But, still the market would function perfectly normally and over time it would eventually recover and go higher due to steady demand from population growth.