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Weekend Edition

The Best of The S&A Digest
Saturday, October 13, 2007

Here's an interesting way to play the subprime crisis... buy the property insurers. These companies are trading at their cheapest multiples since 2000 based on fears that they hold large chunks of subprime debt. In reality, subprime only constitutes 1% of their fixed-income assets.
 
The S&P 500 Property & Casualty Insurance Index dropped 6.2% in the third quarter, worse than the 4.9% drop of the S&P 500 Financials, which includes subprime-mortgage originators Lehman Brothers and Bear Stearns. The average property and casualty insurance stock trades at around 8.3 times earnings now, down from 17 a year earlier.
 
Shares of Allstate, the largest publicly traded U.S. home and auto insurer, dropped farther during the subprime scare (18% from peak to trough) than they did after Hurricane Katrina, when the company lost $3.6 billion.
 
We just published our latest issue of the S&A Oil Report this week, titled There Are No Easy Barrels Left. One look at Matt Badiali's current portfolio forces me to admit, that yes, it is a big, big bull market in oil right now. Twenty-one of Matt's 35 recommendations are up double digits, and only seven are down. His three biggest open winners have soared 82%, 80%, and 56% in less than two years.
 
Matt's latest recommendations are in the nascent field of deepwater drilling services. This is a very young sector of the oil business. Up until the mid-1990s, Big Oil didn't have the computing power to map large sections of the ocean floor. With the leap in technology of the past 10 years, however, spending on deepwater oil exploration is exploding... and large oil fields are turning up in the Gulf of Mexico.
 
Signs of a market top? The spread between the risk premiums of put and call options on the S&P 500 is unusually high. Normally, the spread is around 6%. But since August, speculators have favored puts, causing the spread to widen to 8.1%. The last time this indicator approached these levels was in July 2001, just before the S&P 500 fell 34%.
 
To Americans of a certain age and persuasion, savings are only dollars you haven't spent, yet. According to The Wall Street Journal, "more individuals have been borrowing from their 401(k) plans or taking hardship withdrawals in recent months." The official statistics won't be released until next year, but a number of 401k plan providers report a "noticeable" uptick in the demand for loans.
 
These are my kinds of communists: The number of billionaires in China jumped to 108, up from 15 last year. "Communist" China now has more billionaires than any country besides the U.S.
 
From a reader: Where did I just read that inflation makes debt cheaper? With all the money the US owes, don't you want hyperinflation?
 
Ignoring for the moment the morality of what you suggest (using inflation to steal from creditors and reward debtors), what all of the fans of central banking (i.e. inflation) forget is that while inflation devalues debts, it also devalues assets at the same rate.
 
Take the subprime crisis. We guess investors could hold $250 billion worth of bad subprime debt. Assuming 50% of the amount is recovered through foreclosure, the industry could suffer a $125 billion loss. According to Bill Bonner's latest book, Mobs, Messiahs, and Markets, Americans hold $46 trillion worth of financial assets denominated in dollars. Assuming a slightly increased rate of inflation to help solve the subprime crisis – by 2 percentage points – you'll see a $920 billion loss of purchasing power.
 
Why would you destroy close to $1 trillion in purchasing power to bail out a $125 billion problem? Because you don't have to raise taxes to do so and because most people have no idea what inflation means or what it costs.
 
Marty Whitman – one of our favorite value investors and the long-time head of Third Avenue Value – has established a huge position in Hong Kong real estate companies. He says: "In the next several years, lots of income producing real estate located in Hong Kong, Mainland China, and Singapore may be sold to captive Real Estate Investment Trusts (REITs) at very attractive prices..." He owns Cheung Kong, Henderson Land, and Wheelock. Graham Summers outlined the reasons for Whitman's extraordinary success in Growth Stock Wire earlier this week.
 
S&A Penny Letter pick International Coal Group (ICO) gained close to 10% after a Stifel Nicolaus analyst upgraded shares of Massey Coal, suggesting production volume and pricing will improve over the next few quarters. A Bank of America analyst also initiated coverage on ICO with a "neutral" rating. Analysts believe metallurgic coal will have a high demand due to the current steel boom.
 
Regards,
 
Porter Stansberry




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