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Weekend Edition

The Best of The S&A Digest
Saturday, July 12, 2008

Financially speaking, it might be the end of the world...
 
Shares of Fannie Mae and Freddie Mac plunged this week. The collapse was helped along when bond traders began marking down the "agency" bonds of both companies. These are packages of mortgage securities guaranteed by Fannie or Freddie.
 
The spread between agency debt and U.S. Treasuries reached a 22-year high, which indicates bond traders no longer have confidence in Fannie's or Freddie's ability to guarantee their mortgage securities. If the agency bonds continue to trade lower, it will spark chaos in the financial markets – a kind of global run on the bank.
 
Most U.S. banks hold agency debt as their reserves. Banks would have to sell agency debt (at a loss) and buy U.S. Treasury bonds or else risk falling under the standards for capital reserves.
 
 This is exactly the kind of crisis I warned my subscribers about in my last newsletter:
 
...most people don't realize how important the U.S. mortgage market has become to global liquidity. Ten years ago, the total U.S. mortgage market was about $3.5 trillion, roughly equal to the U.S. Treasury market. Today, the U.S. Treasury market has grown to $4.5 trillion. But the U.S. mortgage market has more than doubled to about $9.5 trillion.
 
These mortgages, packaged into securities guaranteed by Fannie Mae and Freddie Mac, make up the reserves of financial institutions all over the world. As these securities fall in price, they're reducing the amount of available outstanding credit globally on a leveraged basis.
 
PSIA, June 2008
 
 What should you do? Ideally, if you've been reading my letter, you're already short several of these hemorrhaging financial stocks (not to mention GM), so you're well protected. The next step is very hard to predict because it's unprecedented. But I believe the U.S. Treasury will act directly to prevent the collapse of Fannie and Freddie from spreading into a global banking panic.
 
It will take action to support the value of agency bonds. What it will do precisely, I can't know. But when it happens, when the world sees the U.S. Treasury defending the value of agency debt, the dollar will come under tremendous pressure. The price of gold and silver (especially silver) will soar. If you haven't protected yourself by selling short financial stocks, don't wait to buy gold and silver.
 
 Cash America's second quarter closed June 30. Yesterday, the pawnshop and payday lender raised its earnings guidance for the quarter by about 20%... and said business was booming. Its shares went up 16%.
 
Pawnshops are the perfect businesses to own in hard times. And they make money when gold rises. Gold is the most popular collateral on pawnshop loans. When gold goes up, people take bigger loans, and the pawnshop earns more interest.
 
I've got a pawnshop operator in my International Strategist portfolio. We're up almost 40% in this position since April. Gold is on a journey to $2,000. So this gain is getting much bigger.
 
 From a reader: My lackluster performance over the years has driven me to subscribe to your newsletter. Can you please recommend how I should reposition myself?
 
This is a very frequent question, one we've addressed several times before. While we don't provide any individual investment advice, here's how we think everyone should begin using our letters.
 
First, you have to learn how to avoid losing money before you're likely to be successful. That means, keep the majority of your assets in safe, fixed-income positions while you get to know our analysts and their recommendations. Second, always remember to use good discipline – which means appropriate position sizing and trailing stops. Third, approach our recommendations with a firm eye on risk. Buy the recommendations you believe have the least risk.
 
Once you've mastered safe investing, you can begin to buy one or two of our more speculative recommendations. I would recommend spending at least one year getting to know our analysts and their recommendations before I would even consider being "fully invested."
 
One last piece of advice: I believe almost all individual stock investors lose money, nearly every year. And they all fail for the same reason: They put far too much of their portfolio in one or two risky stocks they don't really understand.
 
If you lose your risk-management/position-size discipline, you will most likely fail, no matter what newsletters you're reading.
 
Good investing,
 
S&A Research




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