January 2009

Porter Stansberrys

Investment Advisory
What to Do with Your Money Now

What to Do with Your Money Now

By Porter Stansberry

What do I think is going to happen in 2009? I think well see a gradual shift in the market from the great unwinding to the great debasement. I call this trend The End of America because I believe well end up losing control of the worlds financial system. The dollar is on its way out as the worlds reserve currency. The enormous growth in the Federal Reserves balance sheet and the unprecedented increases to the federal deficit mean a new hyper-inflationary period is just around the corner. (See the December 2008 issue for details). I dont know how long the transition from our current deflationary panic to the next inflationary crisis will last probably a lot longer than I think but I know the shift must occur. You cannot have a lasting deflation with a worldwide paper reserve currency because nothing limits how much money the government can create or constrains what it does with it. So far, the government has given this money to banks and bought mortgages with it two approaches that havent worked very well. Soon, it will build huge, wasteful infrastructure projects. But what if it simply bought stocks? Imagine how much the Dow would go up overnight if the Federal Reserve began buying blue-chip stocks. It could easily happen. The only real question is how much damage will occur when the inevitable inflation arrives and people realize its not safe to hold dollars or lend at fixed interest rates? That question will have to be answered in the next crisis. For now, I think you have to position your portfolio to prosper in a mild to moderate inflationary scenario. And that means buying high-quality companies at good prices, buying high-quality corporate bonds with short durations, owning gold, and selling long-dated government bonds. Well do most of these things in this issue.

The Best Opportunity of 2009: Long Corporate Bonds/Short Government Bonds

The current economic problems have their roots in the vast expansion of debt in the United States over the last three decades. Americans have borrowed far more money than they can ever hope to repay. Most of this debt remains tied to residential real estate, but there are also record amounts of credit-card, commercial real estate, and public (state and federal) debt. It is extremely unusual to see real estate prices fall without employment declining first. Assuming credit remains available, housing prices are always correlated with employment and wages. But in the late 1990s, real estate prices came untethered from wages. A bubble formed, powered by a huge increase to mortgage debt. When those debts began to sour, asset prices began to fall even though employment and wages remained strong. The only time thats ever happened before was in the early stages of the Great Depression. This marked the beginning of the great unwinding as the excess debt began to unravel. The result has been a sustained decline in the underlying asset prices upon which layer after layer of debt had been securitized.

Declining asset prices and the large amount of mortgage debt already outstanding makes it virtually impossible for the private sector to create any additional credit. And because Americans (in aggregate) have not saved a penny in almost a generation, theres no way to keep the economy going. Americans have become credit junkies; without more credit, Americas economy falls apart. But according to the Federal Reserve, outstanding U.S. consumer credit fell in November by $7.9 billion the largest monthly decline ever. Thats a 3.7% annualized decline in consumer credit. Thats never happened before not since 1943 when the records begin. Credit-card balances declined by $2.8 billion, and auto loans declined by $5.2 billion. The declines in credit made a huge impact on consumer demand. Car sales fell by record amounts in December (32%), and retail sales fell across the board at Christmas. It was the worst holiday retail results in more than four decades. These declines to credit set the stage for what would normally be a long-lasting recession and a massive decline in asset prices. Imagine how far car prices would fall if it became impossible to get a car loan? Imagine how far home prices would fall if it became impossible to get a mortgage? But the U.S. government has one weapon no other country has the worlds reserve currency. The government clearly plans to make up for the shortfall in consumer demand by increased spending. And both the outgoing and incoming administrations have shown no hesitation to print as much money as necessary to restore the availability of credit. The U.S. budget deficit for 2009 is now projected to be $1.1 trillion more than 8% of GDP. Only during World War I and World War II did the government ever have bigger annual deficits. None of these figures include any of the new stimulus package OBAMA! has promised, which means the actual deficit next year might grow to $2 trillion around 15% of GDP. Given our total debt already exceeds $10 trillion, it seems improbable this level of deficit spending can continue without sparking a run on the dollar via foreign governments selling U.S. Treasury bonds. No one believes our creditors will ever sell the dollar. But theyre wrong. Our creditors will not allow us to print money forever. We are squandering and destroying the greatest advantage of our country control over the worlds reserve currency. Next year, we should see government spending including health care expenses approaching 30% of GDP. That level of government involvement in the economy is much larger than Europes socialist states. And these figures dont reflect the Federal Reserves actions. The Fed has tripled the size of its balance sheet, creating enormous amounts of new money by lending to hundreds of ailing banks and buying up billions worth of dodgy mortgage securities. Recently, the Fed pledged to buy yet another $500 billion of Fannieand Freddie-guaranteed mortgage securities, helping to force mortgage interest rates down. This is how America ends with the lie that we all can live at the expense of our neighbor. Rather than simply face a downturn in the economy, we plan to borrow trillions of dollars our children and grandchildren will be forced to repay. Rather than let all those people and institutions that took on too much debt (like GM) be liquidated and restructured, we plan to risk a hyperinflation. Rather than insist homeowners who cant afford their mortgages lose their homes, we would jeopardize the credit rating of the country.

It is all madness. None of the governments bailout plans will solve any of the problems. The government can only shift the burden of the failures. Instead of bondholders and shareholders being wiped out, taxpayers are put on the hook. These actions will temporarily resuscitate the economy but cause a permanent decline in the value of the dollar. Fortunately for us, we have an easy and safe way to profit from this trend. And the opportunity has never been better. All you have to do is buy short-dated, high-quality corporate bonds and sell long-dated U.S. government bonds. As the dollar loses its value and inflation returns to the economy, the value of corporate bonds will increase dramatically because the risk of default will decline. Meanwhile, inflation will wipe out much of the value of long-dated U.S. government bonds, causing their prices to plummet. You can take both positions easily with low-cost ETFs and closed-end mutual funds. To buy high-yielding corporate bonds, I recommend the AllianceBernstein Global High Income Fund (NYSE: AWF). This closed-end mutual fund trades like a regular stock, but is really a basket of bonds. It owns U.S. corporate bonds and high-yielding foreign bonds. Specifically, the fund holds 42% of its assets in corporate bonds and the rest of its assets are mostly foreign government bonds. The average maturity of its bonds is less than 10 years. In total, the fund has $714 million in assets at current prices. With 76 million shares outstanding, the liquidation value of this fund, per share, would be about $9.39. Today, it trades for roughly $8. Thus, you can buy the fund at a 15% discount from fair value. While its not unusual for closed-end mutual funds to trade at a significant discount from fair value, it is unusual for this particular fund, which has traded at par as recently as May 2008. Also, the bonds it owns have declined significantly in price, which means the real discount on the assets is significantly more than 15%. If you assume the average bond in this mutual fund has declined from par by at least 34% (which is accurate based on historic fair value), then youre not only buying these assets at a discount from todays fair value, youre really buying at a cumulative discount of nearly 50% from par. In plain English, youre buying a basket of bonds that should provide you with something around a 50% capital gain as the market for bonds recovers. In the meantime, this fund will pay you about 10 a month to hold it. Thats an annual yield of 15%. One reasonable question is: Why mess around with a hybrid bond fund that includes foreign sovereign debt? The point of owning this fund is to capitalize on the new, massive flood of dollars. Dollars will find their way into bond markets both domestically and around the world. By having exposure to both groups, we diversify a bit while more fully capturing the real underlying economic trend the deluge of dollars. Im also going to recommend you pair your investment in AWF with a matching short position in a U.S. government bond ETF the iShares Barclays 20+ U.S. Treasury Bond (NYSE: TLT). This will cost you about 3.5% per year, as youll have to cover the coupon payments on the bonds youre shorting. However, when paired with the AWF bonds 15% yield, you have a net yield of about 11.5%. In the parlance of bond traders, this setup is known as a positive carry. Thats part of the beauty of this trade: Youll be getting paid to wait while the inevitable happens. Theres no reason to believe corporate bonds and foreign bonds are worth substantially more than U.S. government bonds, especially when we know the U.S.

government is simply printing money to pay the interest on its debts. Thus, sooner or later, the huge spread that erupted last fall between U.S. government bonds and other bonds around the world will not last.

Being long AWF and short TLT, youre long short-dated corporate and foreign debt and short long-dated U.S. Treasuries. The chart above shows you how the spread the huge gap between these two investment vehicles was created last fall. As this gap closes again (and it must), youll make money on both sides of the trade (as the prices converge again) and also on the carry (the difference between the two yields). In all, I expect well see annual gains of around 40% on AWF and gains of around 20% on the TLT short. Thats the best safe-and-easy way I know to make at least 50% this year. As always, I recommend a reasonable position size. The combined position shouldnt be larger than 10% of your entire portfolio. And you should use a 25% trailing stop loss on both sides of the trade.

Two Other Ways to Play TLT

If your brokerage account will not allow you to short TLT or if you simply dont want to short it, you can do the second part of this trade in two other ways. The first is to buy AWF and the ProShares UltraShort 20+ Year Treasury (TBT) ETF. This returns 200% of the inverse of the daily movements in Barclays Capital 20+ Year U.S. Treasury Index (TLT). If you prefer to do it this way, heres how you would execute it: Buy half the amount of TBT that you are putting into AWF. For example, if you are buying $10,000 worth of AWF, also buy $5,000 worth of TBT. The second way is to buy AWF and the Rising Rates Opportunity ProFund (RRPIX) instead of shorting TLT. This returns 125% of the daily movements of the most recently issued 30-year Treasury bond. In this case, if you buy $10,000 worth of AWF, you would buy $8,000 worth of RRPIX.

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Porter Stansberrys Investment Advisory 1217 St. Paul Street Baltimore, MD 21202 1-888-261-2693