Bearish News

Gold bears are on the prowl again, having apparently recovered from their 10 year scorching, and it looks like some are launching a new counter-offensive.

Exhibit A:

The gold chart below was included in a recent post by John Ameriks of Vanguard. It shows gold prices over the last 139 years (1871-2010), adjusted for inflation.

The intent behind these types of charts is clear. It makes gold look very bubbly indeed.

Mr. Ameriks furthers his bearish gold argument thusly:

Bottom line: Any value that gold has as an investment appears, historically, to have accrued to investors who had a position prior to certain episodes of economic or financial distress. And to generate truly eye-popping returns from a gold-based strategy, you’d have needed to be selling at the peaks of these past price spikes, not buying.

The basis for making an investment in gold now is a conviction that the worst is yet to come. I’m not saying it can’t happen. But looking at how far these prices have come already, and thinking about the kinds of truly disastrous events that are included in this 140-year period, I’m skeptical.

First off — Yes, of course the worst is yet to come. Have you heard about the state of state governments? The double dip is getting rolling, and QE 2.0 is right around the corner. For more on that see this must-read piece from DoctorHousing Bubble.

And regarding the use of long-term charts to predict future prices, it is folly. In 1472 the inflation adjusted price of silver is around $800/ounce.  Is it headed back there any time soon? No, though I would welcome the move.

I did a more thorough writeup on why gold bears are wrong over at WealthDaily.com.

2012 BP puts offer some interesting possibilities. I’m using them as a speculative bet on a worst-case Gulf scenario, but they could also make a nice hedge for longs.

Jan ’12 BP LEAP puts expire 566 days from today (7/14/2010). That’s a lot of time for something to go wrong.

For example, there will be two hurricane seasons between then and now. Just one poorly-placed hurricane could push millions of gallons of crude further into sensitive areas along the Gulf Coast, multiplying the eventual bill for BP. Warm water conditions mean NOAA is forecasting an abnormally high 13-23 named storms in the Gulf of Mexico in 2010.

Potential Profit from BP Puts

Let’s use Jan ’12 $2.50 BP puts as an example. They closed with an ask price of $0.16 today. One hundred contracts at that price would cost $1600 + commission. Each put gives its holder the right to sell 100 shares of BP stock at $2.50 on date of expiration (Jan 21 2012 in this case).

If BP shares are wiped out, the maximum potential profit on 100 $2.50 puts would be $23,138 (assuming a $.02 share price at option expiration). Max loss is the initial cost of the puts, $1600 + commission.

So the max ROI would be 1446%, or around 14x the initial investment. BP filing for bankruptcy is still a highly hypothetical scenario, but I think the risk/reward ratio is good here.

The fact that you can make 14x your money on these options means investors are essentially betting on a 1 in 14 chance of BP going bust by the expiration date, Jan 21 2012. I think there’s more like 1 in 4 chance of bankruptcy, hence the bet.

Buying the $2.50 puts is an aggressive strategy. It’s betting on total disaster. A more conservative strategy use puts closer to the money ($15, $25, etc). The potential upside would be less, but it’s a little bit safer. I own a few different 2012 strikes, including some $2.50s.

BP is an international giant with deep pockets and political clout to match. But its risks are high too. The litigation costs alone will be staggering. Other potential potholes include legislation, reputation, well casing degradation, environmental devastation, and other “ations” we have yet to fully grasp.

On the legislation front,  today the U.S. House Natural Resources Committee passed an amendment which could effectively ban BP from future offshore drilling leases. More on that over at Bloomberg BusinessWeek.

For BP, it all adds up to unknown liabilities, slower growth, and higher drilling costs going forward (no more shortcuts, hopefully). That’s why I think that even a behemoth like BP could buckle under the weight of this mess.

Bankruptcy Scenario

One big question that would emerge from a BP bankruptcy is how claim seniority is handled. Would bondholders and other creditors retain seniority over economic and environmental claims?

I’m guessing common shareholders would be wiped. But a Bear Stearns-esque buyout, with Exxon or Shell reprising the role of J.P. Morgan and U.K. gov’t subbing in for the Yanks is certainly possible. We won’t know until the situation plays out and the full extent of the damage is known.

Further harm to BP investors would be unfortunate. It’s a staple of retirement funds and the demise would have widespread financial impact. However, if it comes down to a lack of funds at some point, it would be an even greater tragedy to punish innocent parties adversely affected by the spill, and shortchange cleanup efforts in favor of investors. An investment comes with risks, always. If someone has to suffer, it’s gotta be stakeholders of the at-fault party.

But that probably won’t happen based on what I’ve read. In the fallout from asbestos/mesothelioma bankruptcies, creditors were placed above victims in most cases (as I understand it). More on that here.

Disclosure: Long BP puts including Jan 2012 $2.50s.
Note: This is NOT financial advice. It is provided for informational purposes only.

• Bought more GOOG this week, it is really really cheap here. I wrote a bull-case article for Wealth Daily on Tues.
• Re-shorted BP today @ $32.50 with a stop @ $36. Still holding some pure gamble 2011/12 LEAP puts at multiple strikes ($2.50 to $29).
• Bought XOM this week, partially as a pair to the BP short, but mostly cause it looks cheap and I needed more energy.
• Trimmed AAPL to near the bone, used proceeds to buy GOOG. Recent developments in China may look bad for Google, but I think they’ll be worse for Apple in the long run (labor costs set to skyrocket).
• Trimmed PGJ (domestic-driven Chinese ETF) a bit. Nothing against this China really, just finding other options more attractive and taking some profits.
• Bought Acergy (ACGY), a Norwegian offshore drilling services firm. Among other things, ACGY are some of the guys who run those ROVs hovering around BP’s Macondo well. Co. just merged with Subsea 7, which should work out well for both parties.

Anyone else got ideas? This market is obnoxious.

That’s the official story, for now. But what a schizo day in the markets. I suspect there is a catalyst at play we’re not aware of yet. Something nasty coming down the pipeline.

Does anyone really believe this panic was caused by a simultaneous collective realization that the EU is in deep sh*t?Anyone who follows business and has a frontal lobe has known this is coming for the past 12 months (expect a similar American crisis within 2-5 years, with similar levels of seashell-collecting until the tsunami hits).

Point is, this can’t be all EU/Greece scare. Lots of potential issues to ponder here. Off the top of my head, here’s three:

• Banks may actually be forced to bring all that toxic sh*t back on their books, and they’re not happy
• Another unknown in the Financial reform bill (possibly breaking up the TBTF crew)
• Bad Spain/Italy/Portugal news coming soon (hidden debts maybe)
• German voters reject Greece bailout package

Whatever the cause, it was a hell of a day. Stocks crashed, dollar soared, and gold skyrocketed. What’s wrong with this picture? Gold pops 3% on a day where the dollar is up almost 1%? Not your typical action to say the least.

Pondering Gold’s Future

I think this could be the start of a big move up for gold.  Yesterday David Rosenberg made a  $3,000 price call, saying it should hit that in the next few years. Targets like that were laughed off just a year ago.

Now even people who don’t follow metals are telling me about $5k gold. Could be a contra-indicator, but I don’t think we’re there yet.  I’d guess 95% of investors have zero exposure to gold, through bullion or miners.

Plus, I am convinced that the Fed will be forced to re-start the printing presses very shortly. And when it does, gold’s going to go even higher. Forget about Fed tightening. They can’t/won’t. Too much political risk, as the situation could get ugly temporarily if they stopped pumping. That’s my opinion, anyway. Take it with a healthy pinch.

Occasionally I write about what I’m buying on this site, so thought it would be worthwhile to review my picks and the reasoning behind them.

Note: Performance %’s are from date of post to 03/05/2010. In many cases, I stopped out earlier on losers or sold winners. I provide additional color when possible.

The Bad

Long Gamestop (GME) @ $24.50: Down 26%. A devious value trap, which still looks cheap to me at 7x trailing P/E. But it gets no respect on Wall St. Everyone’s too busy speculating on BAC and the TBTF mafia, over-leveraged REITs, etc. I am still long GME, but it’ll probably be even cheaper soon.

Short Simon Properties (SPG) @ $51: Down 54%. I’ve traded around this position a few times, with total losses of around 25% on it. I didn’t cover my initial $51 short in the $20′s when I had the chance. Got greedy, figuring they were headed to zero just like GGP. Then the Fed/Gov stepped in with more liquidity than God, and raising capital became much easier, especially for a well-connected REIT like SPG.

Expensive lesson learned, covered that $51 short in the high 40′s. I’ve re-shorted since and been stopped out for losses a few times (and am still stubbornly watching for signs that the inevitable and long-awaited CRE shoe is finally dropping).

Long GRZZX (May 2009): Down 49%. I sold this short-only mutual fund for a 20% loss, as the bull market picked up steam and bailout bonanza really got under way. Theory was that it would be nice to have a diversified basket of shorts for the inevitable double dip.

At that point the market had already bounced 28% from lows. The world was ending, and this little bounce was dead-cat in nature. Boy was I early. Not to mention generally naive about the effects of government-mandated recklessness. A few days after I bought GRZZX in May, I wrote The Deck is Stacked Against Shorts. A month earlier I warned bears that More Bailouts and Inflation Loom. Shoulda been bargain hunting or speculating on garbage stocks.

The Good

Long AAPL @ $81 (Jan 2009): Trades at $218.95: Up 168%: Apple was a lesson in how to trade the next panic. When that crazy growth-monster momo stock you lust after (but don’t want to pay a premium for) crashes, BUY IT. Other examples: VMW, GOOG.

I bought more AAPL at prices ranging from $81-$93, and ended up with quite a large position (for me). If I remember correctly,  Apple was trading at around a 16x P/E with screaming earnings growth and $30/share in cash. There really were some bargains there for a while… Still holding around 1/3, house money. Sold the rest from $160-$194. The stock is a beast, no telling where it’ll stop. But I am skeptical of the iPad’s prospects.

Long Palladium bullion @ $250/ounce: (June ’09) Now trading at $470/ounce – Up 88% (June 2009). I think my thesis was solid, and appears to be playing out. Back then I said, “It may prove to be a good hedge against an inflation-fueled recovery. As the world continues to print money in an attempt to stimulate industry/consumers, demand and inflation could increase dramatically. This may in turn cause commodities like palladium to rise significantly, as governments artificially goose the markets.”

Long PGJ @ $13: (Jan ’09) Trades at $24.21 – Up 82%. My favorite China ETF. It has minimal financial sector exposure (unlike FXI, where the index is 40%+ finance stocks). Still holding most of this.

Long TRAMX @ $5.66: (May ’09) Now trades at $6.99 – Up 23%. Africa and Middle East mutual fund. If traditional emerging markets aren’t risky enough for you, you can buy this fund and get exposure to these politically volatile but fast-growing markets. Still holding.

Long EKWAX @ $45: (Jan 2009) Now trades at $73.29 – Up 58%: I love this gold fund. These guys know how to pick winners in the mining space. It’s up 602% over the last 10 years. I agree with George Soros here. Gold may eventually be a bubble, but it’s one that I want in on. And it has not come close to peaking yet, with countries around the world engaged in a currency race to the bottom. Still own it.

Morals of the Story, Lessons Learned

Overall I’m happy with the picks I’ve posted here. They either crushed it or bombed, not much in the middle.

I didn’t have enough long equity exposure in ’09, but the ones I did have made up for it. I also own gold and silver, which have done well.

One of the biggest lessons for me was the difficulty of shorting in an environment like this. The Fed has been pumping liquidity into the system like mad, and outcomes depend more on the actions of a few questionably-motivated creatures (who have abysmal track records) than actual fundamentals. Nothing to be done about that though, from an investing perspective anyway.

In hindsight, it was clearly better to bargain-hunt and speculate than short in ’09. My best gains of the year were pure speculation or value plays. I didn’t publish two of the big ones here, but I did post them on my old Motley Fool CAPS blog. One was CROX at $1.20 (trades at $7.49 today, 524% gain).  The other was Men’s Wearhouse @ $11.20 (trades at $25.17 today).

Reading hedge fund veterans like Bill Fleckenstein was quite helpful. I’ve been subscribing to his service for a while, and he closed his short-only fund near the market bottom, after a hugely profitable year. His short positions have been burnt by Fed Chairmen past, so he knew what effect all that Fed liquidity would have. He told readers he’d rather be in precious metals and cheap stocks than short.

I learned a lot about government intervention in general, and its impact on markets. Next time it looks like the world is ending, everyone should buy horrible pig stocks that will  benefit from the Feds’ clumsy/corrupt attempts to “stabilize the markets”, AKA bail out politically-connected mega-firms.

Telling chart by Jesse, showing the returns of various asset classes, 01/01/2000 – 12/31/2009. Note – If you factored in the 25% price inflation since 2000, it’d be even uglier (official CPI inflation # via BLS’ CPI tool).

How bout that Nasdaq 100? Kinda shocking from this vantage point. Down 49% in 10 years (excluding dividends, which wouldn’t improve the situation much for these low-yielders. Especially if you take inflation into account). Ugly all around, minus hard assets.

It’d be interesting to see an energy/oil stocks index included in the mix. I’ll put it on the to-do list.

In another 10 years, I suspect we’ll all be looking back on this period with 2020 hindsight. Har har… ha. Saw that on Reddit today, couldn’t resist.