Protecting Your Portfolio in Crisis

(No, We’re Not Chicken Little and the Sky Isn’t Falling! Just Short-term Interest Rates, the Dollar, Housing, Stocks and the Economy…)

Special Note from Erika Nolan, The Sovereign Society’s Executive Director and Founding Publisher for the past 10 years.

Dear A-Letter Reader,

I admit we’ve used words like “emergency” and “crisis” quite a bit lately, but if the shoe fits…

In September we held an emergency video conference on the falling dollar.

In January, we did one on the “Retirement Crisis,” based on the idea that most of Wall Street’s most popular stocks would do terribly in 2008 – and that you needed diversified, global, big-quality, big dividend stocks to weather the storm and get positive returns for your retirement portfolio.

Our February investment conference in St. Kitts centered around “What Will Boom and What Will Bust in 2008.”

So what gives? Are we always so gloomy?

Only when the financial markets and the Fed are too giddy. And they’ve been as giddy as teenage school girls for the last decade.

Unprecedented low interest rates, the mass securitization of loans, “creative” lending practices and an accommodative Fed helped create one bubble and bust after another… from the hi-tech wreck to the housing bust to the current crash of the financial sector.

Turns out cheap money eventually exacts a high price.

And as much as we’d like to start cheerleading and telling you the worst is over, and trust in the wisdom of Washington and Wall Street…we can’t. Maybe it’s not in our nature. Or maybe it’s just a little premature. There may be quite a few shoes yet to drop.

But there is also plenty you can do to protect your portfolio and even continue to profit during financial crisis – and even as we enter recession.

For the rest of this month, our investment and financial editors will help give you a clearer picture of what’s actually going on in the markets and help you understand your investment options.

Today, Sovereign Society Research Director Mike Burnick will tell you why we are not likely out of the woods yet and why you should maintain a defensive position in your portfolio. Tomorrow, he’ll also show you how – as a trader – you can use well-timed options trades to profit from market volatility like this. Also, Mike will reveal how – even as longer-term investor – you can use options to hedge your portfolio against downside risks.

Later in the week, our currency ace, Jack Crooks, will explain what impact the Fed’s slashing of the Fed Funds rate will have on the dollar. He’ll also provide strategies for protecting your purchasing power and taking advantage of profitable trading opportunities with currency options you can trade from your regular stock trading account.

Next week, Sovereign Society Investment Director Eric Roseman will give you the flipside of a sinking dollar in the world of commodities. He’ll tell you why his forecasts for US$2,000 gold and US$75 silver remain as firm as ever. And he’ll talk about the one sector of the commodities complex that was a “laggard” but is now outpacing all others and could soon make new all-time highs and a lot of investors a great deal of money in the process.

Plus, you’ll continue to get our best ideas on secure, longstanding, well capitalized and conservative offshore banks that can provide a safe haven for some of your capital during the financial storms in the United States. You’ll learn why the end of the “Japanese Carry Trade” may give birth to a “New Carry Trade”…where the cheap borrowed currency now becomes the U.S. dollar (!)…and the tremendous long-term investment opportunities this can create…and much more.

In short – believe it or not – at The Sovereign Society we are never pessimists. We’re simply realists. Though we may not buy the financial fairytales sold by many, we never believe in hiding your head in the sand or simply wringing you hands in desperation.

There are always specific steps you can take to protect your wealth and reduce your risk during systemic crises such as the one we’re facing right now. And there are always emerging opportunities for profitable investments. And we intend to bring you some of the very best of these in the coming days, beginning with Mike Burnick’s article below.

So stay tuned…

In Wealth & Prosperity,
ERIKA NOLAN, Executive Director

Double Your Money While Wall Street Bleeds...

What’s the Financial Sector Really
Worth in a Fire-Sale?

If investors needed a reminder about just how IRRATIONAL financial markets can be, Monday’s drama surrounding the Bear Stearns meltdown was a great lesson.

At Friday’s close, the stock market said Bear Stearns was worth US$20 billion. As trading began on Monday morning Wall Street’s fifth-largest firm was valued at less than US$300 million! That’s all J.P. Morgan was willing to pay at fire-sale prices – amid the biggest financial panic to grip Wall Street since the Great Depression.

That’s a huge swing in the stock market’s estimation of the firm’s value. And it isn’t just Bear Stearns subjected to this wild swing in valuation. Lehman Brothers was worth about US$21 billion last Friday. The company’s worth plummeted to less than US$11 billion at Monday’s low. And Lehman managed to climb back near US$24 billion at last night’s close!

National City Bank’s value swung by about US$4 billion between Friday and Monday too – a difference of more than 50%!

“Perilous Times” Call for Desperate Measures

As Bloomberg columnist Caroline Baum wrote recently: “We live in perilous times. Crises are cropping up faster than the Fed can propose solutions to stabilize them.”

How true! In fact, in such a manic-depressive environment as this, who can really be certain of the quoted value of anything?

Wall Street firms thought they were certain about the value of asset-backed securities. However, the assortment of CMOs, CDOs and other securities at the center of this credit storm are just too illiquid right now to be valued at all. The bottom line is that these securities are only worth what someone else is willing to pay…at fire-sale prices.

So far Wall Street’s have announced nearly US$200 billion in losses and write-offs. That number is bound to climb much higher in coming weeks as more firms announce dismal first-quarter results. You have to wonder: How many more losses are still lurking on Wall Street’s collective balance sheet?

How much more of this can the stressed-out financial sector take? How many more Bear Stearns are out there…is Merrill Lynch safe, what about Bank of America or Wachovia?

Who Will Lose Their Seat Next When the Music Stops?

Estimates are of course all over the map. When the credit crunch first began last summer, Treasury Secretary Henry Paulson confidently claimed that total losses should be confined to US$50 billion. WRONG! Actual losses are four-times that amount already and still growing.

I have seen estimates that these credit crunch losses will range anywhere from US$400 billion, to upwards of US$1 trillion dollars before we’re through. The truth is, no one knows for sure.

The saga of Bear Stearns is a sobering reminder of the fragile state of the highly leveraged financial sector. In this game of musical chairs, the music stopped last Friday at four o’clock. And by Monday at nine, Bear Stearns had lost its seat.

According to Bloomberg, the firm was “too big to fail, too weak to continue operations, and too intertwined with counterparties to go down without causing serious collateral damage.”

What Keeps Me (and Ben Bernanke) Up at Night

I wrote about this potential for more “collateral damage” last July here in the A-Letter. Collateral damage is what keeps me up at night, wondering about where (and when) the next shoe will drop.

Minimizing collateral damage in the financial system is exactly what’s on top of the Fed’s agenda too. That’s clear from the dramatic steps the Fed is taking to guarantee US$30 billion worth of Bear Stearns “at risk” securities as part of the fire-sale to J.P. Morgan.

The Fed is also slashing interest rates and injecting liquidity as never before. Capital in the banking system has already fallen hard, amid US$200 billion in announced losses and write-offs, with more to come.

Once “bank capital falls below regulatory minimums relative to assets, financial institutions have to sell assets, which sets in motion the kind of downward spiral the Fed was looking to prevent,” according to Bloomberg.

In spite of the big rally yesterday, led by financial firms, I doubt we’re out of the woods just yet.

In tomorrow’s A-Letter, I’ll show you just how little impact the Fed has had in easing this market shock. The next desperate move the Fed is likely to make will lead to more short-term profit opportunities – and will also have important long-term implications for your investments. Stay tuned!

MIKE BURNICK, Senior Editor & Global Markets Analyst

EDITOR’S NOTE: Since this credit crunch began last July, Mike has been profiting from Wall Street’s biggest mistakes with his Market Shock Trader service. Back in October, Mike grabbed quick gains of 50%, 131% and 142% by shorting the financial sector just as the bloodbath on Wall Street began. And during the last two months, he recommended his subscribers take gains of 114%, 111% and 121% by selling well-timed energy and materials plays. Click here to find out how this well-tested strategy can profit from the worst market crises.

Why Bear Stearns Was Only One Domino
to Fall in Global Banking

Bear markets typically end or crescendo at the point of maximum market pessimism. Though we’re not there yet, Bear Stearns’ effective demise last Friday is another domino in the growing list of troubled banks in the United States, Canada and Europe.

I don’t feel bad for the executives at Bear Stearns. These guys deserve to have their heads handed to them for throwing the company into effective bankruptcy last Friday. They had already loaded-up on mortgage-backed securities to the hilt. Then one of the most successful hedge funds with US$25 billion in assets announced they were dropping Bear Stearns as their prime broker. That was probably the straw that broke the camel’s back.

By mid-week, other hedge funds began withdrawing their assets en masse. And by Friday, the party was over at Bear Stearns. Or maybe, the “mirage” finally disappeared.

Right up until Friday, Bear Stearns exclaimed that they still had significant liquidity and investors were wrong to assume it was suffering a liquidity crisis. Of course, a few hours later, the firm avoided bankruptcy only because of the Fed’s insistence that JP Morgan Chase buy the wounded investment bank for just US$225 million, or US$2 per share.

What a disaster – and not just for shareholders. I feel bad for the 14,000 Bear Stearns’ employees who were obliged to plunk about a third of their salaries into company stock. These people not only face massive layoffs following the JP Morgan Chase consumption, but also have seen their entire investment portfolio basically destroyed.

The Federal Reserve, in my eyes, did the right thing, even though they did wipe out many investors in the process. The alternative, however, could have been significantly worse. Other banks could have possibly joined Bear in a domino-like liquidity freefall. The perception of a liquidity problem was rampant across several smaller investment banks last week, and by Friday fear had spread to Lehman Brothers, a major player on Wall Street.

Forget moral hazard. The Fed did the right thing because right now the market would be at least several hundred points lower and other banks might have probably failed.

The broader economy is now in a freefall and letting Bear Stearns go under would have resulted in a crash because big hedge funds park their cash at the firms’ prime brokerage unit. The economy can’t afford losing a major player.

So where do we go from here? Like I’ve suggested in the A-Letter over the last several months, you should be heavily diversified across major asset classes, including high-value blue-chip stocks that pay dividends, foreign currencies, gold, commodities, alternative investments that appreciate in a bear market, and cash.

We’re not at the bottom yet for this bear market, but we’re certainly getting closer as the Fed throws major amounts of credit to arrest deflation in financial assets.

ERIC ROSEMAN, Investment Director

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