BUY TO COVER Wachovia (WB)

Wow.

Amid the sturm and drang of the bailout vote and the market crash after the U.S. House decided “no,” an important subplot today was the demise of Wachovia (WB), the fourth-largest USA bank, shares of whom we have been short intermittently since last November.

Although WB stock traded as high as $24/share intraday just ten days ago on misplaced optimism, it became evident over the weekend that the weight of the toxic paper WB acquired when they purchased Golden West two years ago—compounded by bad loans and other inauspicious financial transactions the company made on their own—were dragging Wachovia into insolvency. Following emergency weekend negotiations, Wachovia issued a joint announcement with Citibank (C) this morning detailing an agreement for C to purchase WB’s retail bank, corporate and investment bank, and wealth management businesses for $2.1B.

As part of the transaction, Citibank will assume Wachovia’s $53B in senior and subordinated debt. Citi will acquire more than $700B of assets of Wachovia’s banking subsidiaries, and related liabilities. The catalyst for the deal is a government guarantee (reportedly U.S. Treasury officials inveigled Citibank to participate in the negotiations). The Federal Deposit Insurance Corporation (FDIC) has agreed to provide loss protection in connection with approximately $312B of mortgage-related and other Wachovia assets. Citibank is responsible for the first $42B in losses; the U.S. Treasury is responsible for anything beyond that. U.S. taxpayers get $12B in preferred stock.

WB will be left with their minor player brokerage business and their Evergreen Asset Management subsidiary. The deal was announced just before the market opened  and it was unclear how investors would value the remaining Wachovia entity. The stock opened at $1.26—down from the $10 close last Friday—and rose as high as $5 before crashing down with the rest of the market following the failed bailout vote, sinking as low as one cent(!!) before settling at $1.84.

Wish we had been nimble enough to score that one cent price, but with the effective demise of Wachovia here, there’s no reason to maintain this short position, and we are putting in a buy-to-cover limit order for tomorrow at $3.68 (twice today’s close). This will result in us covering our short position if WB opens at or below $3.68 tomorrow. If it opens higher, then we will still cover if it trades at or below $3.68 during the day tomorrow. If our position is still open after trading closes tomorrow, then we will reconsider what to do after the close.

Beazer Homes (BZH) update #12

Given the current financial tsunami, you have to work really hard to find any good news for a homebuilder. But Beazer Homes (BZH)—shares of which we have sold short in the expectation that the company is in for extremely tough times and may not survive—generated a genuine candle in the dark this week with the announcement that they have reached a settlement with the SEC. BZH were being investigated for possible fraud, internal control failures, and reporting violations, but under the settlement announced Wednesday, the company “consented, without admitting or denying any wrongdoing, to a cease and desist order requiring future compliance with certain provisions of the federal securities laws and regulations. The settlement does not require the Company to pay a monetary penalty and concludes the SEC’s investigation into these matters with respect to the Company. In the order, the SEC stated that in determining to accept the settlement, it considered both remediation efforts undertaken by and cooperation from the Company,” according to the press release.

We still think Beazer’s prospects are dicey here—aside from the terrible underlying business climate, they still face an ongoing DOJ criminal investigation relating to the way they treated their customers prior to 2007—but kudos to the new management team for working hard to clean up the mess and committing to do business on an ethical basis going forward. While we believe BZH stock is still overvalued here at $6.18—up 5% since this settlement was announced—if the company does survive, shareholders will have their new management to thank.

Vertex (VRTX) update #17

Vertex (VRTX) stock rocketed up 16% today after the company released new data on their ongoing phase 2 trials of their anti-hepatitis C drug candidate, telaprevir. According to published reports, the data indicated that a two-dose-per-day regimen of telaprevir was just as effective as the three-dose-per-day regimen (at a lower dosage) that had been exclusively used up to now.

This is important for two reasons: [a] it is easier for patients to take a drug twice a day than three times a day and [b] some prospective competitors to telaprevir are designed for twice- or once-a-day dosing, which in the event any of them prove as effective, would have given that drug a big advantage if telaprevir required thrice-a-day dosing.

Vertex (VRTX) update #16

Our development-stage biotech is replenishing the war chest with a dilutive issue of 8.6MM shares of common, priced at $25.50. The issue is in line with our expectations (we had projected dilution of about 7.2MM shares this year—a 5% dilution—in our model). The market apparently agrees, as the stock closed today down just 1.7% from the close on 16 Sep, the day before this sale was announced.

We expect the company will continue to need funding for the expensive telaprevir trials currently underway through mid-2011, and that more dilutive stock issues are likely.

BUY UltraShort Consumer Services/Goods ETFs (SCC/SZK)

The DOW soared 400 points yesterday—and is up again in early trading today—on reports that US Treasury Secretary Henry Paulson is shopping a plan to members of Congress that would fund the purchase of “toxic” securities held by banks and other financial institutions by the US government to get them off the balance sheets of the banks and thus hopefully render those institutions credit-worth again. There is a lot of uncertainty here: we have no idea precisely how the plan would work, when or even whether it will be adopted, and only the vaguest notion of who would be included (what about foreign-based financial institutions who have US mortgage-backed securities fouling up their balance sheets?).

However, we can say with utter confidence that the fact this plan is being proposed is not a good reason for stocks to be going up here. Manifestly, Paulson and Ben Bernanke have concluded that the bursting of the housing price bubble has at last spread to the rest of the US economy, in the form of tighter credit. To us this sounds like the final nail in the coffin of consumer spending, which means we are in for at least 12-to-18 months of pain…and it could be worse. This plan to loosen credit—by improving the balance sheets of the financial institutions thus making it easier for them to both lend and borrow—does almost nothing to address the underlying problem of falling real estate values. In effect, it treats a symptom of the disease, which may or may not make our convalescence less painful, but the disease must still run its course.

Consequently, we are persuaded that the time is ripe to short the consumer sector of the US economy. Until now, we have considered that a meltdown of the market was most likely to occur after the US presidential election, but the odds for it to happen sooner have risen appreciably here. Paulson and Bernanke are wielding baling wire and spirit gum and there was never a question about whether or not those tools were adequate to keep the wings of the economy from being blown off—they are not—but only when the winds of the coming storm would rise to the danger level. It is happening sooner rather than later.

The Ultrashort Consumer Services ETF (SCC) is an almost pure reflection of the US consumer sector; the Ultrashort Consumer Goods ETF (SZK) does include some exports, but we anticipate the effects of this consumer slowdown to be felt globally, so we are buying both here. The SCC is designed to rise or fall 2% inversely for every 1% move in the Dow Jones U.S. Consumer Services Index, which is primarily comprised of retail, media, and travel and leisure sectors…hotel, car rental, airline and cruise line companies. The SZK is designed to rise or fall 2% inversely for every 1% move in the Dow Jones U.S. Consumer Goods Index, which primarily includes companies that manufacture consumer products. Managers for both funds aim to achieve their goals by selling short equities and trading futures, options on futures, swap agreements, forward contracts, and options on individual securities or indices.

Aug 08 Intelledgement Speculative Opportunity Portfolio Report

Position	Purchased	Shares	Paid	Cost	Now	Value	Change	YTD	ROI	CAGR
TMY	03-Jan-07	300	3.30	998.00	0.34	102.00	-32.00%	-82.74%	-89.78%	-74.82%
VRTX	18-Apr-07	57	31.65	1,812.05	26.86	1,531.02	-19.15%	15.63%	-15.51%	-11.60%
NBIX	22-May-07	158	11.33	1,798.14	5.17	816.86	9.58%	13.88%	-54.57%	-46.19%
BQI	13-Jul-07	565	3.35	1,900.75	4.15	2,344.75	-30.11%	1.72%	23.36%	20.40%
GSS	19-Jul-07	451	4.19	1,897.69	1.53	690.03	-41.60%	-51.58%	-63.64%	-59.66%
GSS	24-Aug-07	613	3.08	1,896.04	2.62	1,606.06	-41.60%	-51.58%	-50.53%	-49.99%
SLT	5-Oct-07	111	19.75	2,200.25	14.22	1,578.42	-8.44%	-45.45%	-28.26%	-30.84%
BZP	19-Nov-07	245	9.77	2,401.65	19.70	4,826.50	-26.63%	76.21%	100.97%	145.38%
BZP	30-Jan-08	186	11.27	2,104.22	19.70	3,664.20	-26.63%	76.21%	74.14%	160.03%
WB	1-Feb-08	-57	39.99	-2,271.43	15.89	-942.21	-50.19%	58.22%	58.52%	122.84%
BZH	24-Mar-08	-214	10.99	-2,343.86	6.96	-1,489.44	-82.20%	6.33%	36.45%	105.14%
cash				-2,393.50		10,519.71
ISOP	03-Jan-07			10,000.00		24,579.73	-21.40%	12.52%	145.80%	77.05%
Global HF	03-Jan-07			10,000.00		10,645.30	-1.27%	-4.21%	6.45%	4.05%
NASDAQ	03-Jan-07			2,415.29		2,367.52	1.80%	-10.74%	-1.98%	-1.26%

Position = symbol of the security for each position
Purchased = date position acquired (for long positions) or sold (for short positions)
Shares = number of shares long or short in the portfolio
Paid = price per share
Cost = what portfolio paid (including commission); note for short sales, the portfolio gains cash
Now = price per share as of the date of the report
Value = what it is worth as of the date of the report (# shrs multiplied by price per share plus—or minus for short positions—the value of dividends)
Change = Change since last report (not applicable for positions new since last report)
Year-to-Date = Change since 31 Dec 07
Return on Investment = on a percentage basis, the performance of this security since purchase
Compounded Annual Growth Rate = annualized ROI for this position since purchase (to help compare apples to apples)

Notes: The benchmark for the ISOP is the Greenwich Alternative Investments Global Hedge Fund Index, which historically (1988 to 2007 inclusively) provides a CAGR of around 15.1%. For comparison’s sake, we also show the NASDAQ index, which over the same time frame has yielded a CAGR of around 10.1%. Note that for the portfolio, dividends are added back into the value of the pertinent security and not included in the “cash” total (this gives a more complete picture of the ROI for dividend-paying securities). Also, the “Cost” figures include a standard $8 commission and there is a 2% rate of interest on the listed cash balance.

Transactions: None.

News:

• 1 Aug—VRTX 2Q08 results
• 7 Aug—TMY gets stay of delisting from AMEX ’til 31 Oct
• 9 Aug—GSS 2Q08 results disappoint: BIOX processing production costs still rising
• 12 Aug—TMY 2Q08 results: sans new financing, the death spiral continues
• 19 Aug—VRTX announces launch of telaprevir phase 3 trials

Comments: GAK! If you thought our up-till-then worst month ever in July, -8%, was bad, check out August: a minor catastrophe at -21%. We were murdered by both the NASDAQ (+2%) and the Global Hedge Fund Index (-1%); overall after 20 months of operations, the ISOP is now +146% compared with +8% for the hedgies and -4% for the NASDAQ.

Given the almost unanimous meltdown on the part of every holding in the portfolio this month, it’s a little tempting to claim that we purposely engineered big losses in order to prove our point that speculation is a high-risk activity. That’s not the case, but if we had tried to do that, we could hardly have done better than these results achieved by accident. While overall, the market was more optimistic in August, commodity prices were generally down. Thus we suffered from a double whammy: our real estate and banking shorts soared in price (which meant we lost money) while our miners and energy plays declined in value. BZH was up 82% and WB up 50%—we are short both of them—to headline our losses. Our energy plays were all hurt bigtime, with TMY -32%, BQI down -30%, and BZP -27%. Our miners were also down; GSS -42% on continued production cost issues and SLT -8%. Our biotechs were mixed, with VRTX -19% and NBIX +10%.

We believe that this month was an anomoly. If our macro analysis is correct—we are due to pay the piper for years of overspending and the central banks’ easy money policies are merely postponing (and making worse) the eventual day of reckoning—then it makes sense for commodity prices to head south here, as demand will rapidly shrink, but it makes no sense for BZH and WB to be increasing in value (and the market to be moving north overall, as it did this month). On the other hand, if we are wrong, and the credit infusions do rescue the economy, then fine: it would make sense for BZH and WB—and the market overall—to prosper, but there is no good reason in that scenario for commodity prices to decline.

So lacking any clarity in where things are headed in the immediate future, we are standing pat here. While we expect the real estate and finance sectors to continue to decline, the best bet continues to be that the Fed holds things together with the markets in general through November’s USA elections. Having said that, however, the Olympics are over now, so the Chinese government is likely to lose some interest in the collective efforts to apply lipstick to the pig (or, in this case, bear). Therefore, the risk of a serious downturn is now greater and we will be watching closely for signs of same.

Even if we do make it to November relatively unscathed, then it will be time to seriously reevaluate the port and consider more of a short bias.

SELL BPZ Resources (BZP)

Another one we are sorry to see go, but today we are following the lead of the Intelledgement Macro Strategy Investment Portfolio (IMSIP) and dumping everything associated with energy in light of the developing financial crisis.

As we write, oil is selling for $102/BBLS, down from $145 on 30 June, while natural gas is going for $8/MMBtu, down from $13. BZP are developing fields that are tricky to drill and from which transporting the oil and especially the gas is neither cheap nor easy. While the economics here are not as attractive as they were two months ago, they work just fine…but the problem is that the demand for energy is highly likely to decline futher here. Admittedly we just saw all-time highs that most likely overshot the “true value” of crude (whatever the heck that might be LOL), but we foresee additional demand destruction ahead, and if the market behaves as it usually does, an excellent chance of an overshoot to the down side in the value of oil and natural gas…and, by extension, BZP.

For many reasons, we hope to be back here soon. That would mean that the developing crisis is resolved quickly and the world’s economy gets back on a healthy growth path. But be it sooner or later, given the way the wind is blowing, we expect to be back here at a lower price.

We actually hope it is not too much lower, as that would likely only result from a bigtime general downturn. But that risk is large enough to militate selling here.

SELL Oilsands Quest (BQI)

Well…sorry to see this one go. Those of you who have been following BQI along with us here know that we really like this company. What they are doing is good work: work that will help

• People on the planet in general, by significantly extending our supply of hydrocarbon-based energy
• North Americans, in making us less dependent on overseas energy
• Saskatchewans in particular, by boosting their economy (and the company has excellent relations with the local natives)
• Management and shareholders, who stand to get rich (or, at least, richer)…in the long run

Plus, of course, the story of how this gets accomplished is intrinsically an interesting one. And it’s always a pleasure to be able to observe competent managers at work.

However…“timing is everything” goes the cliché, and today we are following the lead of the Intelledgement Macro Strategy Investment Portfolio (IMSIP) and dumping everything associated with energy in light of the developing financial crisis. 

As we write. oil is still selling for over $100/BBLS. BQI is a potential goldmine with oil at $60/BBLS…but the problem is that the demand for energy is highly likely to decline here. In fact, it already has: the price of oil has declined nearly 30% in just the last two months. Admittedly from all-time highs that most likely overshot the “true value” of crude (whatever the heck that might be LOL), but we foresee additional demand destruction ahead, and if the market behaves as it usually does, an excellent chance of an overshoot to the down side in the value of oil…and, by extension, BQI. 

For many reasons, we hope to be back here soon. That would mean that the developing crisis is resolved quickly and the world’s economy gets back on a healthy growth path. But be it sooner or later, given the way the wind is blowing, we expect to be back here (or with some successor company who picks up the thread of developing the Saskatchewan oil sands) at a lower price.

We actually hope it is not too much lower, as that would likely only result from a bigtime general downturn. But that risk is large enough to militate selling here.

SELL Transmeridian Exploration (TMY)

We have been reluctant to give up on TMY despite the manifest incompetence of management, near insolvency of the company, and intractability of the their South Alibek concession in Kazakhstan because we have always believed that the underlying value of the oil (at least 67 million BBLS) would eventually justify the extraordinary efforts required to get it out of the ground, given that demand was rising and supply…well they ain’t makin’ any new dinosaurs these days, so what we got is what we got.

Problem is, in light of the developing financial meltdown, we see demand for energy in general—and oil in particular—taking a powder here, for at least two or three quarters and possibly two or three years. Consequently, the underlying value of South Alibek is going to be discounted here and most likely the shaky financing deal with UEG—which values TMY stock at $1.23—won’t be consummated as presently constituted. (We say “shaky” as there have already been problems doing prerequisite preferred stock transactions and note retirements, the deadlines for which have been extended a half dozen times already, most recently Monday.) Without additional financing, there is no way to increase production from the current 1800 or so BBLS/day to the 4000 BBLS/day needed to sustain ongoing operations and service the debt from past misadventures.

This has been a terribly educational investment, in that the ROI is terrible and the lesson very valuable: the best “story”—and TMY had a great story—can be undone by human error and bad luck. TMY is a poster child for the “investing in individual stocks is inherently risky” campaign. We are sorry, on that account at least, to see it go, but there is just no remaining shred of an excuse to hang on here.

SELL iShares S&P Global Energy Sector Index Fund (IXC)

OK, time to review those Econ 101 notes from freshman year. What happens when increasing demand occurs for a product with inelastic supply? If you said “the price rises” then go to the head of the class.

That’s what we said back in January 2007 when we recommended buying this ETF. But that was then, and this is now…and today’s question is, “What happens when dramatic demand destruction occurs for a product for which suppliers have pushed hard to increase production capacity?” And it’s not just that U.S. driving season gasoline consumption is down 4% as reported last week. That decline is largely tactical, driven by the rise in price per gallon. We are facing a strategic-level, international decline in energy consumption—and concomitant energy company valuation—due to the oncoming recession, which will certainly be wide and steep, and may be long-lasting. LOL the USA may be a lot less important than formerly, but when American consumers stop buying, the effects can still be felt in Paris, Beijing, and Brasilia.

Up to now, we have expected the markets to remain stable-to-bullish through the US presidential elections, but last weekend’s move by the federal government to take over Fannie Mae and Freddie Mac—in effect, undertaking potentially $1 trillion in obligations by guaranteeing those failed companies’ obligations—is a wake up call. Hey, we got trouble. Right here in River City. With a capital “T” and that rhymes with “D” and that stands for “debt.”

We have only the vaguest idea of the impact of the mountains of debt and dollars the government will be issuing over the coming weeks and months to counter the credit crisis that has the likes of Wachovia, Washington Mutual, and Lehman Brothers in the financial ICU (and the line for the emergency room is out the door and around the block)…but the effects on the dollar won’t be pleasant…to say nothing of inflation. And we really don’t know at what point folks begin to question the wisdom of continuing to fund the debt of the USA and the interest rate for treasuries begins to ramp up—in fact, we don’t really want to know—but unfortunately, it seems more and more likely that we are going to find out.

The market was euphoric about this Fannie/Freddie bailout on Monday, but we believe that Tuesday’s downturn was more apropos. No way did the Bush administration want to make this move prior to the election (or at all; they were no doubt hoping the spirit gum and baling wire would hold through to January so it can be the next guy’s problem). The fact that the pulled the trigger on an emergency-over-the-weekend basis tells us that things are a lot worse—and have degraded a lot faster—than they had thought.

Give that energy demand is largely a function of consumption, given that we now anticipate a swift and steep decline there, it is time to step aside here. When we do return—as we will; long term energy demand will continue to climb—we expect it to be at a lower price. Probably—unfortunately—much lower.