The New Breed of Destruction

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The biggest problem the retail investor faces is lack of great ideas and insight from those who are “in-the-know.” That’s why many of our readers have asked me about my private meetings with many of the industry’s top brokers, analysts, investors, and fund managers.

So before we get started this week, I want to ask you a question: If we were to open these private meetings to our readers, would you be interested in joining? Would you be interested in sharing investment ideas with some of the top minds in the industry?

Let me know by CLICKING HERE

Time to Buy? Or Time to Sell?

After a few years of a so-called recovery since 2008, the world is still in turmoil. The markets are still wavering.

Protests in Greece, double-dip housing in the US, Moody’s possible downgrade on Italy’s sovereign credit rating, and China’s inflationary growth issues are all running rampant. The markets have a lost a trillion dollars in value since the S&P came off its highs in April and we’re seeing the index less than a few points away from correction territory.

In Europe, the sovereign debt issues and the monetary system pressures are causing a lot of pain. Billions of Euros are being taken out of the financial system while the financial exposure banks have to the PIG countries is causing major problems.

But have no fear (yet), Greece bailout number two may be here.

On Friday, Greek Prime Minister George Papandreou replaced his finance minister. The markets liked that as investors were optimistic that crucial austerity measures will now be passed to prevent a devastating near-term debt default. After two days of political chaos that threatened to bring down the government, Germany also appeared ready to provide billions more in aid to carry the debt-ridden country through 2014.

So while the market took a sharp dive towards the end of Friday’s trading day, we ended up rallying back up to close relatively even.

Now before you think that I am simply regurgitating last week’s notes, let me explain why all of this matters to your portfolio.

Take a look at this:

Chart Comparison

The Euro’s correlation with the S&P 500 shows a strong relationship to the market.

If you can remember in last week’s letter (see Time to Feel the Pain), I highlighted the fact that the S&P was down for the sixth straight week, yet no major technical support levels were broken. When German Chancellor Angela Merkel dropped her government’s insistence on forcing a rescheduling of Greek government bonds Friday, it ended a six-week standoff that threatened to halt any more loan payouts to Greece. S&P down for six straight weeks. Six-week standoff by the Germans. Coincidence?

The focus of the Greek discussions now shifts to Luxembourg tonight and Monday, where European finance ministers are due to hold talks.

My thoughts on the market: Given that it appears the Germans are being more cooperative in helping, I see the markets moving up to start the week.

While a new aid package for Greece would hold off the threat of a Greek debt default in the short term, it wouldn’t address the bigger challenge facing Europe: the likelihood that Greece won’t be able to repay all of its debt, and the difficulty of cutting Greece’s debt burden without sparking capital flight from other struggling countries around the Euro zone’s fringes.

But the market is not looking that far ahead, so watch for a move upward if we get more news of a bailout.

The only real way out of the European mess is to cut the Gordian knot through federalization, as the United States did many years ago. New America, anyone?

Despite what’s going on in the emerging markets and in Europe, we have our own challenges in North America driven by labour and the housing markets which will take quite some time to work off.

Having said that, the environment in the US, with the prospects of low interest rates and slow growth over the next several years, actually creates very interesting investment opportunities in the companies that will benefit from this type of environment.

Large cap dividend paying stocks and companies with global exposure are great defensive equity plays in this market.

We already know the US government is going to spend more money, with or without QE3. They have already recklessly spent billiions of dollars. Last week was another example of stupid spending when the US’ inspector general for Social Security, Patrick O’Carroll Jr., revealed to us that the Social Security Administration made $6.5 billion in overpayments to people not entitled to get them in 2009, including $4 billion under a program for the very poor. In all, about 10 percent of the payments made by the agency’s Supplemental Security Income program were improper.

$6.5 billion dollars given away for nothing. Good luck getting that back. Heck, good luck getting back the trillion dollars spent on stimulus in the last few years.

The New Breed of Destruction

Not long ago, buying Chinese stocks, or any stocks with the word Sino in it, was a great way to benefit from the world’s hottest emerging market. But in the last few weeks, all of that has taken a turn for the worst.

Chinese companies listed on the world’s most prominent exchanges have tumbled this month after a recent accusation by Muddy Waters’ Carson Block stating that Canadian-listed Sino-Forest (TSX: TRE) is involved in fraud by overstating both its sales and assets.

If you missed these recent events, the report caused a major ripple effect to worldwide Chinese companies causing shares of these companies to tumble.

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click to play Carson Block interview

Following the report by Muddy Waters, international bond markets have shut out many Chinese issuers. But this isn’t the first time it has happened.

In the past year, a string of foreign-listed Chinese companies have been accused of fraud, accounting discrepancies or other corporate governance failings. In the US, the shares of at least 20 Chinese companies have been suspended or kicked off New York stock exchanges in the past year following auditor resignations or accounting problems.

But does that mean we should run for the front door?

While accounting discrepancies and mistakes are found all over the world, everyone has their eyes set on the biggest emerging market of them all: China.

When you’re that big, you’re setting yourself up for a big target.

In the matter of Sino-Forest, I think short seller Muddy waters used it to their advantage to make a boat load of money. We still don’t know if any of the accusations are true. If it turns out to be false, you can bet we’ll see Sino-Forest shares surge and big time lawsuits in the coming months.

Think about it. Just a few short months ago, Sino-Forest was worth over $6.3 billion in market cap. At the time of this writing, it’s worth only $783 million losing nearly $5.5 billion in shareholder value.

Muddy Waters prime objective is selling stock short. By taking advantage of the markets’ nervousness surrounding Chinese companies, it released a negative report on Sino-Forest allowing them and their cohorts to short sell millions of dollars worth of stock and thus making millions of dollars off the losses from investors in the company.

Before the report was released, it was distributed to hedge funds around the world, so that more short sellers would join the party causing the stock to fall dramatically in share price.

Keep in mind that I am just assuming how much Muddy Waters and those involved are making from the short selling of Sino-Forest. It could be thousands. It could be millions. Heck, it could even be billions.

What I do know is that close to $5.5 billion worth of investors’ wealth was lost from one single report created by a firm with no real history of accuracy. A report created by notorious short seller Muddy Waters. Who is Carson Block anyway? Who is Muddy Waters?

I think that while Muddy Waters is doing research on these Chinese companies, somebody should do some research on them. The company has no listed address, and no real history. Carson Block, the man behind Muddy Waters, says that they don’t list an address because of death threats that he has received.

This is what I found on Muddy Water’s website in their “About Us” section:

“Muddy Waters Research sees through appearances to a Chinese company’s true worth. Our research director, Carson Block, is an entrepreneur who’s practiced law and pioneered an industry in China. Our team members are likewise veterans of China’s business trenches who similarly understand how business is really conducted in China. Through their successes and struggles, they’ve developed the knowledge and contacts to navigate China’s muddy waters.

Muddy Waters Research is available to work with institutional investors on an engagement basis.”

So who are the directors? Who is Carson Block? What background does he have in research? None of this is listed on their website.

Last year, a researcher with Muddy Waters told management at Orient Paper, Inc. (AMEX: ONP), the first Chinese company targeted by the short seller back in 2010, that he would write a research report for them in return for US$300,000. Apparently, Orient Paper declined the offer and two months later, Muddy Waters issued their initial report calling the company a fraud. Carson Block denies these allegations.

The report said, “We are confident that [Orient Paper] is a fraud. Its purpose is to raise and misappropriate tens of millions of dollars.” On the front page of the report was a disclaimer that Muddy Waters had shorted the stock.

The report said the conclusion was not based on an analysis of Orient Paper’s books, but by talking to its customers, contacting suppliers of assets comparable to what Orient Paper said it had bought, having “experts” analyze photos of the company’s production equipment, and drawing conclusions from a visit to the Orient Paper factory in January 2010.

Since then, Orient Paper (AMEX: ONP) has refuted every single claim, while Deloitte & Touche (a real firm with real names), hired as independent auditors found Muddy Waters guilty of using false information.

At the end of the day, it doesn’t matter if information or research is real or fake. The market will always react first, and ask questions later.

click to play
click to play

I found it absolutely appalling that even some of the biggest media outlets and names, including Lou Dobbs, would (without their own research) go out on a limb and say that all of these Chinese companies are fraudulent. It’s absurd.

But that’s the stock market. It’s always sell or buy first and ask questions later. There are many groups and websites who issue negative reports on stocks they decide to short in order to profit. With a big enough following, these groups can wreak havoc on companies. I guess to them it’s no different than giving a buy recommendation to hike up the price of a stock they want to sell.

I feel bad for the investors involved in this recent debacle. At the same time, I can’t help but think how smart (or conniving) it was for Carson Block to take advantage of the insecurities of the market.

Do you think Sino-Forest is guilty? Or do you think Muddy Waters is?

Let me know by CLICKING HERE

(results will be posted next week)

Until next week,

Ivan Lo
Equedia Weekly

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