Minutes before I was ready to go on the air with my radio program I received a call from my long-time good friend Ian Gordon, who predicted the market would peak on Friday, Nov. 13. In addition to his usual work, Ian was basing his views on the core of work carried out by W.D. Gann, a brilliant market forecaster in the past who is known for his analysis of cycles and trading patterns in equities as well as commodities. It remains to be seen if this Friday, Nov. 13, was the top of the B wave up. If it turns out to be so, it would be very consistent with Dr. Robert McHugh’s latest views that we are very near the end, based on Elliott wave patterns and a host of other indicators. The market has seen a moderate rise from the 13th, but still believe it is close.

Dr. Nouriel Roubini, who is perhaps the most famous economist of our day, recently wrote an analysis of our global bubble economy in which he suggested that the dollar carry trade may well become the next bubble to collapse and send the global economy reeling once again. Of course that fits very well with Austrian economic thinking, in that the carry trade is an artificial market manipulation caused by the enormous pumping of the U.S. dollar into the global economy. Whereas another deflating economy, namely, the Japanese economy, provided a cheap source of global borrowing for many years, with interest rates continuing to be held at zero it is not difficult for us to see how our monetary thieves are now making cheap funding available to the global economy at this point in time. And as Austrian thinkers know, when you pump enormous amounts of money into an economy, it results in mal investment. In other words, capital is put into inefficient businesses, with the result being that most of them provide poor returns on investment, and over time, a growing number become insolvent and incapable of servicing their debts. 

Bryan Rich of the Weiss Group pointed out this past week that the Fed, the Bank of England, and the European central banks all retained an extremely easy monetary policy. Many people think these banks should start to raise rates because: (a) They think the global economy is on the mend and they fear inflation will return; or (b) They think an asset price inflation will result as new bubbles are formed.

In fact, I believe asset bubbles are definitely being formed already. Check out the 52-Week Global U.S. Dollar Liquidity Growth chart below. Note the first bulge of liquidity growth that peaked in 2000. That was the fuel that drove the equity market to its highs in 2000, before that stock market crash. Why did the market crash? It crashed because of enormous amounts of “mal investments” into such industries as dot-com frauds and telecom debacles. Too much money pumped into the economy too fast, pushing interest rates to artificial levels, thus leading to bad investment decisions. Bad employment of capital meant that companies had bad returns on investment. Yet the debt from which that money was created did not go away.

Now check out the second hump in the chart on your left. Note that this time, the annual 52-week growth rate of money jumped up to about 21%. This force-fed money, created out of thin air by Alan Greenspan’s Fed, was the cause of the housing bubble. Forget “greed” on the part of bankers. Greenspan loaded huge amounts of money into the banking system, such that banks flush with cash kept entering into riskier and riskier loans. Why? Because the banks are charged with providing the best return on investment possible. If they sit idly by while Greenspan pumps money into their coffers, they lose their jobs. The economy simply couldn’t absorb so much capital that was not real capital anyway, because it was created from nothing by our central bank. It was not saved or real capital but phony capital, which diluted the real capital that came from savings. 

So we ended up with the housing bubble that created a much, much bigger problem than Greenspan’s first bubble shown on the left side of the chart above. But now, the mother of all bubbles is being inflated. While the peak of the housing-fueled bubble hit about 21%, this current bubble has been holding at about 40% since the Lehman Brothers collapse caused the Fed to panic and our government to throw everything sacred to capitalism out the window, simply to protect the rich folks, who, in effect, own the system through their ownerships of the Federal Reserve Bank.

This enormous amount of capital has created what is arguably the biggest and baddest bubble ever in our country’s history. Nouriel Roubini and most other economists are not being fooled by the 3%+ GDP number proclaimed by our government. Whatever growth there is, it is phony and not real free-market growth. Our belief is that all this is doing is fueling another bubble that will make the next downturn even worse than the one we had in the fall of 2008. In other words, we have no trouble seeing the underlying roots of what Dr. Robert McHugh is predicting on the basis of a host of technical indicators.

So what should the Fed do now? If it tightens credit, it would most likely throw the economy into an immediate plunge. It would be very painful. In fact it would be a lot more painful than if Greenspan allowed the economy to suffer a serious recession in 2000-2002. He chose to chicken out and pump up another bubble, that being the housing bubble that has resulted in a much, much worse situation of indebtedness and insolvency now.  Now it’s Bernanke who has also chickened out once again. He has pumped up the growth in liquidity to around 40% per year annually, which is leading to the inflated commodity prices and stock prices that are unsustainable. Why are they unsustainable? Simply put, they are not based on real economic growth, which would produce sustaining cash flow. They are bubbles, and bubbles by definition are prone to collapse, because in the aggregate, total debt is growing exponentially while income, at best, is growing in a linear fashion. (Check out the chart above that shows red line debt growing exponentially while GDP (income) is growing in a linear fashion.) 

One of these days, there is going to be one final deflationary implosion that sucks the life out of the establishment. At that time, there could well be a revolution. If we are lucky and we get a bloodless revolution that leads toward a return to true free market economics—the kind espoused by Ron Paul and other Austrian economists, our country could have a bright future once again.

I personally am not terribly hopeful for that outcome, much as I desire it. Why? Simply put, Americans are not only ignorant about economics; they are also spoiled rotten by a standard of living that has been passed on to us simply because we are enjoying the spoils of our empire. 

The trouble is, as John Perkins pointed out on my radio show and as Catherine Austin Fitts also pointed out, the parasitic behavior of our ruling elite is bleeding us dry with debt. Not only has this pattern been employed overseas to suck commodities and raw materials away from third-world countries, Americans themselves are now being given the same treatment. The old saying that the rich get richer and the poor get poorer has never been truer than it is now. Unfortunately, I fear we have only started to see the beginning of a declining living standard, at least for the American empire.  

Jay Taylor
Gold Investor

There is a desire to see this as a bullish market? Who doesn’t like a bull?  If you listen to ongoing discussion on CNBC, Bloomberg, and other media, you get a sense of optimism; or perhaps it’s just a bunch of cheerleaders touting their own book.

I do agree that there is not the euphoria that one gets at market tops. At the same time, review the earnings and PE ratios as discussed by Ian Gordon below and you can see why Wall Street may not be terribly optimistic. Perhaps they don’t really buy the optimism of cheerleading optimists. Also, I’m wondering how optimistic market participants were during the 1930s, year after year during that depression. What needs to be pointed out is that just because a market is pessimistic doesn’t mean that will change any time soon.

True bull markets climb a wall of worry. But sooner or later we have to see some fundamental changes that justify the market’s exuberance. So far, I just don’t see it. And unless we start to see some improvements in the real economy, rather than just a lot of liquidity pumping and deficit spending to get the economy moving, the markets are going to tank to bring the PE ratios back in line from a current PE ratio of 144 to something more normal in the 10 times to 20 times range. (See below.)

Policy has been to pump money into the economy. However, just as during the 1930s, that policy is an abysmal failure. The old analogy of pushing on a string really hits home here. The Fed is pumping money into the system, but the banks are not lending—they’re having a hard time finding credit-worthy borrowers.  

For example, consumers are broke, so banks are cutting credit to consumers as illustrated in the chart above on your right. Money pumped into banks is not finding its way into the real economy. Has it gone into speculative hedge funds?  I think it has which is part of the reason commodity and stock prices have risen and driven up our IDW.  But unless the real economy grows and an engine for world growth is found to substitute for the American consumer, my view is that continued GDP growth is not sustainable.

Profit margins are plummeting (S&P 500 earnings above) because business and the real economy is in a depression.  With business down, commercial paper lending is down sharply as shown in the chart above right. That’s a major reason why banks are not lending or leasing to private corporations as shown on the chart below on your left.

With the real economy not gaining much if any traction as private sector GDP continues to contract and with more and more jobs being lost, it’s hard to make a case for improving profits and hence an increase in consumer and corporate lending. And without that, our economy which is addicted to growing by illusionary fiat money magic, rather than by saving, will have a hard time growing any time soon. In fact, it is your editor’s view that natural laws are now finally coming into play that will force America to reduce its living standards and to start living within its means.  In my view that means an economic depression of one shape or another is in the cards for years to come.

Regarding the recent 3.2% GDP growth for the third quarter of this year, economist John Williams had this to say on October 27th:  “As previously discussed, at least one quarter of quarterly GDP gain has been normal during recessions of the last four decades and does not necessarily signal a recession’s end, irrespective of any happy hype out of Wall Street. With broad money supply in near-term contraction and with no relief to the structural problems impairing household liquidity, there is no economic recovery on the horizon.

In the event that BEA can keep its fourth-quarter GDP estimate in positive territory, the pattern unfolding here soon would become recognized as a double-dip recession. The worst of the U.S. economic contraction still is to come.

Jay Taylor
Gold Investor

Your wondering if we are all turning Japanese analyst,

John Mauldin
Outside the Box & Thoughts From the Frontline
johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

Eclectica November Fund Commentary

by Hugh Hendry
Eclectica Fund Manager

"The power to become habituated to his surroundings is a marked characteristic of mankind."

John Maynard Keynes
The Economic Consequences of the Peace, 1921

This month I will attempt to answer the entrance examination for the Chinese civil service. That is to say, I will attempt to tell you everything that I know. In doing so, I will argue that this year’s rally in inflationary assets, from emerging stock markets to industrial commodities to the fall in the US dollar, could be a FAKE. Let me explain why.

But first, I am indebted to Scott Sumner, professor of economics at the University of Bentley, and his essay on the economic lessons that can be drawn from timelessness in art (see http://blogsandwikis.bentley.edu/themoneyillusion/?p=2542). It is a theme that I will constantly revisit in my arguments below.

Sumner is able to take us from the Flemish forger, Van Meegeren, and his horrendous reproductions of the Dutch painter, Vermeer, to the notion that every recession seems unique and special to its protagonists. So just how did Van Meegeren fool the Nazis with paintings that today look so awful, so un-Vermeer? Jonathan Lopez, the noted art historian, argues that a FAKE succeeds owing to its power to sway the contemporary mind. Or in other words, the best forgeries tend to pay homage to the tastes and prejudices of their time. The present is so seductive.

However, forget the art world. Controlling the psyche of this generation of investor is the indelible mark of the falling dollar and the associated fear of inflation. Monetary inflation has been the distinguishing feature of the last ten years, and it is now firmly embedded in the contemporary mind. I am sure I need not remind you that gold, along with just about every other commodity, has at least quadrupled in price since 1999. You already know my explanation for why this has happened.

The spectacular rise in the Chinese trade surplus, predominantly with America, to $320bn per annum at its peak in 2007, and the mercantilist desire to prevent currency appreciation drove the Asians and the sheiks to buy Treasuries and print their own currencies. The ability of fractional reserve banking to leverage this liquidity many times over provided the monetary mo-jo to instigate ever higher commodity prices. In other words, quantitative easing, masquerading as a cheap but fixed currency regime, has succeeded where Japan’s orthodox version has failed. The QE succeeded because, amongst other features, it raised the velocity of monetary circulation.

However, it was not always like this. As an example, ten years ago it was unthinkable that the dollar would prove so fragile. Recall that back then, when the euro was first launched in 1999, it promptly lost 31% of its value against the greenback. The subsequent reconstruction of modern China, though, intervened. In order to finance the emergence of a new economic superpower, an abundance of dollars was needed. Have no doubt that had we not had the dollar as a reserve currency, the rise of China would not have been as swift nor as decisive.

The Yellow Brick Road

Consider another economy needing to be rebuilt: that of the United States in 1865, the post Civil War era. The rebirth of the American economy was funded from the monetary rectitude of the gold standard, not from the generosity of a foreign and infinitely expandable paper currency. However, all of this occurred before the discovery of cyanide for heap-leaching and the opening up of the huge South African gold fields. In other words, hard money was in tight supply and the recovery was neither swift nor decisive. Indeed, 30 years later, during the presidential election campaign of 1896, Williams Jennings Bryan was still hotly contesting its merits. He railed against the persistent price deflation and argued that the economy was burdened by a "cross of gold" (see The Eclectica Fund Report, December 2005).

Perhaps I Should Stick to the Twenty-First Century?

My previous investment letter attempted to explain the subtleties of the Triffen dilemma and the dollar’s pre-eminent role in regenerating modern day economies. Let me repeat once more: lots of dollars were required, and duly delivered, to build modern China. They did not have to wait on the vagaries of a gold discovery to promote and sustain their economic engine. Instead, they required the willingness of their trade partners to run trade deficits. The US delivered and, partly as a consequence, the Fed’s broader trade weighted dollar index has now fallen 20% since its peak in 2002 (the narrower DXY index compiled by the Intercontinental Exchange has fallen more, but excludes the renminbi and overstates the role of the euro). In return, the world has a new $4trn trading partner: China.

Heady stuff, but not without precedent: recall the Marshall Plan, a watershed American aid program that assisted the reconstruction of the Western European economy during the 1950s and 60s. This was further augmented by America’s willingness to run trade deficits, the modern day equivalent to a gold discovery, which became necessary to sustain the emergence of the new economic trading bloc. This resulted in the dollar’s huge devaluation versus gold in the 1970s. However, back then, the broad trade weighted index kept rising. This time it has fallen sharply.

What an Ungrateful Lot We Are?

The dollar’s role as the world’s sole reserve currency has both assisted and accelerated the development of world trade. America’s trading partners have come to rely upon the bounty of dollars necessary to recycle their trade surpluses and thus finance their growing prosperity. This was done even at the expense of domestic American job losses. Replace the dollar with IMF special drawing rights; I hear your retort. Sure, but have you ever bought a cup of coffee with an accounting identity? And, fundamentally that argument still suffers from the dearth of any other major economy showing any willingness to sacrifice its short term economic standing for the longer-term mutual benefit of having enriched trading partners.

Do not forget that the Chinese could replicate equivalent currency baskets to SDRs at any moment. Instead, they continue to recycle almost three quarters of their trade surplus back into dollars. This is not coercion but simple commercial pragmatism. They know full well that neither Europe nor Japan nor Britain nor Switzerland nor the rest of Asia are willing to sacrifice the implicit loss of manufacturing jobs. They understand that it is only the US that is willing to embrace the benefits of comparative advantage that arise from international trade. Have you ever asked yourself why car prices in America are so low compared with those in Europe? This is my point.

I keep hearing that a dollar devaluation would help matters. I agree; it has. Let me say it again; we have already had the devaluation. That is what the last five years were all about. Now with China rebuilt, and the trade deficit in full retreat (note the -47% contribution from net exports to China’s GDP growth in the first 9 months of this year), there are less dollar bills being exported overseas to ungrateful recipients. Is it not time we drop our fascination with the present and consider the future? Is it really inconceivable that the dollar could now strengthen?

Women in Love, Investors in Love. What’s the Difference?

Of course this is a minority view. Investors have reacted to last year’s deflationary traumas by insisting that it is business as usual. They behave like D.H. Lawrence’s coal miner Gerald from the novel Women in Love, who, just days after his father’s funeral, steals into his former lover’s bedroom and, "…into her he poured all his pent-up darkness and corrosive heat, and he was whole again." Or was he? The trouble is that we are so anchored to the recent past. Investors are fearful of what now seems so familiar and recognisable; at what they perceive as the reckless behaviour of our monetary authorities. "Inflation is a monetary phenomenon" is their Friedmanite dogma. Their salvation can only be found in the safe sanctuary of gold and the embrace of risky assets, but are they truly safe?

This is my home. Don’t be so sure about anything, Big Horace. Not about anything in this world.

The Orphan’s Home Cycle
Horton Foote

And so, just as the Church of England commissioners became convinced by the cult of equity way back in the whimsical days of 1999 and went 100% long the stock market, investors today recant a new mantra of, "anything but the dollar (A-B-D)". Inflation bets are all the rage. Some would insist that it is their fiduciary duty to protect their clients’ capital; I say tell that to the Church of England pension fund, whose assets today are just £461m against liabilities of £813m. Austerity beckons for the clergymen; heaven will have to pay their stipend.

But the spell cast by a contemporary cult is hard to resist. Take another august body, the Harvard Endowment Fund. Not typically renowned as a hotbed of reactionary fervour, the fund is nevertheless radical in its construction and has come to typify the A-B-D stance.

Harvard’s position could well be construed as a one-way bet. Almost half of the fund is invested in emerging market equities, commodities, real-estate, private equity and junk bonds. It is as though the rap artist 50 Cent has taken over the advisory board. The fund is going to, "get rich or die tryin’".

We, on the other hand, approach risk by considering the worst possible outcome. For a current pension scheme the greatest torment would be a repeat of last year’s final quarter when 30 year Treasuries yielded just 2.5%. This would require a CAGR of 20% or more from the fund’s riskier assets at precisely the time that their future returns would seem most questionable; insolvency would beckon. And yet, they blithely run the risk of ruination.

Of course, they are not alone. Another popular argument is that the emerging economies have to urgently diversify their immense dollar reserves. And so the Chinese are colonising the African continent in the pursuit of commodities and the Indian government has just agreed to buy 200 tons of the IMF’s gold hoard.

Is this not a reincarnation of the 1980 trade of the brothers Hunt? It is hardly an exaggeration to suggest that China, for all intents and purposes, is already the commodity market. For despite providing less than 8% of global GDP, China accounts for more than half of the world’s steel production and more than half of global seaborne iron ore freight. Indeed, this peculiarity is circular in nature. Consider that a modern aluminium plant requires 25% of the project’s cost to be spent on buying aluminium in the first place. And remember that investments in fixed capital formation (think new aluminium plants et al.) have made up 95% of Chinese GDP growth this year. China Inc. is Commodities Inc.

Accordingly, China shares the same risk as the world’s largest pension schemes. An over- leveraged American consumer does not return to his/her manic buying of old. As William White, former chief economist of the BIS, has argued:

Many countries that relied heavily on exports as a growth strategy are now geared up to provide goods and services to heavily indebted countries that no longer have the will or the means to buy them.

Surely, the Chinese stash of Treasuries is a prudent elimination of the fat tail risk that private sector deleveraging in the west ends up killing the golden goose of the trade surplus. But instead, in exercising good ol’ Texan tradition, they have opted, like the Hunt brothers did, to double up. It is the old dice game, Mort Subite, played by the employees of the National Bank of Belgium in the busy lunch time cafes of Brussels in 1910. If the players didn’t have time to complete their business, they played a final round with a sudden ending where the loser would be pronounced dead.

Much is made of the comparison between today’s balance sheet recession and Japan’s demise back in 1989. Despite their bubble never coming close to matching China’s prominence in industrial commodities, the loss of Japanese economic growth in the 1990s was nevertheless a major factor in the waterfall crash in commodities. This plunge ultimately saw oil trade for as little as $10 per barrel in the next decade. Just consider how much more devastating the experience would have been had they gone very long the commodity market in 1989 rather than golf courses and Rockefeller Centre. At least the Harvard endowment scheme did not share their enthusiasm for golf. But, this time around, I fear a Mort Subite beckons for the losers in Asia and the pension market.

Last Orders: Inflation or Deflation?

If a poet knows more about a horse than he does about heaven,
he might better stick to the horse… the horse might carry him to heaven.

Charles Ives

I am now going to return to the torturous and binary debate concerning inflation. As you know, I am in the deflation camp for now, and we own a modest amount of government bonds and a series of asymmetric bets which would receive a boost from a return to some form of risk aversion. You could say that I am sticking to my horse.

My intellectual foes, on the other hand, are adamant that long duration government bonds are a short. I even hear that some Wall Street legends are so convinced of the argument made by the likes of Niall Ferguson that they personally own Treasury put options and are actively counselling others to do the same. The argument can be condensed into just two fears.

First, they will suggest that 4.5% is not an adequate return for lending your money to the profligate United States for 30 years. I agree wholeheartedly. Again, I fear it is my accent, but let me stress once more that I do not propose that anyone adopt a buy-and-hold policy for the next thirty years in bonds. However, a nominal rate of 4.5% might prove very profitable over the coming year should breakeven inflation expectations head south again.

Second, the bears contend, a lower Chinese trade surplus will eliminate a very large source of Treasury buyers at a time of burgeoning supply. Again, we find ourselves agreeing vigorously. However, it is our contention that US savings are heading north over the months and years to come. And an America that saves is an America that does not run a current account deficit. It is an American that can finance its own spending domestically. The US produced a small surplus back in the 1990-91 recession, so why not again?

As a consequence the Chinese surplus is set to fall further and, with fewer dollars needing to be recycled to maintain the currency peg, their demand for Treasuries will continue to shrink. Now this is potentially a huge headache owing to the massive projected American budget deficits for this year and next, and the Treasury’s desire to extend the maturity of the existing stock of government bonds which is becoming perilously short dated. Some estimate new issuance of around $2.5trn for the upcoming year. Perhaps, it is better that we buy those Treasury put options after all?

American Gothic

Or is it? I have quoted Don Coxe’s definition of a bull market before and I intend to do so again. "The most exciting returns are to be had from an asset class where those who know it best, love it least." On this point, America has fallen out of love with its own currency and bond market. Foreigners own over half of the outstanding Treasury stock. But, like I said, I think events could reignite some of the natives’ old amour.

It is almost like declaring an enthusiasm for Say’s Law. Think of it this way, a greater supply of Treasuries would be a very obvious by-product of weaker than anticipated economic growth. And in this environment risk aversion stimulates the investment desire for risk free assets. So, in a round about way, there are circumstances when supply and demand can match in the bond market. But weaker economic growth? Surely the governments’ interventions this year have remedied the economy?

The surprise might concern the role that rising leverage has played in boosting GDP and in anchoring investors’ expectations to an unrealistic level of nominal GDP. Over the last decade, each marginal dollar of debt has generated less and less marginal income. We knew that there would be a "zero-hour" for the economy when the creation of new debt would not contribute to GDP growth. The government’s reaction to last year’s demand shock has been to increase its own leverage. But, with the economy operating at its zero-hour, we believe this incremental leverage will actually have a negative impact. That is to say, the public sector will fail in its attempt to bring the economy back to its previous level of nominal GDP. In this scenario, the outcome will disappoint the market’s expectations, which are rampantly bullish as evidenced by this year’s dramatic re-pricing of risk assets.

This zero-hour for America has perhaps arrived sooner than many had anticipated. It was heralded by the Japanese experience. Japan is the bogeyman that confronts all academic thinkers, regardless of creed, from Krugman to Ferguson, as well as all who would choose to intervene in the workings of the economy. In a debate I had with Mr. Ferguson in London last month, he claimed that Japan was an extreme outlier and could be ignored. Really?

No sex, no drugs, no wine, no woman, no fun, no sin, no wonder it’s dark
Everyone around me is a total stranger.
Everyone avoids me like a psyched loan-ranger
That’s why I’m turning Japanese,
I think I’m turning Japanese,
I really think so

The Vapors, 1980

Japan has championed both Friedman and Keynes. They have built bridges to nowhere and dropped Yen notes from helicopters for twenty years and still they have nothing to show for it. Clearly the additional return from Yen debt in Japan is close to zero and it exposes the nightmare of interventionists everywhere: it may just be that there are no policy remedies for a debt deflation. So to elaborate further, our chances of financial success are greatest under conditions where investors believe government spending will succeed but in reality it fails.

However, where will the demand for all of this additional government debt come from? Let us review the Fed’s Z1 numbers. The US has household wealth of some $67trn. Of that, $20trn is accounted for by real estate and is perhaps out of bounds for our purposes. But $8trn is held in the form of private pensions and insurance funds. And yet, remarkably, these institutions presently allocate just $630bn to Treasuries et al. Households have a further $22trn in time deposits and other financial assets. But again they own just $500bn of Treasuries, and commercial banks own a tiny $130bn or, 1% of their total asset base of $12trn.

Consider that in 1952, at the very end of the supernova bond bull market formed from the ashes of the Great Depression and the Liberty Bonds that financed the Second World War, US banks held 40% of their gross assets in Treasuries. That is a potential $5trn of demand from this one source alone, albeit spread out over a number of years. And again, the Japan experience lends support. Japanese financial institutions have quadrupled the percentage of their assets held in JGBs. Furthermore, their households have lifted their government bond weightings five-fold over the last ten years. Should the same pattern repeat itself stateside, American households would need to buy another $2.5trn, but again, over ten years.

And let us not forget that a trend of rising prices allied to the most basic human emotion of avarice encouraged commercial banks and other financial institutions to buy $3.2trn of questionable mortgage backed securities in 2004, $1.9trn in 2005, $2.2trn in 2006 and $2.1trn in 2007. So it is not inconceivable, at least in my mind, that financial institutions, and notable amongst them the nation’s pension and endowment schemes, could be motivated by another basic human emotion, namely fear for their own survival, to snap up all these new government bonds. Perhaps in the end supply will create its own demand.

Again, it all really comes down to your take on the ratio of total debt-to-GDP. If you believe, like I do, that it peaked in 2007 then the repercussions are enormous. The leverage does not necessarily have to come down (after peaking in 1932 at 300% it troughed 20 years later at 150%). Rather, it may well be that low interest rates allow the mountain of debt to continue to be serviced. This has been the Japanese experience to date. However, everything in our economic life exists at the margin, and the consequences of just maintaining the leverage constant would be a very low delta in nominal GDP growth. Consider that the Japanese, under these very circumstances, have managed to grow nominal GDP at just 1% compound since 1990.

In Bernie We Trust?

This is why China’s mad dash for commodities and its investment splurge this year is so worrying. In my marketing presentations I show a picture of Madoff superimposed on a dollar bill and ask, "…in Bernie we trust?" My point is that if the hedge fund fraudster had been given the responsibility for US GDP accounting, he would surely have overstated the figure. And in a similar way, the rise in leverage has probably misrepresented the truly recurring nature of nominal GDP. Now, if we repeat the Japanese experience then it is possible that nominal US GDP will rise from $14trn today to perhaps just $16trn in ten years time. Along similar lines, the German government does not anticipate its economy exceeding its previous GDP high until 2014. And yet it is as though the other surplus countries are behaving like Bernie’s former investors who, believing in the stated NAV and its promise of more of the same (i.e., predictable and attractive compound growth rates), were happy to spend lavishly. The Chinese are building capacity to meet a world where US nominal GDP is $25trn in ten years time. I fear they could be in for a nasty shock.

What Do I Mean?

Consider the steel market. The homogeneous nature of steel, as well as other factors such as its price-to-density, allows for the export of the finished good across trade boundaries. Now with China having been on such an expansionary tear, it may not surprise you to hear that finished Chinese steel prices today trade below their production cost. Furthermore, import license applications to sell steel in the US, the world’s largest export market, rose 24% last month. Now, mostly this comes from Mexican and Korean producers, but clearly there is the implicit threat that their Chinese competitors might also be tempted.

But the Economy is Growing?

Clearly it would be inappropriate to annualise the production of the US steel industry in the fourth quarter of last year when capacity utilisation plummeted to just 32%. So consider, instead, the annual run rate this year from January to August. This was a period of stabilisation in tandem with the cash-for-clunkers program, which boosted the industry’s largest customer, the car sector. It is quite chilling to note that steel production in America is on a par with output back in 1938, when GDP was a mere 7% of its current size. The industry’s run rate dropped to a paltry 13% during the Great Depression. However, output only troughed at its 1908 level; a twenty year retracement that is a far cry from our 70 year retracement. So the physical developments in the western steel markets should raise some concern. However, with an active steel futures market in China turning over $15bn a day (consult the Bloomberg page <RBTA CMDY CT>), speculative fears concerning the dollar have overcome the paucity of industrial demand in the west.

Of course, it is not just steel. Consider the aluminium market. We recently had a very bearish meeting with the Norwegian company Norsk Hydro. Admittedly, their strong petro-currency does not help and you have to discount the solace I seek in finding people even more miserable than myself. Even so, the aluminium situation mimics that of steel, but with an even mightier inventory overhang. Four and a half million tons reside at the London Metal Exchange, perhaps 20% of world ex-China annual capacity. It is probable that 75% of this surplus stock is accounted for by financial players exploiting a contango.

Does Life Imitate Art?

The advocates of Prechter’s socio-economics would not be surprised to hear that the Romanian writer Herta Mueller has been awarded this year’s Nobel Prize for literature for her work depicting "the landscape of the dispossessed". In a Los Angeles Times review of her book, The Appointment, they noted,

"…it is sometimes difficult to tell whether we are reading about people driven mad by a mad regime or people who may not have had all their marbles in the first place."

My partner, Mr. Lee, reflected on this as he sat in the chilly offices of Norsk Hydro last week watching the snow fall outside. The Norwegians continued with their tale of woe: a couple of million tonnes of inventory remains unaccounted for on the world stage and are believed to be hidden in cheaper warehouses in Russia. The rationale behind this is the same as the rationale used by LME speculators. Furthermore, the big Russian players like Rusal are under intense pressure from Putin not to cut capacity (check out ‘Putin bitch slaps Deripaska’ on http://www.youtube.com/watch?v=PprlM5R3Hbg), and are rumoured to be surviving only by not paying their electricity bills.

To make matters even worse, the Chinese have stopped importing and are eager to ramp up domestic aluminium production. They havethe capacity to produce another 13mt annually, which is equivalent to 52% of global production. Lastly, there is the fact that Rio Tinto bought Alcan right at the very top of the cycle, though they dare not admit it is a terrible business.

Poor Old Norsk Hydro?

Who would want to share a stage with so many mad villains? The Norwegians noted that construction demand had just taken another leg down as buildings started pre-crisis are now finished whilst no further pipeline exists outside of China. Even Ryanair are talking about suspending their aggressive growth plans and may delay the purchase of more planes.

The Norwegians suffer the most pain at present, but if the dollar were to strengthen Alcoa could conceivably go bust. Their dollar cost is the company’s only competitive advantage. Let us not forget Alcoa has the most exposure to aircraft construction and still has $10bn of gross debt lording over an almost equivalent market cap. Imagine that we have not even considered their pension liabilities. Yet the Alcoa CDS trades at 200 basis points, down from its high of 1200 earlier this year. Why?!

"May sorrow break these chains of my sufferings, for pity’s sake"

Lascia ch’io pianga
Handel

Now remember I have been describing a positive macro scenario: a world in which low interest rates make the debt load manageable and that we muddle through with lower growth rates in nominal GDP. But clearly the consequences for corporate profitability are very poor. The alarming thing is that my opponents (see Ferguson et al.) believe that government bond yields are going much higher. Effectively, the world’s bond vigilantes are going to punish the Fed and tighten monetary policy. It is almost as if the world’s greatest speculators are agitating for their own demise. It is my contention that the leverage of the economy is only tenable if interest rates stay low and yet, whilst I believe some of them agree, they still fervently expect a rise.

Je consens, ou plutôt j’aspire à ma ruine.

Pierre Corneille
Polyeucte, 1642

Do not forget that the US does not share the distinction of the British or Australian housing markets. According to FSA data, 55% of UK mortgages are fixed rate and 45% are floating. The latter have, of course, collapsed and have proven a boon for disposable income. We must remember, however, that British fixed rates are determined by two and three year swap rates; so effectively the entire stock of UK mortgages are determined by the central bank and could be thought of as floating. In the US, however, things are very different. Total single-family mortgages outstanding are $11trn but $9trn is fixed to the prevailing 30 year Treasury yield. Banks just do not offer variable rate or teaser mortgages anymore. You might say that the American housing market hangs by the tender threads of the bond market’s generosity. Lose it, and let us say that the markets demand 6% yields on 30 year durations and mortgage rates would then shoot back up to 7%. And, I would argue, the economy would come to a crashing halt. Do speculators really want this to happen?

Perhaps I am describing a pressure cooker. The private sector’s debt may be sustained by maintaining low nominal interest rates.But the pressure from so much issuance at a time of great reluctance from financial institutions to purchase bonds could break the stalemate. And with it the ominous precedent of 1931, outlined in our February report, when a back up in ten year Treasury yields from 3.1% to 4.4% undoubtedly accelerated the rate of deflation in the US economy.

We know it’s never different this time.

The thing is though it takes a bit of time to remember that.

For instance, the implicit “it’s never different this time” promise is the biggest problem facing the Democrats push for healthcare reform.

It’s a new entitlement program. And history has proven time and again, in its current form the odds of it reducing costs, increasing efficiency, and making the healthcare system better for consumers are pretty slim. It’s really only a matter of time until the well-documented consequences of the reform are realized.

As the polls have shown, the more time that passes, the more folks realize odds are it won’t be different
this time.

Apple Computer has adjusted its advertising focus in hopes of reminding consumers it’s never different this time too. The company which has built its business around knowing what their customers really want knows consumers know it’s never different this time.  And they’re opening up the war chest to remind consumers of exactly that.

In response to the Microsoft’s Windows 7 launch, Apple has quickly countered with an ad campaign aimed at the implied “it’s different this time” promise. With all the buzz and excitement surrounding the Windows 7 launch, Apple knows it’s easy to forget that it won’t be different this time. Apple is merely taking the opportunity to remind consumers of what they already know, but occasionally forget.

We could go on forever, but you get the point. That’s why we’re taking a step away from the “it’s different this time” crowd and taking a look back at how bear market rallies work and how to navigate them successfully.

Three Stages of a Bear Market Rally

In April it was clear we were in an incredibly strong rally. At the Prosperity Dispatch, we pegged it as a rally you would want to ride all the way to the end. And it would last far longer than most expect.

We also knew it would be a highly emotional ride. After all, when you’re making 20% or more each month, the common mistake is to sell too early. It’s easy to do. The natural desire to sell for a quick profit is a strong one. But history has shown the biggest gains will be made by those that ride out a trend for all it’s worth.

In mid-April we took a historical look at the Three Stages of Bear Market Rallies, how they begin, how they last until the last bear finally gives in, and specific warning signs to look for to know when it’s coming to an end.

Here are three stages of bear market rallies we identified. As you’ll notice, at the end, all signs point to the current rally coming to an end sooner than later.

Stage 1: “This will never turn around.”

The first stage of a bear market rally starts when we get the first signs of a turnaround. This happens when everyone thinks it will never turn around. We hit that point in early March. Since then the markets have been so beat up in such a short period of time that any bit of good news can get things rolling higher again.

As the “Obama rally” turned into a sucker’s rally, each passing week brought progressively worsening economic news. There was nothing to look forward to. Expectations were low and headed lower.

We hit this point in March and once the market started moving up on “not as bad as expected” news, it was clear a bear market rally had begun. And since the S&P 500 was down more than 55% from its 2007 highs, the set-up was in place for an extended, sharp, and lucrative rally.

Stage 2: It’s a Bear market rally, “The easy money has been made.”

This is the stage where you’ll see most commentators admit we’re in a bear market rally. Many of them freely cite some warning about the coming rally they issued and it was to be expected. Most of them go on to warn this is a bear market rally and advise against buying now.

By May 9th, two months into the rally, the S&P was up 36%. That’s a decent return for two years in a good market. In two months, it’s downright fantastic.

By this time no one could deny the rally was real. Anyone, however, could quite easily make a case where the rally had gone too far, too fast and it was too late to get in.

This is also the stage where volatility plays a greater role. The markets quit bounding up day after day and there were real corrections (at least 5%) just to keep the herd on the sidelines.

Stage 3 – “All clear! Don’t miss this.”

This is the final stage. It’s when the bear market has been forgotten by most investors. It’s when the “panic buying” sets in as the big money fears 1) it has missed all the chances to buy low, 2) their performance will suffer, and 3) customers will take their money elsewhere.

To make up for lost time, they buy more aggressively than ever. This is an extremely profitable stage. Yet when the big money runs out of cash to buy shares, watch out, the end of a bear market rally is near.

The clearest indicator we’re in the third and final stage is the stagnating upward momentum. The S&P 500 rose 36% in the first two months of the rally. It rose a respectable 13% in the next three months. It rose 6% in the last three months.

The rally appears to be running out of steam. At this time, however, most investors feel more comfortable buying stocks than they have since the rally began. GDP is up, earnings are up, and corporate executives are issuing positive guidance about their near-term growth prospects (most refused to even venture a guess last year).

The “all clear” has been sounded by executives, analysts, and many others. And investors continue to put more money to work (or, from our philosophy, at risk). Last week was the 34th week in a row in which investors put more money into mutual funds than they took out.

As for the aggressive, panic-style buying we expected, it has been largely masked by the rebound in share prices. For instance, a mutual fund manager who wants to buy 10 million shares of Bank of America only had to put up $40 million in March. A few weeks ago, the same stake would cost $180 million. As a result, a lot more money may be going in, but it’s having a significantly less noticeable impact.

———————————————————–
It’s Never Different This Time

As this rally shows greater and greater weakness, the risk and reward situation continues to turn against going “all in” now.

Also, since most of them have the wind at their backs and a renewed confidence, they’re sure they will be able to achieve the nearly impossible and get out at the top.

Since it’s never different this time, we know those facts are not going to stop investors from trying either one of them.

That’s why right now, the best advice we can follow is what we’ve stuck to since the beginning.

Look for sectors with exceptional fundamentals, identify the best risk/reward opportunities in those sectors, develop a plan, and stick to it.

Although day-to-day it never feels quite the same and emotions, left unchecked, will quickly cloud out reality, we know it’s never different this time. And there’s no reason to expect this rally to play out any different than every one that has come before it and every one that will come again.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let’s look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we’re in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter’s creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won’t know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen’s Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we’ve lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let’s see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish’s very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let’s look at his assumptions:

• Job losses are likely to continue for a minimum of another year.
• When job gains start, they will be very slow at first, then pick up.
• An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
• A falling participation rate (boomers retiring) will continue to mask reported unemployment.
• Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
• The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let’s start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike’s blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let’s look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let’s be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn’t look like that will be the case. So, let’s quickly see what a double-dip scenario might look like. Let’s be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it’s getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I’ve noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Phoenix, New York, and Thoughts on the Internet

Next week I take a quick one-day trip to Phoenix, then back to do a satellite-remote speech to a South African hedge fund conference. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org). Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

The 7 kids, spouses, and grandkids are starting to gather. We will all have brunch Sunday and then a shower for Tiffani. She has another 6 weeks before she is due, and she is really uncomfortable. Walking is literally a pain.

Permit me to reminisce. A little over 9 years ago I started this letter on the internet with about 2,000 email addresses. It was a new version of what had been a print letter, as that was the business I knew. The internet was still a new thing to me, but it seemed like a good idea at the time. Little did I know.

I am still amazed at the growth and the direction my business and life have taken. My letters are sent out by various publishers and affiliates to over 1.5 million readers and posted on dozens of web sites, and the numbers have been growing rapidly of late. I am grateful. But I wonder what would happen if I started it today. Ten years ago there was little in the way of free economic letters. Not a lot of competition.

Today, there is so much free information that it’s staggering. There have to be thousands of blogs and hundreds of free letters, some with very large circulations. It seems a new star is born every few months. While much of it does not add to the level of conversation, some of it is quite excellent. I think I am lucky to have started when I did.

And I am grateful for the kind attention you give me. As I turn 60, I note that this has been a rather overwhelming last ten years. A lot of changes for me, and almost all of them very good. But there are more to come. The last two flights I was on I was connected to the internet at 35,000 feet. I sense a lot more changes coming. I am thinking a lot about how to keep up and not get left behind, how to make sure that you, gentle reader, continue to get my best. That is what, at the end of the day, drives me.

Have a great week. I know I shall. Dad loves it when his kids (from 15 to 32) and spouses and grandkids are all under one roof.

Your amazed at it all analyst,

John Mauldin
Outside the Box & Thoughts From the Frontline
johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

Yes, Blankfein really said this. Follow the link above if you don’t believe it. Even more amazing, he said it to a reporter, during a scheduled interview, knowing whatever he said was on the record.

Now I will admit that in context, Blankfein had a point. The financial system provides funding for new businesses and jobs for people. Most would agree these are good things. Blankfein, however, is not a theologian. He is the head of Goldman Sachs, a firm that at the present time is widely regarded as greedy, evil, excessively powerful, and so forth. Claiming heavenly justification for Goldman’s activities at a time like this is not smart.

No one gets to Blankfein’s position by saying dumb things to reporters. This makes me think he knew exactly what he was saying and simply didn’t care what people would think. It makes perfect sense if he believes what he said to be true.

This being the case, the problem lies not in Goldman Sachs but in those of us who refuse to acknowledge its inherent goodness and worthiness. I suggest we all make amends by holding hands and offering the Lloyd’s Prayer.

Our chairman who art at Goldman
Blankfein be thy name
Thy rally’s come, God’s work be done
In the Dow as it is in the Nasdaq
Give us this day our daily gain
And forgive us our frontrunning, as we punish those who frontrun against us
And bring us not under indictment
But deliver us from regulators
For thine is the cashflow, and the power, and the bonuses, forever and ever. Amen

Patrick Watson
Invest With An Edge

[Note: several versions of this prayer are floating around the web. The one above is my favorite and it comes from Mish Shedlock.]

All signs point to the market heading lower. The major indices are fundamentally overvalued, the real
economy has barely improved, and expectations are approaching lofty highs.

It’s a recipe for a sharp and painful correction. And that’s why I’ve recently turned bearish on the markets in general.

Still though, the market rises. There are many factors for the rise, but the question is what to do now?

That’s where it may get a little confusing. I’m bearish, but I’m still recommending buying stocks.

On the surface, it doesn’t make any sense at all. But the facts reign over everything.

One Year Later…

It’s been more than two years since the Dow set an all-time record high in October 2007.

A lot has changed since then. Unemployment has surged, government has reached its tentacles further into the U.S. economy than ever before, and the markets have been going through their most extreme swings in decades.

The one thing that hasn’t changed is paying attention to the facts and how they should drive your investment decisions.

That’s why I was interested in learning how anyone who took our advice at the height of the market meltdown last November would be doing.

At the time, at the Prosperity Dispatch, we repeatedly proposed:

If you pick your buying spots, develop a plan, and don’t have overly optimistic expectations, you will be rewarded handsomely…

We were talking specifically about gold, silver, platinum, and other investment vehicles like convertible bonds, but I wanted to see how an investor would have done without the advantage of being in the best performing sectors over the past year. .

What I learned was a bit surprising.

Could Not Lose Money if You Tried

In one example, I looked at what would happen if an investor – let’s call him investor A -bought the S&P 500 SPDR ETF (NYSE:SPY) on the first of every month.

This investor, however, is the worst kind. He heard about the subprime crisis. He listened to the Fed when they said it was “contained.” And he waited to start investing when the “coast was clear” as the Dow was setting new all-time highs in October 2007.

This investor bought $1,000 worth of the S&P 500 on the first day of each month from October 2007 up until now. He ended up with a total return of 7.5%.

Remember, he started at the absolute worst possible time, consistently plowed money into the worst market in decades, and still made a total return of 7.5%.

But I realize most investors don’t buy stocks on arbitrary dates like the first trading day of the month. They try to time the market a bit and buy on dips. So I also wanted to see how a market timer would have fared. Not a good market timer though, but the absolute worst market timer.

So I looked at what would happen if an investor bought at the worst possible time each month. You know, the ultimate buy high, sell low kind of investor. Granted, it’s highly improbable someone would be able to time his buying at the exact top each month, but we’re looking to see how the worst did. And you cannot get worse than that.

Again, even the worst market timer fared well. An investor who bought $1000 worth of the S&P 500 at the worst possible time each month starting at the market highs last October would have come out a little under 1% ahead. Once dividends are added though, he would have made a total return of 6.2%.

The table below shows how well both of them did:

Not bad at all considering the S&P 500 is still off 25% from its 2007 highs – the same time these two investors started buying stocks.

A Steady Hand

As you can see, having a reasonable plan, investing consistently, and looking past the daily noise can pay off handsomely.

After all, these investors started at the worst possible time. They rode the ups and downs of the most volatile market in decades. And the market – as tracked by the S&P 500 – is still 25% below where they started buying at.

This is kind of an elementary example, but it does show how having a plan and sticking to it can make you a much better investor.

It also shows why, although I believe the markets headed lower, I’m still recommending buying stocks.

If the markets go down as we expect, we’ll be in position to buy more stocks at lower prices and be well positioned for the next rebound.

Or if the markets continue to rise, we’ll be in position to ride this market rally for all it’s worth.

Either way, they’re both great spots to be in and it’s not nearly as crazy once you take a step back and look at the facts.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we’re headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.investorsinsight.com and search for terms I am writing about. And I will start out by briefly touching on today’s ugly unemployment numbers, with data you did not get in the mainstream media.

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.investorsinsight.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don’t know, I write a brief monthly column for them.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month’s. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let’s look at the real number in the establishment survey. If you don’t seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

"Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual ‘change’ in the underlying labor market situation … in which case, October’s figure of 817,000 represents the fourth LARGEST yet, behind last month’s (September’s) second largest figure of 1,021,000 … for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer ‘in’ the Labor Force …

"… the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

"Bottom line … basis this measure AND the ‘Total Unemployment Rate,’ we could conclude that not only is there NO ‘improvement’ in the labor market, but moreover, that it continues to DETERIORATE, intently."

There are plenty more implications in the data, but let’s turn to the topic of the day.

"I can imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship’s construction, of the company’s policy, or of the captain’s competence. "No one could have seen this coming," would have been their constant refrain. Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today with our efforts to redesign the financial system in order to reduce the number and severity of future crises."

You can get the full letter at www.gmo.com (You will have to register).

Your glad to be back home at least for a week,

John Mauldin
Outside the Box & Thoughts From the Frontline
johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

Just Desserts and Markets Being Silly Again

by Jeremy Grantham

Just Desserts

I can’t tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee’s sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn’t seem deserved. And then it occurred to me. Isn’t that the point these days: that rewards do not at all reflect our just desserts? Let’s review some of the more obvious examples.

1. For Missing the Unmissable

Bernanke, the most passionate cheerleader of Greenspan’s follies, is picked as his replacement, partly, it seems, for his belief that U.S. house prices would never decline and that at their peak in late 2005 they largely just reflected the unusual strength of the U.S. economy. As well as missing on his very own this 3-sigma (100-year) event in housing, he was completely clueless as to the potential disastrous interactions among lower house prices, new opaque financial instruments, heroically increased mortgages, lower lending standards, and internationally networked distribution. For these accumulated benefits to society, he was reappointed! So, yes, after the fashion of his mentor, he was lavish with help as the bubble burst. And how can we so quickly forget the very painful consequences of the previous lavishing after the 2000 bubble? Rewarding Bernanke is like reappointing the Titanic’s captain for facilitating an orderly disembarkation of the sinking ship (let’s pretend that happened) while ignoring the fact that he had charged recklessly through dark and dangerous waters.

2. The Other Teflon Men

Larry Summers, with a Financial Times bully pulpit, had done little bullying and blown no warning whistles of impending doom back in 2006 and 2007. And, famously, in earlier years as Treasury Secretary he had encouraged (I hope inadvertently) wild and reckless financial behavior by helping to beat back attempts to regulate some of the new and most dangerous instruments. Timothy Geithner, in turn, sat in the very engine room of the USS Disaster and helped steer her onto the rocks. And there are several others (discussed in the 4Q 2008 Letter). You know who you are. All promoted!

3. Misguided, Sometimes Idiotic Mortgage Borrowers

The more misguided or reckless the borrowers, the more determined the efforts to help them out, it appears, although it must be admitted these efforts had limited effect. In comparison, those who showed restraint and either underhoused themselves or rented received not even a hint of help. Quite the reverse: the money the more prudent potential buyers held back from housing received an artificially low rate. In effect, the prudent are subsidizing the very same banks that insisted on dancing off the cliff into Uncle Sam’s arms or, rather, the arms of the taxpayers – many of whom rent.

4. Reckless Homebuilders

Having magnificently overbuilt for several years by any normal relationship to the population, we have decided to encourage even more homebuilding by giving new house buyers $8,000 each. This cash comes partly from the pockets of prudent renters once again. This gift is soon, perhaps, to be extended beyond first-time buyers (for whom everyone with a heart has a slight sympathy) to any buyers, which would be blatant vote-buying by Congress. So what else is new?

5. Over-spenders and Under-savers

To celebrate the overwhelming consensus among economists that U.S. individuals have been dangerously overconsuming for the last 15 years, we have decided to encourage consumption and penalize savers by maintaining the aforementioned artificially low rates, which beg everyone and sundry to borrow even more. The total debt to GDP ratio, which under our heroes Greenspan and Bernanke rose from 1.25x GDP to 3.25x (without even counting our Social Security and Medicare commitments), has continued to climb as growing government debt more than offsets falling consumer debt. Where, one wonders, does this end, and with how much grief?

That’s what one of the world’s leading Chinese financiers told me over dinner last night.

It has caused me to rethink the growing bubble in Chinese markets. And that we may have thought a bit too much, looking too closely at key economic fundamentals like electricity consumption and age demographics in the past.

As we’ve professed throughout this rally at the Prosperity Dispatch, we should be looking at taking what the markets gives us. Here’s the new take on China.

Mainstream Media Signals

Just like U.S. stocks, Chinese stocks soared during the rally. Almost anything China related has more than doubled.

The primary catalyst was obviously a surge of cheap – really cheap – money into China’s economy. Banks, at supposedly government demand, ramped up their lending to historical proportions.

The cause was obvious and most pundits jumped on board. And just like they have prematurely called an end to the rally in the U.S., there have been even more who have called an end to the new China bubble.

In April,the Business Insider warned “China’s bubble will burst. And painfully.”

In July MSN stated, “Easy money inflates a New China Bubble” and how it saw an “overheated” China economy.

In August, Paul Krugman, Nobel Laureate economist and New York Times blogger, claimed, “[China] is blowing bubbles.”

They were all on top it. But they all forgot how markets work. The stock market doesn’t care about the long-run costs or impact of the bubble; they just care about the next move.

And right now and in the intermediate future, the trend is up. Here’s why.

It’s the Domestic Economy, Stupid

A lot has been made throughout this downturn of China’s declining exports. Granted, China’s export-fueled growth over the past 30 years has run into some serious roadblocks. But there is two ways to look at this though.

One view – the mainstream view – China’s economy is screwed. U.S. consumers are maxed out. And without them, there’s no one to buy Chinese goods. Sure, exports will not halt completely, but the boom years are pretty much over.

The other view – the one the market is taking – is that this means opportunity. As the thoughtful David Rosenberg points out, “Remember – consumption in China is only 33% of GDP, the lowest of the world’s leading economies.” That means there’s a lot of room to grow.

The key thing here is what is actually going on in China. From what I gather, there has been a fundamental shift in China’s industrial priorities over the past few years. It’s something anyone who merely looks at the GDP, retail sales, or electricity consumption data would completely miss.

The shift is away from the very low-margin manufacturing and into more value-added products. Vietnam has demonstrated its willingness to manufacture clothing, simple toys, and all sorts of low-margin, labor intensive products. The change frees up China, its more educated workforce, and better capitalized companies to manufacture more value added products like electronics, cars, etc.

Think of it like the U.S. during the turn of the century. The U.S. economy shifted from relying on production of steel, textiles, coal, and other raw materials and low-value products to making stuff on the higher end of the value spectrum. That’s what is happening in China right now. And having a willing and able partner like Vietnam who’s rolling out the red carpet (no pun intended) will only accelerate the shift.

It’s going to take time and there will be growing pains, but there are still plenty of growth opportunities in China. And now, China is making great efforts to ensure there is funding available for the upstart growth engines of China’s economic growth.

Go Small or Go Home

Earlier this week China’s financial markets took a giant step forward.

With relatively little international fanfare, the ChiNext stock exchange officially opened its doors for business on Monday.

The ChiNext is set aside exclusively for small, riskier ventures. It’s essentially the NASDAQ of China. The listing requirements are much less stringent than the Shanghai exchange. With the ChiNext up and running, smaller companies no longer need to grow for years to tap into the equity markets.

The ChiNext proved there is a big appetite for riskier ventures in China too. It started trading on Monday with 28 companies listed. The share values of all those companies doubled on the first day too proving there’s a lot of interest for real growth.

And it’s in the smaller firms where the real growth opportunities lie. Even though the big Chinese names get all the headlines, the Telegraph reports, “small- and medium-sized [Chinese] businesses account for 80% of jobs, 50% of tax revenues and 60% of GDP.”

Small businesses in China are the future. And they will be the best opportunities which will leave everything else in China far behind.

China’s Next Favorite Commodity

Over the last decade, China has been one hot sector. The storytellers have painted pictures of 1.1 billion Chinese people buying [insert consumer product here – cars, refrigerators, cell phones] to justify ridiculous valuations for shares of major Chinese companies.

It all made sense too and, for the most part, was real. It just makes sense that as you get more money, you want more stuff and services.

But there’s another sector the crowd isn’t paying much attention too and it’s shaping up to be more lucrative than any Chinese sector to date.

 As a whole, China is still in the early stages of the quality-of-life uptrend. The important thing to understand is the demand for new stuff comes at different stages of this cycle.

We’ve all witnessed surging demand in China. Whether its food, homes, water, cell phones, refrigerators, TVs, air travel, insurance…you name it, they want it.

But I see a next step coming. The next natural progression is one I don’t believe “the herd” has really focused on yet. Although, it’s probably the biggest opportunity in the unfolding China story: healthcare.

That’s right healthcare. It’s the ultimate quality of life product that’s in demand once you get enough money. 

The U.S., again, is the perfect example of what will unfold as China gets wealthier.

From a general perspective, the U.S. is a very rich country. We have high wages, standards of living, high everything.

Yet, right now, the main focus of politicians has been on healthcare. The most commonly figure trotted out by the healthcare reform pitchmen is how much the U.S. spends on healthcare.

Frankly, I still haven’t figured out how this is a “bad” thing. If we have that much disposable income that we can spend so much on healthcare, that’s a good thing? We spend more on TVs, cars, energy than everyone else, but spending more on healthcare is somehow bad? Yes, there are lots of inefficiencies too, but having a lot of disposable income is not a bad thing.

So that’s why, with China’s GDP growing, it’s ongoing increases in national wealth, and everything else moving right along, the next big China boom is shaping up to be in healthcare.

Also, demographics are in favor of a genuine healthcare boom too. China is not just getting wealthier, it’s getting older. And that’s the perfect mix for a real surge in demand for healthcare. It’s the next natural progression.

The New China Strategy

That’s where we’re at right now. Most of the mainstream media see nothing but a massive bubble in China. Frankly, we’ve seen it and tracked it too. Bubbles, however, are truly great opportunities.

Yes, the bubble will end. It will end badly. And it will come when most investors least expect it. But if this is the next great bubble, it would be tough to sit on the sidelines for the next two, three or five years watching fortunes being made just for the sake of being “right.”

As my dinner guest rightfully pointed out, there just aren’t too many places where you can find businesses that double themselves each year for countless years ahead. But China is one of them and I can’t recommend staying away merely because everyone sees a bubble emerging.

After all, if a bubble is forming…all the better.

In a bubble, there will be opportunities to buy on dips and a genuine bubble will just accelerate the gains, push valuations far higher than they should be (and our gains right along with them), and since we have the tools (i.e. trailing stop losses) to ensure we don’t ride it all the way up and then all the way back down, why not.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

It gave advance warnings for each of the past eight U.S. recessions including the double-whammy recession of the early 1980s and the recent one.

That’s why I believe that it may be a good idea to keep following this indicator’s readings.

I prefer the LEI’s year-to-year percent change to get a glimpse of the U.S. economy’s future. During the current business cycle this version of the indicator made its low in March 2009 at -4 percent. From there it improved every month and turned positive in July. This indicated that an economic rebound had started.

Indeed, GDP grew by 3.5 percent in the third quarter!

And While the Growth Isn’t Genuine,
The Market Doesn’t Really Care Now …

Government stimulus is keeping the economy afloat.

As some very good economists have pointed out, this growth is mainly due to government stimulus. This means we’re dealing with an economy on life support.

I don’t expect a genuine and durable boom to start any time soon. The huge balance sheet problems in the private sector and especially in the banks have not been solved. So I suspect they’ll haunt us again, probably in the second half of 2010. At least that’s what the current LEI readings are telling me.

At the same time, the LEI doesn’t differentiate between genuine growth and government-stimulus-based growth.

And the stock market doesn’t care, either — at least in the short to medium term as the monster rally off of the March lows has shown.

So as an investor, I’m not very worried right now about any future setbacks that the economy is likely to suffer.

Currently the LEI is still pointing to a continuation of the economic rebound. After rising 1.9 percent in August it accelerated again in September … up 2.9 percent. It’s also important to note that eight of the LEI’s ten components contributed to this rise, which makes its positive message even more valid.

Bottom line: I cannot see any reason to distrust this time-proven-indicator’s bullish message. Therefore, I expect the rebound to continue.

In last week’s Money and Markets column, I wrote about the technical setup that was signaling a stock market correction. Now that the correction has started, some shorter-term indicators are already entering oversold territory.

This medium-term rally is not over yet.

As I said last week, I expect a somewhat larger correction here, some 10 to 15 percent. So I don’t think it’s time to jump in with both feet yet.

But after this correction has run its course — probably in two to four weeks — I expect the medium-term uptrend that started in March to resume.

This expectation jibes well with the LEI and my medium-term technical indicators. What’s more, comparing last year’s severe sell off and this year’s monster rally to similar historical examples supports this forecast.

Best wishes,

Claus Vogt
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether "it" – hyperinflation – can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson’s recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn’t happen more often.

In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp."

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20th century, Argentina was the seventh richest nation on earth. It’s very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors."

Argentina had actually defaulted on its debt in the late 19th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let’s look at some quotes from Ferguson (emphasis mine):

"The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement… To understand Argentina’s economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon…

"To put it simply, there was no significant group with an interest in price stability…

"Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country’s political economy."

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it’s not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today’s thought process is about what happens if they don’t.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don’t have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

"It’s now official. The proposed legislation to reform America’s financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America’s central bank.

"The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

"The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

"The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

"In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis."

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

"Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more."

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go — and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom — imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally — not the onset of a new bull market) has not swayed their view (or ours for that matter)."

Uruguay, Philadelphia, Orlando, and then…

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed analyst,

John Mauldin
Outside the Box & Thoughts From the Frontline
johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

The recession is over!

GDP grew at a 3.5% clip between July and September.

Wall Street’s fortunes seemingly turned around overnight.

But with the rally reminding everyone how fragile it is, are the boom times really here again?

One of the world’s best investors thinks it will seem that way for a while, but – that could be bad news for the markets. Here’s why.

World’s Great Investor Turns Bearish

Six months ago almost no one believed in the rally. Unemployment was still on the rise. The economy was still contracting. The housing market, despite all kinds of incentives for buyers, ground to a standstill.

There were no fundamental reasons for stocks to rally. There were, however, a few technical reasons.

The combination of low expectations and trillions of new dollars pumped into the system would create a run in whatever asset class was on the rise. Once stocks broke out in March, the hot money would chase them back to reasonable valuations and beyond.

Back in April we proposed the Dow hitting 10,000. It seemed a bit unrealistic at the time, but given the situation, anything could happen. We weren’t the only ones who saw it that way though. One of the most successful investment managers in the world, Jeremy Grantham, saw it similarly.

Now, Grantham considers the market 25% overvalued and is taking some money off the table and you must understand why.

Frustrating Times Ahead

In his most recent quarterly letter (a must read for any investor), he brought up one very important point (emphasis mine):

The 1Q 2009 Quarterly Letter, by the way, said “in a [S&P 500] rally to 1000 or so, the normal commercial bullish bias of the market will of course reassert itself, and everyone and his dog will be claiming it as the next major multi-year bull market.”

Well, now it’s happened precisely that way, and you should not believe them! As we have demonstrated to our clients in earlier cycles, earnings estimates in particular merely follow the market up (not the other way around, as one would hope). So it is a law of nature that strong estimates will abound after a major market rally.

The earnings and economic growth estimates in such cases are usually throwaways. But the economic data next year will indeed look strong.

The irony may well be that just as nine months of weak economic data this year has been accompanied by a very strong market, so the strong economic data next year is likely to be accompanied by a weak stock market.

Think about that for a second.

Most everyone isn’t quite calling for a “multi-year bull market,” but everyone seems to agree the rally has been fueled primarily by aggressive monetary expansion (money printing) and hopes of a recovery.

Now that the masses have realized that, no one is willing to bet against this rise and many more are jumping on board. Meanwhile, the economic data continues to improve (today’s GDP growth numbers were the most positive yet) and the market’s have started show some genuine weakness.

Aside from today’s sharp rise, the markets have climbed in anticipation of good news ahead rather than on good news. As a result, we can conclude they’ve reached the dangerous point of expectations which may be too high.

So what’s going to happen when that good news comes?

As we know, when expectations are great, the risk/reward situation turns upside down.

If the news is really good, the markets may hold up or even go a little bit higher. If the news is not good, they will falter – quickly.

Markets ALWAYS Revert to the Mean

That’s the real risk here. Right now, there’s not much holding this market up besides high expectations.

That’s why, although we don’t foresee a crash like last September or November coming, we do realize the markets have hit an unsubstantiated high. This will lead to a terribly frustrating market for many investors.

Investors who refused to take what the market gave them months ago missed out on a lot. They’re now forced to play catch-up. And with the economy looking better, they won’t mind shoveling more money into the markets.

That’s where the frustration will come in. There’s no doubt the economic numbers will improve. But the markets will not have to go up because almost all of it is already anticipated.

If you consider Grantham’s fair value for the S&P 500 of 860, the overall markets could have another 20% to 25% downside over the next six to nine months even if the economic news is good. If we use his 860 as the average – or mean – the markets could easily revert to that level even while the economic data shows steady improvement.

No True Recovery in Sight

Although the markets will continue to be volatile, we can’t forget we’re undoubtedly entering a period of slow growth.

Yes, the housing market will recover. The government extension and expansion of the homebuyers’ tax credit will help accelerate this in the short-term. But it won’t return to the bubble era anytime soon. (Side note: we’ll go over this situation in detail and how to maximize the opportunity in the next Prosperity Dispatch)

On top of that, it’s looking like the bailouts will continue indefinitely. This week the government announced it will be putting more cash into GMAC for more auto loans and leases, which is nothing more than a backdoor bailout to GM and Chrysler. Also, the dairy and beef industries have gotten bailouts too. Both of these appear helpful in the very short-term, but they merely stave off the natural, inevitable, and necessary right-sizing of the industries to put them back in a sustainable state.

Then there are the unintended consequences of healthcare reform, the impact of higher taxes, and the greater involvement of government across the business landscape. They will all weigh on the economy too.

So although we’ve been as positive as we can reasonable get here, we try to stay realistic too. Today’s GDP numbers were great. The rally was great. But the good news will lead to higher expectations. And we all know before great disappointments comes great expectations.

The recession may be over, but that could mean trouble ahead for stocks. At the Prosperity Dispatch, we’re not about to bet against an uptrend. Now is the time to tighten up stop-losses and be prepared to move when necessary. There’s a very realistic chance of the S&P 500 falling 20% in the next six to nine months even if the economic numbers continue to improve.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

It is especially poignant as I sit in a country that has seen the ravages of hyper-inflation, talking with business leaders and investors who experienced the problems first hand and how they deal with it today. I will be writing about what I am learning this Friday I think. But now I have to run and give my third speech today. Have a good week!

Your very surprised to find Argentinean beef as good as that of Texas analyst,

John Mauldin
Outside the Box & Thoughts From the Frontline
johnmauldin@investorsinsight.com

John Mauldin, best-selling author and recognized financial expert, is also editor of the free Thoughts from the Frontline and Outside the Box e-letters that go to over 1 million readers each week. For more information on John or his FREE weekly economics letters, go to: http://www.frontlinethoughts.com/learnmore

Liquor before Beer – In the Clear

Value Investing Congress – David Einhorn, Greenlight Capital

One of the nice aspects of trying to solve investment puzzles is recognizing that even though I am not always going to be right, I don’t have to be. Decent portfolio management allows for some bad luck and some bad decisions. When something does go wrong, I like to think about the bad decisions and learn from them so that hopefully I don’t repeat the same mistakes. This leaves me plenty of room to make fresh mistakes going forward. I’d like to start today by reviewing a bad decision I made and share with you what I’ve learned from that error and how I am attempting to apply the lessons to improve our funds’ prospects.

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro-thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market’s recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn’t reasonable to be agnostic about the big picture. For years I had believed that I didn’t need to take a view on the market or the economy because I considered myself to be a "bottom up" investor. Having my eyes open to the big picture doesn’t mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time. In a few minutes, I will tell you what Greenlight has done along these lines.

But first, I’d like to explain what I see as the macro risks we face. To do that I need to digress into some political science. Please humor me since my mom and dad spent a lot of money so I could be a government major, the usefulness of which has not been apparent for some time.

Even with this well-known data, the market is going up. The S&P 500 is sporting a mostly gentle uptrend from March to October. The market thinks we’re recovering. Bernanke and company have said as much. However, given that we have the toughest job market in a generation, to me it seems a little premature to declare recovery – at least a strong one.

I’m not alone in my assessment. CNNMoney.com’s Editor At Large Paul LaMonica recently said, “Repeat after us. There is no strong recovery without job growth. There is no strong recovery without job growth. Why does Wall Street not get that?”

A good question. Why is the market going up while jobs are going down?

It makes even less sense when you consider the nature of unemployment. It goes back to demand. When companies experience demand for their products and services, they will seek to meet that demand. If meeting that demand requires more labor, they will hire. It’s ECON 101. If companies hire, then unemployment goes down. People return to Starbucks to order their Double Skinny Lattes.

But that’s not what is happening. Instead, companies are cutting jobs. Why does the market go up while this is happening?

To this humble market observer, it seems that most of the buying pressure is coming from earnings. Quarterly profits have been good, often better than expected, primarily driven from falling operating expenses. Operating expenses are falling because many large companies are…you guessed it…cutting jobs. There are other factors, but job cuts are definitely helping the bottom line.

In recent days, Sun Microsystems (JAVA), The New York Times (NYT), Dell (DELL), St. Jude Medical (STJ) all shed jobs to stabilize their businesses. And these companies aren’t even banks. We just crossed the 100 barrier for failed banks in the US this year. I’m not sure where all those employees have gone, but they aren’t helping keep unemployment rolls under 10%.

Despite the slumping jobs market and rising stock market, I am often reminded of economist John Maynard Keynes’ aphorism. “The market can stay irrational longer than you can solvent.” This may be one of those times.

Brandon Clay
Invest With An Edge

Before getting into to the relationship between copper and pork products, I want to draw your attention to one paragraph from a commentary by Paul van Eeden that offers a contrarian, and undoubtedly unpopular view amongst the Kitco readership, of the gold market:

"Earlier we reached the conclusion that US interest rates could potentially start increasing and cause the US dollar exchange rate to strengthen, which, in turn, would cause the gold price to fall. We can now add that the massive inflation of China’s money supply can cause the renminbi to collapse and send another currency crises rippling through financial markets. A collapse of the Chinese renminbi could also result in a stronger dollar and lower gold price."

Continuing with today’s contrarian theme and what makes me nervous, have a look at these photos from China. They are excerpted from a China Central Television Channel (CCTV) program documenting private speculation and hoarding of metals throughout the country. According to an associate of mine at an Asia-focused hedge fund who was just in China, "It’s pervasive; people are piling this stuff up in their backyards."

Some of the more telling lines from a translated script of the CCTV program (which I assume to be accurate) include:

• Wang Chao lived in Anxin county of Hebei province (rural area). He is in charge of a metal scrap collecting company. He used to purely take commissions for collecting scrap. Since 1H 2009, he started stocking scraps. He told CCTV his business now is like ‘gambling.’ Not only him, Mr. Wang said many people in his town have stocked a lot of metal at their home.
• They told CCTV they believe the metal prices will ‘certainly rise’, and they have ‘a lot of’ stocks. For example, he said, in Laohetou county, every household has dozens to hundred tonnes of copper. Nobody wants to sell. They believe copper price will goes back to Rmb70,000/tonne from currently Rmb40,000/tonne.
• Traders in Wenzhou city of Zhejiang province: A business man told CCTV, they use a lot of bank loans and bought a lot of metals for stocking. For one warehouse, he stocked at least 15 Kt to 20 Kt of copper. For his total personal metal inventories, he invested Rmb1-2 bn. He believe all metal prices will surge with inflation.
• A non-ferrous metal warehouse manager, Mr Qin Baoqing in Wusong District of Shanghai. He said many metals cannot be put in their warehouse, so they have to leave them in the backyard. Many stocks have not been moved for 3 months now. For example, he said, they have many aluminium stocks from Lanzhou Aluminium, Guizhou Aluminium, etc.
• He Jinbi from Maike (metal trading company). He told CCTV they saw many farmers in Guangdong province stocking more than 100 tonnes of aluminium at home. These people used to raise geese for living.
• Because the interest rate is too low in China. Many farmers could make hundreds of RMB profits per tonne, with dozens of Rmb per tonne cost of interests. They use their existing inventories to borrow more from banks. Banks are very ‘happy’ to lend to them.
• [a side bar here: China's 4 trillion stimulus package equals about 15% of GDP and according to the Financial Times, bank loans are up ~140% this year to ~8.6 trillion Yuan and official State investment accounts for 88% of GDP growth. What we are witnessing is Chinese savers experiencing negative real interest rates in their savings accounts: much worse than in the US. At the same time they are able, in fact motivated, to borrow money at rates that are less than the inflation rate. Hence, the massive government stimulus combined with unlimited cheap money has fueled a soaring stock market, real estate prices, and as presented here, commodity speculation. Approximately 60% of the stimulus money is estimated to have gone into these speculative sectors.]
• On the other hand, many stock brokerage firms in China have become futures trading companies this year. Stock brokerage firms are very rich of cash. Private investors plus those brokers have at least invested Rmb20-30 bn in metal futures market. In 2008, only 50 bn Rmb were in the Shanghai futures market. This year, the number has increased to 80 bn Rmb. Everyday, he said, there are more money flowing into the market.

The CCTV program concludes, "Many speculations in metals have sent mis-leading signals to the government and disordered the market. The government should pay enough attention to it." (The Chinese version can be read here.)

A September 17 Bloomberg story by Singapore-based Glenys Sim reports that "Private investors in China, the world’s largest metals user, have stockpiled ’substantial’ quantities of copper as the government ramps up stimulus spending to spur the economy." The article points out that pig farmers and other speculators have amassed in the order of 50,000 tonnes of copper. That is about half the level of inventories tallied by the Shanghai Futures Exchange.

As the chart below shows, commodity speculation is not a China-centric phenomenon. Since the beginning of the year, global fund flows into commodities have been strong estimated at ~US$12 billion as of October 9th.

Combine the speculative fund and pig farmer holdings with the steadily rising copper inventories, as monitored by the London Metals Exchange, and the case can be made that if the copper price is ultimately a function of end consumption (toasters and Toyotas) there is little upside left in the price. In fact, if we assume that copper is a commodity and subject to the laws of supply and demand, the price should fall.

Now I do not know if Paul’s thesis on gold is accurate or not: if it is it could still take many years to play out. Likewise, I do not know how or when the base metal prices will re-equilibrate to the reality of end demand—whatever that is. What is obvious is that gold and now base metals have become speculative investments that in addition to being bought as hedges against inflation and a falling US dollar are the latest get rich quick scheme. The end result is that absent the faith that metals and markets are all headed higher, we here at Exploration Insights are finding it difficult, although not impossible, to find value in junior mining and exploration companies.

Hot money on the other hand is not.

Over the past few months we have witnessed bought-deal equity financings for individual mid- to junior tier gold companies in the 10’s to 100’s of million dollars. These are being bought at nearly the absolute 52-week highs by funds that I know have not looked into the mining, metallurgical, social or political intricacies that make or break a mine. This fearless hot money jumping into the sector worries me. It always precedes a market bubble and correction: sometimes serious, sometimes temporary- sometimes by weeks, sometimes by years.

Adding to the absence of fear and proper due diligence in the market, my recent discussions with corporate financiers confirm that both large and mid-sized gold companies are being offered substantial unsolicited bought-deal financings—no questions asked. At the same time, some of the very same companies being offered the quick money are being hit with heavy selling when a fund manager becomes "concerned" because there has been no news for a couple of weeks or gold backed off $15.

Hand in hand with heavy fund demand for new metals investment ideas most of the major research firms have increased their commodity price assumptions to reflect the "new reality". The primary advantage afforded by the commodity price revisions is that previously overvalued mining companies can instantly become "Buys". Recall that the last major upward revisions from many of these same research firms came as the new reality of higher prices set in 2008.

The problem is that greed is driving the market and so any small hiccup or change in sentiment and the hot money tends to bolt. As last year taught us (remember last year?) when the fast money going in is the liquidity, there ain’t no liquidity getting out.

I remain cautious and somewhat concerned by what appears to be hot and fickle money jumping into a sector that is apparently taking its cue from pig farmers.

That’s the way I see it.

Brent Cook
www.explorationinsights.com

The Nostradamus’ predictions appear to be linear rather than cyclical. It’s hard to say since, like most good prophesy, they’re in code. The cycles described in Mayan calendars still have the more universal appeal. It’s comforting to think things will come around again. Mesoamericans outlined complex calendars that, we’re told, are quite accurate. That does make them useful to time planting, and also to justify the timing of power shifts. We assume feeding people generated much of the early buzz around star gazing, but as usual the technical breakthrough brought hangers-on.

Perhaps it will be 2012 when western economies at the centre of the debt/housing bubble hit that wall of resignation that creates a final bottom. That will partially depend on how the interest rate cycle plays out in each of them. Capital will continue to seek the safety of bonds for a while yet, assuming its not central banks doing all the buying. As long as yields stay low mortgage resets will keep some weaker players afloat. Bottoms are marked by capitulation, which for debt usually comes when rising interest rates submerge those still treading water. Yields would normally have to go a long way to generate this impact but this cycle features many overextended borrowers that need plenty of time to earn down debt loads.

Right now there is much confusion about whether a “typical” market cycle even applies. Asian growth economies that function somewhat differently than western markets (and differently than each other) are clouding crystal balls. These effects are skewed even more by price shifts against currencies. We seem to be between cycles, and probably are. In our little bit of the galaxy this means coming up with a new gauge for the price vs. stocks equation for copper and some other metals.

Most of the capital that flowed into copper earlier this year plans to use the stuff at some point, and sees potential for a supply squeeze. The question is whether taking a gain now will be rewarded with a lower buy-back price before the stocks are needed. Normally that would work but with metals being used as inflation hedges and pair trades against weak currencies prices (at least dollar prices) have gotten detached from the inventory cycle.

Notwithstanding last week’s new highs for gold, producer stocks move hesitantly, with plenty of traders waiting for “the other shoe to drop”, whatever that might be. Metals in general are continuing their anti-dollar rally. While we would still like to see falling inventories on the base metal side inventory levels have at least been flattening in the case of most metals and falling for zinc and aluminum. There is fear of bubbles and a multiplying list of grumpy bears now that the Dow has added a digit the way gold already had. Yes, a lot of this has to do with a flood of liquidity and speculation on what level profits (or the USD) might be at a year or two out. But, as we’ve noted several times recently its better to deal with the market that is than to try and tell it what to do.

Even though it’s considered the height of irrationality by some, renewed strength in many asset classes can continue as long as central banks flood the markets with liquidity and drive down the returns on competing assets like government debt.

The day may come when that won’t work any longer and bond yields take off so taking profits regularly continues to be a good idea. The day may come sooner when other central banks, the ECB in particular, start trying to jawbone their own currencies lower which could give the greenback a bounce and metals a correction. We expect that would be a correction however, not a panic, and those central banks will still have to prove they can back up words with actions. Jawboning is only a stop gap measure and the Dollar Index has breached several important technical levels on the downside. There will be support for most markets as long as decent economic stats continue to be reported and there is belief that the recession is at least easing. While we agree this is mainly (but not wholly) a currency trade, the longs in commodities have reason to be skeptical that central banks will “get it right” or that some turn of events will create a new batch of Dollar bulls. Central ban ks do no have the best of track records when it comes to controlling liquidity flows.

It would be nice to have some magic ratio that says “metal X is a buy when inventories equal Y and the US Dollar Index is at level Z”. We would like to say we that we already know, but we can’t. Unfortunately, we left our codebook in the other computer and, unlike Mayan calendars; we don’t think anything in this market is carved in stone.

David Coffin & Eric Coffin
HRA Advisories

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So far this earnings season, more than 70% of the S&P 500 companies reporting managed to beat profit expectations. Whether this is because the companies were especially successful or because analysts were unduly pessimistic is not entirely clear. Revenues have been less impressive than profitability, which suggests that earnings are still being propped up by cost-cutting and inventory liquidation. Consumer spending is still very weak and seems likely to remain so. The credit-fueled consumption spending that boosted the economy in the last decade is not coming back any time soon. Companies will spend the next few years adjusting to this new reality.

Since last week we criticized JPMorgan Chase (JPM) for its great success, it is only fair that we point out the earnings miss at Bank of America (BAC). The split among major banks into winners and losers is becoming more apparent. JPM, Goldman Sachs (GS), and Morgan Stanley (MS) are all winners. Citigroup (C) and BAC are on the losing end, and they will likely remain wards of the state for years. Given that Washington is at the very least heavily influenced (and some would say controlled) by the leading banks, what is really happening is that the winners are using the government to destroy their competitors. The unwinding of Citi and BAC, along with the liquidation of Bear Stearns and Lehman Brothers, leaves the other group of banks in an enviable position for the moment. They are too big to fail and getting bigger every day.

Bond yields have been consolidating, with the ten-year Treasury rate ranging between roughly 3.30% and 3.48% for over a week now. This has not prevented the dollar from continuing its downtrend. Other nations are starting to react against the resulting strength in their own currencies. Brazil, for example, imposed a new 2% tax on foreign stock and bond investments in an attempt to rein in the climbing Real. Commodity prices are also rising in dollar terms, though analysts disagree as to whether this is a cause or an effect of the dollar move. Crude oil climbed over the $80 mark, and gold is holding its breakout above $1,000.

Sectors

As our momentum chart shows, Materials managed to hang on to the top sector spot but Energy is close behind. Energy was the fastest climber for the second week in a row, having been in seventh place only two weeks ago. All segments of the energy sector are on fire: integrated, exploration, production, services, and crude oil itself. Financials fell from #2 to #6 as one of only two sectors to lose momentum in the last week. The other was Telecom, which has now replaced Utilities in last place.

Styles

The Style categories continue to compress, which means relative rankings can shift dramatically without much actual significance. With that caveat, we will note that Mid Caps continue to hold the top three spots while the Large Cap categories are starting to overtake Small Caps. The two size extremes – Micro and Mega – are curiously both lumped together at the bottom of the list.

International

There was no change in the upper tier of our Global rankings. Latin America, Pacific Ex-Japan, and Emerging Markets are still on top. The EU stayed in fourth place helped by the strong Euro. Canada held its relative place but lost some absolute strength as energy and materials gains could not overcome weakness in the Canadian Dollar. The UK moved ahead of China and the USA as even the much-maligned British Pound gained strength vs. the greenback. Japan separated itself even further from the pack and now owns the bottom of the list with no real competition. As weak as the U.S. Dollar is, the Yen is even weaker.

Ron Rowland
Invest With an Edge

Now an opportunity for similar gains is fast approaching.

Let’s start at the beginning though. Six years ago no one – and I mean no one – wanted to buy steel stocks.

The industry was reeling. The Chinese were making heavy inroads into the U.S. steel market. They were able to deliver the same product as U.S. steelmakers at a much lower cost. Even some pretty steep protective tariffs enacted the year before weren’t able to save the industry.

It was ugly and it looked like the domestic steel industry was dead. A few innovative companies, however, weren’t about to go under without a fight.

When their backs were against the wall, it didn’t take long for companies like Nucor (NYSE:NUE) and U.S. Steel (NYSE:X) to figure out a way to compete in the global steel industry. They did it by changing from giant mega-mills to much more flexible (and profitable) mini-mills.

They innovated their way to success. And when the crisis did pass, they were one of the few left standing. As a result, they had an even bigger share of the domestic steel market than they did before. And investors who were able to spot the success of these new business models were able to make as much 10 to 20 times their money, in five or six years time.

Now it’s looking like it’s happening all over again. This time, it’s in the newspaper industry.

Left for Dead

I know what you’re thinking…

The newspaper industry is on its last leg.

It pretty much is. The industry has been in steady state of decline ever since the Internet boom really took off. Their subscriber rolls fall every year. The current recession has forced the near-capitulation of the entire industry.

The only thing saving the remaining newspapers is their online divisions. For instance, the New York Times (NYSE:NYT) has one of the most heavily trafficked web sites in the world. And the McClatchy Company (NYSE:MNI), which owns such newspaper industry crown jewels like the Miami Herald and the Sacramento Bee, has stakes in CareerBuilder.com, cars.com, and apartments.com.

To top it all off, newspaper ad sales have been in sharp decline. Earlier today Gannett (NSYE:GCI) reported a 53% decline in earnings due mainly to a 28% decline in print ad sales. Gannett’s CEO also expected print revenue to decline even further in the next quarter. And it’s not too often CEO’s give negative outlooks, especially when Wall Street is looking for any kind news to support the recovery thesis.

But this is just part of a much bigger trend and, if you look beyond the obvious, a high-reward opportunity lies behind it all.

Old World vs. New World

The revenue shortfalls for newspapers were widely expected. In fact, the newspaper stocks have been up sharply because the bad news wasn’t as bad as expected.

But here’s the problem. Although the print advertising revenues are down, the online advertising revenues are up.

Consider this. McClatchy’s print ad revenues were down 32% during the last quarter. That’s worse than Gannett’s horrendous showing. The thing is though, McClatchy’s online ad revenues actually increased.

The divergence between the old world print advertising and new world online advertising just further cemented the trend that newspapers are headed for extinction.

To add a bit of fuel to the end-of-newspapers-as-we-know-them fire, Google (NASDAQ:GOOG) announced stellar quarterly results at about the same time McClatchy revealed its poor print advertising results.

Basically, online media companies are aggressively expanding and traditional print media are cutting staff, slashing benefits and pay, and struggling for survival.

At first glance, which one would you rather have your money in?

But if you sit back and think about it for a second, you might think a bit differently.

Right now, everyone is focused on the Internet. A lot of money is going to be made there too. But it’s attracting a lot of competition as well. Google has soundly trounced Yahoo over the past decade and now Microsoft has committed billions to challenging Google. And if the ad deal with Yahoo is approved by regulators, Google may be facing some tough competition.

Intense competition brings higher costs, slimmer margins, and more expensive growth. That’s why I’d actually recommend looking away from the obvious and start looking at newspapers once again. Here’s why.

The Future of Newspapers

Over the next few years we’re going to see continued problems for the newspaper companies. Many are trying a print/online hybrid model. Others are simply cutting back staff and hoping to weather the storm until the economy recovers. Those strategies, I believe, will cause them to miss out on the truly big opportunity here.

Let’s face it, the newspaper industry is dying. Naturally, they’re trying to survive and stave off the inevitable, but cost-cutting measures can only last so long. But there is a very real opportunity for one or two newspaper companies to take a very strong lead.

The newspaper company which creates a hybrid national/local newspaper will be a truly big winner in the years to come. A newspaper which is able to achieve the efficiencies of being produced nationally and that still contains a local section, maybe composed by a small local news bureau to keep a close eye on high school sports teams and local politics, would have a tremendous advantage.

Think of a five section USA Today. It would have the traditional news, money, sports and life sections which would be produced centrally and nationally syndicated. But it would also have a local section for each city and town it’s sold in.

Remember, the most value today’s newspapers provide and why most readers who still subscribe to them is because of the local news.

So the newspaper company which can develop and expand that model would be able to undercut its competitor’s prices, provide what the local markets want, and stake a very large segment of the newspaper industry for itself.

Going It Alone

Now, I don’t know exactly how the newspaper industry is going to look in three to five years. But I’m pretty sure it’s going to be looking a lot different. The efficient and innovative will survive, the rest, will end up like so many steel companies did during the last recession.

And over the next few months, while all looks lost for the newspaper companies, there will be an opportunity for one or two of them overcome the obstacles and lay a foundation for industry leadership.

And if you can start buying into the one that has the right idea when no one is interested in newspapers, you’d be able to pick up an eventual industry dominator on the cheap.

That’s why, in the Prosperity Dispatch, I continue to recommend looking where others aren’t when you’re taking a truly long-term outlook (five years or more). It may get lonely sometimes, but by buying when no one else is and spotting the right companies which see the future and are making the right moves to dominate it, you won’t have to risk a lot of money to make a fortune.

And when it comes to investing successfully, you’ll always find the best opportunities where no one else is looking.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

The S&P 500 has reached its highest point since September 2008. After that time though, it went on to fall 26% in two months.

Earnings season is in full swing. And with each report we see top line revenues and bottom line earnings are not rebounding nearly as fast as stocks have.

The housing market is still proving troublesome for banks too. Aside from the shadow inventory, rising foreclosures, and the expiration of the $8,000 subsidy for home buyers, bank right-offs are still on the rise.

Then there’s unemployment, tax hikes, etc.

Basically, there’s not too much to be excited about from a fundamental perspective.

That’s why, as mentioned in our free e-letter the Prosperity Dispatch, I recommend making three moves now. And whether the market continues to go higher and gloss right over the real risk in this market, or we’re really at the euphoric top, you won’t regret taking the next few minutes to do these today.

The Real Risk in Today’s Market

As we mentioned above, there are a lot of economic roadblocks. Any one of them could easily trip up the recovery – or, more likely, the appearance of a recovery.

But as so many of us learned over the past few months, the stock market and the economy are two different things. The correlation between the two is abstract, not exact.

That’s where the real risk comes into play. If the markets were to take a turn for the worse, there aren’t too many catalysts to stop the overall market from falling.

And any downturn would just be exacerbated by what’s been fueling this last leg of the rally – emotional money.

You see, mutual funds, the favored vehicles of emotion-driven retail investors, have experienced 30 straight weeks of inflows. The Investment Company Institute has tracked a total inflow of $316 billion in the past eight months. The charge is on and any downturn could spark a quick flight from these funds.

You’ve seen what $300 billion of buying can do to push stocks up. There’s no reason to expect a similar sized drawdown to have the same effect, only in the inverse.

For now though, the trend is up, the herd continues to take money off the sidelines and throw it into markets, and the bulls have been able to stampede over any significant bad news. Still though, I recommend taking action of a different sort today.

Long time Outside the Box readers are quite familiar with Dr. John Hussman, as he is a frequent choice for this column. But this week I think he has written one of his bests essays ever. He cleverly weaves in quotes from a Zen master who is his friend and gives us a very fresh look at market analysis. This is a thought piece and you should set aside some time to absorb the lessons. You will be well rewarded.

Dr. John Hussman is president of Hussman Investment Trust. You can find out more about the mutual funds he is involved with at http://www.hussmanfunds.com/.

And I recorded three sessions for Yahoo Tech Ticker in New York this morning. You can go to Yahoo and see them. All the best,

Your on the road again analyst,

John Mauldin,
Outside the Box
johnmauldin@investorsinsight.com

Zen Lessons in Market Analysis

By John P. Hussman, Ph.D.

“The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future.”

This week’s comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for “teacher”) would simplify this by saying that today is his eighty-third “continuation day,” because to say it is his birthday is not very accurate.

If the quote at the top of this page looks somewhat familiar to our long-term shareholders, it may be because the practice of tending to the present moment – responding to prevailing conditions rather than relying on forecasts – is central to our investment discipline.

Focusing on the present moment doesn’t imply ignoring the past or failing to consider the future. It’s clear, for example, that we put a great deal of attention on estimating future cash flows and discounting them appropriately in order to evaluate whether various investments are priced to deliver satisfactory long-term returns. We certainly devote our attention to macroeconomic pressures and latent risks that threaten to become full-blown crises later. Still, we rarely make near term forecasts. Nor do we answer surveys like “where do you think the S&P 500 will be at year-end?” – a question that falls entirely outside of our way of thinking – like asking Columbus what sort of trees he thinks are planted along the edge of the Earth. The reason we avoid forecasts, very simply, is that they are not required, and that they can be a hindrance.

Expectations

One of the major debates among investors is between buy-and-hold investing and market timing. Think of the market as a big hat that has both red and green marbles in it, red corresponding to declines, and green corresponding to advances. The buy-and-hold investor essentially believes that it is impossible to predict which color marble will be drawn next, but that on average the marbles will be green. So the buy-and-hold approach simply holds on, regardless of prevailing conditions. The market return expected by a buy-and-hold investor is the “unconditional expected return” – something that has historically been about 10% annually. Let’s call this E[R]

In contrast, a forecaster does believe that the next draw can be predicted given some information “X”. As that information varies, forecasters will decide to buy or sell. But forecasters typically do something extra. Generally speaking, forecasters are not content with dealing with the present moment, and instead are prone to making bold forecasts about the next month, quarter, year, or even an entire stream of future returns (bull markets and bear markets).

The problem with this, in our view, is that it implicitly assumes that the information set “X” will remain constant. Worse, the size of the forecasts is generally far too large to be rational. A good forecast is most often a humble one.

Robert Hall of Stanford University (also the chair of the NBER Business Cycle Dating Committee that officially dates the beginning and end of recessions) calls this the Iron Law of Econometrics – the variance of a proper forecasting approach will always be smaller than the variance of the actual data. The reason is that if actual returns are equal to expected returns plus a random error,

R = E[R] + e

then a proper forecast is one where the errors are independent of (not correlated with) the expected returns. That means that the variance of actual returns – call it V(R) – must be equal to the variance of your expected returns V(ER) plus the variance of the error terms V(e). As long as there is any forecast error at all, an efficient forecast will always be one where your expected returns are less variable than what actually takes place. Forecasters hate this, because they like to make big, flamboyant predictions about a whole string of events, rather than focusing on the present moment.

Consider that hat full of marbles again. Suppose you are told that 80% of the marbles are green, and that 10 marbles will be drawn (with replacement). If someone asks your forecast, it’s very likely that you’ll be comfortable predicting that 8 of the marbles will probably be green.

Now suppose the first marble is drawn, and suddenly, someone switches the hat, right in front of you. What happens to your confidence in your forecast? Well, it should collapse, because suddenly you’re facing a new X. If the information set X can change, then it is not reasonable to make forecasts that assume that it will be constant over the forecast horizon.

So if we don’t want to assume that market returns are simply constant at 10% regardless of valuations or other conditions, and we also don’t want to make inefficient forecasts, what is the alternative?

For us, it is to focus on the present moment. We focus on “conditional expected returns” – the return we can expect, given the particular information set X that we have in hand. This is generally written E[R | X]. But unlike forecasters, we recognize that the predictable component of market behavior for any given period is so small, relative to random noise, that making specific forecasts is futile. We take our information set one X at a time, and we rely on discipline and the law of large numbers to mute the impact of that random noise over the long-term.

Specifically, we can go back over history and use observable conditions such as valuations, market action, overbought/oversold status, macroeconomic factors, and so on to separate history into various “bins.” Each bin represents a combination of observable conditions occurring together (what I’ve called “X”). Then we can ask, for every observation in the bin, what was the market return over a short subsequent period like a week or a month. Each bin then can be associated with a particular expected return and risk profile. Our basic practice is to align our investment position with the set of conditions that we observe at each moment, and to shift our position as the evidence shifts.

Rather than treating the next week, month, quarter or year as a horizon that demands a specific “forecast,” we simply treat each realization as part of a “repeated game,” and rely on the law of large numbers – that is, the idea that if we follow our discipline period after period after period, over time our inevitable errors will average out, and our long-term results will be largely what we expect. The best way to take good care of the future is to take good care of the present moment.

But isn’t E[R | X] a forecast?

One might object that by aligning our investment position with the average return/risk profile associated with a given set of conditions, we must, by definition, be forecasting. This is true in the sense that we do have some expectation that market returns under a given set of conditions will be satisfactory or unsatisfactory, given the risks involved. But we differ from “forecasters” in recognizing that the expected return E[R | X] for any short period of time is overwhelmed several times over by the conditional error term “u”. It is only over many, many repetitions that the error terms dampen out.

This is a property that statisticians call “consistency.” Specifically, if a process is consistent, then as you increase the number of observations some random outcome, the average value of your observations will tend toward the true “population” average.

[Geek's Note: If R = E[R | X] + u, then over N repetitions, the standard deviation of the average error is the standard deviation of the actual error terms, divided by the square root of N. So if your conditional error terms tend to have a mean of zero, plus or minus 2.5% on a weekly basis, you would expect that over 100 weeks, your average error would be zero, with a standard deviation of about 0.25%. Over a full market cycle, you will have made a lot of individual mistakes in your investment position, but as long as your errors are not systematic, the combination of discipline and the law of large numbers will work strongly in your favor. Your results will be largely as you expected despite the fact that you made lots of individual errors along the way].

This is basically the dynamic at work when you sail a boat. If you hop into a sailboat and start across Lake Michigan, it is not particularly helpful to make predictions about the direction and speed of the wind over your entire journey. Much better to align your sails as those conditions change, making numerous modest errors, but getting across the lake.

Inquiry

“Suppose the mind consciousness is observing an elephant walking. During the time of observation, the object of mind consciousness may not be the elephant in and of itself. It may only be a mental construction of the elephant based on previous images of elephants that have been imprinted in store consciousness.

“Inquiry means not using the mental creation, but allowing yourself to get in touch, and to try to see how things truly are. We practice not to be influenced by the name, because when we are caught in the name we can’t see reality.”

Thich Nhat Hanh

It is important that we don’t place so much emphasis on “average outcomes” that we ignore the facts about particular instances. We still have to look carefully at reality to make sure that we aren’t assuming away particular features that are important.

This is a risk that market participants seem to be taking here in a major way. Specifically, we have seen a great number of research reports with the basic thesis of “The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over.” The difficulty is that these are basically attempts to say “here is an elephant” and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. Specifically, valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.

If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things “different” than they have been historically, then it is best to look closely and get more data.

As an example, during the late 1990’s, it was often argued that technological innovation had changed the economy so profoundly that the market valuations of the time were actually reasonable, if not incredibly attractive (remember Dow 35,000?). So we had to open ourselves to the possibility that things were different in an important way. But when we actually looked at the data, there was simply no historical example – in any productivity spurt since the Industrial Revolution – that could support the sort of growth rates that were implicitly priced into stocks.

When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a “V” shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries – particularly debt origination and consumption growth – are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery.

As I’ve discussed in several weekly comments, this is a subject that I have struggled with in recent months. Even if we could assume that the recent crisis was a standard post-war downturn, and that we are now in a standard post-war recovery, valuations would still concern us because at these levels, stocks are not priced to deliver satisfactory long-term returns in any event. However, we would have a greater willingness to take a moderate speculative exposure based on market action and prospects for sustained economic improvement. On the other hand, when we include other post-crash periods into our data set, and allow for the possibility that those instances better describe present conditions, the case for accepting speculative exposure is much more limited. Of specific concern is the tendency in those periods for strong advances (as we’ve seen in recent months) to be followed by spectacular failures.

So we have to be very careful about how we name things. When people label stocks as being in a “bull market,” the implicit suggestion is that stocks will continue to advance for a sustained period of time. When people say that the recession has ended and we’re now in a “recovery,” the temptation is to look at how the market has performed in previous recoveries, without noting the profound differences between those instances and the current environment.

As Thay says, “We practice not to be influenced by the name, because when we are caught in the name, we can’t see reality.” The picture in our head can be very influenced by the words we attach to it.

As Zig Ziglar says, “You can tell your wife that she looks like the first day of spring, or you can tell her that she looks like the last day of a long, hard winter. There is a difference.”

Koans

In Zen, there is a teaching tool known as a “koan” – a question that serves as the object of meditation, and is intended to reveal something about teachings like mindfulness and interconnectedness. Western observers sometimes mistake these for riddles, non-sequiturs, or nonsensical statements, but if you look at them carefully, they are questions or stories intended to prompt the listener to see things as they really are.

A riddle is something like this:

Q: “How does a Zen monk know his pizza is enlightened?”
A: “It’s one with everything.”

Here is a koan:

A novice monk approaches his teacher and asks, “Is this a bull market or a bear market?”
The teacher replies, “If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?”

Causes and Conditions

“This is, because that is. This is not, because that is not.”

Buddha

“The seed and the fruit are not two different things. The fruit is already contained in the seed. It’s waiting for different conditions in order to be able to manifest. The fruit doesn’t have a separate existence; it’s a formation. Using the word “formation” reminds us that there is no separate existence in it. There is only a coming together of many, many conditions. ”

Thich Nhat Hanh

When we think about events, either in our daily lives, or in the market or the economy, it is important that we don’t think of them as simply existing or coming out of nowhere. This is, because that is. This is not, because that is not. We cannot create or remove a condition, expect it to emerge or expect it to disappear, without understanding the seed that produces it, and the causes and conditions that allow it to spring up.

Generally speaking, the seed we water is the one that grows. That’s why if we spend our energy thinking about what we don’t want, what we don’t like, what is wrong – we’ll tend to nurture and strengthen exactly the wrong things. If we water the seeds of peace, understanding, empathy, happiness, and so on, those are the seeds that will grow.

The basic condition for anything to emerge is for the seed to exist. But that is not enough. The seeds of a bear market are often fully present in the later stages of a bull market – overvaluation, excessive speculation, acceptance of risk without sufficient compensation, extension of credit to poor credit risks, belief in the sustained growth of cyclical businesses, overconfidence, and so forth.

But in order to manifest as a flower, or a weed, or as fruit, other conditions have to be present. Buddhists distinguish two kinds – “same direction” and “opposing direction.”

Conditions in the opposing direction tend to hold back the manifestation of the seed, but can also force it to become stronger before it manifests. If you plant a seed in firmer soil, the roots may be forced to dig deeper in order to establish themselves and find water, whereas a seed in easier soil may grow more quickly but have weaker foundations, so it can be uprooted easily. Conditions in the same direction are those like water and sunlight, which provide the background environment necessary for the seed to grow.

Some of our best investment insights have been driven by this focus on causes and conditions. These often take the form of “Aunt Minnies” – sets of conditions that may not mean much by themselves, but have very strong implications when they occur together (a person may have one feature or another, but if you have just the right combination, you know it’s Aunt Minnie). These include, for example, the conditions I noted in A Who’s Who of Awful Times to Invest, and our recession warning composite. To find Aunt Minnies, we look for a seed, identify conditions in the opposing direction (if any) that have made the seed strong, and then look for conditions in the same direction that are capable of bringing the seed to fruition.

Many of my concerns about the markets in recent years have emerged because too often, financial market participants and policy makers focus on manifestations rather than causes and conditions. This is why investors produced the dot-com bubble, the tech bubble, the mortgage bubble, the debt-financed private equity bubble and the commodity bubble without thinking of the seeds of crisis that were latently emerging, or how violently they would manifest. Our policy makers have bailed out poorly run financials by creating massive federal deficits, and think they’ve solved the problem in the same way as someone who runs over a weed with the lawnmower. The roots have simply grown deeper, because the seeds are still there, but we’ve applied a few conditions in the opposing direction. Those of you who have read these missives for a long time know that my geopolitical views are largely the same. This is, because that is. This is not, because that is not.

We can have an overvalued market and the seeds of a bear market, but if we apply opposing conditions in the form of easy money in order to prop up the market and prevent the consequences of bad behavior, the seed will simply grow stronger, and its ultimate manifestation will be more powerful. We can have a mortgage market that is setting new records for delinquencies and foreclosures every month, combined with increasing unemployment and a heavy reset schedule on Alt-A’s and option-ARMs that is just now picking up. But we lower the bar on financial reporting, fail to restructure debt, and ignore the strengthening seed because we’re single-mindedly enthusiastic about the thin-rooted green shoots of stabilization – born solely of a burst of fiscal profligacy – then we’ll predictably be blindsided when the problems re-emerge.

Predictably blindsided. That’s happened again and again in recent years. And it happens when we fail to think about the seeds we are watering. If we look only for fruit and ignore the seeds of crisis, then every bit of fruit will be followed by crisis, and nobody will understand why.

Interbeing

“As thin as this sheet of paper is, it contains everything in the universe in it.”

Thich Nhat Hanh

If you look closely at a sheet of paper, you can see the clouds, the rain, the soil, the sunshine, the mill, the truck, and so forth, because without these things, there would be no sheet of paper. In Buddhist terms, the paper is “empty” and has no self. That doesn’t mean that the paper is not there, but rather that the paper is made entirely of non-paper elements. Empty of self means full of everything non-self.

There’s a phrase alambana pratiyaya – which means that object and subject are always born together. The idea of interbeing is that nothing has a separate existence – that each thing is connected to the others. It’s an inherently peaceful way of thinking, because it recognizes that we are all made of the same substance, that to take care of others is to take care of ourselves, and that we can only understand something if we understand the context that surrounds it.

So here’s a koan – “What is the sound of one hand clapping?”

If you think about it as a riddle, you’ll keep looking for the punch line. But the koan is really about encouraging the listener to consider the true nature of things. Nothing is possible in the absence of interbeing. Subject and object must occur together or nothing manifests at all.

Here’s another one – “If a tree falls in the forest and nobody is there to hear it, does it make a sound?”

Our immediate impulse is to think, of course it makes a sound. But look more carefully. If a tree falls, it certainly will make the air move, but what is sound? Sound is the interpretation that our brains give to those air vibrations. If we are not there, the air vibrates, but is the experience of sound there? One might think, but wait, we could put a microphone there in the forest. But what is the microphone picking up? The air vibrations. If we play that recording on a video monitor with no speakers, you’ll see visual images, but no sound. In order to get sound, you have to have speakers, and the speakers simply take the recorded signals and turn them back into air vibrations, which become what we call “sound” when there is a brain to interpret them. Subject and object have to occur together.

So here’s another koan – “If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?”

The immediate implication of interbeing is that we are forced to think about “general equilibrium” rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren’t careful.

For example, it immediately tells us that “cash on the sidelines” is not a useful concept, except as a measure of issuance. See, whatever “cash” is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain “on the sidelines” because somebody will have to hold them.

If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of “cash on the sidelines” after this transaction as there was before it.

Similarly, money never moves “into” or “out of” a secondary market, or from one sector to another. If I bring $1 “into” the stock market, that same dollar goes back “out” a moment later in the hands of a seller. If it did not, there would be no trade, no fill.

We can talk about differences in eagerness or in pressure as moving stock prices. But we cannot talk about money going in or money going out. We cannot talk about supply being greater than demand or vice versa. In equilibrium, the two must be equal.

One of the most useful ways of interpreting price and volume behavior is this: if something makes a given trader want to buy, the price must move in a way that either removes that impulse or induces another trader to sell. There is no other option.

Here’s another koan:

A novice monk approaches his teacher and asks “What is the price movement of one share being bought?”

The teacher holds out a cypress leaf in his palm and asks, “Did I catch the leaf as it fell from the tree, or did I raise it from the ground?”

We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about “cash on the sidelines” or talk about “investors” buying or selling in aggregate.

There was no excess of stock that was “sold” in March that has to be “bought” back now. Investors didn’t “get out” of the market last year, and we shouldn’t think that they have to “come into” the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.

Prices and Volume

A good way to think about prices and trading volume is to abandon the idea that money goes in or out, and to think instead about the market as a collection of various groups. Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement.

In this sort of equilibrium, trading volume is a measure of strong views and disagreement. As the market turns weaker, trend-following investors typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks.

Equally important is that net incipient buying from both technical and fundamental investors cannot exist, so large price movements are typically required to relieve the disequilibrium. If you’ve got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply.

In contrast, if you’ve got an undervalued market where fundamental investors raise their outlook, the demand from fundamental investors is not typically provided by technical investors (who would tend instead to buy on advances in price), so the price must increase enough to induce fundamental investors with shorter horizons to supply the stock.

All of these dynamics have been active in the market over the past two years, but the most significant outlier has clearly been the past few months, where volume behavior has demonstrated much weaker sponsorship than we would have expected for an advance of this size. Normally, the volume characteristics we’ve seen have been much more typical of short-squeezes and less durable advances.

Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960’s, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don’t need to assume this in order to be concerned about valuation here. (The green, orange, yellow and red lines imply terminal price/peak earnings multiples of 20, 14, 11 and 7 a decade from now. The dark blue line charts actual annual total returns over the subsequent decade).

Though rich valuations and a fresh overbought condition last week argue for tepid returns going forward, my expectation is that strong downward pressure would be most likely if market internals deteriorate somewhat – particularly in terms of breadth. Again, if technical investors are prompted to sell in an environment where sponsorship from fundamental investors is weak, large price changes may be required to relieve the disequilibrium.

A quick summary

Present moment, only moment. Sound investment does not require forecasts. It is enough to align the investment position with the prevailing, observable evidence.

Labels can help to classify, but they can also obscure truth. There is no quantitative substitute for mindfulness. That said, if “this time is different,” one should be able to find appropriate parallels using a sufficiently broad set of historical or international data.

The seed and the fruit are not two different things – significant market moves are generally the fruit of causes and conditions that latently precede them.

Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.

Finally, Thay would add something more, which is to breathe, bring yourself back to the present moment, and recognize that even the smallest, simplest thing can be the basic condition for your happiness.

“If you touch one thing with deep awareness, you touch everything.”

Ireland’s finance minister calls it “a weapon.”

It’s one of the ultimate temptations for politicians.

And, quite frankly, we’re about to see a lot more of it.

Best of all though, the market is rewarding investors who have taken steps to protect themselves and profit from it.

I’m talking about currency devaluation. But this time around though, we’re not looking at your average currency devaluation though. We’re looking at a much slipperier slope that is more dangerous, more costly (if you’re not prepared), and that will only get worse in the months and years ahead – competitive devaluation.

And if you’re not prepared, get prepared now.

Get a Little Now, Pay a Lot Later

Currency devaluation is pretty simple. It’s when a country’s government or central bank intentionally cuts the value of its own currency. The goal of devaluation is to make exports cheaper.

For instance, Japan let the value of the yen drop precipitously during the 2002 recession. In one period, the yen fell 7% (that’s a huge move in currencies) relative to the US dollar. The move made exports 7% cheaper and was a clear example of how Japan’s leaders were hoping consumers elsewhere would be able to jumpstart its economy.

The benefits of currency devaluation include temporary increases in manufacturing activity and employment. They are loved by politicians who are often looking towards the next election, not the long-run health of the economy.

The costs of currency devaluation are many. Basically, if your currency is worth less, you can buy less stuff. For instance, the immediate impact of devaluation can be seen in commodity prices. When commodity prices go up they make the price of the inputs of manufactured goods like copper for refrigerators, steel for buildings, etc. more expensive. Also, devaluing your own currency is a direct way of subsidizing another country’s consumption.

Basically, currency devaluation is a zero-sum game – you don’t get something for nothing. And the short-term benefits don’t really outweigh the long-term costs.

The Race to the Bottom

What we’re on the potential verge of here is competitive devaluation. That’s when every country (or economic area like the Eurozone) looks to devalue their own currencies. The thing is though, not every central bank can devalue their currencies at the same time.  So there has to be some other alternative.

Lately, that alternative has been commodities.  That’s why gold has been setting new highs. Silver has been rising even faster than gold. And currencies from countries which produce a lot of commodities like Canadian and Australian dollars and the Brazilian real have been jumping higher against the U.S. dollar too.

Regretfully, it’s only going to get worse from here.

You see, the most politically appetizing benefit of currency devaluation is the initial jolt of employment. A sharp upturn in exports means more people will be working to produce those exports. And with official unemployment in the U.S. nearing 10% we’re witnessing the politically-welcomed devaluation of the dollar right now. Economist Simon Johnson has gone as far as calling the devaluation “Obama’s secret jobs plan.”

Worst of all, the political will to devalue the US dollar is only going to get stronger from here because unemployment will continue to be a problem thanks in large part to healthcare reform and the goal of green job creation.

The Biggest Losers in Healthcare “Reform”

All of the healthcare bills on the table have apply fees, penalties, mandates, and/or taxes. Some tax medical device companies, others go after insurance companies, and others hit employers with mandates and/or penalties.

As a result, all the bills will do one thing: increase the cost of employment.

That will lead to higher structural unemployment. It’s simple supply and demand. If the price of something goes up, quantity demanded will decline. It’s true for guns, butter, and labor.

Some opponents have called the bills “job killers” (or worse), but it will be more like job preventers. And with unemployment already high, the quick and politically painless solution will be to devalue the currency.

The Other Side of “Green Jobs”

It doesn’t stop there. The other major legislation staring the economy down is the cap-and-trade scheme. Again, we’re not here to debate the scientific or political merits of global warming climate change. We’re here to look at the impact of the plan on business, the economy, and our investments.

If cap-and-trade is eventually passed, it will have the same effect as healthcare reform: increase the cost of employment.

Those increased employment costs will inevitably lead to – wait for it – even higher structural unemployment.

This is not a theory though. Spain has already been down the “cap-and-trade” road and they don’t like where it has taken them.

Back in March the King Juan Carlos University published a study on the country’s cap-and-trade system and job creation. The study found 2.2 jobs were lost for every one green job created.

Sure, you will have a few thousand folks who work in windmill and solar panel factories (and they’ll make great backdrops for presidential speeches). And the lack of tangibility of jobs lost make green jobs very politically favorable. But the transfer of wealth from some businesses to other less-efficient ones will just add to unemployment rolls here just like it has in Spain and everywhere else.

In the end, the net effect will be higher unemployment. And the politically favorable “quick fix” will be – you guessed it – more currency devaluation.

Run for Cover and Profit

That’s why we should expect more devaluation of the US dollar in the future.

This is a sharp contrast to the past. OvWarren Buffett calls it “a drug.”

Ireland’s finance minister calls it “a weapon.”

It’s one of the ultimate temptations for politicians.

And, quite frankly, we’re about to see a lot more of it.

Best of all though, the market is rewarding investors who have taken steps to protect themselves and profit from it.

I’m talking about currency devaluation. But this time around though, we’re not looking at your average currency devaluation though. We’re looking at a much slipperier slope that is more dangerous, more costly (if you’re not prepared), and that will only get worse in the months and years ahead – competitive devaluation.

And if you’re not prepared, get prepared now.

Get a Little Now, Pay a Lot Later

Currency devaluation is pretty simple. It’s when a country’s government or central bank intentionally cuts the value of its own currency. The goal of devaluation is to make exports cheaper.

For instance, Japan let the value of the yen drop precipitously during the 2002 recession. In one period, the yen fell 7% (that’s a huge move in currencies) relative to the US dollar. The move made exports 7% cheaper and was a clear example of how Japan’s leaders were hoping consumers elsewhere would be able to jumpstart its economy.

The benefits of currency devaluation include temporary increases in manufacturing activity and employment. They are loved by politicians who are often looking towards the next election, not the long-run health of the economy.

The costs of currency devaluation are many. Basically, if your currency is worth less, you can buy less stuff. For instance, the immediate impact of devaluation can be seen in commodity prices. When commodity prices go up they make the price of the inputs of manufactured goods like copper for refrigerators, steel for buildings, etc. more expensive. Also, devaluing your own currency is a direct way of subsidizing another country’s consumption.

Basically, currency devaluation is a zero-sum game – you don’t get something for nothing. And the short-term benefits don’t really outweigh the long-term costs.

The Race to the Bottom

What we’re on the potential verge of here is competitive devaluation. That’s when every country (or economic area like the Eurozone) looks to devalue their own currencies. The thing is though, not every central bank can devalue their currencies at the same time.  So there has to be some other alternative.

Lately, that alternative has been commodities.  That’s why gold has been setting new highs. Silver has been rising even faster than gold. And currencies from countries which produce a lot of commodities like Canadian and Australian dollars and the Brazilian real have been jumping higher against the U.S. dollar too.

Regretfully, it’s only going to get worse from here.

You see, the most politically appetizing benefit of currency devaluation is the initial jolt of employment. A sharp upturn in exports means more people will be working to produce those exports. And with official unemployment in the U.S. nearing 10% we’re witnessing the politically-welcomed devaluation of the dollar right now. Economist Simon Johnson has gone as far as calling the devaluation “Obama’s secret jobs plan.”

Worst of all, the political will to devalue the US dollar is only going to get stronger from here because unemployment will continue to be a problem thanks in large part to healthcare reform and the goal of green job creation.

The Biggest Losers in Healthcare “Reform”

All of the healthcare bills on the table have apply fees, penalties, mandates, and/or taxes. Some tax medical device companies, others go after insurance companies, and others hit employers with mandates and/or penalties.

As a result, all the bills will do one thing: increase the cost of employment.

That will lead to higher structural unemployment. It’s simple supply and demand. If the price of something goes up, quantity demanded will decline. It’s true for guns, butter, and labor.

Some opponents have called the bills “job killers” (or worse), but it will be more like job preventers. And with unemployment already high, the quick and politically painless solution will be to devalue the currency.

The Other Side of “Green Jobs”

It doesn’t stop there. The other major legislation staring the economy down is the cap-and-trade scheme. Again, we’re not here to debate the scientific or political merits of global warming climate change. We’re here to look at the impact of the plan on business, the economy, and our investments.

If cap-and-trade is eventually passed, it will have the same effect as healthcare reform: increase the cost of employment.

Those increased employment costs will inevitably lead to – wait for it – even higher structural unemployment.

This is not a theory though. Spain has already been down the “cap-and-trade” road and they don’t like where it has taken them.

Back in March the King Juan Carlos University published a study on the country’s cap-and-trade system and job creation. The study found 2.2 jobs were lost for every one green job created.

Sure, you will have a few thousand folks who work in windmill and solar panel factories (and they’ll make great backdrops for presidential speeches). And the lack of tangibility of jobs lost make green jobs very politically favorable. But the transfer of wealth from some businesses to other less-efficient ones will just add to unemployment rolls here just like it has in Spain and everywhere else.

In the end, the net effect will be higher unemployment. And the politically favorable “quick fix” will be – you guessed it – more currency devaluation.

Run for Cover and Profit

That’s why we should expect more devaluation of the US dollar in the future.

This is a sharp contrast to the past. Over the last few decades, a lot of countries have gone down the devaluation road for the sake of higher employment. Meanwhile, the U.S. gladly maintained its “strong dollar policy” which allowed the central banks to essentially subsidize U.S. consumption.

The U.S. has tried devaluation in the past. For instance, when President Nixon removed the U.S. from the gold standard and openly devalued the dollar, the greenback went on to lose 75% of its value in the next decade.

Right now, all signs point to us heading down a similar 70’s-style stagflationary path. And although the politicians and pundits may say “it’s different this time,” there’s no reason to expect it to be any different.

It’s already started to happen. The US dollar index is down 16% from its March highs and the Fed has not come out and said it’s going to defend the dollar. Also, Britain’s central banker has deemed any further devaluation of the pound to be “helpful.”That’s why gold and silver have done so well lately. And the future is looking even brighter. They were, are, and will likely continue to be a few of the best places to protect yourself from the long-run impacts of dollar devaluation ($200 oil and GDP growth of 1% anyone?).

This is something we follow closely in the Prosperity Dispatch. To stay current on this subject and more, subscribe today!

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

er the last few decades, a lot of countries have gone down the devaluation road for the sake of higher employment. Meanwhile, the U.S. gladly maintained its “strong dollar policy” which allowed the central banks to essentially subsidize U.S. consumption.

The U.S. has tried devaluation in the past. For instance, when President Nixon removed the U.S. from the gold standard and openly devalued the dollar, the greenback went on to lose 75% of its value in the next decade.

Right now, all signs point to us heading down a similar 70’s-style stagflationary path. And although the politicians and pundits may say “it’s different this time,” there’s no reason to expect it to be any different.

It’s already started to happen. The US dollar index is down 16% from its March highs and the Fed has not come out and said it’s going to defend the dollar. Also, Britain’s central banker has deemed any further devaluation of the pound to be “helpful.”That’s why gold and silver have done so well lately. And the future is looking even brighter. They were, are, and will likely continue to be a few of the best places to protect yourself from the long-run impacts of dollar devaluation ($200 oil and GDP growth of 1% anyone?).

This is something we follow closely in the Prosperity Dispatch. To stay current on this subject and more, subscribe today!

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And now let’s jump right in to the essay.

John F. Mauldin
Editor, Outside the Box
johnmauldin@investorsinsight.com

Quarterly Review and Outlook – Third Quarter 2009

Ponzi Finance

The Federal Reserve reported that as of June 30, 2009 total U.S. debt was $52.8 trillion. Total U.S. debt includes government, corporate and consumer debt. Importantly, however, it does not include a few trillion in "off balance sheet" financing, contingent unfunded pension plans for corporate and state and local governments, or unfunded liabilities of the U.S. government for such items as Medicare, Social Security and other programs. Currently GDP stands at $14.2 trillion, so there is approximately $3.73 in debt for every dollar of output in the United States, a level unprecedented in our history (Chart 1). Normally, debt levels as a percent of GDP would be uninteresting and immaterial; however, the current level of debt is unique in two ways. First, the asset side of the balance sheet purchased by the debt is falling in price. Second, the money that was borrowed to purchase those assets was often fraudulently expended. Neither the borrower nor the lender really expected the debt to be serviced. Rather, each party expected the asset price to rise extinguishing the debt.

This type of financial arrangement was correctly analyzed by the famous American economist Hyman Minsky in his paper, "Financial Instability Hypothesis", in which he described three phases of debt financing. The first is "hedge finance", where the lender expects a return on both principal and interest. The second is "speculative finance" where the lender expects to get interest on the loan but perhaps not the principal. The third case, where the lender expects neither the principal nor interest to be returned, is referred to as "ponzi finance". This was typified in the last business cycle by loans issued without documentation, no down payment home loans, extremely low cap rates on commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the debtor is left with declining asset values that preclude the rollover of their obligations.

Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices that were inflated by the speculation of earlier years. The aftermath of that speculation and its impact on the economy has been thoroughly studied prior to our present business cycle by the economists of yesteryear who marveled at the mania in the collective mindset of private citizens and their elected representatives who produced such bubbles. The most famous of these economists was Irving Fisher (1867-1947), who in 1933 wrote about this problem of over-indebtedness (Irving Fisher, 1933, Econometrica, "The Debt-Deflation Theory of Great Depressions"). He stated flatly that over-indebtedness was the difference between normal business cycles (recessions), which occur frequently through "over-production, inventory misjudgment, or commodity price fluctuations" and extreme business cycle fluctuations (depressions). Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined a pattern of economic developments that will take place when the debt cycle is broken. Seemingly old news, but it is interesting to apply his sequence of events to today’s economic developments as there are disturbing similarities.

A Downward Spiral

Fisher posited that debt liquidation leads to distress selling, contracting bank deposits and declining velocity of money, all of which contribute to the fall in price levels. This accurately describes today’s circumstances. Distress selling is rampant, with home foreclosures reaching all-time highs. Additionally, rapidly rising foreclosures in commercial real estate are causing the closing of financial institutions and the liquidation of their portfolios. Money supply (M2), an imperfect measure of bank deposits, is essentially flat over the last six months even though the monetary base is 100% higher than it was a year ago (Chart 2). Further, the velocity of M2 has contracted at a 12.7% rate over the past two years. The Personal Consumption Expenditure Deflator (goods purchased by consumers) has fallen from a 2.7% growth rate 12 months ago to a yearly increase of only 1.3% presently, and appears to be heading for a zero reading in 2010. GDP has recorded its greatest contraction since the 1930’s, and probably is not yet at its lowest level for this cycle.

Fisher then noticed that this distress selling would lead to a fall in the net worth of businesses, a decline in profits, and a reduction in employment. Fisher may have been talking about 1929 and the 1800’s, but that is precisely our present situation. Despite a 19% gain in stock prices this year, the S&P 500 has declined about 30% from its peak and stands lower than it was a decade earlier. Corporate profits are down approximately 13% on a year over year basis, and in 2008 S&P 500 profits fell for the first time since 1933. The net worth of hundreds of banks and other large corporations has fallen below zero, with some surviving only because of a massive rescue effort by the federal government. Despite these efforts, consumer net worth has fallen, price levels of homes are down about 30% from their peak levels, and business net worth has been impaired by an almost 39% decline in commercial real estate from its peak levels. Industrial production is down 13.3% since its peak, the largest 20 month decline in the post war period (Chart 3). Including potential revisions, the U.S. has lost eight million jobs in this recession, and currently 17% of the labor force is either underemployed, partially employed, or out of work seeking employment.

Fisher seems to be not so historical as prescient. He states that all the above problems create disturbances in the rate of interest, particularly the fall of nominal money rates and the rise of real interest rates. The federal funds rate is now effectively zero, and yet with the steady downward movement in price indices, real interest rates are rising. This, of course, is of concern to debtors.

The uncomfortable conclusion of Fisher’s analysis is that major business cycle fluctuations are, in fact, caused by over-indebtedness and the fall in asset prices. Our present situation appears to mirror the exact sequence of events that have occurred in previous depressions. This suggests that our current "great recession" may morph into a more serious and elongated downward business cycle.

The Impossible Promise

The federal government’s promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro’s book, Macroeconomics – a Modern Approach, p. 370). This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.

From a fiscal policy perspective the outlook for economic growth appears to be one of stagnation for several years due to the size of the federal debt, which is expected to rise 35.7% from 2008 levels to 76.5% of GDP over the next ten years according to the Office of Management and Budget (Chart 4). This exercise in government spending is, of course, an exact replica of the Japanese experience from 1989 to the present. Their debt to GDP ratios have gone from about 50% in 1988 to about 178% today, and yet their nominal GDP is no higher than it was 17 years ago, and their employment stands at twenty year ago levels. It is somewhat unsettling that as of the last employment report the United States employed 131 million people, a level that was first reached in 2000, which means the United States has had no net job gains for almost ten years. Indeed, it appears that the fiscal chain around the free market neck is sufficiently onerous to restrain growth for several years. The promise of the government to revive growth through increased indebtedness is, indeed, an impossible promise.

The Hesitant Fed

As Fisher stated, the write-down of debt and distress selling tends to destroy money deposits and lower the velocity of money. Despite the historical evidence of that fact, our current Fed authorities appear to be oblivious to the lessons of the past. Their initial reaction to the liquidity crisis has to be applauded for their heavy work in insuring the liquidity of the financial system. Similarly, the expansion of their bank balance sheet to $2.1 trillion from $1 trillion was the precise reaction needed to counter the emerging deflation of asset prices. However, their actions increased inflationary expectations, and they have encountered a plethora of critics. In responding to this criticism the most recent statistics suggests they are beginning to lose the fight against the deflationary impulses. Consider that the monetary base rose 1000% in the three months ending December 2008, but has been held essentially flat since then (Chart 5).

The Fed’s purchases of assets to increase this base automatically created deposits that positively charged the money supply growth to a 15.2% six-month growth rate (Chart 2). If the economy were operating near full capacity, a healthy banking system would take these deposits and multiply them roughly nine times; that circumstance could be inflationary. Unfortunately the banking system is not healthy, as evidenced by the fact that we have closed 95 banks this year, more than the cumulative total of the past 15 years, and another 416 banks are on a list destined to become extinct. With consumers’ asset prices falling so rapidly and banks increasingly afraid of failure, banks are more interested in collecting loans than in lending. So with fewer consumers now credit worthy, loan volumes are collapsing. As loans are paid off, deposits are destroyed, and the money multiplier that should stand at nine has gone to zero. This is evidenced by the fact that the six-month change in M2 has fallen to a 1% growth rate, meaning that monetary stimulus is on hold. Get set for negative GDP in 2010.

Dollar Weakness

The inflation outlook from the monetary and fiscal standpoint looks truly deflationary, yet some believe that dollar weakness will reverse this circumstance and create inflation. This is unlikely. First, our imports are about 13% of GDP, and even if the dollar were to halve in value, the price of imported goods would not only have to compete with U.S. producers, but also their price adjustment would have to offset the other 87% of factors included in the pricing indices. Second, unlike the 1930’s a 50% decline in the dollar would be difficult to engineer. Fisher recommended to Roosevelt that the U.S. should exit the gold standard, which he did in April of 1933. That was a fixed exchange rate system, and within three months the dollar lost more than 30% against the gold block countries and fell to 60% of its former value within the next five months. This spurred our exports and provided some price inflation (2.9% per year, GDP deflator) for the next four years. Then, in 1937 the tax increases (the next policy mistake) reversed the positive growth rate of the economy and drove price levels and economic activity downward again. However, even with that small period of price increases the overall price level never recovered from the 25% decline that occurred from 1929 to 1933, and thus deflation reigned. Today the declining dollar is a good thing in terms of our trade balance, but the modest change will be insufficient to offset the negative forces of insufficient domestic demand.

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

_______________________

Note: John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Plexus Asset Management; Fynn Capital; and Nicola Wealth Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

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You see, I’ve been travelling quite a bit in Europe … giving speeches and presentations. This gave me the opportunity to talk to many institutional and private investors, and entrepreneurs. And was I ever surprised about how much things have changed!

From: “The Fed and the Government Will Not Let it Happen” …
To: “The Fed and the Government Can’t Fix It.”

In 2007 and during most of 2008, I was extremely bearish, predicting a severe global recession, a bear market in stocks and commodities, and a banking crisis.

“That’s very interesting, Claus,” is what I was regularly told. “But you’re much too bearish. Don’t you see how the world has changed? The central banks and governments are so much brighter now than they used to be; they just won’t let it happen.”

Back when I said a bear market was on the horizon, many pundits disagreed.

In other words, my very bearish forecasts were met with high skepticism.

Now the story I have to tell is somewhat different … I’ve turned medium-term bullish for the economy and the stock market. I expect a bounce lasting at least until mid 2010.

And you know what? I get more or less the same reaction as I did two years ago, with one twist: “That’s very interesting, but we don’t believe it. The problems are too big to be solved by central banks and governments.”

I’m Left Wondering … Who Is Actually Bullish?

Maybe my experiences are a statistical outlier and not representative of what’s going on in the world of finance. Or maybe this European picture differs totally from what’s going on in the U.S.

But I doubt it.

The bearish reports I’ve read during the past few weeks are constantly referring to too many bulls!

Yet the U.S. sentiment indicators aren’t showing the high degree of bullishness that the bears are constantly referring to when underlining their own bearish forecasts.

Take a look at the chart below, which shows the Investor’s Intelligence Advisor Sentiment.

The bears correctly state that the bullish sentiment is nearly as high as it was when the stock market hit its all-time high in October 2007. But they neglect to mention that in October 2007 the number of bulls wasn’t especially large!

What’s more, during each of the bull market years 2003, 2004, 2005, 2006, and 2007, there were long stretches of much higher bullishness in this indicator. The same holds true for prior bull markets.

So historically, the bulls-to-bears ratio does not look excessively high.

Meanwhile, Many of Those Who Saw the Crisis
Coming Are No Longer Bearish Over the Medium Term …

Over the weekend I was one of the speakers at the Summit of Austrian Economics in Vienna. Many of the European analysts — professors and practitioners — who predicted the global financial crisis were gathered there. Plus Marc Faber and John Naisbitt appeared as special guests. All were given the opportunity to present their current outlook.

For the medium term, I expect the market to continue advancing.

Interestingly, all of these very successful forecasters are still very, very bearish and anxious about the longer-term future … say three, five or even ten years out. But for the medium term, they aren’t bearish anymore!

Of course there were differences about how long this medium-term may last. Opinions ranged from one to three years — with the usual caveat that forecasts will change if developments warrant.

Still, these independent thinkers — contrarians if you will — have shown a very deep understanding of what has been going on economically during the past year. They were on top of the game then … and I think they’re on to something again.

Best wishes,

Claus Vogt
Money and Markets

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com.

Niels Jensen is the Senior Partner of Absolute Return Partners based in London. I have worked closely with Niels for years and have found him to be one of the more savvy observers of the markets I know. You can see more of his work at www.arpllp.com and contact them at info@arpllp.com.

John Mauldin, Editor
Outside the Box
johnmauldin@investorsinsight.com

A Country for Old Men and a Bit of Samba

The Absolute Return Letter October 2009

The Man Card

“Excuse me Sir, can I see your Man Card?” The stone-faced look of the security guard at Dallas Fort Worth Airport gave nothing away and, after two days of celebrating John Mauldin’s 60th, my brain was probably operating somewhat below full capacity. “I need to see your Man Card Sir”. Couldn’t he just go away, I thought to myself, not really sure how to deal with the situation. Suddenly his face cracked wide open and in the broadest possible Texas drawl he said: “With those pink socks on Sir, I need to make sure you are a man”. Welcome to Dallas!

The highlight of the weekend was a two hour roundtable discussion on Saturday afternoon where John had asked 15 of his friends and business associates to share with the group what their fears and hopes were for the next 15-20 years. I duly noted that the issues on the minds of our American friends are not at all dissimilar to what we worry about in Europe – our children’s welfare, unemployment, immigration, racism, the impact of technology and the aging of our society to mention but a few.

This month’s letter is about demographics and is the second in our series about major trends defining the future of the world we live in. Last month I wrote about the energy outlook, and I had an unusually high number of emails commenting on the letter. Many of them made the point that the world is in better shape than I seem to think, even if oil supplies are dwindling, as natural gas reserves are ample. We just need to switch source. Whilst I don’t disagree that natural gas seems the way forward, one should not underestimate the task ahead of us. About 2/3 of all oil is used for transportation purposes and it is an enormous task to reduce our oil dependency. It will take many, many years and cost gigantic sums of money.

It is the banks, Stupid!

Back to this month’s topic – in the financial press, there has been no shortage of attempts to apportion blame for the credit crisis. Disregarding the more obvious finger-pointing (it is the banks, stupid!), there seems to be a growing acknowledgement that large imbalances in the global economy are to blame for the current mess.

Put differently, a large number of countries – mainly Anglo-Saxon in origin but also the majority of our Eastern European friends – became credit junkies and spent beyond their means, year-in year-out. Conversely countries with large current account surpluses (e.g. China, Japan and Germany) were only too happy to deliver the drug to the intoxicated.

It is therefore too simplistic to suggest that only the deficit countries are to blame. The suppliers of credit must accept that they carry no small part of the responsibility, just like the drug dealers do when supplying junkies. In the past, I have been critical of Ms. Merkel of Germany when she stated publicly that Germany should continue to do what Germany does best, and that is to export goods of high quality. The obvious point here is that if Germany pursues such a strategy, the world will be no more balanced ten years from now than it is today, and a crisis similar to the one we have just been through could happen again.

It should therefore be obvious that not only should the deficit nations become more disciplined (i.e. save more and spend less), but the large surplus nations should actually put measures in place to ensure that their citizens save less and spend more. In practice, however, that is easier said than done. Demographic forces have a much bigger say on spending and savings patterns than generally acknowledged.

The Life Cycle Hypothesis

My story begins with Franco Modigliani. In 1985 he was awarded the Nobel Memorial Prize in Economic Sciences for his life cycle hypothesis which (somewhat simplified) states that spending and savings patterns are predictable and largely a function of demographics. When you are in your 20s and 30s, savings are low as much of your income is spent on establishing a family, buying and furnishing your home, putting the children through education, etc. Then comes a phase, from your early to mid 40s until just before you reach retirement age, where your savings grow significantly. The outgoings are smaller during this phase of your life as the kids have left home, and you focus on accumulating wealth to pay for your retirement. Eventually, when you retire, your savings rate turns negative as you begin to live on your life savings1.

Empirical evidence has since shown that this is generally true both for the individual and for society at large. Obviously, you don’t win the Nobel Prize for pointing out something that can hardly be classified as original thinking, but Modigliani’s claim to fame was to demonstrate the effect this pattern has on the general economy as the population ages. Let me introduce you to a chart constructed by fellow Dane Claus Vistesen who is an economist and active blogger. He has made a solid attempt to graphically illustrate the consequences of Modigliani’s work (chart 1).

The blue line represents the current account – it is in surplus when above the red line and in deficit when below. As you can see, when a country’s population is relatively young, the country should (all other things being equal) run a current account deficit. As the population grows older, and the savings rate rises for the reasons described above, the deficit turns into a surplus until such time that the elderly begin to dominate the young at which point the surplus turns into a deficit yet again.

Our export dependency

Why is all this important? Well, take another look at chart 1, but focus on the purple line instead, which represents the country’s export dependency. Translated into plain English, Modigliani’s work implies that a country with an ageing population must grow its exports aggressively in order not to build up an unsustainably large current account deficit. Unfortunately, as you can see from the shape of the curve, it is not a linear function. The problem gets progressively worse as the population ages.

Now, with most OECD countries fast approaching the danger zone where an uncomfortably large part of the population consists of old-age pensioners, how do we get out of this pickle? We can’t all export our way out of the problem. Somebody needs to buy our products. I will get back to answering this question later, but let’s take a quick look at the so-called dependency ratio first. If the ratio is, say, 30, it means that there are 30 people at the age of 65 or older for every 100 people between the age of 15 and 64 (which defines the working population).

Obviously, the higher the dependency ratio, the fewer working people there are to pay for the elderly. At some point the cost of supporting the elderly will reach a level which spells economic disaster, and some of the more exposed countries may quite simply be forced to abandon their welfare standards to cope. More about this later -let’s get some data points on the table. In chart 2 below, I have tried to keep things relatively simple. I have assumed, for example, that the fertility rate will remain unchanged going forward. This may or may not be a reasonable assumption. Only time can tell.

A walk in the park

The first thing that struck me when I produced this chart was how relatively benign the US outlook is. I read an awful lot of US centric macro economic research (my wife thinks too much!) and, more often than not, there is a reference to the bleak future for America given the fact that baby boomers in large numbers will be retiring over the next two decades. However, when you compare the US numbers (a dependency ratio of 19 today growing to 34 by 2050) to most other developed nations, the US demographic challenge suddenly looks like a walk in the park.

No other country is aging as quickly as Japan. Saddled with a large number of old age pensioners already (the dependency ratio is currently 35), the ratio will grow to an astonishing 76 over the next four decades. The Japanese economy has struggled to drag itself out of a slow growth environment for the past twenty years (give or take). The problems in Japan are well publicised and are often blamed on failed policy measures. I just wonder how big a role demographics have actually played in all of this and whether the Japanese mire is a sign of things to come for the rest of us?

Europe is toasted

The outlook for Europe doesn’t make for pretty reading either. In fact, you can argue that we are worse off than Japan given our lower savings, and it raises some serious questions about the sustainability of our entire welfare model. The IMF has calculated that the cost of age-related spending in the average advanced G20 country will cause public debt-to-GDP to grow to over 400%, with Spain and Greece reaching over 600% unless the existing welfare model is cut back. For comparison, Japan has the highest public debt-to-GDP ratio today at about 225%.

As our business partner, John Mauldin, always reminds us, what cannot happen, will not. We may have to prohibit the use of condoms (not advisable for other reasons), import more labour from countries with higher birth rates (immensely unpopular) or simply reduce old-age benefits. The latter carries its own set of challenges as the political influence of the elderly is on the rise, and it won’t exactly become any easier over the next 20 years to pass draconian legislation to reduce old-age benefits. Frankly, I have no idea how we will find a way out of this pickle. But find a way we will.

BRICs versus PIGS

As far as emerging economies are concerned, the outlook is considerably brighter (note the big difference between the BRICs and the PIGS in chart 2) but perhaps not as straightforward as you may think. Most investors seem to buy into the idea that, over the next few decades, emerging markets will offer better investment opportunities than more mature markets, as their economies are likely to grow much faster, and you don’t yet pay for the faster growth through higher P/E ratios. Whilst we wrestle with depressing issues such as how to pay for the credit crisis and how not to bankrupt ourselves as we age, emerging economies should benefit from a growing labour force. In fact, as you can see from chart 3, in the next few years less developed countries, which tend to have very young populations, will actually outgrow more developed countries in terms of the size of the working population relative to the total population (which is good for economic growth).

The growing number of workers should, according to Modigliani, be followed by stronger economic growth and rising savings. If these savings can be invested into new productivity enhancing investments, emerging economies should enjoy much higher living standards in the years to come. You may raise a hand here and say “STOP – didn’t you just argue that countries with young populations should run current account deficits and hence low savings rates?” It is indeed correct that ‘young’ countries should, according to Modigliani’s hypothesis, not be able to generate savings rates at the magnitude we have seen coming out of South East Asia in recent years.

Cheating is omnipresent

But Modigliani didn’t take cheating into account. Virtually every country in Asia has artificially depressed its currency in recent years in order to export itself to prosperity. This cannot, and will not, go on forever. As living standards rise in these countries, and domestic demand fuels economic growth, expect their currencies to appreciate against the old world currencies.

At the same time, one should not ignore the fact that not all emerging economies have young populations. I have included the four BRIC countries in chart 2 in order to make this point clear. As you can see, by the middle of the century, China and Russia will actually both have a higher dependency ratio than the United Kingdom, whereas Brazil and in particular India should continue to benefit from relatively young populations.

In a recent research paper2, BCA Research analysed a number of emerging economies and found that, broadly speaking, they can be divided into 3 categories – those where the working population is peaking just about now, those that will peak in the next 7-10 years and finally those where the peak is still 15-20 years away (chart 4).

It is clear from BCA Research’s work that some countries are in much better shape demographically than others. Most interestingly, China, which everybody (well, almost everybody) raves and rants about, does not look particularly attractive. Obviously you cannot judge the investment appeal based only on demographics, but if you add to that China’s fragile banking system and a construction boom which has left most new buildings half empty and led the Chinese authorities to block local access to hedge fund manager Hugh Hendry’s website, because he had the audacity to point out the insanity of many of the construction projects in China, then the Chinese investment story loses some of its glamour.

Too much of a good thing

A great growth story like China will always attract plenty of capital but, in the case of China, you can actually argue that too much capital has been attracted. As I was taught at university, economic growth loses its momentum if capital spending outgrows labour because of the diminishing return on capital. BCA has illustrated this graphically (chart 5), and it is obvious that China is attracting too much capital for its own good. You want to invest where capital is scarce, not plentiful.

You are therefore likely to earn a higher return on investment by investing elsewhere in the universe of emerging economies. One such country is Brazil which does not attract nearly the amount of capital that China does. I have been keeping an eye on Brazil for some time now as I am intrigued about their fledgling oil industry, and the more I learn about this country, the more excited I get. The story has not gotten any worse in recent days after the International Olympic Committee’s decision to award the 2016 summer games to Rio de Janeiro. But that is an entirely different story which I may write more about another day.

Going back to the question I raised earlier, how do we get out of this pickle? As already stated, we cannot all become exporters as we grow older and domestic demand begins to fade. The only way out, if we want to maintain economic growth, is for the younger and more dynamic emerging economies to become net importers. This will require a sea change in policy, and attitude, in those countries. Most importantly, it will require the exchange rate cheating to stop once and for all. There is no alternative, unless you are prepared to accept negative GDP growth year-in year-out. And that is no fun.

Niels C. Jensen

1 See http://www.princeton.edu/~deaton/downloads/romelecture.pdf for more information on Modigliani’s work.

2 ‘Demographics, Investments and Growth: Where are the opportunities?’, BCA Research, August 2009.

One factor contributing to the downturn was the September payrolls report that was released on Friday. The national unemployment rate rose to a worse-than-expected 9.8%, and would already be over 10% if fewer people had not left the workforce. The economic recovery, such as it is, remains invisible to millions of consumers. This is a problem not only for them but for the businesses that would like to have them as customers, and for the banks to whom they owe money. We will see a little more clearly where we stand as earnings season unfolds in the next few weeks. Alcoa (AA), typically the first blue chip to release earnings each quarter, exceeded expectations by reporting a small profit after the close.

There was much activity in the currency markets the last few days. Reports that oil-exporting nations want to be paid in units reflecting a basket of currencies rather than the U.S. dollar were quickly denied by all concerned, but the dollar nonetheless fell hard on the news. Meanwhile in Australia, one of the few developed nations to avoid recession, the central bank actually raised interest rates. This move was also not helpful to the greenback. On the other hand, the dollar appeared to find some short-term support, so maybe the selling was overdone.

While all this was happening, gold popped higher to a new record of almost $1,045 per ounce today. Whether the breakout is sustainable remains to be seen. Gold bugs point out, correctly, that on an inflation-adjusted basis gold is still far below its historic peak. The bearish response is that there are few signs of inflation anywhere in the economy right now. Also curious was a bond-market rally that pushed the ten-year Treasury yield as low as 3.106% last Friday morning, with a close today of 3.175%. Near-simultaneous rallies in both gold and bonds are unusual, but that is exactly what has happened since early August. One trend or the other is likely to give way soon. If we had to guess, we think the uptrend is more likely to continue in gold than bonds. This doesn’t mean a bond crash is imminent, but further gains from this point are hard to imagine.

Sectors

All sectors lost absolute strength this past week. Materials held on to the top spot again, but Technology moved ahead of Consumer Discretionary to take second place. Consumer Staples climbed two rungs of the ladder. With the devastating plunge of September 2008 now having dropped off, the one-year return has turned positive for most sectors. The biggest exception is Financials, which remain negative despite a ridiculous triple-digit gain in the last seven months. This is a good illustration of some math that investors too often forget: the percentage gain needed to recover a loss is far greater than that of the original decline.

Styles

Mid Cap Value moved back ahead of the more volatile Micro Caps by losing less in the last week. All the Mid Cap categories are now above Small Caps, but the rankings are very compressed with only 16 points separating top from bottom. Mega Caps are in last place with Large Caps just slightly better.

International

Latin America was the only one of our 32 categories to actually gain momentum this past week. Brazil rose nicely as Rio de Janeiro got the nod to host the 2016 Summer Olympics, the first time for the games to be held in South America. Pacific Ex-Japan held up relatively well and received a boost when, as mentioned above, interest rates went higher in Australia. Recent weakness in Japan pushed their equity market into an intermediate-term downtrend. A strong Yen is working against the export-dependent Japanese economy. The U.S. remains in the bottom half of the international markets.

Ron Rowland
Invest With An Edge

This weekend I turn 60 and have been a little more introspective than usual. I am often told that the letter I wrote well over three years ago on ubiquity and complexity theory and the future of the economy was the best letter I have ever done. I went back to read it, and it has aged well. I basically outlined how a financial crisis would unfold, and now it has.

On reflection, I think that there are perhaps other, even larger, events in our future than the recent credit crisis and recession; yet, just as in 2006, there is a great deal of complacency. But as we will see, there are fingers of instability building up that have the potential to create large disruptions, both positive and negative, in our future. And for the political junkies in the room, I offer a brief insight into what may be one of the more intriguing behind-the-scenes developments in recent years. Now, to the letter.

"Any explanation is better than none." – Nietzsche

And the simpler the explanation, it seems in the investment game, the better. "The markets went up because oil went down," we are told (except that when oil went up, then there was another reason for the movement of the markets). But we all intuitively know that things are far more complicated than that. However, as Nietzsche noted, dealing with the unknown can be disturbing, so we look for the simple explanation.

"Ah," we tell ourselves, "I know why that happened." With an explanation firmly in hand, we now feel we know something. And the behavioral psychologists note that this state actually releases chemicals in our brain that make us feel good. We become literally addicted to the simple explanation. The fact that what we "know" (the explanation for the unknowable) is irrelevant or even wrong is not important in achieving the chemical release. And thus we look for reasons.

The credit crisis happened because of Greenspan’s monetary policy. Or maybe it was a collective mania. Or any number of things. Just as the proverbial butterfly flapping its wings in the Amazon triggers a storm in Europe, maybe an investor in St. Louis triggered the credit crisis. Crazy? Maybe not. Today we will look at what complexity theory tells us about the reasons for earthquakes, tornados, and the movement of markets. Then we look at how the world and that investor in St. Louis are all tied together in a critical state. Of course, what state and how critical are the issues.

Ubiquity, Complexity Theory, and Sandpiles

We are going to start our explorations with excerpts from a very important book by Mark Buchanan, called Ubiquity: Why Catastrophes Happen. I HIGHLY recommend it to those of you who, like me, are trying to understand the complexity of the markets. Not directly about investing, although he touches on it, it is about chaos theory, complexity theory, and critical states. It is written in a manner any layman can understand. There are no equations, just easy-to-grasp, well-written stories and analogies.

As kids, we all had the fun of going to the beach and playing in the sand. Remember taking your plastic buckets and making sandpiles? Slowly pouring the sand into an ever bigger pile, until one side of the pile started an avalanche?

Imagine, Buchanan says, dropping one grain of sand after another onto a table. A pile soon develops. Eventually, just one grain starts an avalanche. Most of the time it is a small one, but sometimes it builds on itself and it seems like one whole side of the pile slides down to the bottom.

Well, in 1987 three physicists, named Per Bak, Chao Tang, and Kurt Weisenfeld, began to play the sandpile game in their lab at Brookhaven National Laboratory in New York. Now, actually piling up one grain of sand at a time is a slow process, so they wrote a computer program to do it. Not as much fun, but a whole lot faster. Not that they really cared about sandpiles. They were more interested in what are called nonequilibrium systems.

They learned some interesting things. What is the typical size of an avalanche? After a huge number of tests with millions of grains of sand, they found that there is no typical number. "Some involved a single grain; others, ten, a hundred or a thousand. Still others were pile-wide cataclysms involving millions that brought nearly the whole mountain down. At any time, literally anything, it seemed, might be just about to occur."

The piles were indeed completely chaotic in their unpredictability. Now, let’s read this next paragraph from Buchanan slowly. It is important, as it creates a mental image that helps me understand the organization of the financial markets and the world economy. (emphasis mine)

"To find out why [such unpredictability] should show up in their sandpile game, Bak and colleagues next played a trick with their computer. Imagine peering down on the pile from above, and coloring it in according to its steepness. Where it is relatively flat and stable, color it green; where steep and, in avalanche terms, ‘ready to go,’ color it red. What do you see? They found that at the outset the pile looked mostly green, but that, as the pile grew, the green became infiltrated with ever more red. With more grains, the scattering of red danger spots grew until a dense skeleton of instability ran through the pile. Here then was a clue to its peculiar behavior: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots. If the red network was sparse, and all trouble spots were well isolated one from the other, then a single grain could have only limited repercussions. But when the red spots come to riddle the pile, the consequences of the next grain become fiendishly unpredictable. It might trigger only a few tumblings, or it might instead set off a cataclysmic chain reaction involving millions. The sandpile seemed to have configured itself into a hypersensitive and peculiarly unstable condition in which the next falling grain could trigger a response of any size whatsoever."

Something only a math nerd could love? Scientists refer to this as a critical state. The term critical state can mean the point at which water would go to ice or steam, or the moment that critical mass induces a nuclear reaction, etc. It is the point at which something triggers a change in the basic nature or character of the object or group. Thus, (and very casually for all you physicists) we refer to something being in a critical state (or use the term critical mass) when there is the opportunity for significant change.

"But to physicists, [the critical state] has always been seen as a kind of theoretical freak and sideshow, a devilishly unstable and unusual condition that arises only under the most exceptional circumstances [in highly controlled experiments]… In the sandpile game, however, a critical state seemed to arise naturally through the mindless sprinkling of grains."

Thus, they asked themselves, could this phenomenon show up elsewhere? In the earth’s crust, triggering earthquakes, or as wholesale changes in an ecosystem – or as a stock market crash? "Could the special organization of the critical state explain why the world at large seems so susceptible to unpredictable upheavals?" Could it help us understand not just earthquakes, but why cartoons in a third-rate paper in Denmark could cause worldwide riots?

Buchanan concludes in his opening chapter, "There are many subtleties and twists in the story … but the basic message, roughly speaking, is simple: The peculiar and exceptionally unstable organization of the critical state does indeed seem to be ubiquitous in our world. Researchers in the past few years have found its mathematical fingerprints in the workings of all the upheavals I’ve mentioned so far [earthquakes, eco-disasters, market crashes], as well as in the spreading of epidemics, the flaring of traffic jams, the patterns by which instructions trickle down from managers to workers in the office, and in many other things. At the heart of our story, then, lies the discovery that networks of things of all kinds – atoms, molecules, species, people, and even ideas – have a marked tendency to organize themselves along similar lines. On the basis of this insight, scientists are finally beginning to fathom what lies behind tumultuous events of all sorts, and to see patterns at work where they have never seen them before."

Now, let’s think about this for a moment. Going back to the sandpile game, you find that as you double the number of grains of sand involved in an avalanche, the likelihood of an avalanche becomes 2.14 times more likely. We find something similar with earthquakes. In terms of energy, the data indicate that earthquakes become four times less likely each time you double the energy they release. Mathematicians refer to this as a "power law," a special mathematical pattern that stands out in contrast to the overall complexity of the earthquake process.

Fingers of Instability

So what happens in our game? "… after the pile evolves into a critical state, many grains rest just on the verge of tumbling, and these grains link up into ‘fingers of instability’ of all possible lengths. While many are short, others slice through the pile from one end to the other. So the chain reaction triggered by a single grain might lead to an avalanche of any size whatsoever, depending on whether that grain fell on a short, intermediate or long finger of instability."

Now, we come to a critical point in our discussion of the critical state. Again, read this with the markets in mind (again, emphasis mine):

"In this simplified setting of the sandpile, the power law also points to something else: the surprising conclusion that even the greatest of events have no special or exceptional causes. After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point. What makes one avalanche much larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile just before it starts. Rather, it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size."

Now, let’s couple this idea with a few other concepts. First, Nobel laureate Hyman Minsky points out that stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then, when the trend fails, the more dramatic the correction. The problem with long-term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings in favor of current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior. (And, three years later, we can now all see that truth. But it was not as obvious to a lot of people in 2006.)

Relating this to our sandpile, the longer that a critical state builds up in an economy, or in other words, the more "fingers of instability" that are allowed to develop a connection to other fingers of instability, the greater the potential for a serious "avalanche."

Or, maybe a series of smaller shocks lessens the long reach of the fingers of instability, giving a paradoxical rise to even more apparent stability. As the late Hunt Taylor wrote, in 2006:

"Let us start with what we know. First, these markets look nothing like anything I’ve ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.

"… I’ve had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it."

A second related concept is from game theory. The Nash equilibrium (named after John Nash) is a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while (if) the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium.

A Stable Disequilibrium

So we ended up in a critical state of what Paul McCulley called a "stable disequilibrium." We have players of this game from all over the world tied inextricably together in a vast dance through investment, debt, derivatives, trade, globalization, international business, and finance. Each player works hard to maximize their own personal outcome and to reduce their exposure to "fingers of instability."

But the longer we go on, asserts Minsky, the more likely and violent an "avalanche" is. The more the fingers of instability can build. The more that state of stable disequilibrium can go critical on us.

Go back to 1997. Thailand began to experience trouble. The debt explosion in Asia began to unravel. Russia was defaulting on its bonds. Things on the periphery, small fingers of instability, began to impinge on fault lines in the major world economies. Something that had not been seen before happened: the historically sound and logical relationship between 29- and 30-year bonds broke down. Then country after country suddenly and inexplicably saw that relationship in their bonds begin to correlate, an unheard-of event. A diversified pool of debt was suddenly no longer diversified.

The fingers of instability reached into Long Term Capital Management and nearly brought the financial world to its knees.

So, where are the fingers of instability today? Where are the fault lines that could trigger another crisis? Are there any early warning signs? I see two possibilities, one positive and one negative.

Chad Starliper sent me the following graph. It shows the debt-to-GDP ratio for the US, adding in various levels of debt. For instance, the ratio of debt to GDP for all levels of government debt is 87%. But if you add household and business debt along with the GSE (government-sponsored enterprises) like Fannie and Freddie, the ratio rises to 331%. If you add in future benefits of Social Security and Medicare, the number becomes more like 1,000%.

The Obama administration tells us that the government deficit is going to be well over $1 trillion a year for at least ten years. And that does not take into account the outlier years in the 2020s when the really heavy lifting of Social Security and Medicare kicks in.

There is a truism that goes a little like, "If something can’t happen, then it won’t." Let me make a prediction. We won’t have a trillion-dollar deficit in ten years. Why? Because it can’t happen. The market will simply not allow it.

As I have written, we can run large deficits almost forever, as long as the deficits are less than nominal GDP. While it may not be the wise thing to do, it does not bring down the system.

But when you start adding to the deficit in amounts significantly larger than nominal GDP, there is a limit. Each dollar, like the grains of sand, adds to the potential instability of the system. Is it $2 trillion more? $3 trillion? No one can know, but the longer it goes, the worse the ensuing financial earthquake will be.

The current political class and their intentions are dangerously close to killing the golden goose. It is one thing to steal the eggs; it is an altogether different thing to kill the goose through ignorance of the consequences. And the size of the deficit, for as long as they plan to have it, will most assuredly kill the goose.

Just as I was writing in 2006 about the potential for a crisis, and yet the party went on for quite some time, I think the party can limp along now. But there will come a point when the party is over. Interest rates on the long end will rise precipitously, forcing mortgages up and making the deficit even worse. It will be an even worse crisis than the one we have just gone through. And there will be fewer options for policy makers, and none of them will be good or pleasant. And it will take most people unawares. They will see the current trend and project it into the future. And they will be hit hard.

Can we avoid this calamity? Yes, we can wrestle the US budget deficit back under some kind of control, close to nominal GDP or on a clear trajectory to get there within a reasonable time (say, a few years). As noted above, we can run deficits close to nominal GDP almost forever. But there is no political willpower to do that now. And so, the market will at some point force the hand of the political class. That investor in St. Louis, or China or (????) will decide not to buy government debt at such low rates. The avalanche will start. And everyone will be surprised at the ferocity of the crisis. Except you, gentle reader. You have been warned.

Let me re-emphasize that point. If we do not get our act together, the results could be truly serious. And it is not just the US. Japan, as I have written, unless it changes, will hit the wall in the next few years. There are some really sick actors in Europe. You are going to have to be far more nimble and prepared for this next crisis, should it arise, than you were for the last one. Over the next few months, I will be devoting some space to helping us think through how we do that.

3 Billion and Counting

And now for something a little more positive. From the beginning of the wireless revolution and the development of the internet, it was not until 2001 that we finally had one billion people connected. It only took another six years to add another billion. And sometime in 2011, somewhere in the world, we will add yet another billion. We are adding some 70,000 people a day, with smarter and cheaper computers, phones, and netbooks. By some estimates, there will be five billion connected to the network by 2015.

A study done in 2005 of 21 developing countries by Leonard Waverman of the London Business School "… showed that an extra 10 mobile phones per 100 people in a typical developing country leads to an additional 0.59% of growth in GDP per person." (Jump Point)

Think of each one of those additional connected people as a grain of sand. We have already seen a large surge in productivity from the internet and mobile phones. Farmers in India now know what the prices are for their products and don’t have to take lowball offers from middlemen. Fishermen in Indonesia can call around and find where they can get the best price for their day’s catch.

Tom Hayes argues in his book Jump Point that, because of the growing connectivity, rather large changes are coming to the way we organize our lives. It is a very interesting book and one that I will review in depth at some point.

But what Hayes calls the Jump Point is what I referred to as critical mass. "In mathematics it is called a ‘jump discontinuity.’ In engineering, this is known as a ’step phase change.’ In climatology, it is called an ‘abrupt delta.’ I call it a Jump Point – a change in the environment, in this case the business environment, so startling that we have no choice but to regroup and rethink the future." (from the introduction)

Not all of the changes are benign. The potential for business and marketing models to be turned on their head is rather striking. I recommend the book to those who are thinking about the future. It is easy to read, provocative, and well written. You can get it at Amazon.com.

I wrote this three years ago: "Today more than ever your portfolio should be targeting absolute return strategies. In a world with fingers of instability that may be connected in ways we have not seen in the past, caution is the order of the day. If we do see a slowing US economy later this year, the average complacent investor is not going to be happy as his diversified portfolio all seems to be going south at the same time."

That is still true today. To talk with my recommended managers around the world you can go to www.accreditedinvestor.ws if your net worth is $1.5 million or more. If you are in the US and are still on your way to becoming an accredited investor, you can sign up at http://www.cmgfunds.net/public/mauldin_questionnaire.asp (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

The Texas Senate Race – A Game Changer

Indulge me for a moment while I delve into a little inside politics. I used to be very involved in Texas politics, but when I sold my business in 1999 and had to go back to work for a living, I mostly left out political commitments, although I do keep up and have a lot of friends. There is something happening in Texas that has the potential to shake things up, and I thought I would give my readers a heads up.

Long-time Texas Senator Kay Bailey Hutchison has let everyone know that she intends to come back to Texas and run for governor next year against current governor Rick Perry, who is going to run for his third term. Hutchison has indicated that she will resign sometime this fall, which will give Perry the right to appoint a Senator to fill the seat. He has told associates that if he does, the appointment will be a game changer. Who in the Texas political landscape could be termed a game changer? Not one of the half dozen middle-aged white guys who would love the appointment. Not that some of them would be bad choices, just not a game changer. Another woman? There is not one who has run a statewide race and has the necessary experience.

Then there is my long-time good friend Michael Williams. Michael has run statewide three times as the chairman of the Texas Rail Road Commission which, despite the name, is responsible for energy as well as railroads. It is a very powerful post in Texas. He is wildly popular with the grass roots and conservatives in the state. He is one of the best speakers on the stump in the country. He has a powerful command of the energy problem we face. He is totally electable as a Senator. And he is black.

Now that is the definition of a game changer. He will burst on the national scene with a presence. If Governor Perry truly wants to do something that will change the game not just for Texas but for the country, he will appoint Michael at his first opportunity and allow him to run in the primary as a sitting Senator. Michael will be at my birthday party Saturday night, along with his beautiful and extremely smart wife, Donna. Next week on the 12th of October I will be hosting a small private fundraiser at my home for those interested in meeting Michael. You can click here to respond.

And for the locals wanting to help in the campaign, Michael’s web site is http://www.williamsfortexas.com.

60 Years and Counting

I turn 60 on Sunday, although we will be celebrating with parties on Friday and Saturday. For whatever reason, when I turned 50 I was apprehensive. I can quite honestly say that I am excited about this birthday, and the future. For all the problems we are facing as a country and as a world linked together, I think this is the most exciting time to be alive in the history of the world. And the next 30 years are going to be much better than the last 60!

And you, gentle reader, are part of my reason to be so optimistic about the future. I continue to be amazed that so many people find the writings of this humble analyst to be worth their time. In truth, we are all constantly bombarded with more and more emails, advertisements, phone calls, letters, books, papers, and information, and it is getting harder and harder to focus on what is really critical. You give me the most important gift that anyone can receive in the Information Age, and that is the gift of your attention. You have hundreds of opportunities to divert it elsewhere, and yet you give me some of your precious time. I am grateful, and will always strive to make this letter worthy of your interest.

Finally, my good friend Sir Ed Artis of Knightsbridge fame, who is now in the Philippines, writes that he urgently needs funds to ship needed medical and relief supplies that have been already donated and are waiting on the docks. The disaster in the Philippines is quite tragic and calls out to those of us around the world who can help. You can go to http://currentmissions.blogspot.com/ to learn more and to donate.

My daughter Tiffani points out that I have guests arriving for my party and I need to hit the send button, so have a great week. I am going to run and enjoy my friends and some great Texas barbeque.

Your always in a critical state analyst,

John Mauldin
John@FrontlineThoughts.com

Copyright 2009 John Mauldin. All Rights Reserved

John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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