Warren Buffett says buy. Jeremy Grantham says it will get worse. Both are celebrated value investors. Who is right? It all depends upon your view of the third derivative of investing. Today we look at valuations in the stock market. This is the second part of a speech I have given in the past few weeks in California and Stockholm. I am updating the numbers, as the target keeps moving. While from one perspective things look rather difficult, from another there is a ray of hope. What can you expect to earn from stocks over the next five years? It should make for an interesting letter. Note: this will be a little longer than usual, but part of it is there are a LOT of charts.

I should note that I am rewriting this on Monday. For the first time in over 8 years, I missed my Friday night deadline (see below). Last week's title for the letter was "The Economic Blue Screen of Death." By that I referred to the old "blue screen of death" that we used to get on early versions of Microsoft MS-DOS and Windows. You could be working away and suddenly, for no apparent reason, the computer would freeze up and you would get a blue screen. The only thing you could do was unplug the computer and hit the reset button - losing everything that was not saved when the computer crashed.

I likened this to the economic situation we are in now. With consumer spending "resetting" to a new lower level, we are going to have to hit the reset button on many business plans, and thus investments, as consumers are going to spend less and save more. Is that level 3% less? 5%? More? No one knows, but since we have not had a consumer-led recession since 1982, too many businesses assumed that the US consumer, like Superman, was bulletproof.

What will be the eventual savings rate? Will we get back to 7-9% from less than 1%? Maybe, because people are going to realize that savings today are the key to a happy retirement. That would put the new level of consumer spending a good deal lower than it has been. Thankfully, that climb in savings will not happen all at once but will play out over more than a few years. I think we will look back in the middle of the next decade and be quite amazed at how much US personal savings have increased. However, this is the Paradox of Thrift: what is good for the individual is hard on the economy, as by definition increased savings reduces consumer spending.

This week we look at the growing disconnect between the US economy and the stock markets. One is slowing and the other is exploding to the upside. One of my mentors once said that it is the duty of the markets to prove the most-possible people wrong. So far, I am clearly in the wrong category. We will look at some explanations as to why, ponder if this can continue, and more. (I will conclude the letter I promised last week in next week's letter. There were still a few details I needed to get it ready.)

But first, a quick note. My daughter and associate Tiffani has prepared a photo tour of my recent trip to South Africa and put it on our website. You can click on the following link and see it, as well as find a link to the e-letter about my thoughts on South Africa. (If you do not have a cookie in your computer, you will get our landing page. Simply put in your email address and then either click the link again or hit the link to "Other Material by John" on the upper left-hand side of the page.) http://www.frontlinethoughts.com/africa.asp

Is the market overvalued? Fairly valued? Or are there really rocket boosters underneath the trading floors? We will look at the data, some historical charts which I think you will find very interesting, and some of the recent economic numbers which are important, all in an attempt to answer these questions.

This week's letter was prompted by a very fair question from a reader. I got in late Tuesday night to Orlando where I would speak to the Investment Management Consultant's Association the next morning. I went to the bar to get a glass of wine and see if I could meet anyone from the conference and get a feel for what was happening.

Coincidentally, I immediately met two readers who were attending the conference, and we struck up a conversation. One had been reading me for quite awhile and has read my books. It did not take long before he asked, "Do I still believe we are in a secular bear market? And if the market makes new highs, what will happen to my belief in that premise?" As if to underscore that thought, today the Dow closed at 11,577, a six-year high. Various small-cap markets are at actual all-time highs.

"The U.S. outlook is all about the property market, which has been the wind beneath consumers' wings this decade." Paul McCulley, Managing Director, Pimco

The world seems to be breaking down into two camps: those who, like McCulley, think housing is critical to the growth of consumer spending and believe the housing market may be in for some rough weather, although the forecasts vary greatly from a mild frost to blizzard conditions. On the other side there are those who think the housing market is in fine shape, will not be in for anything more than somewhat less growth and the American consumer will figure out a way to continue to spend more than he makes.

With many sub-market indexes hitting new highs, and given the recent performance of the market, how can I maintain we are still in a long-term secular bear market? Shouldn't we get back in, as so many advise? That is a reasonable question, and the subject of today's letter.

We will start with a few quotes, and then move on to my commentary. A. M. Clifford writes:

"We are witnessing today a most extraordinary financial phenomenon, in the form of a Stock Market which has advanced with a rapidity and to an extent unparalleled in modern financial history.

This week we address the question of whether the stock market is forming a top, take further looks at Fed policy and the unemployment rate and see if there is a connection. I think there is. The relationship is less subtle than it might appear. At the end of the letter, I ask for some help from those in the media (or who have friends in the media) in arranging reviews (and interviews!) for my upcoming book. And in response to readers, I start the process of putting a gold information site and links on my web site. I ask you to tell me your favorite gold and precious metal information sites. There's a lot to cover, so let's get started.

This week we re-visit one of my favorite themes: Why Investors Fail. I am doing the final edits on my book, Bull's Eye Investing, and when I came to the chapters on the psychological hard-wiring we have as humans, which causes us to make the same investment mistakes over and over, it just reminded me how important it is to understand why we do the things we do, and then stop doing them!

This week I want to briefly look at some comments by Stephen Roach and Rob Arnott, two of my favorite analysts. Then we quickly segue into Part One of a series showing the relationship between stock market returns, P/E ratios, inflation/deflation and the economy. This is some of the more practical and significant research I have written about in the last few years, and I think you will find it very helpful in developing your own investment strategy.

Today we are going to look at the world economy, muse on why the dollar is holding its own and when and why it will drop. Then I make a few comments on the current stock market rally. Finally, in a departure from the normal letter, I am going to close the regular e-letter, but add a PS in the form of an essay on the risk of derivatives for those who find the subject interesting.

The US Muddles Through

The world economy is clearly not healthy. Let's look at the US, and then we will go around the world. The US economy grew at 3.1% for the last quarter, which ahs been loudly trumpeted by the cheerleaders on Wall Street. But digging down into the details, we find that if you take out the explosive growth in automobile sales caused by 0% financing, the growth was only 1.5%. The predictions are for a weak holiday buying season. Car sales are now down. Housing was down 11.4% in October, capacity utilization is almost back down to recession lows and the trade deficit widens. Retail store sales are slightly down.

Exactly what use is past performance? How can you spot a trend before it starts, and determine when it will stop? And when will the next big bear market rally start? This week we examine why so many investors fail, and why a few succeed over and over again. While I am sure that none of my regular readers make these mistakes, this will be a useful column to send to your friends who have not been as successful as you. Oh, yes, and I tell you how to know when the next big rally starts. Let's keep that detail to ourselves. No use tipping your friends on this one.