There's a reason economics is called the dismal science, and weeks like this just give it further meaning. In economics, there is what you see and what you don't. This week we are going to examine the headline data we all see and then take a look for what most observers do not see. Then we'll try to think about what it all really means. With employment, housing, and the ISM numbers, there is a lot to cover. And this letter will print out longer than usual, as there are a lot of charts. Warning: remove sharp objects from the vicinity and pour yourself your favorite adult beverage. This does not make for fun reading.

But first, a very quick three-paragraph commercial. In the current market environment, there are money managers who have not done well and then there are managers who have done very well. My partners around the world would be happy to show you some of the managers they have on their platforms that we think are appropriate for the current environment. If you are an accredited investor (basically a net worth over $1.5 million) and would like to look at hedge-fund and other alternative-fund managers (such as commodity traders), I suggest you go to www.accreditedinvestor.ws and sign up - and someone from Altegris Investments in La Jolla will call you if you are a US citizen. Or you'll get a call from Absolute Return Partners in London if you are in Europe (they also work with non-accredited investors). If you are in South Africa, then someone from Plexus Asset Management will ring. And in Canada it is Nicola Wealth Management. And Fynn Capital Management in South America. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

If you are not an accredited investor, I work with CMG in Philadelphia. We have created a platform of money managers who specialize in the alternative management space. By this I mean they do not need a bull or bear market in order to have the potential for profits. (Past performance is not indicative of future results.) You can go to http://www.cmgfunds.net/public/mauldin_questionnaire.asp and quickly read about the past performance of a manager we recently added to the platform, and then sign up to get more information.

Everywhere there are arguments that we are in a "V"-shaped recovery. And there are signs that in fact that is the case. Today we will look at some of those, and then take up the topic of when the Fed will raise rates. We open the case and look at the evidence. Is there enough to come to a real conviction? I think there is. (And at the end of the letter I mention two conferences I am speaking at in the next few months, in Vancouver and San Francisco.)

But first, a little housekeeping. The delivery rate for this letter has not been good for some time now and we are aware of it. We get tons of letters and calls from long-time readers who want to know why we have dropped them from the list. They keep resubscribing but not getting the letter. It is a problem. I was not getting delivery on my own personal accounts from well-known email providers. We apologize for any inconvenience. Please know that we do not drop anyone from the list unless they request it or we get hard bounces or undeliverable messages.

Hopefully that has all changed with this letter. The problem has been that the list is so large that it is blocked long before the letter ever hits your inbox. The computers at service providers just assume anything this large can't be for real. We are now using a service that is a third-party verification of our letter, which hopefully will fix the problem (not a cheap solution, by the way!). So, there may be a lot of you for whom this letter is (hopefully) a pleasant surprise after not getting it for some time.

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For the record, we are working on a MAJOR revision of the website and the letter. There will be a lot more ways for you to interact with me and each other. A lot more information and capabilities. We are excited. It should be here by the fall. Tiffani and I think you are really going to like it. And now to the letter.

Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

"A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.

"Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors' problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions."

- Professor Nouriel Roubini of New York University

The late and great Milton Friedman told us that inflation is always and everywhere a monetary phenomenon. But there is an asterisk to his equation that we need to examine, namely, the velocity of money. Sometimes a fast-growing money supply is not as inflationary as you might think. Then we will take quick looks at why the banking sector is in for more and larger rounds of write-offs, as well as note that the housing industry is in a hole but is gamely digging itself deeper. This week's letter will require you to put your thinking cap on as we travel to a mythical island to get an understanding of how the economy really works. There are a lot of charts, so the letter may again print long, but the word length is normal. And with no "but first," we jump right in.

When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And with my oldest daughter Tiffani getting married this summer (forget gas, you haven't seen inflation until you start buying floral arrangements), more kids in school, "Dad, I need a car," high energy costs, etc., the velocity, at least in terms of how fast money seems to go out the door, seems faster than normal. And what about my business? Travel costs are way, way up, and as aggressive as we are on the budget, expenses seem to rise. About the only way to deal with it is, as my old partner from the 1970's Don Moore used to say, is to make it up with "excess profits," whatever those are.

Consumer spending was much stronger than thought in November, yet Circuit City Stores Inc., Best Buy Co. and other retailers that warned of a slump in purchases. A private report today showed consumer confidence slid to the lowest level in more than two years in December. The stock market chooses to see all things bullish, and so it powers ever upward. This week we take a brief look at the consumer, recent "shock and awe" central bank actions, money supply and more, trying to see how it all fits together.

But first, let's quickly turn our attention to a practical way we can help save the lives of those who are desperately suffering in Darfur and Myanmar. Over the years my readers have generously supported the work of a very special group of guys who help bring aid to places where it is the most difficult, if not dangerous, to reach.

Knightsbridge International is a small group of volunteers who go to places that are not safe but the needs for help is critical. Like the Knights of old, who ran hospitals and relief efforts, these modern day knights go to where the need is the greatest. They took food and medicine to northern Afghanistan before the troops went in (very dangerous!). They went to rebel held territory in Sri Lanka after the tsunami when no one else could get medicine and help in. Whether it's driving in to rescue nuns in Rwanda (fascinating story!), or taking solar power for clinics in Myanmar, Water Purification Units and medicine to Darfur, and a lot more, they go where other groups fear to tread. They have no political or religious agendas, just the drive to get aid to where it can do the most good.

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

As I have written about and documented on many occasions, the economic health of the US consumer is hinged upon the housing market and housing values more than any other single factor. Since the entire economy, not to mention the world economy, is heavily leveraged to a healthy US consumer, the question of whether or not there is a bubble in the housing market is of paramount importance. Today, we begin a series on housing. I have found the research to be fascinating and often surprising and contradictory. I trust you will find it useful, and it is almost guaranteed to be debated, as I will depart from the Conventional Wisdom of both housing bull and bears.

But first, I want to address the recent dramatic rise and now slowing of the growth in the money supply as measured by M-2 and M-3. Many commentators breathlessly see alternatively either doom or a new bull market based upon these monetary measures, or the sinister hand of the Federal Reserve manipulating the markets.

No sooner is my Muddle Through 2003 forecast out, than we get a barrage of data which gives cause for concern. Can we still Muddle Through with an increase in taxes (you read that right!), higher oil prices, more medical costs, and a slowing world economy? Is the Fed actually winning the War Against Deflation? We look at all that today, plus I answer a few critics of my forecast.

Is the stock market the Little Engine That Could? Have I blown it when I suggested you get out a few weeks ago as the Dow rises another 7% and the NASDAQ is up 10% since then and 30% since the recent bottom? Am I early or am I simply wrong? Is there something really different this time?