Thoughts from the Frontline

Once to every man and nation, comes the moment to decide, In the strife of truth with falsehood, for the good or evil side; Some great cause, some great decision, offering each the bloom or blight, And the choice goes by forever, 'twixt that darkness and that light. – James Lowell, 1845 God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference. – Reinhold Niehbuhr "Happy New Year. We enter 2012 with a great deal of hope, but our hopes are not for more bailouts, or money printing, or any of the myriad policies that investors seem to hope will save bad investments and sustain elevated valuations. Instead, our hope is that in 2012, the market will finally "clear," in the sense that bad debt around the world will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the global economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving – and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future. Maybe that is too hopeful, but we are not entirely convinced that bailouts and 'big bazooka' will be as easily procured in the year ahead as a confused public has allowed in recent years." – John P. Hussman, Ph.D. (hussmanfunds.com)

"Whoever cannot seek the unforeseen sees nothing for the known way is an impasse." ― Heraclitus, Fragments Which path will we take? If we could only grow our way out of our sovereign debt problems. But growing debt creates even more problems if not dealt with, making it even more difficult to deal with; yet getting the debt and deficit under control brings its own form of pain. As I keep pointing out, there are no easy choices left. Some countries must choose between difficult and very bad, and others are faced with either disaster or calamity. Greece simply gets to choose what it wants to be the cause of a depression. Long and slow or fast and deep? Choose wisely. It's that time of year when we start thinking about what the next may hold for us. I am reading and thinking a great deal about my annual forecast issue next week, taking some time off from my usual Friday missive; so this week we look at what I think is one of the best pieces of analysis I have read in the past few months. It is from a private letter for the Boston Consulting Group, and Dan Stelter graciously allowed me to let my friends read it. Follow this thinking carefully and then think through their outline of what a country would have to do to leave the euro, which starts at the subhead entitled "What if… ?". Then ask yourself what do you need to do. The short answer from me is that you need to consider more what you already own rather than what you should buy. At the end of the letter is a link to an in-depth review of what scenarios businesses should be considering, but it will also work for individual investors. Now, let me turn it over to Dan and David.

What should business leaders and investors do to prepare themselves for the difficult year(s) head? David Rhodes and Daniel Stelter of The Boston Consulting Group have compiled an excellent guide in which they consider 4 possible economic scenarios. Included are detailed actionable steps that companies and investors can take right now to prepare themselves for 2012 and beyond. Simply enter your email below to download this important, must-read report.  

It’s Christmas Eve and that time of year when we start thinking about what we did in the past year and what we want to do in the next. Why do we make the mistakes we make (over and over and over?) and how do we avoid them in the future? If it seems to be part of our basic human condition, that’s because it is. Recently I have been having a running conversation with Barry Ritholtz on the psychology of investing (something we both enjoy discussing and writing about). Since I am busily researching my annual forecast issue (and taking the day off), I asked Barry to share a few of his thoughts on why we do the things we do. He gives us even more, exploring the three main opponents we face when we enter the arena of investing. Barry is the driving force behind The Big Picture blog, often cited as the #1 blog site in terms of traffic (and a favorite of mine!) and FusionIQ, a software service that uses both fundamental and technical analysis. Over the years Barry and I have known each other, we have become quite good friends. If you ever get a chance to catch us on a panel together, you are in for some fun, as we tend to go at it and each other just for the heck of it, while trying to share the little that we have learned along the way. Barry is all over financial TV and now has a weekly column in the Washington Post. And now, let me turn it over to Barry.

Turning and turning in the widening gyre The falcon cannot hear the falconer; Things fall apart; the centre cannot hold; Mere anarchy is loosed upon the world, The blood-dimmed tide is loosed, and everywhere The ceremony of innocence is drowned; The best lack all conviction, while the worst Are full of passionate intensity. - The Second Coming, by William Butler Yeats (1865-1939) This coming week we shall likely see Congress pass an extension of the "temporary" payroll tax cut, first enacted as a stimulus to the economy in January of 2011. As I write, the extension is just for two months. We'll leave aside the politics and look at the economic implications of the extension, and then go on to examine the deficit in the US. That will give rise to some thoughts about Europe and what would have to happen for a country to leave the euro. We'll finally close with some thoughts and graphs about the more controversial part of the tax cut extension, the Keystone XL Pipeline. Just how radical is it to build such a pipeline in the US? And what are the implications for the deficit? I think looking at a few maps might surprise some readers. It should all make for a rather controversial letter, but then controversy is my middle name. (Note, this letter will print longer as there are lots of charts.) But first, I want to thank one reader for helping to increase my reader base in a rather unusual way. I was sent this bit from a blog by Edward Ream today: "I came across John Mauldin, http://www.johnmauldin.com, when someone left a printout of his blog in a railway carriage. His ‘Outside the Box' column is free to all. "I enjoy his column, and I think some of you may enjoy it too. I especially admire his thirst for knowledge and his tolerance of diverse viewpoints. He actively seeks disconfirming evidence and the views of those who disagree with him. Imo, this stance is a model for what politics should be, and isn't :-) – Edward" Thanks, Edward, and to whomever left the letter on the train. We take expansion of the number of our friends wherever we can find it. And let's see how he feels after this letter.

We have come to the end of yet another European Summit that was supposed to be the one to fix the problem. If you are confused as to what happened then you are not alone. Was it something we will look back on in ten years and say, "This was where it all started," or will it be viewed as just another meeting in what will prove to be a string of even more meetings? I will argue that both views are the correct answer, depending on your frame of reference. But what did come out of the meeting was that some very clear lines were drawn. Will those lines look like the one that Colonel Travis drew with his sword at the Alamo, where those who crossed and joined him knew their fate? Or will it be more like the fabled French Maginot line, thought to be impregnable, which Germany simply went around? Stark comparisons, I know. But then, the choices and sides of the lines you choose to be on offer very stark consequences. I should acknowledge that I spent a great deal of time the last two days reading and talking with friends from around the world, trying to make sense of the omelet that we were served in Europe. Exactly what is in it? This letter is somewhat speculative on my part, taken from my gathered impressions over the week and informed by my readings over the years. I will use some simple analogies to try and make things clear. And I know that using such simple devices has its limitations, but those are the tools that I have to work with. They will have to suffice. I hope they also inform. But first, and speaking of conversations, as part of my discussions on Europe I have scheduled two Conversations next week, one with Lacy Hunt and the other with Barry Ritholtz and Jim Bianco. They will be recorded and transcribed as soon as we can, so that subscribers to Conversations with John Mauldin can listen in before the holiday season arrives. Plus those fabulous archives, with Mohamed El-Erian, David Rosenberg, George Friedman (hmm, I need to do another one with him soon – so much is happening!), Richard Yamarone, Gary Shilling, Nouriel Roubini, and many more. You can "eavesdrop" on my earnest chats with my friends about what's on our minds, just like being at the table. And for the holidays, if you use the code CONV when the signup process asks for one, you get $50 off the regular subscription price. You can subscribe (and learn more) at http://www.johnmauldin.com/conversations/landing/. Join us! And now, let's jump right in.

It is now common to use the term bazooka when referring the actions of governments and central banks as they try to avert a credit crisis. And this week we saw a coordinated effort by central banks to use their bazookas to head off another 2008-style credit disaster. The market reacted as if the crisis is now over and we can get on to the next bull run. Yet, we will see that it wasn't enough. Something more along the lines of a howitzer is needed (keeping with our WW2-era military arsenal theme). And of course I need to briefly comment on today's employment numbers. There is enough to keep us occupied for more than a few pages, so let's jump right in. (Note: this letter may print long, as there are a lot of charts.)

Angela Merkel is leading the call for a rule change, a rewiring of the basic treaty that binds the EU. But is it both too much and too late? The market action suggests that time is indeed running out, and so we’ll look at the likely consequences. Then I glance over the other way and take notice of news out of China that may be of import. Plus a few links for your weekend listening “pleasure.” There is lots to cover, so let’s get started.

Europe is again at center stage. At conferences and meetings and in private conversations, it is the topic of the hour. I have thought a lot this week about Europe and its impact, so once again we delve into what is an evolving situation. This time, we look at possible impacts on the markets, as we ponder the questions, “Are we back to 2008?” and “Is there a Lehman in our future?” and I try once again to keep from making this a book-length letter. And I close with some brief thoughts I brought back from DC on the Super Committee and the deficit cuts. But first, and quickly, I want to say that I am very pleased that Amazon has made Endgame one of their Best Books of the Year for 2011 AND their editors’ pick of “Gift Ideas for a Geeks,” although I am not sure how they define geek (I never thought of myself as smart enough to be a geek). The book has had very good sales of late, which is probably due to the fact that it is out in front explaining the crisis that is being caused by the end of the debt supercycle. Plus, good reviews and favorable mentions from congressional leaders (like Paul Ryan in the New York Times a few weeks ago) have helped. It makes a good gift for Christmas or for clients! You can get it from Amazon at http://www.amazon.com/Endgame. Now, let’s jump right in to Europe and its own particular Endgame.

Europe remains the focus of markets, and rightly so. But the picture is not as clear as one would like. Different analysts point to different problems – if only this one problem could be solved, then all this would go away, they tend to say. Sadly, it is not one problem but three that must be solved, and none of them is easy. In today’s letter I try and offer a basic primer on the problems facing Europe. My challenge to myself is to do it in a short piece rather than the book-length tome it could easily become. Thus, in the pursuit of brevity, we will not be as in-depth as usual, but I think it helps us to step back a few feet and look at the larger picture before we focus on minutiae.

I find myself in Liam's taxi on the beautiful drive to Kilkenny through the Irish countryside for a few hours this very early Friday morning, so what better time to begin writing about employment than in a country that is struggling, just as most of the developed world is, to find good jobs for its people. I'm on my way to a conference that will talk about the economics that is driving the world's leading governments to distraction in Cannes. Is Greece going to vote? Take the money? Will it be an orderly default? Should Ireland default? Whatever I write, the situation will change as soon as I hit the send button tonight. (For the record, I think Greece should have a referendum. You don't go into what they are getting ready to suffer without national buy-in. No elitist deals. Put it to the people to decide, one way or the other.)

Where is the peace dividend that was supposed to come after the end of the Cold War? Where are the fruits of the amazing gains in efficiency that technology has afforded? It has been eaten by the bureaucracy that manages our every move on this earth. The voracious and insatiable monster here is called the Federal Code that calls on thousands of agencies to exercise the police power to prevent us from living free lives. It is as Bastiat said: the real cost of the state is the prosperity we do not see, the jobs that don't exist, the technologies to which we do not have access, the businesses that do not come into existence, and the bright future that is stolen from us. The state has looted us just as surely as a robber who enters our home at night and steals all that we love. - William "Bill" Bonner Exactly what happened in Europe yesterday? The market reacted like it was the Second Coming of the Solution to End All Solutions. No problem here! The European debt crisis is solved! But if you look deeply (almost always dangerous when it comes to Europe) there is more to the market "melt-up" than simple euphoria and relief. What you find is a very disturbing unintended consequence that will come back to haunt us, as, sadly, I have written about in the past. The finger points to our old friends derivatives and credit default swaps. This week, as I recover from a rather nasty bug, we look at gamma and delta and other odd entities that may be behind the real reason for the market response, as we march inexorably toward the final chapters of the Endgame. Let's see how far out on a limb I can go. But first an important announcement. I am very excited to be able to introduce my readers to a mutual fund offered by my friends at Altegris Investments. This special fund is a blend of five commodity trading advisors, or CTAs. Normally, to access a CTA you be to be an accredited investor, with all the net-worth requirements and limited liquidity. But Altegris has figured out how to wrap a mutual fund around CTAs and create a fund of commodity traders with all the usual aspects of a mutual fund (daily pricing, liquidity, etc.). I have long been involved in the commodity-trading advisor space (some 20 years) and am a proponent of CTAs as a way to diversify portfolio risk. I have written a detailed report on this fascinating sector in relation to the fund, and it is available for free at http://www.altegrismutualfunds.com/landing/mauldinreports1.aspx, along with more information on the fund (including the offering memorandum and important risk disclosures, which are also included at the end of this letter). The fund has been very well received since its launch and has grown rapidly to almost $1 billion. There has been very active interest in the professional community, as advisors and brokers are looking for simple and realistic ways to diversify their clients' portfolio risk in a manner that is truly noncorrelated to typical stock funds and many other asset classes. Whether you are a professional or individual, you really should take the time to research what I think is a very solid fund. My partners at Altegris have decades of experience in the CTA space, with the largest available database of CTAs and long-term relationships with many of the managers (I actually started my investment career in the commodity fund space, so I have more than a passing knowledge of the arena). Given the potential for volatility in the global markets, I think it makes sense to have some exposure to funds that can go both long and short (depending on their models). I urge you to read my report: http://www.altegrismutualfunds.com/landing/mauldinreports1.aspx