Thoughts from the Frontline

The news is somewhat "All Greece, All the Time," but most of the pieces miss the more critical elements, and in today's letter we will look at what I think those are, as well as at the important point that Greece is a precursor of a new era of sovereign risk. Plus, we glance at a few rather silly recent comments from economists. It will make for a very interesting discussion. A few weeks ago I mentioned my friend Sir Walt Ratterman, who was in Haiti at the time of the earthquake. Long-time readers know that every Christmas I ask you to make a donation to Knightsbridge and projects that Walt runs. You have been very generous over the years. Tragically, they have found Walt's body. For those interested, I will provide a few details about this true hero, toward the conclusion of the letter. Before we get into the meat of the letter, I want to give you a chance to register for my 6th (where do the years go?!) annual Strategic Investment Conference, cosponsored with my friends at Altegris Investments. The conference will be held April 22-24 and, as always, in La Jolla, California. The speaker lineup is powerful. Already committed are Dr. Gary Shilling, David Rosenberg, Dr. Lacy Hunt, Dr. Niall Ferguson, and George Friedman, as well as your humble analyst. We are talking with several other equally exciting speakers and expect those to firm up shortly. Look at that lineup. These are the guys who got the calls right over the past few years. They called the housing crisis, the credit bubble, and the recession. And, in my opinion, these are some of the best in the world at giving us ideas about where we are headed.

Should Greenspan and Bernanke have seen the bubble in housing and other assets and acted, or should we accept their defense that you can't know whether there is a bubble until after the fact? We will look at research that suggests they should have known, and, at the least, policy makers should no longer be allowed to say, "How could I have known?" Of course, the employment numbers came out this morning, and the results are mixed; but that is better than they have been for the past two years. We dig into the numbers to see what they are really saying. And finally, we examine why the markets are so volatile. Is it just Greece, or is there more? There's a lot of very interesting, and important, material to cover. But first, and quickly, as I wrote in Outside the Box a few weeks ago, I am starting to very selectively buy biotech stocks, and mostly, though not exclusively, companies associated with the regenerative genetic revolution that is coming our way. I am convinced that this is going to be a decade of the most amazing medical breakthroughs, which will literally change (and in many cases extend) our lives, as therapies to treat all sorts of diseases become available. This is the last time I am going to mention it, but here is the link to that OTB, which analyzes why we may see a bubble in biotech stocks before the end of the decade. The OTB was written by my friend Pat Cox, who covers these stocks and other technological marvels in his newsletter, Breakthrough Technology Alert. I have been following Pat for some time now, have talked extensively with him, and think he is one of those guys who have a handle on what by all accounts is going to be an amazing decade of breakthroughs.

"Our immersion in the details of crises that have arisen over the past eight centuries and in data on them has led us to conclude that the most commonly repeated and most expensive investment advice ever given in the boom just before a financial crisis stems from the perception that 'this time is different.' That advice, that the old rules of valuation no longer apply, is usually followed up with vigor. Financial professionals and, all too often, government leaders explain that we are doing things better than before, we are smarter, and we have learned from past mistakes. Each time, society convinces itself that the current boom, unlike the many booms that preceded catastrophic collapses in the past, is built on sound fundamentals, structural reforms, technological innovation, and good policy." - This Time is Different (Carmen M. Reinhart and Kenneth Rogoff) When does a potential crisis become an actual crisis, and how and why does it happen? Why did most everyone believe there were no problems in the US (or Japanese or European or British) economies in 2006? Yet now we are mired in a very difficult situation. "The subprime problem will be contained," said now controversially confirmed Fed Chairman Bernanke, just months before the implosion and significant Fed intervention. I have just returned from Europe, and the discussion often turned to the potential of a crisis in the Eurozone if Greece defaults. Plus, we take a look at the very positive US GDP numbers released this morning. Are we finally back to the Old Normal? There's just so much to talk about. But first, I want to give you a chance to register for my 6th (where do the years go?!) annual Strategic Investment Conference, cosponsored with my friends at Altegris Investments. The conference will be held April 22-24 and, as always, in La Jolla, California. The speaker lineup is powerful. Already committed are Dr. Gary Shilling, David Rosenberg, Dr. Lacy Hunt, Dr. Niall Ferguson, and George Friedman, as well as your humble analyst. We are talking with several other equally exciting speakers and expect those to firm up shortly. Comments from those who attend often run along the lines of "This is the best conference we have ever been to." And each year it seems to get better. This year we are going to focus on "The End Game," that is, on the paths the various nations are likely to take as they try to solve their various deficit problems, and how that will affect the world and local economies and our investments. We make sure you have access to our speakers and get your questions answered, and you'll come away with excellent, practical investment ideas.

When I was at Rice University, so many decades ago, I played a lot of bridge. I was only mediocre, but enjoyed it. We had a professor, Dr. Culbertson, who was a bridge Life Master at an early age. He was single and lived in our college, playing bridge with us almost every night. He was a master of the "end game." He had an uncanny ability to seemingly force his opponents into no-win situations, understanding where the cards had to lie and taking advantage. Traveling to London and on into Europe, I have some time to think away from the tyranny of the computer. Over the last year, and especially the last few months, I have written in depth about the problems we face all across the developed world. We have no good choices left, so making the correct unpleasant choice is now our most hopeful option. As I wrote in my 2010 forecast, this year is a waiting game. There are so many choices we must make, and the paths we will take from those choices vary wildly. But make no mistake, we are coming close to the end game. Some countries and economies are closer to that point than others, but the entire developed world is lurching, in almost drunken fashion, towards our economic denouement. Over the next several months, we are going to start to explore various aspects of the end game. Whither Japan? Are they actually, as I think, a bug in search of a windshield? What does that mean for the world? How safe is the euro? Everyone over here seems to think Germany will bail out Greece. A breakup seems unthinkable to the people I've been talking to (so far). But what about Spain? Italy? Can you spell moral hazard? The Fed has said it will exit quantitative easing (QE) at the end of March. But what if mortgage rates rise? Where do we find $1 trillion (plus!!!) in US savings to fund the deficit, assuming foreigners buy about $400 billion? By definition, savings and foreign investment and the federal deficit must add up to zero. (We will go into that later - just take it as gospel for now.) How can we run 10% of GDP deficits if the Fed does not print money (as they did by buying Fannie and Freddie paper, which became treasuries, as I outlined last week)? That would require almost a 10% savings rate - with it all ending up in treasuries. How can that happen? Really?

Last week we delved into the uncertainties that face us and that make forecasting for 2010 problematical. Will the government actually increase taxes as much as they say, with unemployment still likely to be at 10%? Or will cooler heads prevail? Would such an increase cause a recession? Will the markets anticipate the effects of such a major increase in advance? How will the mortgage market react when the Fed stops buying mortgage securities at the end of March? There are so many things in the air, and today we explore more of them, as I continue (perhaps foolishly) to try and peer into what is a very cloudy crystal ball. But first, and far more important, is the tragedy that is unfolding in Haiti. Long-time readers know that several times a year I mention in this letter my very good friend Walt Ratterman, who volunteers his time going all over the world to install solar-power systems for hospitals and clinics, along with other relief efforts. My readers have been very generous over the years to Knightsbridge and their relief efforts. Walt and other members of Knightsbridge literally go into places where if they were caught by the government they would simply be shot (as in Burma). In Afghanistan, before our troops went in, the Taliban put a very hefty price on his head as he brought food and medicine to the northern tribes. Pakistan, Sudan, Darfur, Sri Lanka after the tsunami, in rebel-held territory, to bring medicine when no one else could get through - the hell-holes of the world. He and I talk frequently about the wisdom of taking such risks, and he cheerfully replies that someone has to. There are people dying. When we talked just a few weeks ago he mentioned he was going to Haiti. At least, I said, that was one place where no one would be shooting at him. He had been there several times. And then we find a different type of uncertainty rearing its head. After all the places he had been where the danger was fellow human beings, this occasion found him in the courtyard of the Hotel Montana, minutes before the earthquake hit. There were teams on the ground the next morning, specifically looking for him, but as of Friday evening he has not been found. We are hopeful, because they are still finding survivors at the hotel. His friends from Knightsbridge will be going there to assist in the recovery. Medical teams from Knightsbridge are going in early next week, and another experienced team will follow later in the week. These are people who know what to do and how to get it done. A few of you who have done this type of work may want to contact Ed Artis (see below) to see if you can be of service (especially medical). As I have often written, these are the good guys. They pay their own way and have no office overhead. It is a total volunteer effort. But they do need money for medicines, supplies, etc., and transport to get them there.

"Lying here, during all this time after my own small fall, it has become my conviction that things mean pretty much what we want them to mean. We'll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cosily comforting belief; we are blindest to precisely whatever might be most illuminating." -- from Transition, by Iain M. Banks Still a man hears what he wants to hear And disregards the rest -- The Boxer, by Paul Simon This will be my tenth annual forecast issue. Time has flown by, and I enter a new decade of writing Thoughts from the Frontline. And even as I write about the high level of uncertainty of the current times, I am optimistic that at the opening of the next decade we will look back and realize that there has been an enormous amount of progress made. None of us will want to revisit the pleasures of the past ten years in some nostalgic dream. I am so ready for a new decade. And speaking of Paul Simon (above), reading the lyrics of The Boxer, one of my favorite songs from my youth, another few words seemed to hit home: ...Now the years are rolling by me, they are rockin' even me ...I am older than I once was, and younger than I'll be, that's not unusual ...No it isn't strange, after changes upon changes, we are more or less the same

This is the season when pundits feel compelled to make annual forecasts. I will make mine, as I traditionally do, in the first letter of January. But already we have seen a wide range of forecasted outcomes. Are we going to grow at 5-6% or at 1-2% or dip back into recession? Why such disparity? I think part of the reason is a basic disagreement on the nature of the just-lapsed recession. Today we explore that issue. Then I point you to a way to help those who are desperately in need and only wish they had our problems. For those interested, I enclose a picture of my new granddaughter. And finally, I start the process of getting ready, after ten years, to actually buy some stocks. Yes, it is true. Am I throwing in the towel and becoming a bull, or do I just see an opportunity? Stay tuned. I did a very interesting one-hour show this week with Tom Ashbrook on his National Public Radio syndicated radio show called On Point. About 20 minutes into the show, Professor Jeremy Siegel of Wharton came on, and we had a pleasant debate and lively Q and A with listeners. Jeremy of course was the bull, expecting that next year the US will grow by 5-6%. I was the "bear," expecting growth in the 1-2% range. You can listen in at http://www.onpointradio.org/2009/12/an-economic-warning. It's also available as a podcast on iTunes ("On Point with Tom Ashbrook") for a few more days. I have liked Jeremy the times we have been on the same platform, and we have traded emails over the past few years. He is a consummate gentleman. He is also the author of Stocks for the Long Run. His thesis is buy and hold. Long-time readers know that I find such thinking to be wrong, if not dangerous. I believe that stocks go in long cycles (an average of 17 years) based on valuations, and that we are still in a long-term secular bear phase. I want to see valuations come way down before I suggest that the index-investing waters are once again safe. That day will come. Just not for a while.

We are clearly starting to get some better data points here and there. But as I pointed out this summer, it is going to be a recovery in the statistics and not in the things that count, such as income and employment. This week we look at the nascent recovery (which could be at 3% this quarter) and try to peer out into the future to see what it means. We look at how recoveries come about, and why I am concerned that we will see a double-dip recession. Plus, I learned some new tricks courtesy of my new granddaughter, to whom Tiffani gave birth this week1 There is a lot to cover, but it should be interesting. But first, a quick commercial nod to my subscription service, "Conversations with John." It was one year ago this week we launched the service, and we are pleased that so many of you have subscribed. As a bonus for renewing or subscribing, I am going to be doing a special predictions issue, where I will interview at least six analysts who have been right the past few years and ask for their specific predictions for the coming year. For new readers, this is where I sit down with some of my friends and hold an in-depth conversation, generally 45 minutes to an hour, and post it on our web site, along with a transcript. We have had some fairly well-known names over the past year, and the reviews from subscribers have been excellent. As a Holiday Special, we are offering a subscription at the special price of $129. Just click on the link and type in the code JM09 when asked to do so in the subscription process (at the conclusion of the process, not the beginning, but we're working on that.) This is a big savings over the regular $199 price. Plus, when you subscribe you get access to the Conversation archives. That is worth the price of admission itself. And now, let's jump into The Statistical Recovery.

This week I am in New York, and have a whirlwind of meetings (and I admit, a lot of fun on the side) and not much time to write. I have been saving today's letter for a month or so, for a time such as this. Damien Hoffman of the Wall Street Cheat Sheet interviewed me and posted the transcript on his web site. I thought it was one of the better interviews I have done recently, and so it is this week's Thoughts from the Frontline. In addition to the wide-ranging economic questions, he asks for my thoughts on how one becomes an investment writer. I often demur when asked that question (what do I know?), but did my best to answer this time. I think you will enjoy the letter. (By the way, he does a lot of interesting interviews, which he posts for free on his web site at www.wallstcheatsheet.com .) But first, a quick commercial. Are you reconsidering your investing strategies for the year ahead? I am pleased to invite you to join me, together with my US investment partner, Jon Sundt, President and CEO of Altegris Investments, for a special live webinar on Thursday, December 17th, at 11:00 am Dallas time (that's 9:00 am on the West Coast and 12:00 noon on the East Coast). In this special webinar, we will discuss the forces that are shaping today's economy and their influence on financial markets, as well as the potential impact on your investing decisions. This is an excellent opportunity to learn about alternative investment strategies designed to provide noncorrelated diversification for your portfolio, as Jon and his team are experts on alternatives. We'll set aside time to answer your questions. Due to regulatory issues, this event is limited to US investors who qualify as "accredited investors" (generally, net worth of $1.5 million or more). It's easy to sign up; just allow yourself a few minutes to complete the steps. First, register online on my Accredited Investor website. From there, if you are a US investor, you'll be directed to register for the webinar.

I admit that of late my writings have had a rather dark tone. There are certainly a number of severe long-term problems that we must deal with, and they're going to serve up a lot of economic pain. But the Thanksgiving weekend with the kids has me in a reflective mood, and one that has only served to underscore my long-term optimism. This week we look at why 2007 will not be the good old days we will yearn for in 20 years, after we briefly visit Dubai and the latest unemployment numbers. While we in the US spent our Thursday eating turkey and watching football, the rest of the world's markets went into a downward spiral as Dubai announced it wanted its lenders to give the country a six-month moratorium on some $80-90 billion in debt. This has the potential to be the largest sovereign debt default since Argentina. Somehow this was a shocking development. (How can too much debt and real estate be a problem?) And by markets I mean gold, commodities, oil, stocks, and risk assets everywhere. They all went down. Today the US markets experienced their own sell-off, though not as deeply as the rest of the world. As I wrote last Friday, the world is now negatively correlated with the dollar, and as money went into the dollar and US treasuries, everything else went down. Vietnam devalues, Greece is looking increasingly risky, Russia wants to devalue some more, the world is still deleveraging, etc. Is this another repeat of 1998, when Russia and the Asian debt crisis tanked the markets? To get an answer, let's look at some facts about Dubai. It is one of the Arab Emirates; but unlike its neighbor Abu Dhabi, oil is only about 6% of the economy. While the foundations of the country were built with oil, the country has diversified into finance, real estate, tourism, trading, and manufacturing. It is a small country, with a little under 1.5 million residents, but with less than 20% being natural citizens - the rest are expatriates. The gross domestic product is around US $50 billion. (Note: http://www.ameinfo.com/67802.html and then converting the currency. I found the numbers on various websites and services strangely at wide discrepancies. This seems close to a median number. I think the discrepancy is mostly people confusing the GDP for the United Arab Emirates as a whole, which includes Abu Dhabi, rather than just Dubai.)

From ghoulies and ghosties And long-leggedy beasties And things that go bump in the night, Good Lord, deliver us! --Old Scottish Prayer Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy. For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background. Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

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. 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%.