Thoughts from the Frontline

Yet another crisis confronts us, as we will have to deal with the aftermath of a rather large number of bank failures over the next year, which is likely to overwhelm the ability of the FDIC to insure your bank deposits. Today we look at the banking system, the FDIC, and Freddie and Fannie. It's not pretty, but as realists we must know what we are facing. But first, I just want to say I am glad that Richard Russell is doing fine. For those who do not know, he suffered a mild stroke last Friday. I talked to him yesterday, and he was a little tired but doing better. He has decided to cut back his writing schedule and relax a bit more, which is a good thing. At 84, he has written a daily (and sometimes lengthy) commentary and has been writing the monthly Dow Theory Letter since 1958. He is the dean of newsletter writers. He has forgotten more than most of us will ever know about the markets. His doctor told him he needed to seek some balance in his life and cut down on the stress. I know how much it takes to write my one letter each week; I can't imagine what it takes to write five. Basically, his plan is now to post his stats and only write about the markets when something important is happening, about every two weeks. I hope he sticks with that plan, as I want to be sharing dinner and drinks with him for many years to come. I am sure you join me in wishing him and his lovely wife Faye all the best and a healthy and quick recovery.

The old mantra was that if the United States sneezed, the rest of the world would catch a cold, as the US was seen as the main driver of world growth. That was then. Economists and analysts began to argue that China and the developing markets were starting to provide a consumer base for the world. And Europe's new and growing markets would be able to stave off problems from abroad and stay on their own growth path. The world, we were assured last year, would not suffer from problems in the US economy. Today, we look at evidence that this might not quite be the case. And if it is not, those who look for diversification in global markets may be disappointed. Also, I quickly look back at my January forecasts and feel it may be time for a mid-course correction. It seems I may have been a little too optimistic. It should make for an interesting letter. But first, a quick commercial. I spent two days at the Caves Valley Golf Club outside of Baltimore with good friend and business partner Steve Blumenthal, the president of CGM. He has developed a platform of money managers who can take direct accounts, and I recommend that readers interested in outside money management take a look at them. Normally, to take a look at the managers, we have you sign up to get a "pass" to take a peek behind the curtain. We decided we would change that policy, at least for this week. If you would like to look at a manager I think quite highly of, you can click on this link to see a few details about him. http://www.cmgfunds.net/sys/docs/118/ARS%20Scotia_new.pdf (Remember, past performance is not indicative of future results.) If you would like to talk with Steve or his team about this manager or the others that are on the platform, simply click on the following link, fill out the form, and they will call you. http://www.cmgfunds.net/public/mauldin_questionnaire.asp

Last week's letter was the first part of a speech I have been giving on what I think will be the rise of a new asset class. This week will be the second and final part. Let me set up this section with a few paragraphs from last week's letter and then a quick summary. If you want to read the entire letter from last week, you can go to the website archives. But first, a quick note. George Friedman from Stratfor was at my daughter's wedding rehearsal dinner last night. He had just found out about the invasion of South Ossetia by Georgia and was keeping track of the events over his Blackberry from his correspondents on the ground in Georgia. The media is not particularly excited over the events in Ossetia and Georgia, and the markets seem indifferent. It's much more important than it looks. This the first time since the fall of Communism that the Russians have directly and openly intervened in the former Soviet Union under the claim, made by Dmitri Medvedev, that Russia is the guarantor of security in the Caucasus. That's what the Russian Prime Minister Putin also said. Russia has claimed a sphere of influence in the Caucasus. And that is of historical importance. (Think Monroe Doctrine.) This is payback for Kosovo. Putin didn't want an independent Kosovo and was ignored with contempt. Payback is an independent Ossetia, with Russian military intervention guaranteeing it. If it's good enough for the Americans and Europeans, it's good for the Russians too. Why the Georgians invaded Ossettia is opaque. For some reason they felt they had to move. The Russians were clearly ready and by dawn had armored formations in South Ossettia and air strikes in Georgia. (The Russian army is about 40 times the size of Georgia, and far better equipped.)

This week I am in Maine on vacation with my son, and next week is my daughter Tiffani's wedding, so for the next two weeks I am going to send an updated version of a speech I have been giving the past few months on what I think is the likely potential for the rise of a brand new asset class. It is too long to be sent as one letter, so we will start with the first part today and finish with the second part next week. This first part can be read as a standalone letter. I think we're at a watershed moment, what Peter Bernstein defines as an "epochal event," with the very order of the investment world changing as it did in 1929, in '50, in 1981, where a number of things came together - it wasn't just one thing but a number of events happening that conspired to change the nature of what worked in the investment world for the next period of time. It took most people a decade after 1981-2 to recognize that we were in a different period, because we make our future expectations out of past experience. It's very hard for us to recognize a watershed moment in the process. We're going to look back in five or ten years and go, "Wow, things changed." As we will see, it's going to be a change that's going to cost people in their portfolios and in their retirement habits. We're going to look at a number of different concepts and separate ideas that in and of themselves don't make that much difference. But I think their confluence in the present moment is going to change things. Now, some of this is new, some of it is old. The old stuff we're going to fly through. Most of you have been reading me for a while now, and you've got the concepts down. So let's start.

"The stock market is a voting machine in the short run and a weighing machine in the long run." - Benjamin Graham The voting part of the equation is tempered by fear and greed. It is largely emotional, although investors like to think of themselves as rational players. That emotion is driven by views of the future. If you can be confident of large and growing returns, you are less likely to be swayed by the erratic movements of a stock. But as confidence wanes? Well, that is the stuff that bear markets are made of. Because at the end of the day, what the market weighs is earnings and the ability of a company to reliably produce them. This week we look at what earnings are likely to be over the next year and see if we can discern what that suggests for the markets. We also take a look at the energy markets, the possibility of a further drop in the price of oil, and muse on what a sane energy policy for the world would look like. There is a lot to cover, but it should make for an interesting letter.

Housing starts rose 9% and the market cheerleaders proclaimed that we have seen a bottom. But not if you look at the actual numbers. New unemployment claims were OK, but not if you look at the actual numbers. And inflation was simply ugly, no matter what numbers you look at. However, oil is down and there is reason to think it may have further to go on the downside. We cover all this and more, as we first look at why the world is not going to end. It is easy to find bad news these days, and the torrent that seems to keep coming can ruin a person's summer (or winter, for my southern hemisphere readers). The credit crisis, as noted last week, is nowhere near an end. Housing, as we will see, is actually getting worse. Foreclosures, auctions, government bailouts, higher taxes, inflation, the price of energy and food - the list goes on and on. I thought, since so many think of me as a rather bearish person, I would show you my more optimistic side. Yes, I am bearish in the short term, for reasons I have documented at length in this letter. But long-term I am a wild-eyed optimist.

It seems that with each passing month the estimates for losses in the international banking system keep rising. This time last summer the largest estimates (from credible sources), if memory serves me correct, were around $400 billion, give or take a few months. By the end of the year it was in the neighborhood of twice that. Then last quarter we saw estimates approaching $1 trillion. Last week, the number being broached was $1.6 trillion, by Bridgewater Associates, one of the top, and more credible, analytical firms in the world. In this week's letter we look at the implications of that projection, analyze recent lending patterns by banks, briefly touch on the implications of the recent unemployment numbers, and end with a few comments on the bear market. It will make for an interesting letter. Warning: remove sharp objects from your vicinity before reading. But first, I need your help, and in return I would like to give you a link to a recent speech I gave, where I speak about what I think is the development of an important new asset class, one which will come about precisely because of the problems I am writing abut today. I have not yet written about this topic in public, and the speech has been well-received. I think you will like it. Now, as to how you can help me ... I get to travel a lot with my daughter and business partner Tiffani (actually she runs the business) and meet new people. Over the years, she has become as fascinated as I have with their individual stories. Everyone has a story to tell or a lesson to teach. We have decided to write a book about those stories, looking at the differences in perspective between old and young, retired and working, those who are wealthy and those who aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money, in how you look at the future, and a score of other items? How do all of these things correlate?

"We appear to be entering a period of serious stagflation with sharply rising expected and actual inflation combined with large downside risks to growth and employment." "I would argue that what we are seeing is an acceleration of expected consumer price inflation in the context of a sharp expansion in global liquidity. It is hardly surprising that the prices of those commodities, such as oil, for which the short-run price elasticities of supply and demand are low move upwards strongly when there is a rise in expected general inflation. The oil market is a very convenient vehicle to speculate on expectations of higher levels of general price inflation. Hence my view is that the 40% jump in oil prices that has occurred over the past few months - roughly the period during which financial conditions have been loosened sharply - is a reflection of the expectation of either an acceleration of global inflation, or a depreciation of the US dollar, or some combination of the two." - Malcolm D Knight, General Manager, Bank for International Settlements It was only five years ago that the central bankers of the world, and especially the Fed, was worried about deflation. Ben Bernanke was introduced to the world at large with his famous helicopter speech about how the Fed could deal with a deflationary environment. Who would have thought that what passed as humor to a group of economists would be taken so seriously by the rest of the world? Today the worry on the mind of investors and central bankers is inflation. It is causing havoc with the markets. In this week's letter, we look at whether we should be worried about inflation, take a mid-year check on the economy, muse on the malaise in the stock market and offer a very contrarian possibility for a positive shock to the world. It should make for a thought-provoking letter.

The Sage of Omaha made a bet that was written up in a recent Fortune magazine article. Basically, Warren Buffett bet that the S&P 500 would outperform a group of funds of hedge funds over the next ten years. A million dollars to someone's favorite charity is on the line. This week we will analyze the bet, using it as a springboard to learn about valuation and value investing. As we will see, there are times that making a bet on the S&P 500 to outperform hedge funds (or bonds or real estate or whatever asset class) makes sense and times when it doesn't. But first, an apology is in order. I get to travel a lot with my daughter and business partner Tiffani (actually, she runs the business) and meet new people. Over the years, she has become as fascinated as I have with their individual stories. Everyone has a story to be told or a lesson to teach. We have decided to write a book about those stories, looking at the differences in perspective between old and young, retired and working, those who are wealthy and those who aspire to wealth. What are the differences in attitudes, in work habits, in how you manage money, in how you look at the future, and a score of other items? How do all of these things correlate? We sent an email to some of you a few days ago, asking you to fill out a survey to help us gather data, with the intention of sending it to everyone over time. After you complete this survey, I offer an audio stream of a speech I recently made.

President Nixon instated price controls on the 15th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled "Whip Inflation Now" (WIN). He famously urged Americans to wear "WIN" buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone's top ten list of such silly gestures. Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for "No Immediate Miracles." They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983. This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the '70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that "core" inflation is what should be paid heed to, and urge caution. This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, "What will Ben do?" It should make for an interesting letter.

I remember in the summer of 2006 I would face my blank computer screen on a Friday and wonder, what I could write about? The media was all Goldilocks, all the time. Today, there is such a target-rich environment. I could probably write three letters a week, there is so much happening that is worthy of our attention. The problem today is trying to decide what not to write about, which means I get emails from readers wondering why I don't mention their areas of particular interest. But at eight pages, I just have to stop. You need a break! Today, we have to look at the unemployment numbers, and the connection between the credit crisis and the rise in oil of about $16 dollars a barrel in just two days! If there is still room, the dollar is certainly being pushed and pulled by central bankers, who are also worried about inflation. And I doubt we will have room to cover what is a very important rise in inflation in Asia. It is all connected. (And you HAVE to look at the picture of my daughter and associate Tiffani at the end of the letter. Too much fun!) But first, a quick note. I will be in Las Vegas July 10-12 for the annual Freedom Fest Conference, where I will speak several times, and the line-up of speakers is as strong as for any conference I have ever been to: Denish D'Souza will debate Christopher Hitchens; and Steve Forbes, Ron Paul, Stephen Moore (Wall Street Journal), Charles Murray, George Gilder, John Goodman, and about 100 other speakers, each impressive in their own right, will be there, as will 1,500 freedom-loving attendees. You can go to http://www.freedomfest.com/promo.htm and click on the list of speakers to register. Mark Skousen is the driving force behind the conference, and he does it right. I hope to see you there.

Last week I wrote that we could see a drop in the price of oil as speculators seemed to be storing oil in very large tankers and "slow steaming" them to port in a bet that prices would rise. When everyone is on the same side of the trade, the time is right for a reversal. This is especially true when there is a large potential supply sitting on the sidelines. This week we briefly look at this prediction, and perhaps even more ominous problems for commodities in general, at least in the short run. The new turn our attention to the euro. It will make for an interesting letter. First off, oil dropped about 4% yesterday and is down almost $10 from its high only a week ago. Yet supplies of crude oil surprisingly dropped by 8.8 million barrels yesterday. Oil shot up on the news as both those who were short covered their bets and even more people piled into the long side of the trade.