Thoughts from the Frontline

Investors are constantly seeking "alpha," that elusive substance which yields returns in excess of a simple market portfolio. While I am flying today to Prague, this week good friend Rob Arnott teams up with associate John West to show that it is just as important to eliminate negative alpha. In fact, you could find an extra 2-4% in your returns just by doing so! Rob starts with showing us what type of returns one can expect over the next ten years from the typical US market fund, and then shows how to remove some of the drags of negative alpha which hurt those returns. This is a very important piece and one I think you will want to read more than once. Rob is the founder and head of Research Affiliates. He has published scores of articles in various financial journals, won four Graham and Dodd Scrolls for his writing, travels and is the keynote speaker at too many conferences to mention and is recognized as one of the top financial minds in the world. He wrote a chapter in my book, Just One Thing .

End of the World or Muddle Through? This week I try to explain in simple terms the very complicated story of how we went from some bad mortgage loan practices in the US to the point of world credit markets freezing up. There is a connection between the retirement plans of Mr. and Mrs. Watanabe in Japan and the subprime problems of Mr. and Mrs. Smith in California. We find the relationship between European banks and problematic hedge funds. And finally, we try and see how we get out of this mess. Oddly, I think it is hedge funds (and maybe Warren Buffett) to the rescue, but not in the way you would think. It is a lot to cover, so let's jump right in. (And there are a lot of charts, so while this will print out long, it is only a little longer than the usual in word length.) But first, since this letter is likely to be forwarded a lot, if you get this and would like your own free weekly subscription, you can go to www.2000wave.com and simply put in your email address. You can be one of my 1,000,000 closest friends who get this letter for free. We will send my Thoughts from the Frontline to you each Saturday morning, along with my Outside the Box , which features the writing of other analysts and comes out on Tuesday. To say the credit markets are frozen is an understatement. Talking to any number of people who have been in the markets for decades, this is the worst in their memory. Ironically, it is the 100-year anniversary of the Panic of 1907, when one banker (J. P. Morgan) stepped in and provided liquidity to the markets. The central banks of the world are providing liquidity; but as we will see, it is not mere liquidity that is needed.

In the early fall of 1998, I remember being on a flight to Bermuda from New York. I was upgraded and sat next to a very distinguished looking gentleman. He was going to a conference about re-insurance and I was going to speak at a large hedge fund conference. We hit it off, and began a very interesting conversation, one that still burns in my mind today. It turns out that he was vice-chairman of one of the largest insurance firms in the world, and was a real financial insider, seemingly knowing every big name on Wall Street personally. After he had a few drinks (he was clearly somewhat stressed), he began to talk about the Long Term Capital Management fund and the problems in the markets. He had had a ring side seat at the Fed-sponsored bailout proceedings. "We came to the edge of the abyss in the financial markets this week,' he told me, "and then we looked over. The world does not understand how close we came to a total meltdown of the markets." This week we look at the similarities and the differences between the credit crisis that is going on today and what happened in 1998, take a quick look at the threat from China to the dollar and see what exotic fish and exotic bonds have in common. There is a lot of ground to cover, so let's jump right in.

With the economy increasingly looking like it will slow down materially in the last half of the year, there is a drum beat for the Federal Reserve to cut rates. But how likely is a rate cut this year? We take a very different look at inflation to see if there is any room for the Fed to give a boost to the economy. We look over our shoulder at Japan and the yen carry trade and ask a heretical question: does the Fed cutting rates make any difference? Last Monday, I used an excellent piece by friend and money manager John Hussman for my Outside the Box. Buried at the end in the piece was a throwaway line that really intrigued me and spurred some research: "If you look carefully at the CPI figures (and tinker with the monthly numbers), you'll also discover that even if the figures average a 2% annual rate in the months ahead, the year-over-year headline CPI inflation rate will be pushing 4% by November. This is already 'baked in the cake.' Since Bernanke is clearly concerned with the inflation expectations of the public, as well as the Fed's credibility, that headline CPI figure may create some complications for cutting rates in the months ahead, unless resource utilization falls out of bed."

As predicted in this letter early this year, the credit markets have finally begun to tighten, as a major re-pricing of risk is underway as a direct result of the subprime markets. The subprime virus seems to be spreading, despite the view a few weeks ago that there would be no "contagion" in the rest of the credit markets. This week we look at the re-pricing of debt and take a rather positive view and explain how a bottom in the credit market is reached. As ugly as it looks on Friday afternoon, it's not all that bad yet. What credit derivatives have taken away, credit derivatives may in fact give back. We look at market volatility, rising interest rates (yes, you read that right), the yen carry trade and more. And I show my penchant for foolishness by making a mid-year forecast on the markets. I also offer you a chance to make your predictions against the pros. All in all, it is a lot of ground to cover, so let's jump in. But first, a quick comment about the recent drop in the stock market. 520 points on the Dow sounds like a lot. It certainly gets a lot of breathless attention on CNBC. But good friend and South African partner Dr. Prieur du Plessis writes in his latest blog that the recent volatility is not all that special. Thursday saw a drop of 311 points. He writes:

This week I am already in Maine and getting ready for a weekend of fishing with my son Trey, so I am going to take off a week from writing the letter. I spoke this morning to the Maine chapter of the Chartered Financial Analysts in Portland. The question of the day was about the subprime markets, private equity and the debt markets in general. And these are the right questions, as this is the part of our economic world with the most risk. And that gives me a chance to send you the following letter written by Michael Lewitt of Harch Capital Management. Michael works in the fixed income world and has a bird's eye view of the turmoil that is going on in the world of bonds due to the subprime meltdown and the related problems that may be spilling over into the rest of the market. "In a capitalist economy capital assets are only incidentally desired because of their technical productivity; demand for capital assets is determined by their expected profitability. In an economy in which the debt financing of positions in capital and financial assets is possible, there is an irreducible speculative element, for the extent of debt-financing of positions and the instruments used in such financing reflect the willingness of businessmen and bankers to speculate on future cash flows and financial market conditions." Hyman Minsky

Is the economy slowing down or is it getting ready to go on a new tear? Judging by the run-up in the Dow, the answer is a major turnaround for the economy in the last half of the year, from the close-to-recession numbers of the first quarter. So, what has happened to my forecast of a slowdown or minor recession? This week we look at some hidden problems in the employment data, analyze retail sales and consumer spending, and speculate about the last half of the year. And we also look at how the dollar is doing, inflation, foreign reserves, and more. And you have got to hear the story about a US government official going to Beijing asking them to buy US mortgages. Seriously. You can't make this stuff up. There is a lot of interesting ground to cover, so let's jump in First, let's look at the good news. Given the increase in inventories, the rise of all the manufacturing surveys, and a smaller trade deficit, most economists think that GDP for this second quarter will be in the 3% range. Given that first-quarter growth was an anemic 0.6%, this will give us an average for the first half of less than 2%, which is more or less the return of Muddle Through I predicted at the beginning of the year. Most of the growth was technical in nature, coming from a drop in the trade deficit and a significant rise in inventories. As we will note below, retail sales are not all that strong, which may help partially explain the rise in inventories. The average Blue Chip economist is pegging the US economy to grow in a very robust 3% range for the last half of the year. Manufacturing surveys suggest that the economy is quite strong and are in the territory normally associated with 3% growth. Employment numbers came in surprisingly robust this week, and Wal-Mart had better sales than expected, even if they were weak. So, the market decided to party like its 1999.

This week we continue to look at an alphabet soup of problems: RMBSs, CDOs, Alt-A, BBB and - a new acronym to put on your radar screen - the very useful CDS. When does an AAA rating not mean an offering is ready for prime time? What type of contagion are we seeing from the Bear Stearns blow-up? I survey my friends in the hedge funds space, trying to find some evidence of cracks in the foundation, and let you know what I hear. We will again look at a wide variety of items and see if we can discern some connections. I was writing last year that the subprime investment market would end in tears, as loans were being securitized as investment-grade that clearly were going to have problems. We are now witnessing the beginning of those travails, and the lawyers are gathering. Let's review what I wrote in early January: "We live in a world where there is an increased appetite for yield by investors at all levels; and armed with growing liquidity, they chase those yields down to a point where traditional risk-reward measures would suggest the potential for problems.

Is the subprime mortgage market collapsing before our eyes, or did we avoid a disaster as Bear Stearns stepped up to the plate with $3.2 billion to help its ailing funds? As we will see from the data, the problems in the subprime world are not over. The Fat Lady has not sung. But will the problems in this market contaminate the rest of the liquidity-driven markets? Is the party over? Not according to the high-yield markets. In this week's letter, we look at what could be the real problem in the next half of the year. But before we touch on the credit world, I want to briefly look at a development in the oil markets which I find intriguing. Dr. Woody Brock, in a recent paper on oil prices, wrote a rather interesting sentence, to wit, that Iran would not have net oil to export in 2014. I found that rather remarkable. Woody is very serious and sober-minded even for an economist, not given to rash analysis, but this was certainly a new idea to me. I knew they were importing most of their gasoline, as they do not have a great deal of refining capacity. As it turns out, there is much more to the story. I have said for years that I expect Iran to be the new friend of the US sometime next decade, as the regime is not popular and the country is growing younger. (Think China, once an implacable enemy.) I thought that the impetus would be the lack of freedom and knowledge of how the world is better off coming from the internet, but it turns out that it may be a desire for more freedom combined with economic problems which help bring about regime change, much as in Russia last century.

This week we look at length at an outstanding new book just hitting the bookstores by good friend Paul McCulley (of Pimco fame), called Your Financial Edge . The main themes will give me an opportunity to weave in a few thoughts about some recent data, and a lengthy telephone interview with Paul, done just before writing this week's letter, will bring us up to date on his current thinking. I think readers will take away a few good ideas, so let's jump right in. Paul McCulley is someone we should listen to. He not only runs a rather large portfolio at PIMCO, his calls on the Fed are critical. In just one day, a correct prediction by McCulley that the Fed will unexpectedly raise or lower its Fed funds rate by a quarter of a percentage point can mean a $3-5 billion jump in the value of the $670 billion worth of mutual funds and private client funds managed by PIMCO. He writes a monthly column that I consider a must read, and his writing has been a feature in Outside the Box more than that of any other analyst. He is simply one of the best financial minds in the country. When he talks, you should listen. Your Financial Edge was co-written with Jonathon Fuerbringer, a reporter for 24 years with the New York Times , who brings a very clear, crisp, and fast-paced style to the book; but long-time fans and readers of Paul recognize the source for the driving themes of the book. The book is subtitled "How to Take the Curves in Shifting Financial Markets and Keep Your Portfolio on Track" and is a marvel in how it simplifies the problems facing investors in the coming years, giving us a framework for both understanding and dealing with them. This book should be read by both investors just starting out and seasoned pros, and both will come away with a lot of new ideas and understanding of how the market works. I really can't recommend this book highly enough, and if you read it you will see why I think it deserves at least a full letter on its own.

Be careful for what you wish, because you may get it, and sometimes as H. L. Mencken wrote, you get it good and hard. The collective brain deficit trust, otherwise known as the US Congress, wish for the Chinese to revalue their currency upwards. Today we look at why they may indeed get their wish and why it is not going to produce their desired results. We look at a possible connection between China and the recent and odd volatility in interest rates, connect the dots on inflation and the US economy. How do you explain higher interest rates on government bonds and a slowing economy, but a relentless march to Dow 14,000? It is a lot to cover, so let's jump right in. Last year, Senators Charles Schumer (D-NY) and Lindsey Graham (R- SC) introduced a bill which would put a 27.5% tariff on Chinese imports. There was not much chance of the bill passing, and given that such a tariff was illegal under World Trade Organization rules, it was clear the Senators were pandering to their various local constituencies. Not that they are not serious about punishing China for have the audacity to sell us cheap goods, while taking our dollars and investing them into US government debt, but their bill was mostly for show.

Are we on a slippery slope of a recession, or was last quarter's weak GDP a turning point? This week's travel shortened e-letter looks at recent data and re-visits some thoughts on consumer spending from friend Joe Ellis' superb book called Ahead of the Curve. This week I wrote from a rainy Edinburgh, Scotland, although this afternoon was pleasant enough, allowing me to walk around some. But on to important matters. Yesterday we learned that GDP for the first quarter was revised down from 1.3% to 0.6%. By anybody's definition that is an economic slowdown. The question is then begged, "Was last quarter the bottom or the beginning of the slide?" You can make a good case that it was the bottom. A good part of the weakness was attributable to the lowering of inventories. Therefore, as inventories are re-built, then there should be a rebound. Further, today's new jobs number of 157,000 is a lot stronger than April's anemic (and revised downward) number of 80,000. And let's not forget that the ISM number came in at 55, which suggests manufacturing is beginning to rebound. If you are looking to be optimistic, there is sufficient data to maintain your beliefs.