Thoughts from the Frontline

This week we look at the US mortgage market to see what fallout there is from the subprime mortgage woes. It is both less of a problem and/or more of a problem, depending on your perspective, as I predicted it would be last year. Score one for your analyst, which said score is needed as the stock market continues to rise in spite of my concerns in the face of a slowing economy. This will be part of a speech I give next Thursday in Edinburgh, Scotland at the Credit Development Academy. While it will print out long, there are a large number of charts and graphs, so it is not as long as it appears. We also look at the recent move by China to enter the private equity world, and show that this is just the tip of the iceberg, while pondering how to interpret the recent housing data. There should be something of interest for everyone.

Summer driving season is almost upon us. I remember more than a few long road trips with young kids, who would eventually get bored and tired and lulled into sleep, and with a stop for gas would wake up and ask, "Are we there yet?" or "Where are we?" They would be impatient to get "there" (ok, so was Dad), and the journey was something to be endured rather than enjoyed for its own sake. Today, traveling with the older kids (6 of them 18-30, with just one still at 13) is a lot different, as we look forward to the time together, with great conversation and lots of laughs. I bring that up as a way to introduce this week's letter. I have been suggesting since last fall that the potential for a recession/serious slowdown was quite high, brought on primarily by weakness in the housing market. Today we look at why I still hold that view, as the data shows a slow leak of the housing bubble and consumer spending starting to slow as inflation eats into buying power, even though some data shows that some parts of the economy are still strong. Unlike Bernanke, who this week said that the problems in the subprime markets will not spill over into the economy, I expect the subprime mortgage predicament to infect the whole housing market and create a drag on the whole economy. Depending on what you want to hear, you can decide that this week's inflation data was positive or a problem, that housing is rebounding or going further into recession, and that consumer spending is starting to rise or fall. Bulls see it one way and bears another. Clearly, from a stock market point of view, there is nothing to be worried about. What slowdown? Recession? I spit on your recession! Like a kid in the middle of a long road trip, it is hard to be patient. There has never been a recession without an accompanying serious bear market. It is tough to be sanguine about the near-term prospects for the stock market if you see a recession in the future. Stock market investors clearly must believe either that there will not be a recession or that for the first time the market will continue to rise. Waiting for that correction brings back memories of the impatient question "Are we there yet?"

"What we call here a Black Swan (and capitalize it) is an event with the following three attributes. "First, it is an outlier , as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." - Nicholas Nassim Taleb In Taleb's world, Black Swans are not just events like 9/11 or the crash of '87. They can be positive events like the introduction of a new technology which changes everything. It is now easy to see the affect of the Internet, but not many saw it in 1987, and those who did were few and considered kind of strange. The steam engine changed a world, slowly at first, but it was a major Black Swan. This week we look at what I think will be another Black Swan with the potential to be one of the most disruptive introductions of technology in the last 20 years. In one sense, it is entirely predictable. On the other hand, it will fundamentally alter the economic equations of the telecommunications world, as well as spawn whole new enterprises and enable radical new ancillary technologies.

Clowns to the left of me, Jokers to the right, here I am Stuck in the middle with you! - Stealers Wheel, 1974 The recent data on the economy is stronger than was expected. Does this mean that the slowdown we have seen for the past few quarters is behind us? Other data suggests the economy is weakening (witness the very slow 1.3% GDP growth last quarter). This week we look at the seeming disconnect in the data, briefly examine where the real stock market booms are happening, and re-visit the housing markets. It's a lot for what will be a quick letter (and lots of charts), as I am trying to leave town, so let's jump right in. (And yes, I was supposed to finish a letter I started two weeks ago on black swans, but a technicality is holding up that letter. It will be resolved next week.)

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

This week I am in La Jolla for my annual Strategic Investment Conference, co-hosted by my partners Altegris Investments. This week's letter is the basis for the speech I will be giving Saturday afternoon on a few of the items in my long-term worry closet. It will come as no surprise to this audience that there are a few things that worry me. I often write about problems in the markets. Subprime mortgage contagion, earnings shortfalls, a slowdown in consumer spending are all on my worry list. But I am not just your average amateur worrier. I am a professional worrier. I get paid to worry. For a professional, worrying is an art form. The amateur worrier spends way too much time worrying about events that are likely to happen. A true professional worries about the unlikely events that create the most problems. It is the things we are not worried about which can cause us the most harm.

This weekend I am in La Jolla at good friend Rob Arnott's conference. Princeton Professor Burton Malkiel, of Random Walk fame, will be one of the luminaries at the annual Research Affiliates Advisory Panel. So, with that thought in mind, this week we take a seemingly random walk through the data to see if we can discern a trend. How much debt does it take to grow GDP? You probably missed it, but the Bureau of Labor Statistics gives us data that contradicts the recent labor numbers. Why is consumer sentiment so moribund? And that recession I predicted for 2007? I have a few thoughts on that as well. It should make for an interesting letter with a lot of great charts and graphs. But first, let's deal with something far more serious than the economy, and that is the terrible situation in Darfur, where government sanctioned violence and murder is literally meaning that hundreds of thousands are starving to death. The conflict in Darfur, a region of Sudan located in the north eastern part of Africa, has been rising for the past 3 years. It is estimated that 450,000 civilians, (men, women and children) have been killed and approximately 2 million people who fled the fighting are now displaced, homeless, starving, and still being persecuted. Many are living in refugee camps but as the violence escalates and the camps are being attacked, aid workers are being evacuated leaving the people of Darfur with no where to go.... and NO hope of survival.

This week we look at something which has far more potential to hurt the economy than subprime loans - the US Congress. We muse on inflation data and why the economy may do better than I think. But first, and quickly, my young assistant Micah Davis is leaving soon to go full time in an entrepreneurial venture (and I wish him the best), which means I will be in need of an assistant. The duties are varied. You get to be the one to read my emails from readers first (and we get a lot, which I do try and read as many as possible), help me with formatting various letters, research and some writing (writing skills are very helpful). Micah has been working a little more than half a day recently as he has been starting his new enterprise, but there are other things that could be added to the list of duties depending on the talent of the person. This is not an analyst position, although we do some. This could be a person just graduating from college. If you know of someone, have them drop me a resume.

At the risk of being all subprime, all the time, this week we look at what I think are the real risks for the economy as a result of the subprime debacle. How can one side say it is a contained risk (and in one sense it is) and not a problem for the economy while another side says it will drag the US into a recession and thus be a drag on the world economy? The answers will give us a handle on the whole issue, as we look at how the problem developed. But first, let me correct an error. Last Monday in my Outside the Box, we used a brilliant piece of work from Dr. Woody Brock on why we need more derivatives and that the real problem in the derivatives market is not the size of the market. If you did not read it, you should. You can read it at www.2000wave.com/otb.asp?otbid=490. I forgot to mention Woody's website, which is www.SEDinc.com. There is a lot of useful thinking there as sample material. I serve on an advisory board for an investment firm in Europe with Woody and have gotten to know his work through them. His research is some of the more cutting-edge and thoughtful that I read, and I encourage my institutional and larger-firm readers to look at his work. I think you will be glad you did. Woody will be just one of the speakers at my Strategic Investment Conference in La Jolla next month (April 19-21), and he is as entertaining as he is insightful. I am also very excited to announce that Paul McCulley of Pimco fame has said he can attend. Paul is simply one of the best speakers on the economy anywhere. That gives us what I think is one of the strongest line-ups of speakers at any conference in the country this year.

This week we look at the yen carry trade, delve deeper into the mortgage lending world, and see if we can find a possible connection between them and the economy in general through something called complexity theory. As I have written for many months, I think the subprime mortgage problems are going to be the catalyst for a recession. We look at some ways that the contagion in this small part of the housing market could spread. Bubbles have consequences far beyond their causes when they burst. That is because they encourage irrational behavior and expectations not just in the asset that is rising in price, but in surrounding areas. As an example, remember the internet bubble? There were 350 internet stocks at the end of 1999, comprising a mere 6% of the market cap of total US equities. But the NASDAQ dropped by over 70%. The damage was not confined to just internet stocks. The massive build-out by the internet and telecom companies produced monster sales at technology suppliers all up and down the food chain. The rise in tech stock values created a mindset that infected all stocks, giving us the highest P/E ratios in history. It was a new era, we were told. And the internet in fact has ushered in a new era in the way many of us work and live. But that new era has to live in real-world valuations.

This week we look at the possible latest entry into the hedge fund world, The People's Republic of China; review the cockroach principle of subprime mortgages; and investigate the possibility of whether we need more derivatives and not less than the $283 trillion or so we now have. It's a lot to cover, but it should all be interesting. But before we get into the meat of the letter, I want to announce a brand new web site. For the last six months, we have been in the process of creating a Chinese language web site of Frontline Thoughts. I have wanted to do this for years, and we are finally ready to go public. If you would like to read this weekly letter in Chinese, you can go to www.frontlinethoughts.cn. You will be prompted to click on English or Chinese and then enter your email address. You must have cookies enabled. We will then send you the weekly letter in Chinese, just like we do the English version. The translation in Chinese will have the English version appended to the end of the letter. Of course, it takes my translator a few days, so typically you will get it on Monday rather than Saturday morning.

This week we look at the recent upspike in volatility, see if we can connect some dots with the recent slew of earnings downgrades and the problems in the subprime mortgage world, and follow the money as risk is being taken off the table. I don't "buy" the China problem, but there may be an Asian connection. Let's try and keep it simple as we try and see what's behind curtain #3 labeled "Which direction is the stock market headed?" But first, if you have not signed up for my Strategic Investment Conference in La Jolla, California, April 19-21, this week's market action is a perfect reason why you should. Want to get the real lowdown on China? Come listen to one of the premier Asian investment experts, Louis-Vincent Gave, give us his on-the-ground view of Asia. Dr. Woody Brock, a regular at Davos (with a bio that is MOST impressive - I sit on a fund advisory board with him and I am excited about him coming to the conference, as those who attend will be!) will explain derivatives and a whole lot more. Dennis Gartman will give us the view inside the head of a trader. And then there's Richard Russell's take on the markets, Rob Arnott (one of the smartest investment minds in the world, in my opinion), as well as Dr. Mike Roizen (You, The Owner's Manual ) telling us all how to live longer. And your humble analyst will add his two cents. Right now, I am working on research and a new presentation on risk. Because of regulations, the conference is sadly limited to those with $2,000,000 in investable assets. The conference is by invitation only, and we are required to verify each attendee's financial situation and suitability prior to their coming to the conference. I wish it were different, but we are very serious about playing by the rules. There will be a select number of hedge funds and commodity funds making presentations and available for questions throughout the conference, so you will have an unprecedented chance to learn about what the press calls the "secretive" world of hedge funds.