Thoughts from the Frontline

What are the odds of a recession? According to a recent Fed study, they may be 51.9%. Close enough to 50-50 for government work. We analyze this study, look at a few graphs which show a major disconnect between the housing market and the US manufacturing and services sectors, and then close with some comments on yet another proposed rule change. But let's start with a few housekeeping items. The latter half of this letter will be written primarily to my colleagues in the financial services area, and to managers, entrepreneurs, and businesses who anticipate the need to raise capital in the future. There are some proposed rule changes at the NASD that will significantly limit the ability of a registered representative to communicate with clients about private offerings, ETFs, venture capital, DPPs, and other offerings. In some cases, it will effectively prohibit communication on the items. This is not just about hedge funds. I think these rule interpretations will have the unintended consequence of the potential to severely impact capital formation in this country. This is under the radar screen of 99% of my colleagues. Many of my US clients and prospects wonder why I do not write to them about my opinions on the hedge funds and private offerings that are offered to them. The simple fact is that the NASD asserts (if you ask, which I did) that even a simple letter, properly disclosing my income relationship with the offerings, would be considered a research report and therefore fall under the research analyst rules. In fact, any marketing material would is in effect considered research, and thus cannot be sent by a registered representative to clients. The NASD has not publicized this interpretation, but they are getting ready to assert it in proposed rule changes. If you are in the industry, I urge you to read the latter half of this letter and make your feelings known.

I have often written about the high probability of a recession following an inverted yield curve (where short-term rates are higher than long-term rates), based upon research which suggests the yield curve is our most reliable indicator of future recessions. I am often asked whether a yield curve causes a recession. The (very) short answer is no. But then what is the mechanism that makes it so reliable? Is it different this time? How can we believe that the economy has a few bumps in its future when things are just so darn good? We ponder these questions in today's letter, as well as peruse the "shocking" housing data released this morning, and look at a very interesting chart on gold. But first, let me call to your attention the official announcement of my 4th annual Strategic Investment Conference, co-sponsored by my friends at Altegris Investments. The conference will be April 19-21 in La Jolla, California. The line-up of speakers is quite impressive. Richard Russell, of course, will be there. It is one of his few live speaking engagements of the year, as he does not travel to speak. So we bring the mountain to Mohammed, so to speak. Dennis Gartman will regale us with his stories and wisdom. Dr. Woody Brock, one of the world's better economists and frequent speaker at Davos will be there. George Friedman of Stratfor (what a treat!) will give us his views on how the world will develop politically over the coming years, and hopefully give us a preview of his forthcoming book. Louis-Vincent Gave will kick things off. Rob Arnott will follow. And Dr. Mike Roizen (YOU: The Owner's Manual ) will give us the latest on how to stay healthy, live longer, and enjoy our lives. And your humble analyst, of course. In designing a conference, I put together a group of speakers that I want to hear and learn from. Many conferences have one or two headliners and then fill in the rest of the time. This conference has nothing but headliners. Every speech is a keynote. And there are plenty of chances to meet the speakers personally.

I start this week's letter somewhere over the Atlantic, halfway through an 11-hour flight from Frankfurt to Dallas. It has been an altogether marvelous 11 days in South Africa, speaking to over 1,000 people at 12 venues, giving a half dozen media interviews, and meeting with many individuals. It had been 12 or more years since I was last in South Africa. The difference cannot be more palpable. The last time I was there, talking with friends and acquaintances about the future of South Africa, the mood was so pessimistic that you had to remove sharp objects from the vicinity before you started the conversation. This week, I want to give you some impressions of not only South Africa, but talk a little about emerging markets in general. But first, a technical announcement. We have had some technical problems with my accredited investor website subscription form (www.accreditedinvestor.ws). If you have tried to sign up and are not sure it went through, I apologize and encourage you to sign up again. My last Accredited Letter went out in January and the next one will be in March. (See the end of the letter for more details about this letter.)

This week I am in South Africa. At the moment I am literally flying from Johannesburg to Durban in a single-engine Pilates PC 12, a very upscale Swiss-manufactured plane. I am told pilots will know and appreciate the plane. It is supposedly the safest plane in the world, which is somewhat comforting as we bounce through a few storm clouds (and thunderstorms later tonight of the way to Cape Town!). My business partners and hosts, Dr. Prieur du Plessis and Paul Stewart of Plexus Asset Management, have kept me busy, but it has been fun. This week's letter is the text of the keynote speech I gave last night at the Raging Bull awards in Johannesburg. There are a number of awards given to the various mutual funds (called here a unit trust or a collective investment scheme) that had the best performance in their respective categories over the last 3-5 years. The winning funds had some very impressive performance indeed. It was a black tie dinner with about 400 attendees. It was one of the more elegant events I have attended in my life. Before we get to the text of the speech, a few thoughts on my impressions of South Africa so far. It has been about 12 years since I have been here. My last visit I drove from Jo'burg to the administrative capital at Pretoria, a distance of about 30 miles. It was basically farm land between the cities.

I am in South Africa as this week's letter is being sent out; so it is with some irony that the letter is focused on a topic that generally concerns only US-based investors, although what the SEC does has an effect on regulatory bodies abroad. This is a letter you may want to forward to your friends and associates. The Securities and Exchange Commission (SEC) has posted a new proposed rule that would raise the minimum net-worth requirement needed to invest in private funds from $1,000,000 total net worth to $2.5 million liquid net worth. This is a major change, and it means that some 7% of American households will no longer be able to invest in private offerings. In my opinion, it is likely to become law in the not too distant future unless there is significant public comment. This week we look at the proposed rule and some of its consequences, as well as a very interesting proposal by SEC commissioner Roel Campos. Let's start with some background. The current definition of an accredited investor was adopted in 1982 and was set at $1,000,000 total net worth, including your home and other assets. At the time, according to the SEC, some 1.87% of all US households were qualified to invest in hedge funds and other private equity offerings. Due to inflation and the growth in all sorts of assets, including homes, today about 8.5% of US households are eligible. The original rule was proposed to keep supposedly unsophisticated investors from getting involved in investments like hedge funds, which were considered riskier than mutual funds.

Are we overbought and overvalued? Maybe. Is inflation coming under control? Maybe not. Did housing construction rebound last month? No. The only rebound was in the statistics. (I know readers will be shocked to learn that some statistics just may not actually be what the headline says.) We look at all this and more as we ponder a world awash in liquidity. One of the more interesting reads I get each week is a column from Dow Jones columnist Spencer Jakab. He has a knack for finding the unusual, and this week his talent was on full display. He did a piece on Sam Zell's latest Christmas card. I have written (somewhere) about Sam Zell, also known as The Gravedancer. He earned this name for his flair for picking up distressed properties and turning them into profitable enterprises. His flagship vehicle is Equity Office Properties Trust (EOP). There is a bidding war for EOP, with Vornado Realty (VNO) now offering $37.6 billion, which would make it the largest buyout deal ever. This is not some high tech growth stock. This is a very rich 22 times 2007 earnings for real estate.

I got a lot of mail as usual from readers about my annual forecast. It was about evenly divided between those who think I am too much of an optimist and those who think the economy will avoid a recession. There are a number of readers who think we have already seen the bottom, and that 2007 will be a banner growth year. Let me be clear about one thing. My call for a mild recession/slowdown stems almost entirely from my thought that housing is going to be a real problem in the coming quarters. This will cause a slowdown in Mortgage Equity Withdrawals and put pressure on consumer spending. It will cause a rise in unemployment, which is also bad for consumer spending. If the housing market does not slow down a lot more than it already has, then my forecast is going to be wrong. It is as simple as that. And as is typical of changes in the economy, there are a lot of mixed signals. Certainly the rather solid December consumer spending number we got today does not suggest there is much pressure on the US consumer. Retail sales account for almost half of all consumer spending, which in turn makes up more than two-thirds of gross domestic product. Today's government report provides a broader picture than industry figures, which showed a disappointing holiday shopping season.

How has another year come and gone so quickly? It seems like someone hit the fast forward button. And once again, all too soon, it is time for me to demonstrate my masochistic nature and write a forecast issue. Rather than going into details on every topic, I will try and stick to the big picture and leave the fine points for later letters. Each year as I do this forecast, I look for a theme. What will be the driving factor which will set the stage for the economy? In 2001 it was the coming recession; in 2002 it was a weak recovery and the beginning of the Muddle Through Economy; in 2003 it was Surprise and Transition. In 2004 it was the Silver Lining Economy; in 2005 it was the See-Saw Economy. Last year it was The Gripping Hand, as Bernanke had the economy in his interest rate gripping hand. Who knew in January 2006 how far he would go? For masochists, you can go the archives at www.2000wave.com and read those forecasts. This year the theme is The Goldilocks Recession. As outlined in the past few months, I think the US will have a mild recession or slowdown in 2007. That premise leads to a lot of other follow-on forecasts. Why the theme? Remember that after finding things were just right, Goldilocks ended running out of the house when the bears came home. And I think the housing bear will finally come home in 2007.

I am taking some time off from writing over the holidays, but good friend Barry Ritholtz offered to write this week's letter. It is a very thought-provoking piece on the importance of what he calls the "real estate industrial complex" to the economy. Loaded with charts and statistics, it is the type of work I have come to expect from Barry over the years. Barry is Chief Market Strategist for Ritholtz Research and Analytics in New York. I will be doing my annual forecast issue for next week's letter, and this piece by Barry is a good set-up. But before turning you over to Barry's capable hands, let me wish you and yours a very Happy and Prosperous New Year. I want to thank you for letting me come into your life with my weekly musings, and sincere note of appreciation for all the comments and kind words.

It is Christmas, and I frankly don't feel like writing a letter about why there will be a slowdown in 2007, or that the stock markets should see a retreat. This is the season for feeling good. And looking at the forecasts of the vast majority of my fellow prognosticators, some of them are feeling very good indeed. So, no bearish thoughts this weekend. We will depart instead from the recent litany of problems I have written about and look for something new. I get several letters every week from readers asking how I feel about missing the recent bull market, sitting on the sidelines in cash. Except that I am not in cash. Others ask about where I am actually invested. I have never written about my personal portfolio; but this week I discuss my investments in general, review their performance, and offer a few thoughts on investing and creating wealth. But first...

The stock market liked both the retail sales and the inflation numbers that were released over the last two days, with the Dow posting successive all-time highs. This week we look behind the headlines and a little deeper into those numbers to see if there is some justification for the exuberance, as well as offer some thoughts on valuation and the recent meeting of the Fed. And I know it will shock you that once again there is a change in the way the government collects its data. It should make for an interesting letter, so let's jump in. It is getting lonelier to be in the bearish camp. I noted this morning on CNBC that Mark Haines introduced good friend David Kotok of Cumberland Advisors as a former perma-bear. Last summer, David invited me to his rather famous Shadow Fed fishing weekend in Maine, where economists, as well as money managers, some press, and the occasional official figures get together to fish, eat, drink, and talk economics. A very eclectic group by any standard. I took my 12-year-old son Trey and we had a blast. In fact, I was instructed by Trey as we left to be nice to David so we could get invited again.

"When," I am asked frequently, "will we see a bottom in the housing market?" This week we look back at what past housing recessions have looked like to see if we can find a bottom anywhere soon. And could things be different this time? (Maybe.) We look at the government statistic on the number of houses for sale and find that it doesn't count all homes that are for sale. (I know it will shock most readers that government statistics might not be 100% accurate.) All this and more, as we muse upon magazine covers and the markets and why the Irish can steal our hearts. It should make for an interesting letter, but first: My most recent (and best-selling!) book, Just One Thing , is now out in paperback. It will make a great present for a friend or client, and works for both the seasoned professional and the new investor just starting out.