Thoughts from the Frontline

One of my favorite cartoons of all time is that of a very scrawny mouse caught out in an open field with a rather large hawk swooping down on it. There is no place to run, no place to hide. All the mouse can do is face the hawk and give him the bird, so to speak. The caption runs something like, "In the face of total disaster the only appropriate response is utter defiance." And while the economic data is not a total disaster, it has not been good this week. Yet the response of investors everywhere is defiance, or at the very least serious nonchalance. Recession possibilities? "What recession? I spit on your talk of recession." They continue to assume that things will turn out much better than merely OK. All manner of investments are priced for perfection, perfection being defined as growth slowing enough to take out inflation risk yet not enough to hurt the ever upward rise of corporate profits. Goldilocks is the name of the game.

It's a slow Thanksgiving Friday, and I decided I would rather be writing to you than shopping in the malls. In fact, I would pay good money not to go to the malls today. Which my kids think I am because they pointed out on Thanksgiving the amazing values I am missing, particularly on items they think should be on my Christmas shopping list. And I agree, I am surprised by the level of discounting, and believe those prices will be there in a few weeks when I actually get around to shopping. (Parenthetically, if holiday sales are strong but prices are lower [and they do seem to be!], what will that do to profits?) So, rather than participate in a shopping frenzy, let's ponder on the value of all those dollars my fellow citizens are spending today. At the New Orleans investment conference last week, there were several constant themes. Gold, of course, would continue its rise. And the dollar would fall. The only variants on the latter theme were, by how much and when and against what. And as if on cue, the dollar made a 19-month low today as gold started to once again attempt to assault its recent highs. Today we look at the dollar from a longer-term perspective, see how this relates to global liquidity, and let you in on a running debate I am having with a few colleagues. But first, a quick note from my partners in London. They (Absolute Return Partners) are looking for a hedge fund research analyst. If you are interested, you can either drop me your resume and I will forward it, or you can reach Nick Rees at www.arpllp.com.

This week I am in New Orleans at the annual New Orleans Investment Conference and quite frankly with so many good friends that I have given myself permission to not write a letter this week. But you will be getting an even better writer than me for this week's letter. I arranged for good friend Gary Shilling to condense his 40 page letter on the housing market for you. While this letter will print long (for those of you who print the letter out), it is mostly charts, which Gary excels in. Gary argues that housing prices are not in for just a small decline but a material drop. I have argued that it is housing that will be one of the main causes of the next recession sometime next year. So without adding too much more copy, let's jump right into Gary's analysis. If you like this type of work, you can subscribe at http://www.agaryshilling.com/insight.html.

We have been told for months that the next interest rate move by the Federal Reserve is dependent upon what the data tells us prior to each meeting. If the data tells us that inflation is too high and/or the economy too strong, the Fed will continue in its pause mode or maybe even hike rates. If inflation comes down and the economy begins to soften, the next interest rate moves will be down. But that begs the questions, "How reliable is the data?" and "How does one interpret the data?" This week we start with a look at a remarkably candid speech by Richard Fisher, the president of the Dallas Federal Reserve. We then look at what the data tells us about inflation, the relationship between housing construction and GDP, and the disconnect between the bond and stock market. The more I learn of Richard Fisher, the more I like. He is refreshingly clear, as well as candid, in his presentations. He will tell you he is not a trained economist, but rather a Harvard MBA with a focus on decision making under conditions of uncertainty. In a speech this week to the New York Association for Business Economics, he talked about the need for more and better data to help in the decision-making process.

With each new slice of economic data the past few weeks, the bond market decided that the economy was getting softer and the potential for the Fed to start cutting rates was growing. Rates have been drifting down for the past few weeks. And then came today's unemployment numbers. The unemployment rate dropped to 4.4%. The bond market simply threw up. Yields on the 10-year bond rose a breathtaking 12 basis points in just a few hours. But wait a minute. Why should the bond market worry about unemployment? Employment is a lagging indicator. In fact, the last time the unemployment rate was this low was during the recession of 2001. The unemployment rate was 4.4% in April of 2001. It dropped to 4.3% in May, before it began its climb to 6.3% two years later. The National Bureau of Economic Research tells us that the official dates for the last recession were from March through November of 2001. Note that the unemployment rate was dropping for two months even as the economy was beginning a recession. This is not an isolated event. It is quite common for the unemployment rate to fall even as a recession is beginning. That is what we mean when we say lagging indicator.

There is an arcane debate going on in economic circles. How fast can the economy grow without inflation becoming a problem? The answer may be, not as fast as we thought. And the answer matters because the people who have their fingers on the interest-rate trigger take this arcane stuff seriously. How you answer the question also has implications for the unemployment rate. Yes, there are people who worry about it getting too low. Plus, we look at the Dow. The Dow may be telling us more about how indexes are constructed than about how the economy and the market are really doing. All that, some thoughts on the housing data, and more as we ponder the question, "Is it really different this time?" But first, one of the really great investment conferences every year is the annual New Orleans Investment Conference. This year it is November 15-19. Originally started by the late Jim Blanchard, the conference has a strong gold contingent, but has expanded to cover a wide range of themes. Last year, the conference had to be rescheduled because of Katrina, but this year it is back and looks to be better than ever. In addition to yours truly, they have lined up Steve Forbes, Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich, plus scores of other well-known speakers, workshops, and private sessions. If you register before November I, you can save $200 on the full price and half off for a friend or spouse.

"Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as they have predicted. I expect to see the stock market a good deal higher within a few months." - Dr. Irving Fisher, Professor of Economics at Yale University, one of the most important US economists of his day, speaking on October 17, 1929, a few weeks before the Great Crash. "What," more than a few readers ask, "do you think of the new highs on the Dow? Don't you have to admit we are not in a secular bear market? Can't you just enjoy the new bull?" If it were a matter of just admitting I'm wrong, that would be the easy part. I have been wrong lots of times and will be wrong again. But the data keeps telling me that there is more to the story. This week we look at earnings and investor expectations. In the man bites dog category, we visit with a very mainstream analyst who says earnings will fall next year. But companies are going to trumpet much higher earnings. There is a coming dissonance that suggests a problem in future valuations.

Are we in for a soft or a hard landing? Did retail sales slow, as the data suggest, or is the underlying data quite bullish? We will look at the arguments, and then look at the most reliable of all economic indicators to see if we can get an idea as to which view is right. But first, I want to announce a new addition to my free information services. In addition to this letter, I send out a free newsletter every Monday evening called Outside the Box, where I feature the work of another analyst or writer, often looking for thought-provoking views which disagree with my own. Yesterday, I sent you a special Outside the Box highlighting an essay by George Friedman of Stratfor on the problem the US faces because of our military being stretched. I see about 3-4 Stratfor letters each day, with thoughtful analysis and up-to-the-date lists of major geopolitical events. I am very pleased to announce that George is going to let me choose one of these essays every two weeks to send to you. You can of course opt out if you like, but I really think you are going to like the additional insight and information. I find the work they do to be of the highest quality and quite useful as I think about how everything "fits" together in a rapidly changing world.

This week we had two more Federal Reserve members repeat what has become the theme for their chorus, but not one the market seems to be paying much attention to. It should be. The market believes the Fed will soon start to cut rates, perhaps as early as first quarter of next year. It is not altogether clear that this will be the case. I must admit to being somewhat baffled as to the apparent disregard by the stock market for what I view as a tough environment in the medium term with either a slowdown or a mild recession being suggested by numerous factors. While there are a lot of positive features to the economy, to me the risk to the economy still seems to be to the downside. I take small comfort in the fact that this perspective is shared by Fed Vice Chairman Donald Kohn, a very solid economist and financial market observer. On Tuesday night at New York University, Kohn stated that he is more concerned about inflation than slowing economic growth because a recession is unlikely. "In the current circumstances, the upside risks to inflation are of greater concern...I am surprised at how little market participants seem to share my sense that the uncertainties around these paths and their implications for the stance of policy are fairly sizable at this point."

It's been a random walk through the data fields this week. The headlines say that inflation rose a mere 0.1% in August. The markets liked that. But digging deeper, the data is not as sanguine. We had the depressing Philly Fed manufacturing index last week, but today we find that Chicago is doing more than fine. The Dow flirted with a new all-time high, but then took the train home early for the weekend, leaving those who care about such things feeling like a teenage boy at a Baptist youth camp, flush with excitement during the day but frustrated as you go back to your dorm. But there's always tomorrow. Or maybe not. Copper is the metal with a Ph.D in Economics. But has the metal been too smart for its own good? Looking at some recent trends in copper usage, we can learn something about an economic concept called substitution and the cure for high prices. I comment on my "debate" on Kudlow and Company this week, and muse on growing older and the passage of time. Let's jump right in.

Yesterday the Philadelphia Fed Business Economic Survey came in at the lowest level since the recession in 2001. Some argue that it is just one month's worth of data, and "...besides, it is Philadelphia. Those numbers are always quirky." And why pay attention to the Conference Board's Index of Leading Economic Indicators? The bond market has its own opinions, and they are different than that of the stock market. With all of this as backdrop, we will then think about why we should be optimistic. Things are going to get better. All it takes is a little innovation. The data seems to be pointing to an economic slowdown of some kind. It is getting increasingly difficult to suggest that we are in for a Goldilocks scenario where growth runs at 3%, inflation drops below 2% and housing starts to recover. The debate is between those who say we are in for a soft landing or a hard landing. A hard landing is one in which the economy enters a recession. A soft landing is normally defined as one where the economy slows but stops somewhere north of an actual recession.

The market, my various mentors have all told me, is designed to cause the most pain to the largest number of people. And while I am not in pain, the recent move up in the various market indices is certainly not in keeping with my thoughts that the economy is going to slow down and thus should exert downward pressure on the equity markets. Has the world transitioned to a kinder, gentler Mr. Market? One who views investors with compassion and encouragement? Has he truly turned over a new leaf, and this time promises to be different? Should I simply smile and be patient, or throw in the towel and buy the Vanguard 500? And is the stock market really all that good at predicting the direction of the economy? This week we look at a few random ideas, throw out a few thoughts on China, comment on oil, and analyze today's inflation data. The good news for long-suffering readers is that this letter should be briefer than usual, or that is my intent as we start out. Let's see how it ends.