Thoughts from the Frontline

"The opera ain't over 'til the fat lady sings." And speech after speech by members of the Federal Reserve over the past few weeks suggest that the fat lady is still waiting offstage, not sure of her cue. Today we look at a thoughtful speech given last night to a private gathering by Richard Fisher, President of the Federal Reserve Bank of Dallas. We then look at a few worrisome charts on global liquidity and inflation and some more data on housing. But first, I want to welcome all the new readers. There has been a noticeable upsurge in new subscribers to the letter lately, possibly caused by the fact that more people are forwarding the letter to friends. If you do get this letter as a forward and you would like to join my 1,000,000 closest friends and get your own free copy each week, as well as my Outside the Box, where I feature the work of another writer, often with a different opinion than mine, you can go to www.frontlinethoughts.com and subscribe by simply entering your email address at the website. We don't ask for any other information or need a secret handshake. I like to keep it simple. Daughter and business partner Tiffani spent a few days this week reviewing readers' comments from the past few months. She wrote them saying she loves that I enjoy researching and writing; and if they did, too, she asked them to refer the letter to their friends and colleagues.

I had occasion to be in my car this morning, listening to CNBC, when the host of the show (Bob Pisani, a very nice gentleman on the few occasions I have had the opportunity to meet him) was arguing with a modestly bearish guest. Yes, there are a lot of reasons for concern noted by bears, but the market is clearly disagreeing with their pessimistic views. Stock indices are hitting cycle highs and seem poised to go higher. He and many other optimists seem to be of the opinion that since the market is going up, it is telling us that the economy is ready to find a Goldilocks "Ahhh, this porridge is just right!" soft spot on which to land. However, as I remember it, the end of the Goldilocks fairy tale is not so sanguine. The final lines are "Just then, Goldilocks woke up and saw the three bears. She screamed, 'Help!' And she jumped up and ran out of the room. Goldilocks ran down the stairs, opened the door, and ran away into the forest. And she never returned to the home of the three bears." But Bob makes a good point, which should give us pause. How does one argue with Mr. Market? Shouldn't the collective wisdom of hundreds of millions of investors give us reason for concern when they clearly disagree with our own modest insights? Fighting the trend is never a good way to stay alive in today's markets.

This week we revisit some ideas on how change occurs. We are in a transition in the world economy, and it sometimes helps to think about how these transitions take place. What is the mechanism for change? Can we see it coming soon enough to avoid the problems and take advantage of them? But first, a few comments on the housing market. As we all know, this week the news on both new and existing home sales was ugly. And we should remember that the data is from last month, and anecdotal evidence suggests this month will be worse. This is going to put a damper on the economy at large. I have been writing for some time that the US economy is going to slow down or go into recession. How much of an effect will that have on the markets? We will look at two items. The first is a chart from David Rosenberg, North American economist for Merrill Lynch. Quoting: "The chart below is rather intriguing - the NAHB homebuilders index leads the S&P 500 by 12 months and with a near-80% correlation - a correlation that over time has actually strengthened, owing to the growing influence that the real estate market has exerted on the overall economic and financial landscape over the past five years. In fact, we can trace almost two-percentage points of the 3 1/2% average annual rate in real GDP over that time frame to the boom in housing construction and home prices - the direct impact on homebuilding, the spin-offs to other sectors like real estate services, architecture, engineering, legal, etc and the multiplier impact from the 'wealth effect' on consumer spending, especially on home improvements and household furnishings."

The markets have closed up for five straight days. So much for my concern that either the economy might be slowing down or that if the economy does not slow down inflation will be a problem forcing the Fed to take action later this fall. Clearly, the majority of investors think we are in a Goldilocks scenario. In fact, Ed Yardeni uses that term in an interview with Mark Gongloff at the Wall Street Journal Online . Mark then contrasts my views with Ed's in an excellent piece called "Soft Landing: Many See a Goldilocks Market, While Others See Stagflation Light." That interview will be the basis for this week's letter, as it serves to contrast the tension between those who see the markets rising to new heights and those like myself who see problems. I am in the smaller group, at least for now. But first, there is an interesting pattern developing in the markets, called a "W" formation. While I normally do not talk about technical charts and patterns in this letter, I think this bears (pardon the pun) looking at. This is from good friend Bill King in his daily King Report :

The Fed elected to pause in its rate hiking assault on inflation this week. With the backward looking data pointing to higher inflation that must mean they expect the economy to slow down and thus tame what incipient inflation is lurking around the corner. But wait, the data this week suggests the economy may not be slowing down. The market thinks that means the Fed will have to pick up the rate hike cudgel and once again do battle with inflation, which means higher short term interest rates. But the Bond King himself, Bill Gross, declares we are at a turning point and another bull market in bonds is about to appear! Ed Hyman of ISI (no slouch of a prognosticator) says the economy is going to slow down and therefore we are getting ready to have a new bull market in stocks - starting now! (Huh? Did I miss something?) Dennis Gartman thinks the next move the Fed will make is to cut rates, which means the economy will be visibly slowing. And on and on. It is like watching a tennis match, as each new "data point" suggests seemingly conflicting information. It is enough to give a soul economic whiplash. But if we look at the data, it may not be all that inconsistent. The problem may be that it is not telling us what we want to hear, that both inflation and a slowing economy are a concern. Today we sort through a mound of data and see if we can make some sense of it, all the while pondering what Bernanke must be thinking late at night.

Today we take another look at the energy picture and how it will change over the next decade. Just as the world switched from whale oil to kerosene and from coal to diesel, we will see a change in how we find and use energy. That is inevitable. But the transition will not necessarily be easy or smooth. And there are some surprises along the way. The things we "know" and the assumptions we make about conservation of fuel and peak oil are probably wrong, and we need to get some key concepts down as we consider how the world will adjust to rising oil demand but at some point potentially falling production. We are going to review a most excellent book by Peter Tertzakian called A Thousand Barrels a Second: The Coming Oil Break Point and the Challenges Facing an Energy Dependent World . It is balanced, thoughtful, and well written. Not only dealing with the present problems, Peter takes us back into history to see how humankind dealt with previous energy break points. I highly recommend his book for anyone thinking about investing in energy or for those interested in how energy will affect our lives in the next decade. You can get it at www.amazon.com.

The GDP data released Friday suggests the economy seems to be slowing. So naturally the stock market surges forward in a very strong move, convinced the bull market is back. After all, how can the Fed raise rates in a slowing economy? And if the Fed is not raising rates, then it follows, does it not, that the stock market will rise? Or so the logic of a 119-point rise, tantalizingly close to a new high for the Dow, seems to suggest. A review of the data says that may not be case, however. This week we take a look at the economy, housing, and inflation, with a view to pondering whether stagflation will return in earnest. It should make for an interesting letter. But first, Andy Kessler's new book The End of Medicine that I wrote about three weeks ago seems to have struck a nerve, with both doctors and entrepreneurs. Feedback from readers is running quite positive, but with some very decisive disagreements from doctors denying that changes in medicine are needed or will happen, countered by enthusiastic entrepreneurs who are working on DNA detection chips, on blood tests to detect the likelihood of a stroke in the next year, and on imaging techniques to find all sorts of disease early. Andy tells me his feedback from the book is running hot, with some name calling from doctors but lots of business plans for early detection and even a few for next-generation eye surgery and stomach stapling. It's great to see that medicine is not a static business. No matter what the business model, there will always be entrepreneurs who seek out change, and we'll all be better off for it. I love to get your responses, by the way.

This week I write from Grand Lake Stream in Maine. It has been a long time since I have taken a week off from writing, but I think this is the week to do it. But that means, gentle reader, that you get an upgrade in quality, as my friends (thanks, Louis!) at GaveKal have graciously permitted me to use one of their most recent newsletters, where they talk about the recent inflation numbers, survey the markets in Japan and discuss Chinese growth and taxes. It is an interesting letter, and I trust you will enjoy it. I will return next week. You can find out more about GaveKal at www.gavekal.com. Authors: Louis-Vincent Gave, Arthur Kroeber, Anatole Kaletsky, Pierre Gave Which is the greater risk: inflation or recession? The markets may be struggling for an answer, but Ben Bernanke has made up his mind: he isn't worried about either!

The economy seems to be slowing. Will this be a mid-cycle slowdown as it has been the last two decades or will it evolve into a recession? In either event, does it presage a bear market in equities? Or is this just another oversold buying opportunity, a gift courtesy of panic selling because of the Israeli-Lebanon situation? If you follow the markets with any sense of history, we do in fact live in interesting times. But before we jump into our main topics, let's turn our eyes to Israel and Lebanon. This week's events have made it clear why as investors you need to be able to get a handle on world events. My single best source for commentary on geopolitics is George Friedman and Stratfor.com. ABC News recently said they are able to predict world-changing events in ways that no one else can. They are consistently ahead of the curve with their thoughtful analysis of events all over the world. I caught up with George this afternoon and discussed the situation with him.

This week we look at a very intriguing new book by good friend Andy Kessler called The End of Medicine , subtitled "How Silicon Valley (and Naked Mice) Will Reboot Your Doctor." As long-time readers know, Andy ran a high-tech hedge fund which went from $100 million to a $1 billion and got out more or less at the top with his client's money (and his) intact. Since then he has written a series of very fun books on the inside world of investing, all of which are on my recommended list. But with The End of Medicine he turns his eye to trying to find the next new thing which will drive the markets, or at least a segment of them, to new highs. This is a very well-written story in Andy's sarcastic, witty, and easy-to-read style, but the message is also one of how fast the world of medicine is going to change in the next ten years. The changes are happening in labs and fabs all over the world, but under the radar screen of almost everyone. This is a story that we can analyze from two angles. First, there is the investment aspect to it. There is going to be a 1990s tech-size run in our future. Finding the right ways to play it will be as difficult and interesting, not to mention rewarding, as the last big tech run. Secondly, this is going to dramatically change the way we approach our personal health care. In many ways, this is going to be a more profound, intensely personal change in lifestyle than anything the tech world has given us. Before we explore some of the implications, let's look at exactly what Andy has found. (You can get The End of Medicine at www.amazon.com.)

Thursday saw a powerful response by the markets in stocks, bonds, commodities, and currencies to the communique from the Fed after its recent two-day meetings. Clearly, some were interpreting the communique to mean that the Fed had finally come to an end of its interest-rate-hiking ways. The immediate spin was quite "dovish" in terms of future rate hikes and concern about inflation. That has become a pattern in the last year. The Fed releases its minutes, the immediate spin is that we are ready for a "pause," and the market rallies. Then we start to listen to the speeches from Bernanke and various Fed governors and are shocked - shocked, I tell you - that nothing has really changed and they intend to keep on raising rates in a measured manner. But is yesterday something different? Can we see a glimmer of hope that the Fed is ready to pause? Is that the way to interpret the mere three paragraphs of content? As a surprise to no one, I take a contrarian view, just as I did with the May release. So, this week we parse the Fed release, take a look at the yield curve, and glance over our shoulder at Japan. Maybe it will give us a clue as to whether this week was a sucker's rally or the beginning of a bull run.

This week we will venture into the always hazardous area of making my semi-annual forecast. I make some non-consensus projections as to the economic climate for the next six months, and of course look at Fed policy. We will also quickly review my beginning of the year (2006) forecast and see what changes should be made. I also point you to a solid resource on gold and gold stocks at the end of the letter. It will be a very interesting letter, I think. But first, a quick note on today's reversal by the District of Columbia Court of Appeals on the SEC requirement for hedge funds to register. If you read the brief 19 page ruling, it is clear that the Court did not buy into the argument of the SEC about the meaning of the word client, which was the legal basis for the SEC to require hedge funds to register. While I am neither a lawyer nor the son of a lawyer, it appears to me that they did not offer any other suggestions for the SEC to take another tack in their effort to regulate hedge funds. It will be interesting to see if the SEC tries to appeal what the court felt was such a clear cut case.