Thoughts from the Frontline

Where will Treasury rates go? What about inflation/deflation? The dollar? The stock markets? Gold? We cover all this and more in this week's letter. I normally do an annual forecast at the beginning of each year. In conversations with a number of clients and readers, I've come to realize it might be helpful to do a midyear forecast as well. In January, I suggested that 2005 would be the year of the See-Saw Economy. So far, with one major exception, my forecast is in the middle of the fairway. I wrote:

At precisely what point can we say that there are too many hedge funds? Are too many funds the reason hedge fund returns were down in 2004? What does the answer say about the potential for future returns? And how large might the industry grow in the next ten years? We deal with this and more in this week's E-Letter. This letter was originally sent to those who have subscribed to my free Accredited Investor Letter a few months ago. The Financial Times recently ran an edited version as my first article with them. It has had a lot of positive responses, so I thought I would put it out to a larger audience. There is information on the Accredited Investor E-Letter, at the end of the letter.

Looking at a recent magazine covers one is left with the impression that the whole world is concerned about US real estate prices. This is borne out by the fact that if you go to Google and type in sex you get 78,000,000 hits. If you type in real estate you get 110,000,000 hits, which makes housing about 40% more interesting than sex. Is there a greater sign of a bubble? But if you type in housing bubble you get "only" 1,120,000, so there is not much worrying going on. While the above facts do not constitute a scientifically valid study, they make a fun launching point for this week's letter. Are we in fact in a housing bubble? How long will prices continue to go up? Will they start to fall, or even crash, and when? We explore all this and more.

This week we return to Europe, as what is happening there is one of the most important questions of the day. It is every bit as critical to our long-term world economic future as the valuation of the Chinese currency or US trade deficits or Fed policy. Let me set the stage with this note. I am not happy about and take no pleasure in what is happening in Europe. For a variety of reasons, I view it with some concern. A united Europe is simply better for the world at large, even recognizing the problems associated with unity. I recognize the polarities and difficulties. But I had always hoped (and still do), that somewhat like Massachusetts and Texas, or California and Alabama, a political union could emerge.

This week we will look with fresh eyes at an old problem: US pension funds, both public and private, are under-funded, and the situation is getting worse. And the US taxpayer is going to get to fund the difference. The recent slew of data on pension funds suggests that little is being done to correct the huge and mounting problems I have written about for years. Even the recent market upturns of the past few years have not been as big a help as it should have been. I wrote this over two years ago:

What if the Malthusian doom and gloom crowd is wrong? What if the trend of lower population growth clearly evident in the developed world is echoed in the rest of the world? This week we look at a remarkable book by Ben Wattenberg called simply "Fewer." It is about "How the New Demography of the Population Will Shape Our Future." His thesis has implications for currency valuations, public pensions and the future of Europe, among many other things. The book has given me a great deal of food for thought, and I share some of those deliberations with you. Not all of my speculation is pretty, but these are topics which will be addressed, because the markets will not allow them to be ignored.

The questions of the day seemed to revolve around Fed policy, the US trade deficit and the dollar. We look at all of these questions and more in today's letter. Specifically, I want to try to lay out three scenarios involving future Fed policy actions and what each possibility might mean for the US and global economies. The Fed is in an extraordinarily difficult position. Some very distinguished observers believe the Fed should stop their tightening cycle now. Others think that not only should they keep hiking rates at a measured pace, they should continue to do so for the rest of the year (for a variety of reasons). Raising rates too much or too little each bring their own set of problems. But it is not altogether clear what the appropriate level of short term interest rates should be, and even if we found that appropriate level, it is not clear that the results would be what was first intended.

"It seems like kicks just keep getting harder to find, All your kicks ain't bringing you peace of mind, Before you find out it's too late, You'd better get straight," - The Monkees Substitute the word "returns" for "kicks" in the classic Monkees hit and you get an updated boomer generation anthem. (Or maybe Peter, Paul and Mary singing "Where have all the returns gone? - a long time passing.") This week we look at issues involving pension funds, muse upon the size of the financial service industry (is it a bubble?) and speculate about Chinese currency manipulations. There's a lot of interesting ground to cover.

"There is little doubt that, with the breakup of the Soviet Union and the integration of China and India into the global trading market, more of the world's productive capacity is being tapped to satisfy global demands for goods and services. Concurrently, greater integration of financial markets has meant that a larger share of the world's pool of savings is being deployed in cross- border financing of investment. The favorable inflation performance across a broad range of countries resulting from enlarged global goods, services and financial capacity has doubtless contributed to expectations of lower inflation in the years ahead and lower inflation risk premiums. But none of this is new and hence it is difficult to attribute the long-term interest rate declines of the last nine months to glacially increasing globalization. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum. Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience." Alan Greenspan, before Congress, February 16, 2005, (my emphasis)

This week we look at index funds, and specifically at the problems that the certain types of capitalization weighted index funds have. It is intuitively obvious that capitalization weighted indexes have a larger proportion of their assets in the larger stocks. But is this what a rational investor should actually want? I think the information we look at today will surprise many. My good friend Rob Arnott has challenged the conventional thinking with an explosive new study just published in the Financial Analyst Journal. He also summarized it in a speech at my Accredited Investor Strategic Investment Conference last month. We're going to look at a part of that speech today.

This week we look at a speech given by Paul McCulley (Managing Director at PIMCO funds) at my recent Accredited Investor Conference in La Jolla. In it he introduces to us the concept of a stable disequilibrium to describe the state of affairs in world monetary matters. It made a great deal of sense to me and I will try and give you the gist of his thought. For the past few weeks I've been thinking about stable disequilibrium's throughout history and throughout the world of today and think the concept offers us an interesting paradigm through which to view the world. We look at China and Europe, General Motors and Ford and matters both small and great through the prism of a stable disequilibrium. I think it should make for interesting letter, so let's jump right in.

This week we look at the "The Triumph of Irrational Expectations over Long Run Experience." It is a cautionary tale, but enjoyable in the telling, and one that investors almost invariably ignore to their own chagrin. Also, at the end of this letter, I tell you how to get a free coy of Andy Kessler's book, "How We got Here." This is a book you want to read and then give to your kids. This past weekend, I along with my partners at Altegris Investments sponsored a conference for accredited investors. In addition to a number of investment managers, attendees heard from Richard Russell, Paul McCulley, Rob Arnott, Andy Kessler and Mark Finn, as well as yours truly. We recorded the main sessions, and in some future letter, I will tell you how you can get a copy of their speeches for your listening pleasure.