Thoughts from the Frontline

Is the US stock market rolling over? What are insider investors telling us? Are there sectors that might run counter to the overall trend? We look at a variety of topics this week, I point some of my hedge fund and institutional managers to an excellent source for information on insider investing and point the rests of my readers to a new book which shows you how to separate the "Vital Few from the Trivial Many." All in all, it should be an informative letter. But before we delve into the arcane matters of the market, I want to direct your attention to a hot-off-the-press new book by Peter Bernstein entitled "Wedding of the Waters." Peter is the author of the best-selling (and one of my all time favorite books) "Against the Gods: the Amazing Story of Risk" and the fascinating and well-told tale of "The Power of Gold: History of an Obsession." Whenever Peter writes anything, it will be worth your time. His economic advice and research is some of the most keen and insightful anywhere, as attested by his numerous awards and well-deserved honors. But his knowledge of history and the ability to tell a story puts him into league of his own among financial writers. (He and Richard Russell are my heroes. Both are in their early 80's and doing their best work. I hope to be going as strong as they do in 25 years.)

This week we begin what will be a series of occasional letters on China. The topic, like the country, is so vast that it cannot be adequately dealt with in one short letter. Today, we will take a long range view into the future, looking at how China will develop vis-a-vis the developed world. There is a mountain of material on China, as I can personally attest to, having gone through hundreds of pages of reports, essays, and data in the past few weeks. Much of the writing falls into two camps, it is like they are holding the same coin but only looking at one of the two sides. The first camp sees China as an emerging empire which will eclipse Europe and the US in a few decades, offering a rival military power to balance a uni-polar world. They will stop purchasing US debt, precipitating a major decline in the US and force us into a long and permanent recession. After reading some of the extremes of this group, I feel like buying a shovel and digging a hole so we can just go ahead and bury ourselves.

Last week we looked at my 2005 Forecast. This week, we ponder the far more interesting question of where I could (or will be!) be wrong and why and what would be the consequences. This week's topic came about as I was talking on Tuesday with Van Hoisington of Hoisington Investment Management Company. He and Dr. Lacy Hunt had just published their 2005 Forecast and I considered it quite thoughtful. I called to ask if we could use it for next Monday's Outside the Box.

Once again it's time for me to demonstrate the foolhardy part of my nature by putting to electronic pen my forecast for 2005. I spend more research time on this one letter than on any four or five combined, simply reading hundreds of pages of research, looking at mountains of data all in an effort to try and catch the gist of the markets. It is a daunting task, but one to which I actually look forward, as it challenges the mind like few other endeavors. If I go into as much detail as I usually do on each topic, there is the potential for this e-letter to be much too long. Therefore I will try and take the larger picture, make specific and shorter predictions and save the details and the arguments for later issues. Let's begin by quickly reviewing how we did last year.

We start the year off with a little controversy. This week we take the long view of a problem created by current government policy as a result of the War on Terror that may not show up for 20 years, but if not corrected will have far-reaching consequences for the global balance of power and the US economy. This week's letter will be a little shorter than usual, for a variety of reasons, not least of which is I am both taking a little time off and also doing a lot of research for next week's 2005 Forecast Issue. At the end of this essay, I also mention a way for you to personally help in getting $5.5 million dollars of medicine to Sri Lanka for $.02 on the dollar, a very good investment, if I do say so.

English coal miners, starting around 1911, would put a canary in the coal mine to warn them of air quality problems. This practice of two canaries in each pit continued until 1986, at which times electronic sensors went into use. In the world of economics, there are also things which are the equivalent of a canary in a coal mine. This week we will look at yield curves in England. Can we look over the pond and see the future of the US economy? But before we get into that, let's look at something far more important.

Be careful what you ask for, the ancient wisdom says, because you just might get it. The world markets are asking for a return to balance, where the US trade deficit shrinks, the US saves more and we balance our government budget. All laudable goals, and ones I would applaud. But the road to a balanced global market may not seem like a walk in an economic Lake Woebegone, where stock market returns are strong, stagflation does not darken the path and where all our portfolios have above average returns. Having had the luxury this week to read more than my usual mountain of material, I am struck by the sheer complexity of the world economy. It is a puzzle with seemingly obvious answers yet exceedingly difficult to solve; or a riddle with many answers, none of which are exactly right; or maybe it is more like a great mystery, where there are clues on every page, but it is only when we come to the end that we can recognize that we had been given a clue.

Why do we do the things we do? How can two people, or even large groups, look at the same set of facts and come to such widely different conclusions? Maybe even more important would be to ask why? Is there some bias involved? Does being a "professional" help you avoid these biases? We will examine these questions and more, and end with a few comments on the important and very strategic sleeper event you probably missed this week. It should be a fascinating letter. Warning: some of the studies which I discuss can (or at least should) give rise to some serious soul-searching for your own personal biases. This latter activity is best done at night with good friends and your favorite adult beverage. Since the holidays are coming up and we tend to look for reasons to get together with friends anyway, this process will simply help you on your way to finding your own Inner Spock.

From ghoulies and ghosties And long-leggedy beasties And things that go bump in the night, Good Lord, deliver us! --Old Scottish Prayer Coming back from Canada this morning, where the Canadian dollar is on a breath-taking rise, and reading several lengthy (and very conflicting) reports on the international currency situation, I feel compelled to weigh in with a few observations. Basically, the numbers of things that are out of balance in the world are increasing. How long can the current status quo maintain itself? This week, we visit my worry closet. Now, there are numerous writers who would tell me not to worry. Isn't the market going up?

With many sub-market indexes hitting new highs, and given the recent performance of the market, how can I maintain we are still in a long-term secular bear market? Shouldn't we get back in, as so many advise? That is a reasonable question, and the subject of today's letter. We will start with a few quotes, and then move on to my commentary. A. M. Clifford writes: "We are witnessing today a most extraordinary financial phenomenon, in the form of a Stock Market which has advanced with a rapidity and to an extent unparalleled in modern financial history.

This week we enter the realm controversial. The election is over, and now reality will impinge its often unpleasant odor over the political landscape of the hopes and dreams of all sides of the debates. I explore the world of Republican political reality and how it will be affected by the economy over the next four years. We look at Bush's national agenda and muse upon whether it can come to pass. This will, of course, be guaranteed to annoy most of my readers, as those who oppose Bush will not like my suggestions and those who align themselves with him will not enjoy my raining upon their parade before they have had a reasonable time to bask in the glow of victory, or reminding them of real potential problems in 2008. A quick caveat. I will style this as an open letter to Karl Rove. Although not active in the last few years due to time constraints, I was quite active in Texas politics in the 80's and 90's, working on numerous committees and campaigns, finally serving on the Texas State Republican Committee where I served on a small committee that represented the party to the governor's office when Bush was governor of Texas. You cannot run in such circles in Texas without bumping into Karl Rove from time to time, and we bumped often. I like the man, as do most people who have met him. He is currently the finest political mind in the country - a verifiable second coming of Lee Atwater, the architect of Reagan's victories and the Republican Renaissance of the 80's. I have not always liked how he runs a race (especially if I had a "horse" he was not backing), but I always admired his skills. His horses tended to win.

In March of 2002, I wrote an e-letter entitled "King Dollar and the Guillotine," which as the title suggests was a quite negative view of the future prospects for the dollar. Two weeks earlier, I had written a bullish letter on gold, having been bearish (really more agnostic) on gold for years. Since that time, we have seen gold and the euro rise over 50% from the cycle bottoms in dollar terms. Other currencies have not risen against the dollar at all. The Chinese Renminbi is exactly where it was and has been for many years. Almost three years later, we will review the future prospects for the dollar in this week's letter. This is the third in a series of letters in which I review my major investment themes. The first two were on secular bear markets and the Muddle Through Economy. You can find them at the archives at www.2000wave.com.