What I find amazing is that the bull market lasted exactly 5 years to the day. The bull market began on Oct. 9, 2002 and ended on the exact same day in 2007. (What I find even more amazing is that nobody has pointed this out yet!) Back in October, I was convinced that the market couldn’t possibly peak on the fifth year anniversary of its beginning, but the significant punishment taken by the financial stocks convinced me to stick with my strategy and thankfully I did as my clients have profited nicely ever since.

With the bear market official, several questions will now become common banter among financial pundits. What’s next for the market? When will the bear market end? How much further do we have to go?

Market technicians and historians will agree that 1170 in the S&P will be a critical support level. The average bear market eliminates half of the previous bull market gains which also just so happens to be a 50% retracement. (Often markets will experience a 50% or 67% retracement.) Furthermore, the current trendline that the market is careening down will intersect 1170 in mid-August which would bring a neat conclusion to this downleg.

But allow me to punch some holes in these theories that perma-bulls will be spewing out as the market approaches 1170. Even though, the average bear market does eliminate half of the previous bull market gains, bear markets are rarely average. They are either mild or more severe than average. The average loss in the last 7 major bear markets in the S&P 500 has been 33.6%. Three of these bears saw losses of less than 28% but two lost in excess of 48%. Only the 1987 bear market was average in terms of losses coming in at 33.2%. Given the historically high valuations of the current market (P/E’s >22), one should not count on this bear market being less severe than average.

I am looking for two different scenarios to play out. Either the market will find support in the 1170 area and consolidate before heading lower or the market will crash though its trendline on its way to much more significant losses. If the bear market behaves in similar fashion as to the 2000 – 2002 bear market, it will find support and consolidate.

However, for quite some time, I have compared the current bear market to those of 1937 and 1973. These were the last two inflationary bear markets (IBMs) which I wrote about in my Market Outlook. The difference between an inflationary and deflationary bear market is the behavior of interest rates. In a deflationary bear market, interest rates fall but in an inflationary bear market, rates rise.

The last two IBMs saw prices crash though support trend lines established by the first leg of the bear and ensuing dead cat bounce (i.e. bear market rally). It would be understandable that this bear will behave like the one in 2000 because it is involving many of the same participants but it is also reasonable to assume that it will act like ’37 and ’73 because it will not get support from lower rates as most bear markets do. Only time will tell which scenario plays out, but regardless, the market’s behavior at 1170 will be critical.

Dear Clients,

I am preparing my Quarterly Update along with your performance reports and fee statements. I am hoping to mail them out by Thursday, but may not get them out until the beginning of next week. In the interim, I wanted to report on your account performance so far this year:

Here is how my performance measured up to the averages on a YTD basis:

Honestly, I am little surprised how well your accounts recovered this past month. I wasn’t expecting much until Q3 but several positions in your portfolios performed very well in June. While we are not quite back to where we were earlier in the year, we are still far ahead of practically everyone else. My Core Portfolio has outperformed the S&P 500 by 30% YTD! In a $1M account, that equates to a $300k swing. None of the market neutral funds I track have even delivered double digit appreciation much less gains in the 20% neighborhood.

While the balance of the year should prove disastrous for equity and bond investors, I expect to continue to deliver positive gains. There are virtually no bullish signals in the equity marketplace over the intermediate or long-term. We may see bear market rallies which will be short and spectacular such as the one from mid-March through May, but the long-term trend is down.

I believe that two very dangerous trends for equities are beginning to converge. First, there is a weak economy which leads to falling earnings. Actually, I would argue that we have vanishing earnings as much of the earnings in the financials where a smokescreen to begin with. The financials, which accounted for 40% of the S&P 500 Earnings last year, are gone with little or no means of replacing them.

The second trend is that inflation is bound to lead to rising interest rates which in turn will lead to equity valuation contraction. As you know, I’ve been harping on this topic for several months now. In Part IV of my January Update, I detailed why and how rates will start to rise. (You’ll have to scroll down to Part IV of the update if you click on the link.) On 6/30, the BIS said that, “Global inflation is a ‘clear and present threat’ to a world economy that needs higher interest rates…” (source: Financial Times).

According to Dow Theory, when interest rates rise it results in valuation contraction meaning prices will fall even faster than earnings. Given that valuations for equities are far higher than their historical average, the result could be a substantial correction in the market’s P/E ratio which currently stands at 22.

Historically, the combination of falling earnings coupled with valuation contraction has led to a sharp correction in equity prices. There are times to be invested in equities, but now is not one of those times. My written update will delve into this topic in much more detail.

If you have any questions or concerns about your account, please do not hesitate to call me.

All the best,

Matt

Have you noticed that what you pay at the pump or the check-out counter seems to have little correlation with government inflation figures? Does it seem that prices for daily necessities are going up at a rate far greater than 4%/year? Well, the following will attempt to explain why your experience is far different than what the government is telling us.

Over the past 20 plus years, the government has made several “adjustments” to the primary measurement of inflation known as the Consumer Price Index (CPI). In this article, I will explain what those adjustments are and why they have resulted in the significant understatement of the CPI.

If I were a lawyer (which I’m not) and if I were prosecuting the government, the first steps I would need to take is to establish that the government and more specifically the Bureau of Labor Statistics (BLS) has both the means and motive to manipulate inflation statistics.

Several decades ago, US citizens became wise to the fact that the US government was willing to inflate the money supply which leads to price inflation in order to cover up budget deficits. So in order to keep the government in check and limit their ability to create inflation, the CPI was created to adjust future government liabilities for inflation.

Currently, the US government has the largest pension plan in the world and is the largest employer in the world. Every single pension payment and practically every employee salary of the US Government is adjusted according to the CPI. Furthermore, Social Security payments are adjusted by the CPI. Therefore, if the government wants to reduce its current expenses and its future liabilities, (so that it can spend more money on pet projects that are more likely to generate votes) understating the CPI is one of the most effective means of doing so.

John Williams, founder of Shadowstats.com, states that “Social Security checks today would be double had the various changes [to the CPI calculation] not been made.” Furthermore, every government retiree would be receiving higher pension payments and current employees would be receiving higher salaries.

So the motive is clear. Put aside less money today for current salaries and liabilities and future obligations so that the government can spend more on projects that will get votes now.

Now that we’ve established a motive, the next step is to establish the means of manipulating the CPI. Does the BLS have the means to manipulate the CPI data? Unfortunately, the answer is YES. The following are seven different adjustments made by the BLS to the CPI calculation which invariably suppresses the inflation figures.

For each “Adjustment”, I’ll start with a simple explanation of the adjustment, then provide an example or illustration and finally I’ll add my own editorial comments as to why the adjustment negatively impacts the CPI.

Adjustement#1: Geometric weightings

What is it?
Many years ago (I think it was around 1996) the BLS created weightings for each consumer product to determine how much it accounted for the average person’s annual spending. These weighting are reset each year to their original value regardless of how much a particular product increases in price. For example, Gasoline is 5.215% of the CPI calculation and even if Gasoline increases 10 fold, it will never account for more than 5.215% of the calculation.

Illustration:
Let’s continue with energy as an example. Gasoline is approximately 5% of the CPI calculation. Assume the price of gas doubles in year one (don’t have to use too much imagination on this one) but the price of everything else stays exactly the same. You would think that in year 2, gas’s price factor in calculating the CPI would be 10% - but not with geometric weightings, because the factor is set back to 5% after year 1. Now assume that in year 2 the price doubles again and the price of everything else stays level. In reality, the consumer would experience price inflation of 10% but using the BLS’s geometric weighting, reported price inflation would only be 5% because the weightings were reset. The result would be that reported inflation would be half that of reality.

The rub….
The problem with using geometric weightings is that it assumes that the prices of all things are equally elastic which they are not. The best example is Health care which is extremely inelastic. From 2000 - 2007, health care insurance costs rose 114% compared to the CPI which went up just 25%. (Source: Kaiser/HRET Survey of Employer-Sponsored Health Benefits). (BTW, Health Insurance costs only account for 0.537% of the CPI calculation. And no, I didn’t misplace a decimal point, according to the BLS, only ½ of 1% of your annual expenditures goes towards health insurance.)

The other huge problem with geometric weightings is that it totally eliminates the compounding effect of price increases. Back to our gas example. Assume the price of gas doubles every year for five years while the price of everything else stays exactly the same. In year 5, the CPI using arithmetic weighting would be 50% due to the compounding effect of gas doubling each year. But using geometric weighting, year 5 inflation would be a mere 5%. So as time goes on and weightings are continually reset, the reported inflation number for items whose price outpaces the CPI will continue to be further and further from the actual experience of US consumers.

Adjustment#2: Substitution bias

What is it?
The government assumes that an individual will substitute similar items for each other if one of the items becomes more expensive.

Illustration:
Assume that the government makes the subjective decision that steak and chicken are interchangeable. So as the price of beef goes up, people will eat less steak and more chicken so they substitute chicken for steak.

The rub…
First, who is the government to say that chicken and beef are equal or any other two food items for that matter. The CPI is supposed to measure the cost to maintain the same standard of living – not a substituted standard of living.

What keeps them from saying that steak and ground beef aren’t equivalent. While they cannot directly substitute steak for ground beef, they could do it progressively. Let’s say that in one year that the price of steak skyrockets so they decide that chicken is an appropriate substitute for steak. Then a few years later, the price of chicken shoots up so they decide that hamburger is an appropriate substitute for chicken. While no one could reasonably make the case that steak and ground beef are equivalents, the case could be made that chicken is a substitute for steak and the case could be made that ground beef is a substitute for chicken. So gradually they can get there.

Adjustment #3: Owner’s Equivalent Rent

What is it?
In order to calculate the cost of housing, the government uses what is called a rental equivalent which is basically what it would cost a homeowner to rent his or her home.

Illustration:
In this decade, home prices have risen 87% while rents have largely remained flat. But the CPI does not use the increased cost of a home but rather the cost to the rent the home so this component of the CPI has been severely understated. Since shelter accounts for 32.6% of the CPI formula, you would think it would be important to get this right.

The rub….
The problem with using Rent instead of actual home prices is that as home ownership became more prevalent driving up the demand and prices for housing, it actually drove down the cost of renting since the demand for rental units declined. So while “housing” costs increased substantially, the housing component of the CPI was actually suppressed – the exact opposite of reality.

Adjustment#4: Hedonic Adjustments

What is it?
Essentially, the government can arbitrarily decide how much a product improvement is worth to the consumer and discount the product’s price for the value-added benefits of the improvement.

Illustration:
Let’s say you bought a Honda accord in 2006 for $25,000 that was not equipped with side curtain airbags. In 2007, the exact same Accord is now sold with side curtain air bags and costs $27,000. You might say that the price went up 8% but the government would say that you are wrong. The government would look at the new Accord and decide that a car with side curtain airbags is more valuable than one without.

From there, they would subjectively calculate how much more it is worth. They may conclude that there is a 1% chance that the new airbags will save your life and that the average human life is worth $1M. Therefore, the new airbags are a value added feature to the car worth $10,000 (1% x $1M). And since the car is worth $10k more with the side air bags, but only costs $2k more, the price of the vehicle actually depreciated $8k.

The rub….
This adjustment is by far the most egregious one of the lot. Essentially, the government is getting away with offsetting CPI with progress. Our economy should progress. Manufactures should produce better products each year. This year’s computer should be faster than last year’s. This year’s TV should have a better picture than last year’s. But the government is essentially offsetting improvements in technology by discounting the CPI in line with their subjective hedonic adjustments.

Adjustment#5: Impact of new product launches

What is it?
Whenever a new product comes out, it is priced at a premium and then it is discounted significantly in the first few years of production. If the BLS adds a product that just came to market as soon as it is launched, the price of the product will eventually come down bringing inflation down with it.

Illustration:
Take Apple’s iPhone. When if first came out, it sold for nearly $500. In less than one year the price has fallen to $300 – a 40% price decline.

The rub…
I have no idea if the BLS implements this tactic or what impact it would have on the CPI. I just know that every time the CPI report comes out, there is huge price declines in electronics.

Adjustment#6: Seasonal Adjustments

What is it?
Simply, the CPI seeks to smooth out seasonal price spikes in products.

Example:
Orange juice prices spike in the summer, heating oil prices spike in the winter, ect, ect. Therefore, the BLS doesn’t want monthly inflation data to spike in reaction to price spikes, so they smooth out the data.

The rub…
Cannot not the marketplace figure this out on their own? What is the need to smooth out prices especially when seasonal goods only make up a small part of the CPI calculation? Technically, this adjustment should have no impact on the long-term calculation of the CPI, but it wouldn’t surprise me if the BLS found a way to use it to shave a few points here and there.

Adjustment#7: Focus on Core CPI

What is it?
Core CPI is Headline CPI minus food and energy prices (you know, those nagging daily necessities). While government pensions and social security are adjusted according to Headline CPI, the Federal Reserve uses the Core CPI as their preferred measure of inflation when determining monetary policy.

History:
During the 1970’s, the government started reporting Core CPI because energy and food prices were deemed “too volatile”. Of course, the reason they were too volative is because they were shooting to the moon. Personally, I think it is asinine that anyone pays attention to the core CPI. It would be simple to create a mean reversion calculation for food and energy that would smooth out price volatility.

The rub….
Technically, this is not an “adjustment” but rather a point of emphasis, but there are two significant issues I have with the government’s emphasis on Core Inflation versus Headline Inflation. First, it is more difficult for them to manipulate food and energy prices. The government likes to report Core CPI because they know they can hedonically adjust non-core figures but they cannot apply these subjective adjustments to food and energy. Last year’s burger is no different than this year’s.

The second and much larger issue is the impact of non-core prices on those least able to deal with rising prices. Rising food and energy costs have a much bigger impact per capita on low-income households and retirees. My 89-year grandmother doesn’t spend much on electronics, clothing or housing, but nearly all of her expenditures go towards energy (gas and utilities) and food. I am surprised that retirees are not being far more vocal about the impact of inflation on their livelihood.

I’ve established the government has both the means and motive to manipulate the CPI in their favor which has resulted in the gross understatement of reported inflation over the past couple of decades. Finally, I would like to take a hard look at the actual data and compare non-government inflation figures to the government figures which provides compelling evidence to support my thesis.

Sources:
CRB Commodity Index, Energy Sub-index and Foodstuffs – Commodity Research Bureau.
Home Prices – S&P/Case Shiller Home Price Index
Health Care Insurance - Kaiser/HRET Survey of Employer-Sponsored Health Benefits
PPI and CPI – Bureau of Labor Statistics

(A tremendous resource regarding the topic of government manipulation of the CPI is a website founded by John Williams – Shadowstats.com. Williams reverse engineers the current inflation data to calculate the CPI without all the adjustments. He is essentially calculating it as it was done in the 1970’s. According to Williams, inflation according to the original CPI is running in excess of 11% YOY.)

While the prices of the daily necessities such as food, energy, housing and healthcare have all increased anywhere from 60 – 300% over the past six years, the government figure used by the Federal Reserve to create monetary policy is a measly 13%. The most telling disparity is the difference in prices throughout the supply chain. Notice how PPI – Intermediate Goods is almost three times that of the Core CPI. Each layer of reporting is subject to more and more manipulation therefore the prices are further suppressed.

It is apparent that the Government’s calculation of the CPI is far different than that of the experience of the average US citizen. Unfortunately, the CPI lie hits hardest those who can least afford it. Low-income persons who spend the majority of their income on energy and food or elderly persons who are living on a fixed income are financially crippled by rising prices.

As an investor you need to understand the reason why the government must inflate the economy and why they lie about it. Over the past couple of decades, our country has operated huge deficits (both trade and budge) amassing enormous debts (this year alone the Governments budget deficit is suppose to top $500B). There are only two ways for a government to finance deficit spending – taxes and/or inflation. The current funding method is debt, but debt is nothing more than deferred taxes or inflation. Taxation is too unpopular and can be self-defeating so inflation is the only plausible way for our government to bail itself out of the current hole it is in. US Inflationary policy will continue – it has too.

The government and the Federal Reserve have a fiduciary responsibility to the US populace to control inflation which puts them in a bind. Since inflation is the unintended consequence of irresponsible government spending and since they are root cause of the inflationary mess, it is difficult for them to admit responsibility much less find viable solutions to the problem. So they lie about it. The government and the Federal Reserve had no intention creating inflation, but they did and now they either have to come clean or lie about it. Given the prideful nature our nation’s top elected officials and bankers, I’m compelled to believe that they find it easier to manipulate the data and lie about inflation than to admit responsibility.

Dear Clients,
The following is my Performance Update and Outlook for May. All prices and returns are as of 05/29/08.

Just as the smoke has cleared from Act I of the credit crunch, everyone is now up in arms about inflation. While the threat of inflation is real and growing, unfortunately, the credit crunch has not played itself out. In fact, the curtain maybe just going up on Act II which I’ll discuss in Part IIIb of this update.

I’ve started to find myself in pretty good company as more and more investing legends are coming around to the probability of Stagflation. On May 20th, Yahoo Finance wrote the following regarding Warren Buffet’s and George Soros’ views on the economy, inflation and the credit crunch.

Soros was particularly concerned about inflation, which is front and center today as crude prices surge toward $130 and core PPI was higher than expected…While the less dramatic than the uber-skeptical Soros, Buffett was certainly direct in his assessment that the credit crunch is not over, contrary to popular belief on Wall Street. “I don’t think the effects of the credit crunch are far from over at all,” Buffett said during a presentation in Europe, according to wire reports. “I think there will be rippling, tertiary effects.”

Bill Gross, CIO of PIMCO Funds and manager of the world’s largest bond fund, is the latest guru to throw himself into the inflation camp which I find odd since he was a proponent of lower rates last year which would have resulted in more inflation. He says in his June Investment Outlook, “…we’ve been foolin’ ourselves [believing] that inflation is under control.” (when he says “ourselves” he is making a general reference to US citizens – not to himself.)

Of course, the continuing inflation in our economy is not surprising as it is a necessary evil. Our government must continue with its inflationary policy to finance trade and budget deficits. They are seeking to repay our debt to foreigners with a discounted currency. Its not an ideal situation but it is likely better than the alternative. Until the US becomes more fiscally responsible with individuals becoming net-savers, industry becoming net producers and government maintaining balanced budgets, inflation is imperative.

Here is how my performance measured up to the averages for the first five months of 2008:

The most encouraging development in May was the relative performance of the mining stocks. I bought into these shares far too early and while averaging down has softened the blow, there are some fairly significant unrealized losses in these positions. They represent a small portion of your account so the losses in these shares have had a nominal impact compared to the gains we’ve made in the rest of our portfolio. The performance of the mining shares has baffled many of the analysts that I follow but as I’ve contended for six months now, I think they are due to outperform the actual metals.

I have rebuilt all of the commodity exposure that I had liquidated early in the year. These positions are down since I repurchased them this month which hurt May’s performance, but the repurchase price was far below what I liquidated them for back in late February. Our YTD gains in these funds is still very positive.

I believe the pieces are continuing to fall into place for an incredibly strong performance in Q3. The current equity rally may or may not have some legs so it will be interesting to see how it plays out in June. When the countertrend rally in equities is exhausted and the bear market trend resumes, I think we’ll see impressive gains.

The fundamental picture for domestic bonds and equities continues to deteriorate. The odds of a Stagflation economy are increasing which will have serious implications for the capital markets. While there are a few hurdles that this bear market needs to get over before continuing in earnest, the long-term outlook for equities is miserable.

There are few significant developments this month that I’d like to address. And I just updated my
Stagflation Alert post if you would like to check it out.

Technical strength
There is not much to update here, which is news in and of itself. Despite the uptrend in equities, there is still no leadership in the equity markets. In the last week in May, more stocks hit 52 week lows than highs, even though the Wilshire 5000 index advanced every day last week and is less than 10% off of its 52 week high. This is not the type of leadership we should be seeing if we were truly entering a bull market.

Breadth is flat which typically signals no immediate move one way or the other. The relative strength of the market does suggest weakness over the next few weeks but this indicator could easily turn bullish.

Perceived Market Risk (aka. the ^VIX Index)
The CBOE Volatility Index or the ^VIX is a measure of option activity in the marketplace. It is generally assumed that the lower the ^VIX index the less perceived risk there is by market participants. This index serves as a valuable contrarian indicator as when perceived risk is low, market participants are overly confident in equities.

The ^VIX index hit a historical low in early 2007 before shooting up when whispers of the credit crunch began working their way through the markets. The index peaked in March of this year just before the BSC bailout and has fallen precipitously since then. The index has formed a double bottom which may or may not hold. If the double bottom holds, it means the index is headed higher which is not good for stocks.

Consumer Strength
Consumer Confidence and Sentiment are at 16 and 27 year lows, respectively. The S&P Retail index is nearly 25% off its 52 week high. GM is at a 27-year low and GE hit it’s 52 week low in May which suggests that that the weakness in the stock market is not isolated to just the banks.

Probably the most disturbing development for me personally has been the number of my young clients dipping into their savings to meet daily expenses. Over half of my clients under the age of 40 have inquired about liquidating their IRA accounts and about a quarter have actually withdrawn money from their IRA’s despite the steep penalties and my verbal berating. What is most discouraging is that in every single case, with one exception, the individual has not suffered any hardship (i.e. loss of job or medical emergency). They are dipping into savings purely to finance daily living expenses. The Housing ATM is shut down, credit cards are maxed out and the only thing left is 401k and IRA savings. Eventually, consumers are going to have to curb discretionary spending.

Bond Yields
Treasury bond yields increased substantially in May as investors looked past the credit crunch and focused on inflation. The 10-year US Treasury bond rate increased from 3.75% to 4.05%. This is a critical development as higher treasury rates lead to higher borrowing costs for consumers and businesses alike.

The relative strength in bonds is weak meaning bonds should continue depreciating resulting in increasing yields. This development is the lynchpin in my Stagflation strategy. I’ve been saying for some time, that in order for your account to appreciate substantially, we need to see bonds and equities fall in unison. (For more about this subject, please read Part IV of my January 2008 Update.)

Rising interest rates as a result of inflation wreaks havoc on equity markets for two reasons. First, and most obvious, is that inflation impacts company earnings in two ways. Either rising input costs puts a squeeze on margins or if companies pass rising costs on to their customers, higher prices reduces the demand for end products. For example, Dow Chemical announced on May 28th, that they would raise prices up to 20% to offset the soaring costs of raw materials. (source: Associated Press)

But the other impact is that rising interest rates results in equity valuation contraction. According to the Dow Theory, the foundation for valuating equities is in part based on the opportunity costs of owning risk-free treasuries (and by risk-free, they mean default free as inflation is a big risk to “risk-free” treasuries.) So, as inflation discounts future income streams, risk-free treasuries must provide a higher yield. Consequently, if bonds are providing a higher yield, then the yield one receives from owning equities must appreciate as well. But if earnings are falling, the only means of achieving a higher yield on equities, or you could say lower equity valuations, is for prices to fall.

Energy Prices
The big news from capital markets this month was the precipitous increase in energy prices. Oil hit $130+/bbl and gasoline is near the $4/gln mark. The rise in crude prices over the past year is truly remarkable.

In my Market Outlook which I posted last July, I state that the next surge in energy prices will be supply driven rather than demand driven. There is several pieces of evidence that supports this hypothesis and I’ll like to address two of them.

First, refinery utilization is down considerably from the last few years. In May of ’07, Capacity Utilization was over 90% where as it was under 87% this past month. With today’s gasoline prices, refiners would be running all out if there was ample supplies of crude.

Second, the disparity between diesel and gasoline prices suggests that the current energy crunch is due to falling supply. Our nation’s refiners are set up to make a certain ratio of gasoline, diesel, jet fuel, ect. Diesel demand is more inelastic than gasoline because it is an industrial fuel while gasoline is largely a consumer fuel. It is easier for individuals to curb gasoline consumption by carpooling, limiting trips to the store, ect. But is it difficult for rigs pulling a full load to consume any less diesel. When total demand for fuel falls, the demand for gas will fall faster than the demand for diesel because it is more elastic. Therefore, as the price of gasoline decreases relative to diesel, it suggests that overall fuel demand is falling. And if demand is falling, the only explanation for higher prices is declining supplies.

Before continuing, I would like to address the issue of the impact that speculators have on the price of energy. The claim made by our government and the media that speculators are partially to blame for the run-up in energy prices is utter nonsense. While speculators may have a short-term impact on the price of any consumable commodity (i.e. all commodities except Precious Metals), the long-term price is set purely by supply and demand. The derivatives market for commodities is a zero-sum game that in the long-term has absolutely no impact on the price of any commodity. The following quote appeared in last week’s Economist regarding this issue.

Stuck for answers [regarding the rise in energy prices], politicians have been looking for scapegoats. Top of the list are the speculators profiting from other people’s hardship…But that is plain wrong. Such speculators do not own real oil. Every barrel they buy in the futures markets they sell back again before the contract ends. That may raise the price of “paper barrels”, but not of the black stuff refiners turn into petrol. It is true that high futures prices could lead someone to hoard oil today in the hope of a higher price tomorrow. But inventories are not especially full just now and there are few signs of hoarding.

All futures contracts have to eventually be delivered at the spot price so if speculators were driving up the price of futures, they would get cleaned out at physical delivery. Other ways to play movements in the price of energy commodities is swaps and options which are both purely paper bets and a zero-sum game. For every winner in these markets there is a loser.

The truth is that reckless monetary policy by central banks worldwide coupled with massive trade deficits in the western world has created a surge in demand in emerging economies. And now that energy production and supplies are declining, these two trends are colliding resulting in a formidable impact on the price of energy products.

Over the next several weeks, I think it is probable that the Credit Crunch will rear its ugly head once again. I’ve said all along that the Financials will lead the market in which ever direction it is headed. They led the market down all of 2007 and conversely led it higher starting in the Feb/Mar timeframe this year. In the month of May, financials significantly underperformed the market. The I-shares Financial Sector ETF (IYF) lost over 8% since 5/3/08 while the S&P 500 index was essentially flat. The performance disparity between these two indexes in the month of May was comparable to July and November of last year.

The action in the Credit Default Swaps (CDSs) for some of the largest investment banks is providing the most acute evidence that the next wave of the Credit Crunch is upon us. Lehman Brothers and Merrill Lynch saw massive jumps in the price of their CDS’s over the past two weeks. The price to insure yourself against a default in Lehman’s bonds more than doubled in the span of 10 business days.

Many financial stocks are nearing their 52 week lows from early March. IYF is less than 7% from its 52 week low.

The write-downs from the credit crisis are far from over. It was just a few months ago that Jim Cramer on his infamous show Mad Money stated that “The Financials of the Financials cannot be trusted.” Warren Buffet said recently in a news conference that “You’ve got a lot of leeway in running a bank to not tell the truth for a quite a while.” The Enron-like accounting games played by the investment and traditional banks are not over. There will be even more write-downs over the next couple of years.

Supporting the idea of the continuing credit crunch is a report from Fitch’s. They state that bondholders for 1/3 of all junk bonds going into default will not receive more than 10 cents on the dollar. Another 1/5 will likely get no more than 30 cents on the dollar. This compares to a historical recovery rate in the range of 45 cents on the dollar. Global defaults in 2008 have already surpassed the total for all of last year by 25%. Standard and Poor’s “optimistic” estimate of 2008 defaults is three times last year’s level! (source: Bloomberg)

If these predictions by S&P and Fitch’s hold true, the owners of the collateral, primarily the large banks, will suffer catastrophic write-downs as many have yet to discount their junk bond holdings. Given the precariously overleveraged balance sheets of the banks, any significant writedowns could spell DISASTER.

The following quote comes from a RBC Capital analyst named Gerard Cassidy via Marc Faber’s most recent newsletter…

We continue to believe the biggest issue confronting the banking industry over the next 12-18 months will be credit deterioration. Residential mortgage delinquencies are at record levels, home equity loan defaults are steadily rising and residential construction and land loan nonperforming assets are skyrocketing for lenders with excess exposure to the weakest housing markets in the US. The “Next Shoes to Drop” for credit in conjunction with the slower economy will be in the commercial and industrial and commercial real estate loan areas.

Q2 is a seasonally weak period for the non-cyclical commodity plays in my model portfolios. Conversely, Q3 has historically been a very strong period for these same commodities so while I’m not sure what June will hold for these positions, I’m confident that they should do well in the second half of the year.

However, I always try to maintain a healthy skepticism about my strategy. My biggest current concern is how a pullback in the energy space might impact our precious metal exposure. The Gold:Oil ratio is at its lowest level ever, except immediately after Hurricane Katrina, so I would expect that Gold and Silver would be partially insulated from falling energy prices but there are no guarantees. The precious metals have historically done well when there is negative real interest rates as there are now. (The “real interest rate” is simply the nominal rate minus inflation. When inflation is higher than nominal rates then you have negative real rates.)

I’m also leery of the changing relationship between equities and the precious metals. From the summer of 2005 through Q3 of last year, these asset classes were exhibiting a strong positive correlation which is not the historical norm. This was mainly a factor of large infusions of liquidity into the capital markets as a result from loose monetary policy by central banks. The Credit Crunch resulted in liquidity being squeezed from capital markets as banks, hedge funds and private equity groups start to deleverage. This deleveraging process resulted in all asset classes falling last August. In order to account for the deleveraging risk, I had implemented a long-short strategy which took advantage of the secular bull market in commodities but shorted equities to hedge a massive deleveraging scenario.

In Q4 2007, as the credit crunch began to unfold, it seems that equity and precious metals finally decoupled, meaning they were no longer positively correlated. Over the past couple of months, it appears that not only have these assets classes decoupled, but now there is actually a negative correlation between them. This resulted in terrific volatility in your account over the past several months. If these assets classes remain negatively correlated, my strategy will be highly profitable once the bear market reasserts itself. However, there is a concern that a massive deleveraging event could bring everything down as money managers have to liquidate anything with a bid on it. I think this is unlikely but not entirely out of the realm of possibility. So, I’ll be keeping a close eye on the liquidity issues in the market and the relationship between equities and the precious metals to determine if it would be prudent to liquidate some of your precious metal exposure.

As always, please call me if you have any questions or concerns about your account.

Matt

Dear Clients,
The following is my Performance Update and Outlook for April. All prices and returns are as of 4/30/08.

The last two months have not been kind to my model portfolios but we are still well ahead of all the equity and bond market averages for the year. Even though the recent activity in your account might be discouraging, I am growing increasingly confident in my long-term strategy and the opportunities for your portfolio. While the current trends could last a little while longer, by Q3 I should be generating returns similar to those we realized in the first part of the year.

The fundamental case for my strategy is stronger than ever. I can’t find any evidence that the economy is improving or that inflation is cooling which are the trends I’m seeking to capitalize on. Stagflation, a unique economic condition that only occurs every several decades, will prevail as long as the Fed can keep the credit markets from crashing – a scenario far worse than what I’m expecting. We are currently experiencing a bear market rally in stocks and a bull market correction in commodities (except energy) but these trends should reverse themselves within the next couple of months. I think we are far closer to the end of the countertrend than the beginning.

The following essentially describes the action in your accounts over the past 15 months. Last year, every asset class (bonds, equities and commodities) was highly correlated which is not the historical norm. I’ve mentioned on numerous occasions over the past year that the historical correlations would be reestablished and now it is finally taking place. Furthermore, I have stated that the normal correlations between these assets classes must be reestablished for my strategy to truly provide significant returns.

Since every asset class was correlated for the first 10-11 months of last year, my long/short strategy was not very volatile as my long and short positions worked against each other. If my long positions appreciated, then my shorts fell and visa-versa. We made money on the margin but that was about it.

Starting in Q4 of last year, the commodity markets, specifically the Precious Metals (PMs), began decoupling from equities. While this decoupling took place, my long/short strategy became far more volatile as my long and short positions started moving in lockstep with one another. From December ’07 through February ’08, everything in the portfolio made money as equity prices fell. Conversely, equity prices started rising in mid-March and all of my positions started to fall in unison. The net result is still a fairly nice gain YTD but far from where we were at a couple of months ago.

I went through a similar rough patch in Q2 of last year but I stuck to the fundamentals and we outperformed the market handsomely in the second half of the year. I believe that the second half this year will be even better as we’ll make money both in falling equities and rising commodities rather than just on the margin as we did in ’07.

Here is how my performance measured up to the averages for the first four months of 2008:

My feelings from February were certainly validated as everything we were invested in plunged the next two months. But just as frustrated and pessimistic as I was in February, I am now equally encouraged and optimistic. While the current equity bounce and commodity correction may have a bit to go, they are both long in the tooth.

I’m encouraged because the fundamental case for my Stagflation strategy continues to improve. The economic data continues to be miserable while inflation pressures continue to heat up. In Q2 of ’07, inflation cooled off, so once we hit August of this year, YOY inflation data will not be easily ignored by Wall Street.

The current activity in your account is a necessary step to bigger gains in the future as equities and PMs had to decouple at some point. I wish the pullback in your account value was not so severe, but I knew that it would come at some point, which is why I was so nervous in February. Now that it is nearly over, we can look forward to some very exciting returns over the next few quarters.

One of the four pillars of my investment philosophy is to invest in assets that truly fill a legitimate need. There is a legitimate need for the real assets (i.e. commodities) that dominate your portfolio. Foreign central banks and SIVs have a real need for an alternative to fiat currencies, specifically the US$, and Gold and Silver offer the best alternative. The emerging middle class in developing countries are going to change their eating habits and the need for foodstuffs will be tremendous.

Conversely, the markets are learning that nobody needs the junk that banks have been producing over the past few years, mainly securitized debt. US consumers and companies are already so overburden with debt, there will be little need for banking services going forward. Being long non-cyclical commodities and short financials is still a solid fundamental play. Furthermore, the fundamental case for the other themes I’m focusing on, such as the falling US$ and alternative energy plays, are continuing to build.

In the next month or two, equities may continue to rally. Marc Faber has called for the rally in the S&P to end between 1400 and 1450. I am inclined to agree with him and would not be discouraged to see it go even a little higher. Thus far, the similarities between the current market and 1973 and 1937 are undeniable. These equity bear markets saw rallies of 11% and 14% after the initial sell-off which would put the S&P between 1413 and 1451. (This is not a call, just a point of reference.)

Here are several fundamental and technical reasons why the market rally will exhaust itself at some point in Q2.

Technical…

• Despite stable breadth, leadership is not giving us a bullish signal. Leadership has improved as should be expected during a rally, but only marginally, which is not what we should expect of a healthy bull market in equities. On May 1, the NASDAQ saw more 52 week lows than highs despite rallying nearly 3% and closing at its highest level since early January. The number of 52 week highs on the NYSE barely surpassed the new lows. This is not a technically strong rally.
• The relative strength in bonds is weak meaning bonds should begin depreciating resulting in increasing yields. This development is the lynchpin in my Stagflation strategy. I’ve been saying for some time, that in order for your account to appreciate substantially, we need to see bonds and equities fall in unison. (For more about this subject, please read Part IV of my January 2008 Update.)
• Commodities are severely oversold and will be entering a seasonally strong period in Q3. Now that commodities and equities have decoupled, commodity strength should result in equity weakness.

Fundamental…
It would be impossible to hit on all the fundamental issues pointing to further weakness in equities but I’ll touch on the big ones.

• Bankruptcies: Eight mid-sized retailers have claimed bankruptcy in the last 6 months. Four airlines declared bankruptcy in April alone!
• Consumer sentiment and confidence continue to tumble and are currently at multi-decade lows. We have not had a consumer led recession since the early 90’s but it is looking increasingly likely that consumers, who are responsible for 70% of our economy, are starting to throw in the towel. A very disturbing trend that I am noticing is several of my young clients are liquidating their IRA’s to fund everyday living expenses. These are not young adults who have lost their jobs or have experienced unexpected expenses such as medical emergencies and such. They just can’t pay the bills because their bills are going up. People aren’t making big sacrifices yet, but they will be soon as necessities such as food and energy consume more and more of their paycheck.
• Commodity Inflation: Over the last decade, commodity indexes have underperformed in Q2 and this year is proving no different with the exception of the energy space. Since 1999, the average change in the CRB index in Q2 is 0%, but averages a 3% gain in the other quarters. Last year, the CRB index fell in Q2, which reduced the pressure on PPI. Since July of last year, commodity inflation has been red hot. Once last year’s Q2 figures are cleared out of the inflation calculations, YOY inflation data will be excessive.
• Fed policy changes: The Fed pulled all sorts of tricks, some legal and some illegal according to former Fed Chairman Volker, to support the banks. Without that support, credit markets might have collapsed. A lot of the new lending facilities and notes will be coming due starting in Q3. When these issues are revisited and investors realize they didn’t magically go away, financials are likely to sell off and lead the market down again.
• Earnings: Earnings this quarter were absolutely terrible. The P/E for the S&P 500 is now over 23 - the most expensive equities have ever been with the exception of the 2000 tech bubble! Banks, airlines, retailers all reported significant if not massive losses. The market ignored much of the bad news for a couple of reasons. First, they perceived it as “baked in the cake”. Second, a lot of the losses were chalked up to “one-time items”.

  One-time items is a little accounting trick I learned about back in my days at Arthur Andersen. Companies would defer taking a write down if they were going to make their numbers. Then when a quarter came around where they weren’t going to make their numbers, they would take all their write-downs at once. There are all sorts of tricks that can be played with financial reports and they should rarely be trusted. (BTW, after serving on an audit of an Oil and Gas client who was planning on doing just what I described, I resigned shortly thereafter.)

  The market hasn’t priced in two consecutive quarters of abysmal earnings. The market can easily shake off a one-time event but when the data is reconfirmed a second time, it tends to take notice. For example, the market largely ignored the initial warning signs of a credit crunch last spring when a couple of hedge funds required emergency funding. It wasn’t until the meltdown in a couple of Bear Sterns’ funds in July that the market actually took notice.

  Financial earnings were responsible for over 40% of our economy’s total earnings. These earnings don’t exist any more and there are limited means of replacing them. (BTW, government spending is ultimately responsible for a lot of the rest, so without banks and government, our economy is practically running in place.)

• Housing: The housing market is showing no signs of bottoming. Rather the depression in housing is seemingly growing and while some areas maybe protected from the malaise, far more areas will be hit by the housing downturn than will be protected from it. Despite the decade lows in housing sales and the all-time highs in home inventories, builders are still building more homes than they are selling, which is not sustainable. Eventually, homebuilding will slow even further causing more strain on our economy. Considering that over $650B of Adjustable Rate Mortgages will be resetting in the balance of 2008, repos and mortgage defaults are sure to increase.

The question is: Will an increase in debt provide an increase in the GDP? And why is this important? Very simply, if additional debt does not contribute to GDP, then all of the Fed’s actions are not only futile but in a high inflation environment, they will inevitably cause even more harm. The mantra “Don’t fight the Fed” is based on the idea that the Fed can magically increase the GDP by simply lowering borrowing costs which leads to more debt. But if increasing the amount of debt doesn’t result in a boost in GDP, then the Fed is impotent, an idea that I’ve touched on in several of my previous updates. (The term most often used to describe this phenomenon is that “ the Fed is pushing on a string.” )

Faber says, “Recoveries from other financial crises in the post WWII period have worked because they have reignited the growth in private borrowing.” In other words, The Fed created debt and that stimulated GDP. In the early 70’s, before Nixon nixed the Gold standard, a $1 increase in debt resulted in $3 of additional GDP. (Source: Fekete) Ever since the Gold Standard was overturned, the debt-to-GDP ratio has consistently declined. According to Fekete, “[The debt-to-GDP ratio] went negative in 2006, forecasting the financial crisis that broke a year later.”

If the debt-to-GDP ratio is truly negative (or at least zero), then this plays perfectly into my Stagflation theme. Increasing debt inevitably leads to inflation but according to Faber and Fekete, it may not boost GDP. (Technically, increasing debt increases the money supply which is the true definition of inflation, but in today’s political environment, inflation is commonly known as an increase in prices.) The end result would be Stagflation at best.

The reason why I fear this outcome is that it passes my “Irony Test”. Wouldn’t it be ironic if just when every last soul on Wall Street believes that the “omnipotent” Fed can bail the economy out by increasing debt, the Fed loses it’s ability to do just that.

The only time that the Fed significantly cut rates in the last 40 years and the stock market still fell was the most recent bear market in 2000. Couple that knowledge with the current equity market weakness in spite of unprecedented Fed actions and this provides some level of empirical evidence to support the thesis that Faber and Fekete have argued.

12 months ago, Wall Street was clamoring about a “Goldilock’s Economy”. Not too hot to stoke inflation but not to cool to cause recession. Now, we all know the story of “Goldilocks” was nothing more than fiction. Regardless of what was said by the financial media and our government, I maintained that we would see stagflation which now looks highly probable. Currently, Wall Street is making the case for a mild recession and not stagflation and unfortunately they have it wrong yet again. A recession maybe priced into the market, but you have to look no further than bond yields to know that Stagflation isn’t.

We need to understand that Wall Street and the US Government are living off of inflation; in fact, they are profiting from it. They will be the last ones to acknowledge it or do anything about it because it is not in their best interest to do anything about it.

The government is running up huge deficits estimated to be over $500B in 2008 alone (which is $1,786 per every living man, woman and child in America). Those deficits must be funded and there are only two ways to fund them – taxes and/or inflation. Debt is nothing more than deferred taxes and inflation. Since nobody likes raising taxes, inflation is the only other option – and possibly the least painful as much of the burden is exported to foreign investors. Wall Street makes a mint off the debt issued by the federal government, not to mention the commissions and fees off of nominal appreciating assets. (For a telling snapshot of the debt/money being injected into the system, click on this link to view a graph of the Discount Window Borrowings from the St. Louis Fed’s website.

Current market action can be chalked up to the commonly held notion that you “Don’t fight the Fed”. But as I said above, the Fed is growing increasingly impotent. In numerous interviews, legendary investor Jim Rogers has advised people to, “Short Bernanke” [Chairman of the Federal Reserve] and he might just be proven right.

Please, do not be discouraged by the recent pullback in your portfolio. This is a snap-back rally in equities and corresponding correction in commodities. This was a necessary step in the process that I’ve acknowledged for some time. I just wish it wasn’t so severe. I’ll admit that mistakes I have made over the past couple of months have contributed to the severity of your account’s losses in March and April, but I have still beat the market soundly YTD and last year I generated returns significantly above average. You can never bat 1.000 in the markets but I’ll continue do my best to beat the averages. I’m confident that as long as I stick with fundamentals and factor in technical indicators, we’ll do well. I should have you back on track by mid to late summer.

Within the next few months, the S&P will be back in the 1270 – 1300 range. At that point, if I’m wrong about Stagflation, the market will show technical strength and a new bull market will be born. If that is the case, hopefully, I will have the wisdom to acknowledge the strength in equities and we’ll buy shares cheaper than we sold them a couple of years ago.

If I’m right about Stagflation, the market will pause for a bit in that range and continue lower. If it follows the lead of ’73 and ’37, equities will fall precipitously for several months before gaining some traction.

As always, please call me if you have any questions or concerns about your account.

Matt

Dear Clients,

I am preparing my Quarterly Update along with your performance reports and fee statements. I’m aiming to mail them out by Friday, but there are some analyst reports coming out at the end of the week that I’m waiting for so I might not get them out until Monday. In the interim, I wanted to report on your account performance so far this year:

Here is how my performance measured up to the averages on a YTD basis:

The quarter provided a lot of excitement in the market that resulted in losses in most portfolios. The S&P 500 had its worst quarter since Q3 of ’02 – near the bottom of the worst bear market in 70 years. Given that Q1 is typically a strong quarter for equities coupled with the monumental easing by the Fed, this is not a positive omen for the market.

The market has seemed to grab some traction as the government has provided a backstop to the financial sector on March 16th compliments of the US taxpayer. Since all the fun began last August, the fed has pledged over $1,300 for every man, woman and child in America. Fortunately, while our government has been increasing the liability side of your personal balance sheet, I’ve been increasing the asset side.

My performance for the last quarter has been pretty remarkable even though I gave a nice chunk back in March. I explained it to one client that “we went in at half with a 30 point lead but only won by 20”. (He appreciated the sports analogy which McCracken’s are famous for.) So far this year, my Core and Focused Strategy have beaten the S&P 500 by over 24%. In a $1M account, that equates to a $240,000 advantage.

Equities were severely oversold and commodities were equally overbought so a move back to the mean was expected (not necessarily welcome, but expected). The good news is that the long-term fundamental outlook for my strategy improved significantly this past quarter. But the technical short-term outlook is less favorable and I expect that many of our best performing positions might continue to correct. For that reason, I’ve reallocated a fairly significant percentage of your account to lock in profits while trying to find some risk-friendly returns over the next few months. I’ll cover all of this in detail in my report.

As always, please do not hesitate to call me if you have any questions or concerns regarding your account.

All the best,

Matt

Dear Clients,
The following is my Performance Update and Outlook for February. All prices and returns are as of 2/29/08.

The Stagflation theme has finally caught on with the investing public. On February 21st, both the Wall Street Journal and Larry Kudlow’s show Kudlow and Company dealt with the prospect of Stagflation. I just got an e-mail from an analyst in Dallas by the name of John Mauldin and his article is titled Stagflation and the Fed. (I think these guys are bit late to the party as I’ve been preaching about Stagflation for some time. Last April I wrote a post titled Goldilocks or Stagflation which concluded that Stagflation was the more probable outcome.)

Stagflation is simply persistent price inflation coexisting with a cyclical slowdown in the economy. It’s not the end of the world, but it can do nasty things to a portfolio invested in equities and bonds.

Inflation pressures are undeniable. I wrote in my Annual Update that we are experiencing unprecedented long-term inflation. The 5 year appreciation in commodities as measured by the CRB Index is running at it fastest clip since the index’s inception. The CRB index is up almost 200% since the beginning of 2002. And this month it got worse as the CRB Index increased by 12.4%. Since the “omniscient” Fed started their rate cutting campaign in August, the CRB Index is up 36.8% - the second largest 6 month increase since the index’s inception. The biggest increase was in 1973, not exactly the best time to be invested in equities as they fell 49% in 18 months. (Are you growing tired of me quoting that stat in every single update? If so, my apologies, but I feel the need to include it for non-clients who might be visiting this site for the first time. Feel free to skip over such redundancies in the future.)

Another certainly is the reality of a slowing economy. For reassurances about the slowing economy you can check out my Stagflation Alert or just read any of the latest Fed minutes, speeches or Congressional testimonies. (Federal Reserve Website link)

But this introduction has run on long enough; let’s get to the good stuff.

Here is how my performance measured up to the averages for the first two months of 2008:

In last month’s update, I stated

If the current investment trends continue, your account should continue to perform well – but I would not get used to 9+% returns every month. Nearly 80% of your account’s allocation did very well and 20% was flat to down. I invested the portfolio to be more balanced and I expect it to act accordingly going forward.

Fortunately, I was wrong about not being able to generate 9+% returns but I stand by the idea that we should not count on near double-digit monthly returns going forward. In January, 80% of the portfolio appreciated where as in February, practically 100% of your positions made money (with the exception of an individual stock that I bought in the last week of the month. Also, a couple of trades I made in my swing allocation, consisting of Direxion funds, had small losses but the average return for all of my Direxion funds’ positions were up for the month.)

Certainly, we cannot count on every position making money in any given month. It was just 10 months ago, that the majority of my positions went down as I was early implementing my Stagflation strategy. In fact, I question my ability to generate any significant gains in the next few months which I’ll discuss in Part IV.

Before I continue with my Market Outlook and Forward Strategy, I need to provide you a back drop for the next two sections.

While February was certainly a Red-letter month for your accounts, I have to honestly say that the last couple of weeks have been as exhausting as any time in my professional life. Just as my strategy began to “hit on all cylinders” causing your accounts to jump in value, I started agonizing over everything I was doing in your account. Starting on 14th of the Month, numerous anomalies began to develop in the market which has caused me to question everything about my strategy. Currently, I have severe doubts about which way the capital markets are headed over the intermediate term and for those of you who know me well, this is not an insignificant development.

Valentines Day: There was an ominous jump in bond yields despite nothing really happening in the equity or currency markets. I originally discounted this move as I had long been predicting an increase in yields but for some reason it just didn’t seem right. From that point forward, the markets have not acted in the same fashion as they have over the last several months. All the correlations that I had counted on started breaking down. Trend and Technical analysis were rendered useless in the last two weeks.

President’s Day:Then came the worst news I’ve heard in quite some time. On President’s Day, the PBGC made the following announcement:

The Pension Benefit Guaranty Corporation has adopted a new diversified investment policy to help ensure the federal insurance program can meet its long-term obligations to America’s retirees, PBGC Director Charles E.F. Millard announced today. “The PBGC is responsible for the pensions of 1.3 million Americans, but we don’t currently have the resources to keep all of our future commitments,” Millard said.…The PBGC currently has approximately $55 billion to invest in the new investment policy. Under this new policy, the PBGC will allocate 45 percent of its assets to a diversified set of fixed-income investments, 45 percent to diversified equity investments and 10 percent to alternative investment classes. The agency’s previous policy set an equity investment target of 15–25 percent, although the actual level of equity investments was 28 percent at the end of FY 2007. (emphasis mine)

The reason so many Pension plans have been turned over to the PBGC is because their original investment strategy was too aggressive! The PBGC is implementing the exact same strategy that doomed these plans in the first place. We should all be very scared that the PBGC is turning up their risk levels as we are entering a cyclical bear market. If there are doubts about its ability to reach future commitments now, what if their higher allocation to equities falls 20-40% as I’m expecting equities to do over the next 18 months?

Week of February 18th – 22nd: Since July, the market volatility has been gut-wrenching with 1-3% daily swings in both directions. From the 18th through the 22nd, the market trended sideways for five straight days, the longest such stretch in over a year. Markets don’t go “sideways” in a bear market – they either go up or down.

February 22nd: Never in all my days of investing have I seen a “melt-up” like the 22nd. There were several disturbing attributes of this rally. First was the leadership or lack there of. Prior to every rally in the last 8 months, a couple of sectors were leading the market up by a day or two. On the 22nd, these sectors were hitting multi-day lows and headed down and magically they shot up once the news of an imminent AMBAC bailout was rumored (which coincidentally still hasn’t been confirmed). Another ominous detail about the rally was how broad based it was. An AMBAC bailout should have mainly benefited the financials but all equities rallied with the financials trailing the rally.

Week of February 25th – 28th: A slew of terrible economic and inflation reports were released and the market never sold off with any conviction. PPI and CPI were far hotter than economist’s expectations. Existing and New Home Sales were disappointing, Durable Goods orders were lackluster and GDP was not revised higher as expected, but the market never sold off. In fact, everytime the market tried to sell off, there was a significant rally. Furthermore, all the rallies were broad-based. There was no leadership. There wasn’t one sector under or over performing by any significant margin. Technical trading indicators were rendered useless as markets defied trends and correlations.

For two weeks, I struggled mightily with the market action and what it would mean for your portfolios. I subscribed to numerous newsletters racking up over $1,000 in fees in addition to the dozen or so newsletters that I am already subscribing to in the hope that some piece of news or analysis would give me a better idea of what in the wide-wide world of sports was going on.

One thing I knew for sure was that Wall Street was not behind the rumor or the rally because the financials did not lead it. I’ve never been a conspiracy theorist and while the Fed and the Plunge Protection Team have been given marginal authority to stabilize the markets, I have a difficult time believing that the government would outright manipulate stock prices. So, I’m still at a loss as to what has happened over the last few weeks. Perhaps, it was simply the PBGC reallocating hoards of cash (approximately $10+b) from bonds to equities. That would explain the steep sell-off in bonds and the broad-based nature of the equity rally. Perhaps it was a fundamental shift in the markets that I am not yet aware of. Maybe it was just an anomaly and the markets will return to their historical correlations. Unfortunately, I cannot say for certain.

Regardless of what was the prime motivator behind the rally was, I’ve decided to “take my foot off the gas” and position your account more conservatively until I can get a better understanding of what is going on.

I fancy myself as an intermediate term investor. I’m a lousy trader so my outlook must take on a longer-term perspective than a few days or even weeks. However, I believe in a semi-efficient market that does provide above average returns for opportunistic investors who can identify intermediate trends. My focus has always been the 12-24 month timeframe. There are a lot of reasons why this timeframe is exploitable but I don’t have the time to get into them here.

The market’s unusual behavior in the past month has led me to question my 6-9 month outlook and my near-term investment strategy – a strategy that has generated 30% returns in my Core Portfolio over the past 3 months. I stand by my 12-24 month outlook of continued Stagflation. Here is a rundown of the primary macro trends that I’m studying in attempt to create a profitable strategy over then next couple of quarters.

ELECTION YEAR MARKET STRENGTH: Why both parties seem to disagree on practically every issue, there are two issues that both parties are in complete agreement. One issue is the idea of bigger government. The other issue is maintaining equity bull markets in election years. Nobody on either side of the isle wants to see an equity bear market in an election year which may result in them not getting reelected.

At the beginning of the year, I was convinced that a combination of high valuations, weakening economic pressures, increasing inflation pressures and a credit market teetering on collapse would be too much to overcome in stopping the ensuing bear market. But now I’m not so sure.

The Congress passed a stimulus bill earlier this month to provide a handout to Middle Americans with the hope of increasing consumer spending which will help keep the economy afloat. Given the bloated deficits that the government is currently running and a War with no foreseeable end, this type of stimulus plan can be deemed irresponsible in the long run but helpful in the short-term.

The government stimulus package, the ominous timing of the PBGC reallocation and the actions by the Fed (see below) are making a clear statement that this government will pull out all the stops to keep the stock market up this year.

DOVEISH FEDERAL RESERVE:

“Don’t fight the Fed” is a popular Wall Street saying and it certainly is valid. Only on a couple of occasions has the market continued to plummet during a Fed cutting campaign – 2001 being one of them.

It is quite obvious that the Central Bank is pursuing a reckless attempt at keeping both the equity and credit markets afloat with little regard to the consequences. Since the Fed started cutting rates in August, the US$ has dropped over 10% and commodity inflation has increased at a 70% annualized rate! A sizeable percentage of commodities are at all-time, record highs. The things that we consume everyday such as energy and food are experiencing substantial price increases.

In order to get a better idea of where Bernanke and friends stood on the economy and inflation, I reluctantly sat through his congressional testimony last week. Bernanke reiterated his fears about the economy while downplaying any real inflation threat. He keeps saying things like “inflation expectations remain anchored”. I don’t know where he’s getting his intel, but when I talk to clients and friends, it seems that inflation is anything but “well anchored”.

In a Bloomberg article posted on Monday (3/3/08), the following was written…

The Federal Reserve is wrong to lower interest rates while inflation is still a threat and shouldn’t bail out investors who made wrong-way bets, economists said in a survey by the National Association for Business Economics.

There are only two conclusions that can be drawn from the Fed’s actions. Either the Fed is far more scared about the situation in the credit markets than they are letting on or the Fed members are total fools. There is no other way to explain the hyper-inflationary monetary policy that they have adopted. To keep rates this low with the prospect of even lowering them further (the market is betting on another 50 bps cut in March) is completely irresponsible unless there is a very sound reason to do so.

Regardless of the reasoning behind the Fed’s actions, it seems clear that they are going to keep cutting. Bernanke is auditioning for reappointment and if he allows the markets to fall this year, he’ll likely be replaced. The question is will he succeed?

BOND YIELDS: Long-term Treasury bond yields are ridiculously low right now given the inflation pressures in the economy. I’d like to meet the people buying 10-year treasuries at 3.5% when reported inflation is at 4.5% and commodity inflation is running at a 70% annualized clip – not to mention the freefall in the US$ which is what these bonds are denominated in. I’ve addressed this issue many times and I’m of the opinion that rates have no where to go but up. But I’ve felt that way for a while now while rates continued to trend sideways to slightly down. About the only play I’ve lost money in over the last few months is betting on higher rates. (I think the first post I made that went into depth in this topic was my November 2007 Update and I addressed it even further in last month’s update.

But as long as bond yields stay this low, equities are relatively attractive meaning they can sustain higher valuations. Bond yields will be a key in determining the sustainability of equity prices. If bond yields increase, which I’m convinced that they will and I have your account positioned accordingly, than equities could sell off regardless of the actions of the Federal Reserve and the US Government.

AVAILABLE CASH: There is still a lot of cash sitting on the sidelines in Foreign Sovereign Wealth Funds, money market funds and brokerage accounts. While Equity Mutual Funds are as fully invested as they ever have been, there is cash sitting in a lot of other places that if deployed in the equity markets, could cause them to rally.

BOND & EQUITY FUNDAMENTALS: I’ve harped on this topic for nearly two years now, but the fundamental situation for bonds and equities continues to worsen. Inflation is an enemy to equity and bond prices. Furthermore, the falling US$ should make equities less attractive to foreign investors (I’ll address this subject more below).

The lynchpin is falling earnings which seemingly peaked in the middle part of last year. Once you extract financial earnings from the S&P 500, something I’ve long argued for as their earnings are merely a smokescreen, the P/E for the S&P 500 is probably north of 21 or 22. Historically, the outlook for equities when valuations are that rich is very poor regardless of the inflation picture. When you factor in excessively high inflation with sky-high valuations, the outlook for equities is downright miserable.

TECHNICAL STRENGTH: Again, I’ve covered this subject ad nauseam for the last 18 months. Nothing has changed in last couple of months except that the market did reach a significantly oversold situation in late January. Breadth is still neutral to bullish and while I question it’s predictive ability due to numerous factors, a turn towards bearish levels would provide some much needed confirmation that markets are headed lower.

CONSUMER STRENGTH

The consumer buoyed the economy throughout the last recession and the hope was that they would remain strong regardless of what happened to credit markets, banks, ect. Unfortunately, the Housing ATM is out-of-order and inflation in necessary goods such as energy and food has put the kibosh on discretionary spending. The fall in both Consumer Sentiment and Confidence in the last couple months has been monumental. Sentiment is at a 16 year low. (source: Bloomberg) Without consumer strength, the economy and the equity markets have no hope. Unless the Government continues to pump out $600 checks to every man, woman and child, consumer spending is likely to slow.

THE IMPACT OF A WEAKENING US$ ON THE TRADE DEFICIT: In my opinion, this is the biggest wild card of them all. The US government, despite its countless ascertains to the contrary, are seeking a weak US$ policy. The primary motive is to improve the trade deficit. A secondary motive would be to reduce the debt burden by paying back debt with a cheaper currency.

But what if their strategy backfires? In economic theory, a declining currency should help trade deficits; however, a country’s economy has never thrived when its currency is purposely debased. Here is the how and why a declining US$ may actually hurt the trade deficit.

Compared to other countries, we buy a lot more stuff from foreigners than we buy from ourselves. If the demand for stuff we import is more inelastic than goods that we buy domestically, a declining currency could actually make our deficits worst. For example, the demand for Oil has proven to be extremely inelastic. Despite the price of gasoline increasing nearly 200% in the last 7 years, we are consuming more of it today than we did 10 years ago. By debasing our currency, imported goods become more expensive and if we keep buying the same amounts of them, then our trade deficit will worsen. (In absolute dollar terms, the trade deficit could go down because we would simply buy less stuff, however the ratio of imported goods to domestic goods could get worse.)

Furthermore, when economies go into decline, consumers shift their buying patterns towards more affordable goods. Everyone on Wall Street knows that Wal-mart is a counter-cyclical play and where does Wal-mart get all their stuff from - China! Goods from China, India, East Asia and Latin America are currently more affordable so when our economy weakens, we could increase our consumption of cheap foreign products and reduce our consumption of expensive domestic products.

So despite our governments best intentions, debasing our currency may not solve our deficit woes. As with so many government agendas of the last decade (The War in Iraq, healthcare, house ownership, ethanol, ect) this one may backfire in the end. If our declining currency actually leads to an increase in our trade deficit, I shutter to think what will happen to our nation’s producers and their stock prices.

THE RESILIENCY OF US DEBT HOLDERS: The inflationary policies of the last decade have caused a massive decrease in the strength in our currency in addition to an unsustainable valuation for US treasury debt. The US$ is down almost 40% since it peaked earlier in the decade. Since the Fed went on their money printing spree six months ago, the US$ is down over 10%

Treasury yields simply cannot stay at their current level given 20% plus annual commodity inflation worldwide. I touched on this idea in last month’s update where I quoted what George Soros and Nobel-prize winning economist Joseph Stiglitz had to say on the subject – two gentlemen whose opinion carry a bit more weight than mine. Eventually, it seems that foreign investors will abandon our treasury bonds yielding 3.5% while the US$ falls over 10% in six months. While our government can bail out its own companies and the PPT can use its various tools to manipulate the market, they cannot control the behavior of foreign central banks and investors.

However, there is a global prisoner’s dilemma game going on. While our government is endlessly sticking it too foreign investors by debasing our currency and creating massive amounts of inflation, there are economic incentives for foreign central banks to do nothing about it. If foreign debt holders dump our debt it could hurt their own economy b/c it would further erode our currency handicapping US consumers from buying goods from them. It is in everyone’s best interest for the US$ to remain strong but fundamentally, US$ strength can not be maintained.

So when will it break? I certainly don’t know and it seems that very few others do either. Some of the brightest investors in the world are calling for a US$ rally in the first half of this year. Maybe the great selloff in US debt will begin in Q3 or Q4 or perhaps in ’09. What I do know is that when it happens, we should expect much higher rates in the US, an increase in inflationary pressures and consequently much cheaper equities.

IMPACT OF THE FALLING US$ ON US EQUITIES: For the last several years, we’ve exchanged billions of US$’s for foreign goods. A lot of these dollars were recycled into US Treasury debt but recently, there has been a trend of foreign governments to invest their imported US$’s into US equities through vehicles called Sovereign Wealth Funds.

While the US equity markets have been challenging to say the least for US investors over the past 9 months, foreign investors have seen equity losses compounded by losses in the US$. So, will foreign investors eventually get fed up with US equities given the currency headwinds or will they see US equities as “cheap” because the currency has fallen so far? I don’t know, but if foreign investors abandon the US equity markets, not even “Helicopter” Ben will be able to drop enough money from the sky to sustain any sort of significant rally in US stocks.

GSE AND OTHER BAILOUTS: The Government Sponsored Entities (GSEs) are in very bad shape. For confirmation of this fact, just check out the 5 year stock chart for Freddie (FRE) or Fannie (FMA). Unfortunately, nobody knows just how bad of shape they are in because they are not subject to the same accounting standards as our nation’s publicly traded companies. Fannie Mae, Freddie Mac are basically insolvent. If they were a private company, they would be in Chapter 11. The PBGC is on the brink of collapse (see above).

Will the government be able to bail out all the GSE’s? Are they responsible for bailing them out? If they do, who inevitably pays for it? Somebody has to pay for all this. Somebody will have to pay for all of the bailouts, all the handouts, all of the failed attempts by our government to provide economic security to Americans. Nothing is free.

There are only two ways for the government to pay for their amazing deficits. First, they can inflate their way out of the problem. Second, they can tax their way out of the problem. I don’t know which they’ll choose but both provide for a catastrophic outcome for the US economy.

Unfortunately, I have no answer for any of these issues over the short-term, which means I’m essentially “flying blind” when it comes to investing your portfolio. I’m actively searching for answers but until I find some I’ll remain conservative with your accounts. Over the long-term, the inevitable will take place but that might be several months from now.

As I’ve alluded to a few times in this post, I don’t expect to be able to generate the same types of returns in the coming months as I did in January and February. Due to breakdowns in various asset class correlations, I’m not comfortable with taking an excessive amount of risk in your account. I have a fair amount of cash in your account and while I’m anxiously looking for ways to deploy it, I’m not going to jump into something unless I can achieve some level of comfort that I won’t be putting your YTD returns in jeopardy. I’m not going to be satisfied with ending the year up 22% but I sure as hell will be upset with myself if your account loses anything between now and then.

If correlations in the market return to some level of normalcy, I’ll feel confident in taking some more risk in your account, but until I see evidence of it, I’ll stick to the few things that I’m more confident in even if they don’t offer the opportunity for explosive returns.

I significantly reduced your commodity exposure in the last couple of weeks of February. Every commodity fund in your account was up 25-40% over the last 3 months and I thought it was prudent time to lock in some profits. Furthermore, we are entering a seasonally weak period for non-cyclical commodities which are the positions I liquidated.

The spring shoulder season for energy coupled with increasing inventories should result in some kind of pullback in the energy space. However, if OPEC announces production cuts, then all bets are off and we could see energy prices shoot much higher.

Furthermore, I think we’ll see some pullbacks in the agricultural space. Last year, prices came down in the spring and early summer as farmers reported planting record crops. As I mentioned on this website last year, record planting doesn’t necessarily result in record crop yields. The US government provides incentives to farmers based on the amount they plant, not the amount they harvest, so farmers will plant regardless of conditions. In the long-term, I’m still bullish on these funds and I will be rebuilding many of those positions in coming months. Hopefully, I’ll be able to buy in at lower prices.

I have continued to maintain your Precious Metal exposure and I’ve even added a few positions in this space over the last couple of months which are up marginally. I’m tracking several indicators which should help me decide when to liquidate these positions but for right now, the PM space looks healthy over the intermediate term.

But I can’t be so certain about the short-term. I stated in my Year-End report that I thought Gold might see a fairly quick ascension to $1000 because that was the consensus price for it in 2008. I had no idea just how quickly Gold would ascend to that level. I’d expect the PMs to take a break now that Gold is in the $1k neighborhood.

Possibly the best news is the action in the mining stocks which are starting to show a little life. After falling in January, they are now beginning to catch up to Gold and Silver. Furthermore, Silver is finally providing some long anticipated leverage over Gold.

Finally, our foreign bond exposure is starting to show some nice returns. The discount in our Foreign Bond ETF’s is finally starting to diminish. I believe that the precipitous fall in the US$ will result in money being attracted to these funds.

The aforementioned quote actually appeared in an article about Brazil and a few of the “big government” programs they had just adopted contradicting Lula’s previous agenda (BTW, I’m a big fan of President Lula). But regardless, the principal is true for all governments and our government has become so bloated, they have no choice to inflate or tax their way out of it. The article includes debt as a third option but I’d argue that debt is nothing more than deferred inflation or taxes.

Our government has to pay for the enormous debts they have incurred. I’ve addressed this issue in many posts and specifically in my Market Outlook. The Republican’s answer, starting with Nixon, was inflation. The democrats answer to the problem typically leans towards taxation but the neo-liberal Clinton was not shy about inflating the economy either – he just had more economy to work with. What we all need to understand is that somebody at sometime has to pay for deficits.

By using inflation, we can shift a lot of the burden to foreign investors but we will have to bear some of it. This has all happened before. It happened to Great Britain in the 1900’s. It happened to us in the 70’s, the late 30’s and the early 1900’s. It’s a part of the cycle compounded by irresponsible government intervention. Once the cleansing is done, the US economy will come out just fine on the other side (if our government doesn’t totally destroy our currency) and we’ll be able to buy some incredibly cheap equities. And in the interim, we’ll make some money investing in Stagflation themes.

In the near-term, don’t be alarmed that I’m a little flustered with the current market activity. I think it’s better for an adviser to question his strategy and occasionally admit to being unsure of what he is doing than just blinding accepting the path that he is on. A lot of buy-and-hold investors are just sitting around hoping the market turns and by the time they question their strategy, their clients will be selling their incredibly cheap equities to us.

I’ll get us back on track. I’m actively reading and studying new research. I’ve worked harder this month than I have for some time and I believe that my frustration has focused me even further. I have discovered numerous new technical trading tools which will aid me in buying and selling new positions. I discovered a non-cyclical sector that I’m turning bullish on and will likely be building a position for you over the coming weeks or months. I will go into more detail about this sector in my written quarterly update.

Until I figure out how to fully reinvest or reallocate your account, we can take comfort in knowing that we have a 30% head start on the market. I have no official statistics, but I’m assuming that your accounts have done better than 99% of the investors out there. I haven’t come across any who has even delivered double-digit returns this year. I do know that several of my clients have made more money in their retirement accounts in the first two months of this year than they ever made in a full year of working and I’m very encouraged by that.

As always, please call me if you have any questions or concerns about your account.

Matt

Dear Clients,
The following is my Performance Update for January. All prices and returns are as of 1/31/08.

If this old adage has any validity, than equity investors are in for one hell of a time in 2008; conversely, we could see spectacular appreciation in your accounts this year. Over the past several months, my strategy has gained considerable momentum and your accounts have profited substantially.

While the large-cap indexes (S&P 500 and DJI) have not technically reached bear market territory, it is essentially a foregone conclusion that they will in the near future. For the first time ever, equities fell over 10% in January. The market volatility has been “gut-wrenching”. After falling nearly 11% in the first 14 days of the year, the S&P 500 rallied 5.2% in the last seven days of the month, but only after the Fed took drastic actions in cutting the Fed Funds rate 1.25%. The average intraday movement in the S&P 500 for the month of January was just over 2.4%!

Despite the recent rally, the stock market has never faired so poorly during a Fed cutting campaign. The S&P 500 is down nearly 10% since the Fed started cutting rates in August. We are in unprecedented territory. Furthermore, the actions by the Fed given the astounding inflation picture, which I’ll cover later, are a sure sign that they are panicking. It is uncertain whether the Fed can bail out the credit and equity markets, but if they do, it will mean a lot of money creation which always leads to even more inflation. The book has been closed on Goldilocks.

Here is how my performance measured up to the averages for the first month of 2008:

If the current investment trends continue, your account should continue to perform well – but I would not get used to 9+% returns every month. Nearly 80% of your account’s allocation did very well and 20% was flat to down. I invested the portfolio to be more balanced and I expect it to act accordingly going forward. Nearly everything went our way in January and we shouldn’t count on that to continue but I think we can count on beating the market by a considerable margin for the next couple of quarters.

I’m certain that my “swing” position will not perform as well in the coming months as it did in January. If you recall from past updates, I’ve allocated a portion of your portfolio to Direxion Funds to adjust my equity long and short bias in your account. In early January, I also added a Proshares ETF to further tilt my equity bias short. For the month, I played the volatility almost perfectly and if you’ve followed my performance over the past year, you’re aware that this hasn’t exactly been the case in the past and may not necessarily be the case in the future. Furthermore, I don’t expect there to be any significant upside volatility for the next few months to play.

While I believe that the current market cycle could be one of the most profitable opportunities we will see for many years, my returns this month are likely to be at the high end of range. My primary goal is to protect your accounts from losses in what will prove to be a significant bear market correction. My secondary goal is to profit from the trends in the market which I’m confident that I can continue to do for the foreseeable future. However, I’m placing a higher emphasis on protection than accumulation so I’ll be locking in profits if I become uncertain about future market activity.

I’ve used the word “warning” far more than I would like in recent months. For an investment manager who tries to maintain a fair amount of equanimity about market direction, I don’t take this lightly…Still, I am emphatic that investors should evaluate their risk exposure and tolerance now, in order to allow for substantial further market weakness. (emphasis mine)

I believe that we are entering the “middle innings” of a significant correction that will defined by Stagflation. The S&P is now 4 or 7 months into its correction phase that should last 9-15 additional months. (I say 4 or 7 months because it depends on how you measure the S&P 500. In US$, the bear market started in October but in the US$ trade-weighted index, it started in July.) Historically, inflationary bear markets have lasted 13-20 months, but since there have only been three in the last 100 years, it’s difficult to create an accurate expectation for how long this one will last. Unfortunately for equity investors, the losses accelerate in the latter stages of a bear market correction.

As for the technical strength of equities, Steve Saville has provided another nail in the coffin for the equity markets. He writes:

There were more than 1100 new lows on the NYSE on Tuesday [1/22/08], which is something that has only happened on four prior occasions over the past 40 years. It happened in May of 1973; it happened on the day of the 1987 stock market crash; it happened on August 31, 1998 (the day of the US stock market’s bottom during the 1998 financial crisis); and it happened at the peak of last August’s financial market panic.

A few of the worst times to be in the market! I’d like to add that the 1987 and 1998 episodes came at the bottom of the bear, not at the top. 1973 was the only time leadership was so dismal at the beginning of a bear market. And it has happened twice in the current cycle while it only happened once in each of the others.

The odds of stagflation are continually increasing and the Fed seems more than willing to keep pushing our economy in that inevitable direction. In interview with CNNMoney.com, Jim Rogers discusses the Stagflation outcome. The article says, “Rogers looks at the Fed’s willingness to add liquidity to an already inflationary environment and sees the history of the 1970’s repeating itself.” And then the author asks Rogers if that means Stagflation and he responds, “It is a real danger and, in fact, a probability.”

One more fundamental change in the market needs to take place before my strategy “starts hitting on all cylinders” and I believe that we are the verge it happening. And more importantly, George Soros believes it on the verge of happening as well. The trend that is about to change is the direction of the bond prices. Since July, US treasuries have appreciated significantly in-spite of the heightened inflation pressures. Inflation typically leads to a discounting of bonds as investors need to be compensated for a loss in purchasing power. Soros says the following on the subject:

Because of the reluctance to hold US$’s and because of the inflationary threat, a point will come, when the lowering of the short-term rates will actually lead to long rates going up. I am actually surprised that interest rates have fallen as far as they have without a much more steepening of the yield curve. (source: Financial Times, Jan. 24, 2008)

(For those who unfamiliar with George Soros, he ran the Quantum Fund with Jim Rogers and has since managed his own Fund. Soros is known to be the man who “broke the Bank of England”. He is one of a handful of exceptionally successful investors whose opinion on economic matters should always be considered.)

In addition to Soros, Nobel Prize winning economist Joseph Stiglitz agrees that long-rates will start moving up. In an interview at the Davos 2008 convention, he warned,

The biggest fear is that long-term bond rates won’t come down in line with short-term rates. We’ll have the reverse of what we’ve seen in recent years, and that is what is frightening the markets. The mechanism of monetary policy is ineffective in these circumstances. I’m not saying it won’t work at all: it will help the banking system but the credit squeeze is going to go on because nobody trusts anybody else. The Fed is pushing on a string. (source: The Daily Telegraph)

I think the most compelling reason to believe that long-term rates will rise in-spite of falling short term rates is the sheer irony of it all. In 2004, then-current Fed Chairman Greenspan called it a “Conundrum” when long-term rates didn’t rise when he raised short-term rates. They didn’t rise because his policies resulted in such a substantial increase in the money supply that excess money flowed into treasuries driving up the demand for bonds which kept rates low. Currently, Soros and Stiglitz (and myself) are making the case that the Fed’s excessive money creation has lead to an increase in inflationary pressures and a weakened US$. Consequently, long-term rates must rise to compensate investors for inflation. And it gets worse, when more money is created by the current Fed by keeping short-term rates low it will invariably lead to even more upward pressure on long-term rates. In conclusion, the Fed inflated the money supply so much that it kept long-term rates from rising when they wanted them to rise and conversely will cause long-term rates to rise when they don’t want them to. The irony is that their “Conundrum” is of their own making.

And this sums up why I have long argued that both equities and bonds would depreciate in the next cyclical bear market as inflationary pressures persisted in the face of a weakening economy leading to Stagflation. (You can read more in my Market Outlook) Obviously, we are well positioned to take advantage of these trends however the capital markets are having a difficult time accepting this outcome. The most compelling evidence of Wall Street’s denial of Stagflation is the recent reversal in the rel