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    <title>Reality Bites</title>
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    <dc:creator>stateless</dc:creator><description><![CDATA[This week's writer of the Outside the Box is no stranger to long time readers. Michael Lewitt writes the HCM Market Letter and is one of my favorite writers and truly deep thinkers. He has recently decided to turn his letter into a subscription based model and is meeting with some success, as he should. So, sadly, he will no longer be a regular feature of OTB, but he did allow me to use the current letter, as I think it is one of his more provocative letters.

This is a piece you want to think through. Michael discusses the continuing series of bailouts, the consequences of the stimulus package, the various policy options and the likely response of the economy to all of the above. Plus he makes a few market calls and some interesting observations. I am truly pleased to be able to send this to you.

If you are interested in subscribing, you can to go www.hcmmarketletter.com/home.html or email info@hcmmarketletter.com.

John Mauldin, Editor   Outside the Box




Reality Bites
The HCM Market Letter by Michael E. Lewitt


"So long as risk is effectively concealed from borrowers and lenders or actually shifted to others, risk-taking will be excessive. The initial phase of excessive risk-taking will manifest itself as an economic boom, but eventually, when actual losses begin to change the perceptions of borrowers and lenders and begin to impinge upon unsuspecting others, the boom will give way to a bust....(A) market system whose credit markets involve risks that are partially concealed from the lender and partially shifted to others will be biased in the direction of excessive risk-taking. And excessive risks are converted in time into excessive losses." 

Roger Garrison1


The problem with bailouts is that you have to know what you're bailing out. But neither the U.S. government nor anybody else is capable of estimating the ultimate cost of bailing out such corporate giants as Citigroup, AIG, General Motors, Fannie Mae, and Freddie Mac (and the list goes on). There are two reasons for this. First, on a stand-alone basis, these companies are opaque and indecipherable entities. Financial innovation left transparency in the dust. Wall Street devoted much of its intellectual and political capital to concealing the risks it was creating. This concealment was deliberate; products needed to be priced inefficiently to produce profits. Second, these companies are integral parts of a networked global economy; as such, their value is completely dependent on the overall health of that network. Unless the network can be restored to health, these assets will remain severely devalued. Right now, the network is very sick. When a system is allowed to hide risk for so long, it is ill-equipped to manage that risk when it finally emerges from the shadows. 

The Economic Policy Conundrum 
The Obama Administration is facing a near-impossible task trying to bail the U.S. economy out of the muck of years of ill-begotten economic policies. The biggest challenge facing policymakers is not short-term recovery, however. Eventually, stimulus is likely to arrest the forces of economic collapse and stabilize matters – at least temporarily. But the real problem is sowing the seeds of long-term, sustainable, organic economic growth. This is really the crux of the policy challenge. The United States in the midst of the worst economic downturn in 80 years as the result of a panoply of extremely poor economic policy choices. Economist Roger W. Garrison draws an important distinction between "healthy economic growth, which is saving-induced (and hence sustainable), and artificial booms, which are policy-induced (and hence unsustainable)."2 In other words, monetary policy that kept interest rates low for an extended period of time, tax policy that favored debt over equity, regulatory policy that allowed financial institutions to operate opaquely, and social policy that pushed home ownership regardless of affordability, all combined to create artificial economic demand that could only be financed with debt because the savings (i.e. equity) to purchase them did not exist. 

Moreover, as more and more debt was created through financial engineering and policy prescription, the prices of these were bid up higher and higher. This led these products to become grossly inflated in value compared to any inherent economic worth they might possess. Once the bubble burst, their value dropped precipitously. Unfortunately, the face amount of the debt used to purchase these assets did not adjust downward at the same time. Assets that were purchased at inflated prices are now worth a fraction of what they were purchased for, leaving behind a serious dilemma for the owners of these assets and their creditors. 

Following conventional economic thinking, the government believes that the solution lies in policies designed to reflate the value of these assets. The problem with this approach is that it is based on the incurrence of trillions of dollars of additional debt to create the demand needed to purchase these assets. Debt begetting more debt is a poor prescription for sustainable long-term economic growth. At best the government may be able to provide a short-term boost to the economy, but what the economy really needs is a solid, organic foundation for growth. Debt-financed government demand can't be sustained indefinitely, which is why this policy is doomed to fail in the long run. The U.S. balance sheet is not a bottomless pit, although it is increasingly coming to resemble a Black Hole. At some point, the economy will have to generate sufficient tax revenue to pay for this government spending or the country will lose its AAA rating and ultimately become a troubled credit. Economic demand will ultimately have to become savings-driven or it will again collapse. 

This does not necessarily mean that the government should walk away from creating short-term demand, but it should be extremely circumspect in how it does so. This is where political reality collides with economic reality. The optimum long-term economic solution would be to allow the economy to hit bottom and then begin to rebuild demand naturally. But such a scenario would likely entail an unemployment rate on the order of 15 or 20 percent and an even worse human toll than is already being exacted by the downturn. But it would give the economy an organic base from which to rebuild. The government's job in such a scenario would be to provide the right kind of safety net (not only of financial support but also job and educational training) to see the citizenry through the crisis. What the U.S. really needs is an economic Marshall Plan to rebuild itself, with all of the sacrifice and public service that would entail. Apparently, that is asking too much in today's me-first society. Accordingly, the government finds itself compelled to follow policies that may or may not create unsustainable short-term growth and will have to be carefully targeted to promote sustainable long-term growth. 

There is a profound difference between healthy, sustainable demand and unhealthy, unsustainable demand, just as we are living the unhappy lesson that there is a great difference between healthy economic activity (i.e. activity that contributes to the productive capacity of the economy) and unhealthy economic activity (i.e. speculative trading and corporate finance transactions). Propping up bad banks through a "good bank/bad bank" model would simply direct funds to the sustenance of past unhealthy economic activity. Starting a new Economic Reconstruction Bank, as HCM has recommended, could make loans available for new productive projects and direct funds into healthy long-term economic activity. 

Another bout of policy-induced growth will not only repeat the mistakes of the past, but leave the economy even weaker, teetering on an unstable foundation of government support that cannot be sustained indefinitely without impairing America's balance sheet, credit rating, and ultimately its geopolitical might. Whether America's short-term political orientation can ever address this conundrum is the greatest question facing policymakers today. HCM has no hesitation in saying that much of what the government has proposed thus far to deal with the crisis won't come close to dealing with the long-term issue of creating savings-induced or organic growth. This means that any near-term relief (i.e. relief that occurs within the next five years) is most likely to give way to years of below trend growth because the economy will be lacking the organic foundation of growth it needs. 

Dow 5000 Update 
Year-to-date through February 27, the S&P 500 was down 18.62 percent and the Dow Jones Industrial Average was down 19.52 percent. Moreover, strategists and investors are increasingly coming around to the conclusion that corporate earnings are going to be nothing short of horrendous this year and that stocks are headed even lower, as HCM has been arguing for months (without pleasure, we hasten to add). Very recently, three of the smartest forecasters on Wall Street sharply lowered their earnings forecasts for the S&P 500. 


On February 13, David Rosenberg, Bank of America's North American Economist, recently reduced his 2009 and 2010 S&P 500 operating EPS forecast to $46 (from $56) and $55.50 (from $63), respectively.i Mr. Rosenberg is now forecasting an S&P 500 low of 666 based on a 12x multiple of forward (i.e. 2010) earnings. 
Francois Trahan of ISI Group dropped his S&P 500 earnings forecast from $60 to $45 on February 23. Mr. Trahan used a 13x multiple to forecast a potential market low of 585. 
On February 26, Goldman Sachs' David Kostin dropped his 2009 and 2010 S&P 500 operating EPS forecast to $40 and $63, respectively, after deducting $23 and $8, respectively, for provisions and write-downs. Mr. Kostin uses a 13.2x multiple of 2010 earnings (pre-write-downs and provisions) to come up with a year-end 2009 S&P 500 target of 940. 

These sharply lower forecasts are consistent with HCM's dim view of corporate earnings, but we believe that all three analysts are clinging to overly optimistic earnings multiples in predicting ultimate stock market lows. At this point, there is clearly a growing Wall Street consensus that S&P 500 earnings will come in well below $50 in 2009 and that the correct multiple on these earnings should be in the 12-13x range. HCM continues to believe that the multiple should be lower based on the fact that (a) we are in a debt deflationary spiral, and (b) government yields are artificially depressed and signal economic distress and do not signal an attractive investment alternative, and corporate yields are extremely high and offer real competition for investor funds. 

Last November, HCM set 2009 price targets of 5000 on the Dow Jones Industrial Average (DJIA) and 475 on the S&P 500 based on applying a 7x multiple to Goldman Sachs' then 2009 S&P 500 earnings estimate of $65. (See The HCM Market Letter, Nov. 15, 2008, "Dow 5000") At the time, the S&P 500 was at about 850 and the DJIA was at about 8600. Our low multiple was based on our view that an environment characterized by debt deflation deserves a 6-8x multiple. Now that Mr. Kostin and others have lowered their multiple, it is only fair to raise the question whether we should be further lowering our target prices on these equity indices at this time based on applying our multiple to a lower earnings number. 

For the moment, the market remains far above our previous targets. Our targets are intended to be directional in nature and we see no reason to lower them further at the current time. We have made our point, which is that the stock market is likely to head sharply lower in the months ahead. Moreover, the earnings estimates have been lowered primarily based on expectations for further write-offs by financial companies (and non-financial companies that wandered into the financial space). Investors may treat these write-offs and provisions as nonrecurring items and look to higher recurring S&P 500 earnings in pricing the market. While we continue to believe that the multiple should be in the single digits, the correct recurring earnings number remains a moving target. Accordingly, at this time it would be premature to lower our estimate further. Needless to say, we remain extremely comfortable with our prior estimates of 475 on the S&P 500 and 5000 on the DJIA. 

A bear market rally is possible at any time. Investors should be aware that as the market moves lower, rallies have the potential to be extremely sharp since they are starting from compressed levels. Such rallies should be used to reduce overall equity exposure. That does not mean that equities should be abandoned totally. There are a number of stocks that are trading at well below book value (even taking into account the declining transfer value of their assets) that may be worth buying in the months ahead. The debt of these companies, which HCM is particularly active in, is even more compelling as an investment. But investors need to identify longer term changes in market behavior and the economic environment before becoming bullish again on stocks. Right now, there are no such signs, such as better employment, housing or GDP numbers, or tightening credit spreads, or improving market technicals. HCM is starting to sense that the forces of denial, as potent as they are, are starting to weaken. Accordingly, investors should structure their portfolios for further equity declines. 



The "D" Word 
The fourth quarter GDP loss of 6.2 percent (did anybody really believe the 3.8 percent estimate?) illustrates just how deep a hole our economy has to climb out of. The economy fell into this hole almost literally overnight, but it's going to take much longer to climb out. A quick recovery is out of the question. HCM expects first quarter GDP to be in the -6.0 to -7.0 percent range based on our reading of employment, housing and other economic data as well as the data we are seeing from the 200 or so companies in our portfolios across a wide variety of industries. Moreover, based on our view that the stimulus plan will be largely ineffective this year and that more large-scale business failures are in the works (many of them slow-motion car wrecks), we do not expect to see positive economic growth until sometime in mid-to-late 2010 (and then only modest growth). 

Investors expecting a conventional bear market/bull market cycle are likely to be sorely disappointed. Over the past several decades, U.S. stock market investors have been conditioned to believe that the market will bottom and then rebound. Bear markets have been brief within the context of a long bull market that stretches back to the 1980s. But the current environment is likely going to be different. We are now experiencing a destruction of wealth on a scale that is both unprecedented and permanent because much of that wealth was built on a fragile foundation of debt; in reality, much of that wealth didn't really exist in the first place. As a result, what people believed to be economically valuable and stable was in fact nothing of the kind. In many respects, the latter stages of the bull market were little more than an illusion. Real corporate earnings and genuine productivity peaked years ago, and the economy has been operating on debt-induced fumes for years. 

Accordingly, investors need to prepare themselves for a future that will not resemble the recent past. Ray Dalio, the wise man who runs Bridgewater Associates, noted in a recent Barron's interview that investors need to recognize that the current environment more resembles a depression than a recession: "Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis of the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process." (Barron's, February 9, 2009, "Recession? No, It's a D-process, and It Will Be Long," pp. 38-40.) Mr. Dalio's view is consistent with HCM's long-argued view that we are in a debt-deflationary spiral whose end is nowhere in sight. 

The characteristics of our current economic situation are as follows: 


Interest rates have dropped to zero. 
Bank stocks have plunged by 90 percent or more. 
The Federal Reserve's balance sheet has exploded. 
Credit spreads have widened to historic levels. 
The economy is seeing massive asset deflation. 
Debt is being destroyed in record amounts. 
Unemployment is increasing each month. 
The financial industry is shrinking radically. 
Manufacturing activity has slowed sharply. 

This is not a situation that is consistent with recent American experience. HCM has previously described a depression as an economic condition in which traditional monetary and fiscal policy is rendered ineffective. For the moment, we are deeply entrenched in such a situation. The question is how long the economy will remain depressed before some of the remedies that have been proposed start to work. Unfortunately, HCM fears we may be in for an extended stay. 

For these reasons, HCM believes that after the stock market bottoms, it will drift along at a depressed level for an extended period of time. The American economy will experience less-than-trend growth for a similarly prolonged period of time. The economy will have to absorb trillions of dollars of bad debts and transition its resources away from speculative activities and toward new productive endeavors. The economy has to be completely retooled, and this process will not happen overnight, particularly because such a program must be directed by a highly inefficient democratic political system that is inefficient in reaching consensus about its goals and how to achieve them. Unfortunately, the deeper involvement of the government in the financial and other sectors of the economy is likely to stifle growth, innovation and creativity and further contribute to lower growth for years to come. 

Investing Today 
This by no means is intended to suggest that investors will be unable to make money. It does suggest, though, that the era of bull market geniuses is probably over. Too many were paid too much for doing too little over the past several decades. Being at the right place at the right time is not going to cut it anymore. But as the debt destruction process plays out, new investment opportunities will arise in the capital structures of restructured and surviving companies. 

As investors go about reallocating money to new opportunities, they may want to keep in mind something that HCM recently read in The Economist. 


"Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dotcom. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started." (The Economist, "A special report on the future of finance," January 24, 2009, p. 17.) 


There are a limited number of investment opportunities that make sense in today's market, and there are a limited number of managers qualified to execute those strategies. Unfortunately, managers in out-of-favor or discredited strategies are now trying to reinvent themselves as managers of the few in-favor strategies in which they have limited or no experience. HCM is seeing this occur in the corporate credit space, where firms that have previously operated in areas peripheral to the credit markets such as private equity or mortgages are suddenly touting their expertise in corporate credit. These managers are wading into uncharted territory. Investors must insure that managers possess the expertise that is required for the strategies for which they are being hired. They have already experienced the disastrous results of private equity firms thinking that doing deals would prepare them for investing in bank loans. 

Bank Nationalization 
We are quickly learning the flaws of the half-baked approach to supporting the nation's banks that the Bush Administration adopted and the Obama Administration seems hell-bent on continuing. At least the Bush Administration had an excuse – the former Treasury Secretary was a career investment banker who saw the world through the eyes of Wall Street. Perhaps HCM was naïve in hoping that the new Treasury Secretary, having been a career regulator who viewed matters through the opposite end of the glass, would see things differently. We probably should have known better since Mr. Geithner participated in the Bush Administration's bailout. But the quasi-nationalization approach is clearly a disaster for all concerned (the recent article describing the hall of mirrors that used to be Citigroup is a case in point - see The Wall Street Journal, February 25, 2009, "Citigroup Chafes Under U.S. Overseers," p. A1.) There seems to be little disagreement that two of the country's major banks – Citigroup and Bank of America – are in the zone of insolvency. Their assets are worth less than their liabilities and their shareholders have been wiped out in all but name (and in the little drill-bits of stock that trade publicly as make-believe options on their long-term recovery). But the system can't seem to bring itself to admit that these banks have been effectively nationalized in all but name and that taking the final step of nationalizing them is in many respects just a matter of form over substance. The only thing worse than a banking system that has been privatized is one that has collapsed, but that is the choice we are faced with. The Rubicon has been crossed and we need to clear away tons of debris that are clogging up the river before we can cross back to the other side. 

Moreover, maintaining the illusion of public ownership has enabled some of the individuals running these institutions to engage in some of the most irresponsible behavior ever seen in the history of American business. HCM is speaking specifically of the pay-out of billions of dollars of bonuses to the executives and employees of Merrill Lynch on the eve of its forced takeover by Bank of America. This act, which Bank of America's Chairman Ken Lewis claims he was powerless to stop (HCM does not believe him) and former Merrill Lynch Chairman John Thain, in what can only charitably be described as a gross breach of conscience and good judgment, somehow sanctioned, are prima facie evidence that the hybrid public/private TARP model is totally untenable and should be shelved immediately. Those banks that can repay the TARP money (or produce a believable plan to do so within three years) should be permitted to do so forthwith, and those that are teetering on the brink of insolvency should be nationalized. Otherwise, the managements of these firms are going to pay more attention to figuring out how to game government compensation limitations than maximizing the value of their troubled assets over the next several years. HCM never thought we would say that there are worse things than nationalization, but there are and we saw them when billions of dollars was paid out to the people who lost even more billions of dollars at Merrill Lynch. This has to have been one of the most brazen thefts in American history. 

Let GM Go 
General Motors has been insolvent for years. Yet political expediency has prevented recognition of this harsh truth. The company's unions have blocked efforts to bring the company's cost structure into line with changing economic realities. Michigan's powerful Congressional delegation has blocked efforts to improve American automobiles' fuel efficiency, creating an opening for foreign manufacturers with lower cost structures to steal the hearts and minds and pocketbooks of American consumers. Years of bad choices have now left the U.S. government with a terrible choice – whether to give GM billions of dollars of money inside or outside of bankruptcy. The correct decision, as unpalatable as it may be, is painfully obvious. All of the king's horses and all of the king's men are not going to be able put GM back together again. It is time to let this American icon declare bankruptcy in order to maximize the chances of salvaging something out of this American tragedy. 

GM is still paying or accruing billions of dollars of annual interest payments on the company's more than $40 billion of debt. The company is negotiating with holders of $27.5 billion of this debt, which is unsecured, to reduce it to $9.2 billion (by exchanging stock for bonds). Yet all of this debt and stock is worthless. Instead of wasting time haggling with debt holders over exchanging a portion of their worthless claims for worthless stock, the company should declare bankruptcy so these claims can be wiped out. GM's ability to meet the government's February 17 deadline was delayed by its inability to come to an agreement its bondholders. The bondholders are institutional investors who believe they are exercising their fiduciary duty to their beneficiaries by trying to squeeze the best deal possible out of the automaker. But the sad reality is that they made a bad investment and should suffer the consequences. We need to stop trying to save everyone from the consequences of their errors or else they will keep making them. 

The unions are also trying to salvage an ownership stake out of this mess. The company is negotiating to exchange half of approximately $20 billion of Voluntary Employee Benefit Association (VEBA) obligations into equity. Unfortunately, 100% of the VEBA obligations are likely worthless since GM will never be able to pay them. The VEBA was part of the bargain that the unions made with GM over the years. Workers gained generous wages, benefits and work rules that rendered the company uncompetitive. This was not a secret – the company's loss of market share and weakening financial position was apparent for years to the unions as well as to everyone else. The unions won the bargain but they lost the war. The company doesn't owe the workers anything more than what can be granted in bankruptcy, which is likely a meaningful equity stake in exchange for the VEBA and the billions of dollars of other healthcare and pension obligations owed to current and retired workers. This is undoubtedly a tragedy of enormous human dimensions, but responsibility for it is shared by all Americans who sat by while their politicians and business leaders allowed GM to sink into insolvency. Accordingly, America owes the workers a safety net when they lose their jobs and benefits. But this should be the same safety net society owes all of its displaced workers, not a special one for former GM workers. 

Allowing GM to file for bankruptcy will be a blow to the American psyche. But GM has already gone bankrupt in all but name. In suggesting that it will require $125 billion in financing to undergo a bankruptcy, the company may be playing chicken with Congress but is more likely indicating just what a Black Hole of liabilities it has become over the decades. America must have the courage to deal with this reality. Bankruptcy will give the company, and the country, an ability to make the hard decisions that it refused to make before. Either way, GM's failure is going to cost taxpayers tens of billions of dollars. But until we are willing to be honest about our failures, we are never going to put ourselves in a position to avoid future ones. 

Obama's Budget 
President Obama's is in many respects a dramatic break with the past, although in many respects it falls short of the type of radical tax and other changes that are really needed (but may simply not be politically feasible). We just hope that Mr. Obama's reach does not exceed his grasp. Many things may have changed economically in recent years, but one thing has not: a country can't tax and spend its way into prosperity. Moreover, we are confident that the growth rate assumptions used in years 2, 3 and 4 of our new president's proposed budget are unrealistic. The economy is unlikely to grow at anything close to 3 to 4 percent in those years, and relying on that much growth to close the budget deficit by the end of Mr. Obama's first term will only lead to disappointment. This economy, which shrunk at an annual rate of 6.2 percent in the fourth quarter of 2008 and will almost certainly not show any growth at all in 2009, is not going to magically spring back to life in 2010. Mr. Obama is setting himself up for failure with these projections. 

HCM was very happy to see that the Administration is prepared to rid the tax code of the egregious treatment of private equity carried interests, which we have recommended before (see The HCM Market Letter, April 1, 2008, "How to Fix It"). Now that private equity has become a loss-leader for its partners, we would caution those drafting the legislation to make sure that private equity does not gain an unintentional windfall from this legislation. This could occur if private equity partners were permitted to deduct claw-back payments (i.e. repayments of carried interests earned early in a partnership based on losses incurred later in a partnership) at the new higher tax rate if they were taxed on those original payments at the lower rate. In order to prevent such a benefit, if the original payment was taxed at 15 percent, repayment of that money should only give rise to a deduction at 15 percent, not the higher ordinary income tax rate. 

We think limitations on charitable deductions are poor public policy. The argument that wealthier people should not receive a greater dollar-for-dollar benefit for charitable deductions than less affluent people is a red herring, particularly in view of the fact that the Alternative Minimum Tax already haircuts high earners' charitable gifts. We also believe that limitations on mortgage deductions would be better handled by limiting deductions for mortgages over a certain dollar amount rather than by income; such a methodology would be more effective in fighting housing speculation. 

We are opposed to raising taxes on capital, but we also recognize that we are in a fiscal emergency and that raising the capital gains tax from 15 percent to 20 percent on the wealthiest Americans would not impose undue hardship and would keep the rate relatively low. We would prefer to see capital gains rates implemented on a graduated scale based on the amount of capital gains reported in a single year. Someone who earns an especially large gain could certainly afford to pay a little more in tax. We commend the plan for maintaining the 15 percent tax rate on dividends, which should not be taxed at all since they are already taxed at the corporate level and remain an extremely inefficient means of returning capital to shareholders. 

The biggest problem with the budget – and with any budget, not just Mr. Obama's – is that the government just wastes so much stinking money. The reason people find higher taxes abhorrent is not because they don't want to help those less fortunate than themselves, or fund necessary government programs, but because they don't want their money to be treated like Congress's personal piggy bank. We would love to see the list of the $2 trillion of wasteful programs that Mr. Obama claimed his team has already identified for elimination. The amount of government waste is truly mindboggling, and Mr. Obama must insist on spending discipline if he is to have any chance to keep the budget deficit from exploding over the next four years. 



The Coming Meltdown in Eastern Europe 
By all accounts, the former Eastern Bloc countries that so successfully navigated their entry into world capitalism after the fall of communism have borrowed themselves into near oblivion and are about to inflict frightening losses on their own banks and Western European banks, their main aiders and abettors. Our good friend John Mauldin has been out front on this story, which has enormous implications for the global financial system. The ever prescient Christopher Wood has also been warning about an Asian-style banking crisis in the region, with serious ramifications for the Western European banks that loaned these institutions by some reports trillions of dollars. This is a story that needs to be followed in the coming weeks because it will have major negative consequences for world financial markets. To state the obvious, this is the last thing the world economy needs to deal with right now. 

Michael E. Lewitt 

Available By Paid Subscription Only - Copyright 2009 The HCM Market Letter, LLC All Rights Reserved


Footnotes:    1 Roger W. Garrison, Time and Money The Macroeconomic of Capital Structure (New York: Routledge, 2001), pp 111, 120.    2 Garrison, p. 56. 

     
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    <title>Top 10 links; China twists America’s arm; the near meltdown on Sept 15</title>
    <dc:date>2009-02-11T05:25:41+00:00</dc:date>
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    <dc:creator>stateless</dc:creator><description><![CDATA[Finally the Chinese get heavy

For a long time the unspoken fear of global financial markets and many US politicians is that China would use its ownership of the biggest single chunk of US Treasury bonds to start trying to influence US budget policy or to try to somehow use it as leverage in any political disputes. US interest rates are dependent on Chinese purchases of US debt and the upcoming mountain of US Treasury issuance will have to be bought at least partly by the Chinese.

Now Bloomberg is reporting that a former Chinese adviser to the Bank of China (and there is no such thing as a former Chinese official…) has said China should demand a guarantee that America doesn’t embark on ‘reckless’ budget policies. He says China will demand a guarantee from Hilary Clinton that America won’t do anything to devalue US assets. This means China is pushing back on the currency manipulation issue and not so quietly telling America to run smaller budget deficits and not print money. Oh dear. Finally somone has called America’s bluff on all these spend-ups.

The Chinese problem

Inflation is dropping fast in China, which is a worrying sign as it indicates demand and activity is slowing. Producer Price Inflation fell 3.3%. This from Bloomberg.

Also here is more signs of collapse. Chinese export shipments fell 17.5% in January after falling 2.8% in December. This was worse than the 14% fall economists expected. Yikes.

Just nationalise them

Nouriel Roubini comments again today, but with more force after Geithner’s damp squib, that the US government should nationalise the major banks. Here’s a taste.

This “nationalization” approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze. Japan ended up having a decade long near-depression because of its failure to clean up the banks and the bad debts. The US, the UK and other economies risk a similar near depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.

Roubini is behind a subscription firewall, but this piece is worth the price if you need to know what could happen to the global banking system. 



The big debate

It’s clear the big debate in Washington right now is how to save Bank of America and Citgroup. It seems Bernanke and Geithner are firmly in the camp they have always been in, which is to use taxpayer money to bail out their mates in Manhattan. This from Chris Whalen at The Institutional Risk Analyst lifts the covers on the debate going on in America right now.

Winding in the credit lines

Bloomberg has an excellent piece here showing what’s happening on the ground in America where the big banks are rapidly winding up unused credit facilities for medium to large companies. A tad chilling.

It’s your fault Alan

…Greenspan that is… Alan Kohler at Business spectator reports on RBA Governor Glenn Steven’s hachet job of a speech attacking Alan Greenspan’s negligence in allowing the US asset bubbles by keeping rates low from 2001 onwards. Steven is right on the money. I’ve been pointing the finger at Greenspan for at least two years.

Why TARP V2.0 will fail

Martin Wolf at the FT has a strong argument to say the Geithner plan to fix the banks will fail.

Make them pay

Nassim Taleb doesn’t mince words in this interview with Jim Saft from Reuters (a nice guy I used to work with). Taleb, who wrote the Black Swan, says the first TARP was a scandal that enriched bankers that should never happen again. He says banks should be nationalised and any bankers taking risks should do it with their own money. Fair enough.

Jimmy hates it too…

Even Jim Rogers, the guy who blew the whistle on UK Plc’s bankruptcy, thinks the Geithner plan is a dead duck. Here’s what he told CNBC.


It is mind-boggling to me. If I were on your show 15 weeks in a row and was wrong, you’d probably never invite me back. These guys have been wrong year after year after year consistently and here they are making the same mistakes again. This is not going to solve the problem, it’s going to make it worse.


10 dirty tricks

This is fun from Paul B Farrell at MarketWatch (a great bunch of people I used to work with), pointing out the 10 tricks lobbyists would use to try to start a new bull market.

We were this close to collapsing….

In a strange revelation, a little known congressman has spilled the beans here on what the Federal Reserve and the Treasury told Congress back in September that scared them into TARP. Paul Kanjorski tells of how the US financial system was a few hours away from complete collapse on September 15. Chilling to watch. The revelation is 2 minutes 20 seconds in. Hattip to Mark Frauenfelder at BoingBoing for the spot on this one.






    


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    <title>Where Will the Growth Come From?</title>
    <dc:date>2009-02-09T19:51:28+00:00</dc:date>
    <link>http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2009/02/09/where-will-the-growth-come-from.aspx</link>
    <dc:creator>stateless</dc:creator><description><![CDATA[One of my most significant learning experiences came from a basic forecasting mistake. Back in 1998, I looked at 40 years of documented evidence that 50% of all large programming projects ended up coming in late. That set of data was consistent over all industries and over decades. I checked it out with industry experts. I really did my homework. And thus I said that the Y2K bug would be a problem, as a sufficient number of corporations around the world would have bugs that would create supply and management problems, which would slow the economy down. I did not suggest that we would see blackouts or major problems, just enough to slow things down and, when coupled with other macro issues (like the tech bubble), could trigger a recession. We had the recession, so my investment advice actually turned out to be right (lucky?), but it was not caused by Y2K.
  Almost 100% of the Y2K fixes came in on time. From a metric that said 50% was the norm, we went straight to 100%. What caused the change? I had a debate with (my good friend) the late Harry Browne, who many of you will remember as a very wise investment counselor, multi-book best-selling author, two-time presidential nominee of the Libertarian Party, gold bug, and from the school of Austrian economics. He said that Y2K would be a non-event. When presented with my marshaled facts, he said, "John, each company will figure out what it has to do to survive. That is the way markets work." And sure enough, faced with extinction if they failed, it seems that CEOs found ways to get the programmers to meet a very clear deadline. Besides knowing they fudged deadlines in the past, we now know if you hold a gun to their heads and give them resources, they can in fact perform.
  Why this comment to open today's Outside the Box? Today we read a piece sent to me by my friend Louis Gave of GaveKal (and who will be at my conference in April). It is entitled "Where Will the Growth Come From?" It reminds us of the lessons that Harry gave me. Each person and company is responsible for their own part of the recovery. You can't rely on mass statistics, or you miss the important lesson in individual responsibility.
  I don't think anyone can accuse me of being bullish the past few years. Interestingly, I get a lot of emails from people telling me the end of the world is coming, and deriding my longer-term optimism. They are convinced we are going into some deep national morass worse than the Great Depression (and such deflationary times will somehow make their gold go to $3,000!?!?). Yet they are working to make sure their own personal worlds are covered. I get no letters from people who are simply giving up. What company will keep a CEO who does not work hard to figure out how to keep the company alive? If you lose your job, do you not try and get another one or figure out how to make ends meet? Do you not put in extra hours to try and make your personal life or business or job better? Even if it is terribly difficult, the very large majority of people don't throw in the towel. Each of us, in our own way, gets up every morning to fight the good fight, even when the swamp is full of more alligators than we ever counted on. We just pick up a baseball bat, wade into the swamp, kill as many alligators as we can in one day, and then go home to get ready to fight the next day.
  The lesson from Harry is the same as it was in 1998: It is the individual working to get his or her own house in order that will help us all collectively get our national house in order. This is not to diminish the Herculean tasks we have in front of us, collectively. We have dug ourselves into a very deep hole of credit and leverage. It is going to take lots of time. The way back is not entirely clear at this point. This is not an ordinary business-cycle recession. But each of us will do what we can to make our small corner of the world better. And in the fullness of time, we will collectively get back to trend growth and a rational market.
  Of course, we will then find we have other problems to face. There is no nirvana. There will always be more problems. But that's what a free-market collection of motivated individuals does: We face problems and solve them to the best of our ability. And as a group, the clear path for centuries is one of growth and progress. Cautious optimism is the proper long-term stance.
  So, today Louis speculates about what sectors might come back first, and offers a good lesson in economics along the way. I think you will enjoy this Outside the Box, unless you just want to believe in the end of the world.
  John Mauldin, Editor   Outside the Box 
  
    Where Will the Growth Come From?   In a book written in 2005 and entitled Our Brave New World (now out of print but available for free download from our website), we argued that the defining feature of the global economy was overcapacity. Back then, it was hard to fully appreciate the overcapacity that existed in the world, and in the subsequent years, we can not remember how many debates we had with clients trying to dispel the notion that the world was going through simultaneous "peak oil", "peak copper", "peak wheat", etc. One of the pillars of our case was that what was masquerading as consumption was really investment; global growth dynamics were running full steam, and OECD manufacturing capacity was very quickly being replaced by ASEAN capacity. Fast forward to today, and with production now collapsing at unprecedented rates around the world, the overcapacity to produce everything is now blindingly obvious. In the race to the bottom: 
     The International Labor Office recently warned in its annual report that 51 million jobs are likely to disappear by the end of 2009 as a result of the economic slowdown, pushing the global unemployment rate to 6.5% by the end of the year.     The IMF warned that global growth would slow to 0.5% this year, well below the 2.5% typically used to define a global recession.    We could go on but our readers know the dismal stats by heart. Everywhere one cares to turn to, one finds recession, and a grim economic outlook and nowhere more so than in the US where overcapacity is manifest in falling capacity utilization and declining employment. We combine these variables in what we call Economic Utilization (which is just capacity utilization minus unemployment) and compare that to the OECD's output gap measure for the US. As the chart below makes clear, given the continued rise in the unemployment rate and drop in and capacity utilization, predicting a much deeper drop in the output gap is not really heroic: 
   
  Most investors have a natural tendency to project their most recent experiences far out in the future. Thus, we probably should not be surprised that the question on everyone's lips today is "where will the growth come from". And undeniably, answers to that question are hard to find - which means that we should probably go "back to basics" in a bid to identify the winners of the next cycle. 
  1- A Quick Theoretical Primer on Different Growth Models   In his Law of Eponymy, statistician Stephen Stigler wrote that "no scientific discovery is named for its original discoverer". As far as we can tell, this is definitely true of economics! 
  Take the notion of "comparative advantages" as an example. It was first introduced by Robert Torrens in 1815 in Essays on the External Corn Trade but it was David Ricardo who formalized the idea in On the Principles of Political Economy and Taxation in 1817. And the idea, like all good economics idea, was simple enough: Ricardo showed conclusively that a country can gain from trade even if it is technologically inferior in producing every good. Instead, a country is said to have a comparative advantage in the production of a certain good if it can produce that good at a lower opportunity cost than any other country. And by introducing this notion of relative opportunity cost, Ricardo identified the first potential source of growth for an economy: the rational reorganization of production that results when an economy moves form a state of autarky to one where trade becomes the norm, whether through better infrastructure, lower barriers, less regulations etc... In our research we have called such impetus the "Ricardian growth". 
  Or take the notion of "creative destruction" which we all associate with Joseph Schumpeter's explanations that it is the entrepreneur's job to break out of the steady-state circular flow of the economy and develop new methods, techniques, and products and which, as highlighted in Our Brave New World (calling it Schumpeterian growth), is the second pillar on which economic growth rests. That notion was actually first developed by Johann Heinrich von Thunen who transformed the incomplete marginalism of classical Ricardian theory into comprehensive neoclassical marginal productivity. Indeed, Ricardo assumed that there was only a single factor of production—labor. But this does not account for improvements in capital, nor for a deepening of the capital base. Thunen was the first to treat labor and capital symmetrically, showing that each is subject to diminishing returns and that labor's marginal productivity is an increasing function of the quantity of capital per worker. Thunen's work on capital deepening and the resulting productivity addressed the chief shortcoming of the mistaken Malthusian and Ricardian prophecies of doom. 
  In his book Isolated State, Thunen also wrote the first algebraic production function—a set of recipes or techniques for combining inputs to produce output. His original algebraic production function, it turns out, is basically the same as the well known Cobb-Douglas production function, created in 1927 by University of Chicago economist Paul Douglas and Amherst mathematics professor Charles Cobb. And further confirming Stigler's rule, Robert Solow also built on the work of the Cobb-Douglas duo, creating the Solow Growth Model, for which he won the Nobel prize in 1990. The Solow Growth Model is the most modern and simple algebraic production function one can use to illustrate the different foundations for growth. The equation is simply: 
  q = Ak.5, where:    q = output per worker     A = multifactor productivity      k = capital per worker    This equation gives us a simple tool to illustrate economic growth based on capital accumulation, productivity, or some combination of the both. In other words, it helps us understand the constraints on growth offered by Ricardo and the opportunities for growth offered by Schumpeter. 
  
  2– The Concrete Use of Multi-Factor Productivity   Consider, in our first example, a country like China that has recently moved out a state of autarky and is saving, and accumulating capital, furiously. For illustration sake, let us say that China is not yet generating multi-factor productivity (MFP) as it is still figuring out how to organize its enterprises and is still learning how to use its capital efficiently. Still, despite the lack of MFP, China's output is still growing at a very rapid pace due to the low starting point and a rapid accumulation of capital financed by a very high savings rates (25% in our example). But, in due course, rapid growth rates slow and, within twelve periods, output per worker grinds to a halt, resulting in the stationary state that Ricardo predicted. From that point onwards, growth becomes solely a function of workforce growth, i.e.: demographics. 
   
  Now, let us consider a second example of a country like the United States with a lower rate of capital accumulation, say 15%, but MFP of 1%. In such a case, output very quickly falls, but it never falls to zero. For as long as the US maintains a MFP rate of 1%, output per worker—or labor productivity—remains at 2%. Combined with a small incremental growth of the workforce of say 1%, the US can thus maintain 3% GDP ad infinitum. 
   
  From the above two examples it is easy to understand: 
     Why the growth dynamics of countries like China (or other emerging markets) are so different from those of mature economies like the US or Europe.     Why productivity growth is so important for a country to achieve as it opens the door to endless growth and wealth creation.     Why emerging economies need to have high savings rates, while developed economies need to have sustained productivity.    While the Solow growth model is designed to take a macro-economic perspective looking at countries, it is easy to translate the ideas into micro-economic terms looking at companies. Companies generating sustainable productivity growth have, in theory, limitless growth as the continuous achievement of multifactor productivity allows for infinite capital accumulation, output and wealth creation. And this brings us back to the pet theory that ran through Our Brave New World, namely the fact that a new business model has emerged (in our book, we called it the "platform-company" business model) whereby companies increasingly focus on the processes in which they have the most value-added and outsource the rest. 
  3– The Emergence of Platform Companies   Our work on platform companies has led us to some simple conclusions that we will briefly reiterate: 
     Platform-companies have fractionalized their production process, keeping knowledge intensive activities like design and distribution in-house, while outsourcing low-value added physical production. For those companies that still have significant manufacturing assets, they are devoted to complex processes or products, where knowledge is embedded in the fixed capital.     Platform-companies have worked furiously to develop new products, new markets, and new products for new markets. The US in particular has been very aggressive about investing in foreign countries. Foreign direct investment accounts for some 10% of total nonfinancial corporate assets and generates some $4.7 trillion a year in sales and some $700 billion a year in earnings.     
     Platform-companies have piled up huge cash hoards as they optimize supply chains and monetize productivity. Due to the backward tax laws, US multinationals have hundreds of billions of dollars stored up in overseas bank accounts. It is estimated that the nine largest US pharmaceutical companies alone have $113 billion stashed abroad. US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act.     
  The net result of all this is that platform companies are productivity passthrough vehicles that monetize the continuous evolution of the global production possibility frontier. In other words, platform companies are the beneficiaries of both Ricardian and Schumpeterian growth. 
  4– Platform Companies & the Financial Crisis   As everyone knows, one feature of the current financial crisis has been a complete evaporation in trade finance. Letters of credit to secure shipping have become hard to come by and local producers have suddenly found it challenging to secure financing from local banks. And while this is undeniably a consequence of the global credit crunch, it is also a side-effect of the overcapacity discussed above. In the current environment, no one wants to take the risk of a ship full of rapidly depreciating widgets making their way from Shenzhen to Long Beach. As a result of these new trends, the Institute for International Finance, a Washington association of international financial firms, estimates that private capital flows to emerging markets will tumble over 60% in 2009 to $165 billion, further exacerbating the global squeeze. 
  Undeniably this new landscape presents both challenges and opportunities for astute platform companies and the question now has to be how platform companies navigate, and thrive, in this tricky environment? As we see it, there is tremendous opportunity for platform companies to take advantage of the dislocations now prevalent in the global economy. These companies can further their aspirations through any of Peter Drucker's three conditions for success: 
     Businesses Can Improve. A good example here would be IBM, who, faced with the current highly challenging environment, has chosen to make its current offerings more efficient rather than embark on the more costly endeavor of developing something entirely new. In recent months, IBM has found a number of new uses for old software that was originally designed to help casinos apprehend card counters; now, with minor modifications, the same software is used to monitor immigration in both the US and UK. Another system, developed to mitigate traffic congestion in Stockholm, has been adapted to function in London and Singapore. In a similar fashion (pardon the pun), American Eagle has taken steps to trim 4-8% from its pergarment manufacturing costs by moving its production from Chinese factories to cheaper labor markets in Southeast Asia. And with the collapse in transportation costs, some embroidering and bead work will further move to India to help cut costs.     Businesses Can Expand. The decision to expand into new markets also presents significant prospects for companies like Wal-Mart, Coca-Cola, Inditex, H&M, Fast Retailing and many others. Wal-Mart (not to mention other retailers) is on a rather aggressive expansion schedule in international markets, with plans to add more square footage abroad in the next year than in the U.S. With a new, internationally-focused CEO, Wal-Mart plans to add 80-90 new stores in Brazil as well as continue expansion in second-tier Chinese cities (the company already has 217 retail units in China) in an effort to boost its international sales, which currently account for about 24% of its total sales. Coca-Cola is yet another example of a business that is surviving in spite of the downturn. In Russia, for example, the company's impressive distribution system stocks some 480,000 stores—a critical asset in a time where many distributors are unable to secure credit in order to deliver goods. And, to take advantage of falling advertising rates across the country, Coke has opted to maintain its ad budget in the hopes of increasing its market share. Then there is Inditex, Fast Retailing and H&M—all apparel retailers planning to continue growing, each opening hundreds of new stores from Cairo to Beijing to Singapore in order to take advantage of the current, rather favorable, leasing terms.     Businesses Can Innovate. Finally, platform companies can choose to innovate their way to achievement. Both Cisco and SAP appear ready to delve into the world of cloud-computing and software as a service. Cisco's potential foray into the computer market have spurred discussion of the commoditization of computers and networking. In its response to the economic slump, SAP has plans to allow users to pay for and use specific pieces of the product, rather than an entire system. As large, maturing tech companies, Cisco and SAP are seeking other avenues of growth; this volumemonetizer, platform company-esque strategy highlights the increasing importance of cloud computing. In a similar vein, Siemens plans to offer lowcost products—simpler versions of goods, based on the same technology as their high-tech counterparts—in the hopes of capitalizing on faster growing markets such as China and India. Capitalizing on Clayton Christensen's concept of low-end disruptive innovation, it can't hurt to sell those same lower-cost products in newly budget-conscious developed markets, too; when the production costs are kept low by manufacturing them in countries where labor is relatively cheap, margins can look the same as those of more sophisticated designs.    In a combination of each of these three attributes, we are hearing rumblings that a large, U.S. multinational household retailer, started last week to offer guarantees and financing to its Chinese manufacturers, in exchange for heavy discounts on current finished inventories and future production. Additionally, this company is actively buying inventories from bankrupt firms at deep discounts. Far from being deterred by today's extraordinary circumstances, the company is seizing the opportunity to improve its procurement efficiency, strengthen its supply chain, advance its open innovation, and possibly gain a better foothold in the local market. 
  
  5- Conclusion   The platform model came to the fore a little over a decade ago as: 1) information and communications prices plummeted, 2) global trade soared and 3) global capital flows surged. This convergence of factors enabled emerging economies to specialize, accumulate capital, and establish new comparative advantages, leading to a dramatic increase in the efficiency of global production. This process also triggered an accelerating pace of creative destruction among the world's developed countries, raising the stakes on the achievement of multi-factor productivity. 
  The current financial crisis is the first real test of the twin Ricardian and Schumpeterian growth dynamics that gave rise to the platform business model and the growth trends that we have witnessed in recent years. And today, most of our clients seem to believe that the crisis actually marks the death-knell of the model; the coming years are bound to be marked by growing protectionism, collapsing productivity and consequent economic misery. 
  We disagree and instead believe that recent evidence suggests that, far from being the beginning of the end for the platform-company model, we are simply going through the end of the beginning. With every day that goes by bringing another spate of earnings disappointments, bankruptcies, and examples of mismanagement, it would seem intuitive to expect corporate behavior to reflect these grim times, with companies retreating, retrenching, and regressing. But, in recent weeks, we have started to pick up on examples of the exact opposite, as the well-capitalized platform companies have used this period of turbulence to position themselves for the next phase of growth. 
  Our bet is thus that the platform model itself will emerge stronger from the current crisis, and play a larger role in future global economic development than most investors currently believe. Globalization is far from dead and the companies that are positioning themselves today to reap its rewards will be the winners of tomorrow.

     
]]></description>
<dc:subject>China GDP Recession Depression Financial_Crisis Growth GaveKal Platform_Companies David_Ricardo Joseph_Schumpeter Solow_Growth_Model Johann_Heinrich_von_Thunen Ricardian_Growth Schumpeterian_Growth Louis_Gave Harry_Browne</dc:subject>
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<item rdf:about="http://www.interest.co.nz/ratesblog/index.php/2009/01/18/opinion-dash-for-cash-leaves-questions-unanswered/">
    <title>Opinion: Dash for cash leaves questions unanswered</title>
    <dc:date>2009-01-17T22:26:09+00:00</dc:date>
    <link>http://www.interest.co.nz/ratesblog/index.php/2009/01/18/opinion-dash-for-cash-leaves-questions-unanswered/</link>
    <dc:creator>stateless</dc:creator><description><![CDATA[Governments around the world are gearing up to borrow and spend unprecedented amounts on infrastructure, tax cuts and social spending in Keynesian-style attempts to boost their flagging economies. But the question rarely asked so far is: who is going to pay for it all?

The immediate answer is someone else right now, and then taxpayers sometime later. But who else will lend the money right now and when will we have to pay it back?



The inevitable result is taxpayers now and in the future will have to pay for this extra spending, often many times over once interest payments are included. In the desperation to avoid a long and deep recession, policy makers are choosing to spend now and deal with the consequences later.

This may be the right thing to do, given the fallout from a deflationary depression and economic collapse would be much deeper and longer-term than the big rise in public indebtedness. But it is a debate that should be had.

It’s worth teasing out just how this spending and borrowing will unfold and how it might affect interest rates and taxes. Let’s start with the biggest economy and the heaviest borrower.

United States is set to borrow well over US$2 trillion (NZ$3.7 trillion) over the next two to three years, which will soak up much of the cash available on global credit markets for government borrowers, including New Zealand.

Don’t say it loudly, but the US is hoping China and Japan will buy many of the bonds it plans to issue over the next couple of years.

These North Asian exporting powerhouses essentially lent America the money to go on a consumption binge from 2004-07. It made sense for China and Japan because Americans spent much of the money buying Chinese and Japanese exports.

This heavy buying of US dollars to buy US bonds also suppressed the value of the yen and yuan, again boosting their export earnings.

The assumption is that the Chinese and Japanese, who now hold more than half the US Treasury bonds in non-US government hands, will keep on buying. Many question this assumption, given the US dollar’s drop against these currencies and the heavy spending by both the Chinese and Japanese governments to bolster their own economies.

The one saving grace for all these governments, including our own, is that private investors are desperate to get their hands on government bonds right now because they don’t trust many other types of investments.

But at some stage that private investor appetite will dry up, particularly when bond yields start rising and prices start falling, as they inevitably will once the huge bond issues hit the market through 2009 and 2010.

This all has implications for New Zealand’s new National Government and taxpayers in the longer term. The Government’s debt-to-GDP ratio is set to double over the next decade under the weight of new bond issues.

There is a significant risk that the mere act of selling these bonds will put up longer-term interest rates in New Zealand, which are the ones many have relied on in the form of their fixed mortgage rates.

The decision this week by Standard and Poor’s to put New Zealand’s AA+ sovereign credit rating on review for possible downgrade is another warning sign that simply spending our way out of trouble is no easy option.

National may well face some tough decisions in 2010 and 2011 in the run-up to the next election about how to reduce its borrowing funding deficits to keep interest rates low and avoid credit rating downgrades. These could include big spending cuts or tax increases.



   


    


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    <title>A Daily Snapshot Of Market Moving Developments</title>
    <dc:date>2008-12-22T18:21:17+00:00</dc:date>
    <link>http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/12/22/a-daily-snapshot-of-market-moving-developments.aspx</link>
    <dc:creator>stateless</dc:creator><description><![CDATA[Have you done your Christmas shopping yet? Research shows that more of us are putting it off in expectations of better prices. In other words deflationary expectations! The prices I have seen while out shopping the past few weeks are simply amazing. I have to admit to have made a few purchases for some items that I was not planning to buy just yet because prices were off by 60% or more. A few days ago a friend came in sporting a new black cashmere sweater top with jeweled embroidery and quite fancy. She said she got it at Saks. But the real story is that when she walked into Saks looking for a present for her kids they handed her a coupon with a 30% off any one item from whatever price it was already marked down. That top? At one point it was almost $500. She bought it for $75. I have to confess that made me worry about retail sales and future unemployment. I like low prices, but I like profitable companies and employment. I went and talked to a Saks salesperson a few weeks ago who had been there 25 years and asked if they had ever discounted like that before Christmas and he said never. It was Saturday in New York and the place looked busy. I asked why? And he said, "The store is empty during the week." And I bought a few sweaters at 60% off. Tiffani just got some presents from J Crew at over 60% off. Before Christmas! How many readers have seen the same sales? And yet shopping is down?
  As a side note, this year most of the kids and in-laws are all going to get a Visa gift cards so they can take advantage of what I think are going to be even better sales after Christmas. It is not that Dad put off his shopping to the last minute (which I did) but the kids are really looking forward to finding their special items on sale. I wonder how many more are doing that?
  This week we look at David Rosenberg's latest missive. While listing a number of negative data points, the thing to watch for is all the deflationary news. I have been pounding the table for YEARS that deflation is going to be the problem, and there would be massive stimulus from the Fed to fight it. We are now coming to that inflection point. Rosenberg is one of my favorite main stream economists and the North American Economist for Merrill Lynch. I would say enjoy this week's Outside the Box, but it is not enjoyable reading, but you should read it anyway.
  Have a Merry Christmas. And enjoy the after Christmas sales! All the best,
  John Mauldin, Editor   Outside the Box
    A Daily Snapshot Of Market Moving Developments  North America: Morning Market Memo     by David A. Rosenberg 
  Overseas Overnight Market action Outside of Japan, which rallied 1.6% on speculation that the BoJ would buy corporate debt to ease credit risk, equity markets across Asia were weaker across the board. The Hang Seng sank 3.3%, or -505 points, to 14,622. India's Sensex was off 1.7% while China's Shanghai Composite dropped 1.5%. The Korean Kospi, however, fell just 0.1%. In Europe, equity markets are trading lower and off about 0.8% in the aggregate. US equity futures, however, are pointing to a higher open across the major indices. Bonds are trading mixed across the globe, with yields down 2-4 bps in Europe but up a bp in the US. JGBs were down a bp to 1.2%. On the commodity front, we see that gold is rallying, up $6.50 an ounce to $844.75. 
  
  On the data front   This is a truly global recession. We learned overnight that Japanese exports collapsed 26.7% year-over-year in November; that's the biggest drop on record. Shipments to the US plunged at an unprecedented 34% year-over-year rate. Meanwhile, imports into Japan sank 14.4% year-over-year in a sign of weakening domestic demand. A similar story out of Thailand, where exports dropped 18.6% in what was the biggest drop in at least 16 years. In China, interest rates were cut for the fifth time in three months. The key one-year lending rate was cut 27 bps to 5.31%. The reserve requirement was cut 50 bps to 15.5% for big banks and 13.5% for smaller ones. Chinese policymakers are trying to head off social unrest. Take a look at page A8 of today's WSJ, "China Faces Unrest as Economy Falters." For a read of how another BRIC nation has hit a wall in the face of a deepening global recession, turn to page A10 of today's WSJ, "India's Textile Industry Unravels." 
  Across the pond, signs of deflation abound. Germany's import price index dropped 3.4% MoM in November on top of a 3.6% drop in October. This was well below the consensus estimate, which was looking for a 2.5% decline. In France, producer prices plunged 1.9% in November on top of a 0.9% decline in October, well below the consensus, which was looking for a 0.9% drop for the month. Meanwhile, European industrial orders dropped 4.7% MoM in October on top of a downwardly revised 5.4% decline in September. This took the year-over-year rate to -15.1%, which is the the worst on record. We also see that German consumer confidence remained essentially unchanged at 2.1 in January from 2.2 in December. 
  The next bailout: commercial real estate   Now that the auto-makers have secured a $17 billion bailout, the next group heading to Washington for government assistance is property developers. Take a look at the front page of today's Wall Street Journal, "Developers Ask US For Bailout as Massive Debt Looms." Developers are warning policymakers that office complexes, malls, hotels and other commercial real estate are headed into default and bankruptcy. According to Foresight Analytics, some $350 billion of commercial mortgages will be due for refinancing over the next three years. And, with credit virtually unavailable, borrowers will have give up the property to lenders. 
  Whiffs of deflation in pharmacies   Take a look at page B3 of today's WSJ, "Pharmacies Fight Tough Battle on Generic Prices." In response to a discount prescription drug program from Wal-Mart, retail pharmacies like CVS, Caremark, Walgreen's and Rite Aid have started to aggressively promote their discount drug programs. 
  Breaking News Today's events   It is quiet today with no economic data released. Tomorrow, we'll get the final take on third quarter GDP, which is expected to remain at -0.5% QoQ annualized. The U of M index of consumer sentiment is due as well and expected to drop to 58.7 in December from 59.1 in November. New home sales are expected to drop again to 415,000 units annualized in November from 433,000 in October. Existing home sales are up too and expected to drop to 4.93 million units annualized in November from 4.98 million units in October. On Wednesday, we'll get the personal income and outlays report. Personal income expected to come in flat in November while spending is expected to drop 0.7% MoM in November on top of a 1% decline in October. The core PCE price index is expected to drop to 2% YoY in November from 2.1%. Durable goods round out the week and are expected to drop 3% MoM in November after a 6.9% collapse in October. Ex-transportation orders look to drop 2% too after a 5.4% plunge in October. 
  
  Making it up as he goes along   The latest news out of the Obama economics camp is that the upcoming fiscal plan will create 3 million jobs instead of the 2.5 million pledged just a few weeks ago. It begs the questions: How does the government "create" jobs anyway? What jobs? Where will they come from? Doesn't the government really help create and nurture the backdrop for the private sector to generate employment and economic growth? See "Obama Expands Recovery Plans As Outlook Dims" on the front page of the Sunday NYT. Indeed, 3 million jobs sounds good and makes for front page headlines, but it would be useful to see a line-item list of where these bodies are going to come from and whether they have the skills to build new ports, medical infrastructure, mass public transit infrastructure and expanded electricity grid and "green" technologies. 
  Let's do the math   We have 1.2 million unemployed construction workers. We have 123,000 unemployed architects and engineers. We have 83,000 unemployed machinery workers. We have 145,000 unemployed transportation-related workers. So that brings us to barely more than 1.5 million of a labor pool the government can tap into for all the new building activity. But the bulk of the joblessness is in financials (up to half a million), retail/wholesale (1.2 million), leisure/hospitality (1.3 million) and health/education (1.2 million). And if investment bankers, shopkeepers, bell captains and medical chart technicians have anything in common it is that they don't have much experience in shovel-ready activities. 
  Urban renewal in Obama's fiscal package   As an aside, we published a report two weeks ago highlighting the need for urban renewal as part of Obama's fiscal package - and it looks like somebody in Washington shares our view. See "Top Democrat Seeks to Boost Mass Transit's Share of Funding" on page A4 of the weekend WSJ. This is a secular theme. Another place we can see Obama's infrastructure program touch is the nation's levees, where repairs have lagged. See the front page of today's USA Today for more, "Most Levee Repairs Lagging." 
  Deflation risks are intact   Households have lost over $7 trillion in terms of net worth in the year ending 3Q, and it looks like this wealth destruction will top $10 trillion when the 4Q Fed flow­of-funds data come out (that already exceeds the entire $4 trillion loss during the tech wreck). For a great synopsis, see "A Deflation Maelstrom In the Making" on page 11 of BusinessWeek. Friday's WSJ (page B1 - "Retailers Drop Prices to Avert a Flop") was filled with stories of how merchants are discounting more now than they were on Black Friday. Macy's has cut the prices of its diamond earrings from $800 a pair to $249 and the GAP just sliced another 60% off its already discounted clothing prices (as Bloomberg News reported over the weekend) and we are supposed to be consumed about deflation fear. Really? As a sign of how consumers are delaying their purchases in anticipation of even lower prices, only 47% of shoppers have completed their holiday activity versus 53% a year ago. We regard this as evidence that deflation expectations are creeping in. 
  And one of the conditions for deflation is, of course, wage flexibility, and everywhere we look, we see an increasing number of companies cutting back on their wage bills. FedEx is just one example - slashing wages for 35,000 employees by 5% (that is 16% of the company's workforce), including a 20% base pay cut for its Chairman and CEO (plus no company contributions to 401k plans in 2009). We also see that Nortel, Eastman Chemical, Newell Rubbermaid, Agilent Technologies, Atlas World Group, and AK Steel Holding have all cut wages and salaries in the past few weeks. According to Watson Wyatt Worldwide, another 6% of companies also plan to cut wages and benefits and 23% intend to reduce the size of their staff in 2009. Also have a look at the front page of "In Need of Cash, More Companies Cut 401(k) Match" - again, the labor market is definitely deflating. Not only that, but these cuts to 401(k) contributions are going to accelerate the process towards rising personal savings rates in coming quarters and years - again, a highly deflationary development and we are not sure that there is an appropriate response to this given that the savings rate is already at rock bottom levels of around 2%. 
  Moreover, the national labor market has frozen to such an extent that labor mobility has contracted significantly - see "Data Show Drop in Americans On the Move" on page 27 of the FT. Also have a look at front page of today's New York Times, "More Companies Cut Labor Costs, Without Layoffs." Companies are implementing four-day workweeks, unpaid vacations, wage freezes and pension cuts but keeping their headcount. Finally, take a look at page 13 of today's Financial Times, "Christmas Shutdown in Silicon Valley." What is usually limited to traditional manufacturing industries like auto has now hit tech. Companies across Silicon Valley are shutting down until after the holidays to cut back on spending. In spite of the forced time-off, some workers will be required to use up part of their holiday entitlement or if they don't have vacation days, take unpaid leave. 
  Historians may title this era GDII   As we said, historians may look back on this era and title it GDII: After all, look at how people are behaving - one of the newest fashions is renting movies about the Great Depression, or that have a similar theme like the "Grapes of Wrath" and "It's a Wonderful Life". See "Reality Can be Escaping, Too" on the front page of the Sunday NYT's Week in Review section. 
  Consensus still loves equities and despises bonds   See Barron's for more on the 'groupthink' theme - every single strategist surveyed (outside of us) sees the 10-year note yield backing up next year from current levels (page M12). The consensus is 3% for the end of 2009. As for equities, the Roundtable (see page 23) is at 1,045 for the S&P 500 (which would be +15 from here). Nobody is lower than 975 (Rich B's prediction) so +10% is at the low end of the entire spectrum. Health care was cited as a 'favorite sector' by 10 of the 12 pundits, and at least one of utilities/staples/telecom showed up on the top list of two-thirds of the respondents. So the view seems to be that we are going to have a bounce next year, led by ... the defensives. Interesting. 
  We don't understand why so many are bearish on rates   What we truly don't understand is why it is that so many folks are bearish on interest rates when in fact we need a sustained period of very low yields to help blaze the trail for the next sustainable economic expansion: After all, isn't it good news that, because of Mr. Bond's strength and resolve, we now have the benchmark 30-year fixed-rate mortgage at the lowest level in at least 37 years (5.27%)? Mortgage rates are now down 7 weeks in a row (it does the beg the question, however, as to why it is that mortgage applications for new purchases slid at a 20% annual rate in November and are off in 9 of the past 10 months). And despite the best affordability ratios in 35 years, what did we hear from Lennar last week - that its order book collapsed 46% in the past year and backlogs are down 67%. Maybe the classic affordability ratios that use conventional mortgages don't tell the complete story - because nonconventional mortgage rates have lagged with jumbo loans still costing 6.9%. 
  Homebuilders pressuring Washington for a bailout   As the bailouts pile up, we thought that the best read of the weekend was from the Weekend WSJ - see page W1 ("Is the Medicine Worse than the Illness?"). And now we see that the homebuilders are pressuring Washington to provide first-time homebuyers with a $22,000 tax credit. It's as if there is now a pervasive belief that there is a bottomless pit of cash ready to be put to use to correct all the excesses of the past decade from financials, to autos to builders. It's amazing that we could have let so many tech companies go belly up in the last cycle but have gone this route of accelerating rescue packages this time around. At least in the last cycle, we were running balanced budgets as opposed to trillion-dollar deficits. What does concern us is the risk to civil liberties when bankruptcy judges can alter contracts, the government can force banks to accept public capital injections (Jamie Dimon said on CNBC he didn't want or need Paulson's help), the government by fiat can bring mortgage rates down as opposed to market forces, the government tells lenders how to price their credit card business (since when did a piece of plastic become a right instead of a luxury?). 
  
  The major risks for 2009   We continue to believe that trade protectionism, competitive devaluations and military conflicts are the major risks for investors for 2009 - this is, after all, the most broadly based global recession (according to the IMF, not just us) in the post-WWII era: Ecuador defaulted on its foreign debt. Since the G20 meeting in Washington in October, five of those countries - Russia, India, Indonesia, Brazil and Argentina - have announced their intentions to raise import tariffs or otherwise restrict trade. Russia has announced plans to raise tariffs on autos; India has already lifted duties on iron, steel and soy; Brazil and Argentina are putting together a case within Mercosur for boosting external tariffs. Vietnam just raised taxes on steel imports to 12% from 8%. The EU said it may reimpose duties of 79% on a paper-binder component in retaliation against China. French President Sarkozy has established a $7.5 bln fund to invest in domestic companies so as to avoid foreign takeovers. China has reinstated export rebates and now we see that US steel, textile and paper markets intend to file complaints against Chinese imports, and did anyone notice that this auto-bailout excludes foreign companies? 
  It's all about self-preservation. We think that for anyone who missed it, the article on the front page of Friday's NYT is a worthwhile read ("After 30 Years, Economic Perils on China's Path"). Russia also cannot be regarded as a stable data point either as it just posted its first monthly budget deficit in November and the sovereign debt was just downgraded by S&P for the first time in a decade (Friday's WSJ reports says "public panic is one of the Kremlin's greatest fears"; the NYT reports that "as Beijing worries about strikes and mass layoffs even in some of the its most prosperous areas, official tolerance of political dissent has seemingly narrowed".) Gold will be an important hedge against policy missteps 
  Gold, in our opinion, is going to be important hedge against such policy missteps in 2009; and not only gold, but security of supply and government procurement policies may end up putting a floor under the beleaguered commodity complex earlier than a lot of folks think. As the chart below attests, there is a pretty good link between government spending as a share of GDP and the CRB index, because governments don't buy clothing or jewelry but they do buy "material". 
  And as for gold, the chart looks good against a vast majority of currencies and has broken out against Sterling. See chart below. 
   
  As we said before, the new growth engine for the economy is government spending, which is already on the rise and set to take out the prior high of over 23%. After all, when you are in trouble, you go to family members for help first. Uncle Sam.....? 
  

     
]]></description>
<dc:subject>Housing Deflation Japan Consumer_Spending Consumer_Price_Index Global_Economy Gold Depression Merrill_Lynch Germany Barack_Obama David_Rosenberg Commercial_Real_Estate Employment</dc:subject>
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    <title>The Stock Market is Not in Uncharted Territory</title>
    <dc:date>2008-11-17T23:07:31+00:00</dc:date>
    <link>http://feeds.feedburner.com/~r/John_Mauldin_Outside_The_Box/~3/456510901/the-stock-market-is-not-in-uncharted-territory.aspx</link>
    <dc:creator>stateless</dc:creator><description><![CDATA[This week we visit some very thoughtful analysis by an old friend of Outside the Box, Dr. John Hussman of the Hussman Funds (http://www.hussmanfunds.com/index.html). Is it 1932? Are we in a Depression? Where is the bottom? John gives us a very balanced view and actually offers some positive insight on the markets. There may be light ahead.
 (Note: there is a chart from Ned Davis Research that is, as John notes, not to be distributed further. I did call Ned Davis Research and they graciously gave me permission to use it as well.) Have a great week, and enjoy some positive thoughts below.
 John Mauldin, EditorOutside the Box 
   The Stock Market is Not in "Uncharted Territory" By John Hussman, PH.D.
 One of the fallacies about the recent financial turbulence is that the markets are in "uncharted territory" and that there are no historical precedents for the volatility, panic, or economic uncertainty that we've observed. To make statements like this is to admit that one has not examined historical evidence prior to the 1990's. The fact is that we've observed similar panics throughout market history. This decline has been deeper and more rapid than most, but that is largely a reflection of the rich valuation and overbought condition that characterized the market in 2007 (see the July 16, 2007 comment - A Who's Who of Awful Times to Invest). 
 If we seriously deem it necessary to talk about the Great Depression, fine. Even the Great Depression can be adequately used as a precedent for current conditions provided that one recognizes that the market's valuation during the Depression didn't fall to the levels we currently observe until 1931 when the rate of unemployment was already 15%. Sure, if U.S. unemployment is headed to 25%, as it did in the Great Depression, then stock prices might fall in half even from here, as they did by 1932. But this is important - even if stock prices were to fall further, it would not be because of earnings losses that would permanently impair the fundamental value of U.S. companies. Rather, if further losses emerge, it will be because of increases in risk premiums that will be associated with extremely high subsequent returns. Indeed, even though unemployment shot to 25% in 1932, the S&P 500 more than doubled in the year following the 1932 Depression low, and tripled off of that low within less than three years. 
 
 The handful of historical instances when stocks fell to 7 times prior record earnings were also points that were accompanied by 15-25% unemployment, 12% yields on commercial paper (as at the 1974 lows), or 15% Treasury yields (as at the 1982 lows). Similar data is unlikely in this instance - and even if conditions deteriorate to that point, it will involve months and months of ebb and flow in the economic reports. We can be virtually certain that stocks would experience enormous rallies, not simply continuous decline, while the evidence accumulates. Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) - points where stock prices were not far from their lows even though negative economic news persisted for a longer period. 
 The chart below (reprinted by permission and not to be distributed further) is from Ned Davis Research. Note the points at which similar spikes in volatility and credit spreads occurred. None of this provides assurance about very near-term risks (very short term fluctuations can be obscured by monthly charts like this), but it underscores that similar panics have typically been associated with washed-out market lows, and in any event, should further reinforce that this decline is not particularly "uncharted." 
   
 That's not to say that I believe stocks have "hit their lows." We always have to allow for the market to move significantly and unexpectedly, and there is plausible downside risk from here. Our activity as investors is not to try to identify tops and bottoms - it is to constantly align our exposure to risk in proportion to the return that we can expect from that risk, given prevailing evidence. 
 If I was confident that the market's downside risk was tightly limited, I would remove our hedges. Instead, the Strategic Growth continues to hold a put option defenses against 70-80% of the holdings at about the 850 level on the S&P 500. Above that level, we are accepting a good deal of day-to-day market fluctuations. Below that level (which is something of a line in the sand for us since it represents the October lows), our option defenses can be expected to increasingly mute the impact of any further market losses. I don't anticipate lowering those strikes in the event that market losses continue, at least until we observe fresh evidence of improved market internals. That said, in the event of a substantial further decline, I do expect to very gradually reduce the percentage of the Fund's holdings that are hedged. 
 In short, with stocks both undervalued and oversold, it is appropriate to accept a modest amount of market risk and a good sensitivity to "local" fluctuations, but we remain hedged to defend against any major and unexpected deterioration. 
 Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are "uncharted territory." Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions. Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows. 
 No thoughtful investor "calls a bottom" in the markets. Stocks are undervalued here, but they could decline further. Economic conditions are poor, but may be over or under-reflected in stock prices. Investors will find out over time, and the ebb-and-flow of information is slow enough to allow very large market fluctuations in the meantime. Current market conditions are extremely compressed, to the extent that the market could soar by 30% even in the context of an ongoing bear market. At the same time, investors remain skittish, and we should allow for fresh weakness into next year or perhaps a wide and prolonged trading range. We continue to have something of a line-in-the-sand at the October lows, which is largely where our index put option strikes are positioned. We'll alter that as the evidence changes. 
 
 Price Fluctuations, Support Levels, and Valuation in Bear Markets  If we seriously need to talk about the Great Depression (I personally believe that it is an outrageously dire comparison), we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support. Below is a chart of the Dow Jones Industrial Average during the Depression. Even if one hung on after the enormous rally of nearly 50% that followed the initial 1929 low, the market's initial break of that low (the first horizontal bar) was followed several months later by a rebound to that prior level of support. The break of the second intermediate low of early 1931 (the second horizontal bar) was followed by a rebound later in the year to that same level. Third break, same story. 
   
 It is a typical market dynamic to have massive rallies toward prior levels of support, even within ongoing market declines. Once valuations are favorable, that tendency is even stronger, even in a weakening economy. Only the final panic decline of a bear market offers investors virtually no chance to get out on rebounds, but it is precisely that final decline that is recovered almost immediately in the subsequent bull market. 
 It's possible we've already seen the final panic of the current "bear market," though we certainly wouldn't remove our hedges on that expectation. Given the slim prospects for an economic recovery in the near future, my impression is that regardless of what happens over the very near term, we'll observe an additional spate of weakness (possibly from higher levels) early next year as investors give up their remaining patience and decide -as they often do near the end of a bear market - that there's no way that the market or economy can recover, and that there is no "catalyst" that is capable of driving stocks higher. 
 Even if the U.S. economy experiences a much deeper recession, I believe that the 1000-1100 level on the S&P represents a reasonable estimate of "fair value" for the S&P 500. That estimate is somewhat conservative since I am adjusting for the fact that earnings in recent years have been based on very wide profit margins, but could be too conservative given that long-term interest rates are very low. Long-duration instruments like stocks should not be priced off of short-duration instruments like 10-year Treasury bonds, or even 30-year Treasuries, so low interest rates shouldn't make investors recklessly optimistic about their valuation estimates. In any event, I do believe that current levels represent value from the standpoint of long-term investment prospects. 
 As for extreme and less likely benchmarks, the 780 level on the S&P 500 would represent a 50% loss from the market's peak, and would put the market in the lowest 20% of all historical valuations. I would expect heavy demand from value-conscious investors about that level if the market was to decline further, and a decline below that level could be expected to reverse back toward 780 fairly quickly. Further down, but very unlikely at this point from my perspective, the 700 level on the S&P 500 would represent the lowest 10% of historical valuations, 625 would put the market in the lowest 5% of valuations, and anywhere at 600 or below would put the market in the lowest 1% of historical valuations. I don't expect to see such a level, but there it is. Note that these estimates are unaffected by how low earnings might go next quarter or next year. Stocks are not a claim on next quarter's or next year's earnings - they are a claim on an indefinite stream of future cash flows. 
 Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they've lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can't rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all. 
 As I repeatedly noted when valuations were rich, gains in an overvalued market are generally not retained over the full market cycle. Likewise, weakness in an undervalued market tends to be temporary and impermanent. This distinction is essential. The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines. Even in ongoing bear markets, once valuations become favorable, declines through prior levels of support are typically followed by advances back to that support. Remember that if and when things look frightening. 
 It is also important for investors to separate near-term earnings risks from long-term valuations. Earnings are more volatile than stock prices, and year-over-year fluctuations in earnings are not correlated at all with year-over-year fluctuations in stock prices. It is only over the long-term, when we examine stock prices versus the smooth trend of normalized earnings across multiple business cycles, that earnings really matter. 
 Again, if the market cleanly breaks the October lows, our investment position will become less sensitive to market fluctuations because that is where our put option strikes are largely set, but valuations have already improved beyond the point that would justify a full hedge against 100% of our holdings. 
 
 Market Climate  As of last week, the Market Climate for stocks was characterized by moderately favorable valuations and unfavorable but extremely compressed market action. The initial improvements we observed in market action a couple of weeks ago are now more tentative, and the market is only slightly above the level where we would lose that early favorable evidence (which is, not surprisingly, why we have set our option strikes at that same level). If the October lows hold well, we may very well observe a scorching advance in the range of 20-30% as investors re-evaluate the extent to which the market's decline has discounted the probable negatives. A significant break of the October lows could prompt "weak" holders to abandon stocks, which would create a need for a sufficient discount for "strong" holders (mainly value-conscious investors) to purchase those shares. Again, my impression is that in the event of a clear break of October's lows, 780 on the S&P 500 would most probably be where value-conscious investors would exhibit very strong demand. 
 As a side note, do your best to filter out comments like "investors are moving out of stocks and into ..." or "investors are selling into this decline" or "investors are buying into this rally." On balance, investors do not sell shares, and they don't buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the "market" consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you're at a poker table and you don't know who the patsy is, you're the patsy. 
   Your hoping we do get a major rally analyst,
 John Mauldin

     
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