ProfitScore IQ

Two Steps Forward and Three Steps Backward

2009-11-20T14:19:00Z

Our Monthly Performance Update
Dollar Reality Check
Are Valuations Justified?
The Mother of All Carry Trades
Market Summary
Portfolio Performance Analysis
Can I Do It This Year?

Timing is everything and being early with your investment decisions can be almost as painful as being late. Since most investors lost significant sums of money in 2008, they feel a deep-seated fear of getting left behind. It is called the herd instinct. This important emotion kept us alive when we hunted with knives and spears, but today it runs investors off a cliff. In dealing directly with retail clients, the herd instinct is the most prevalent emotion I see.

Over the past several months, the markets powerful advance has made me feel like I have been standing in front of a train. I had this same feeling back in May 2006, when I sold my house to move into a rental home because I felt the real estate market no longer made any sense. I feel the say way today about the stock market. The Fed and the Treasury have many tricks up their sleeves to buy short term relief. But, what long-term price will future generations have to pay?

The dollar has been bouncing off its all time low for the past couple of weeks and the market continues to rally. As you will learn from reading this letter, a weak dollar is feeding leverage and liquidity into the market. Over the past 90 days, there has been an inverse correlation between the dollar and the S&P 500 of approximately 75%. So when the dollar goes up, the market goes down, and vice versa. It feels good when asset prices go up, but when these assets are compared in dollars or gold, there has been no gain at all. As a matter of fact, there have been further declines in the United States global buying power.

In this newsletter, I have decided that a picture is worth a thousand words, so we have provided lots of charts and graphs. The picture these charts paint about our economy is not pretty, yet the market continues its advance. Hopefully, our research at least makes you pause and ask why?

"Whether you are investing in real estate in China, equities in Peru, or indexing the S&P 500, you are putting your faith in the ability of the U.S. Government to pull off a miracle. Expectations will be tough to meet, and the risk of the Administration losing a handle on the situation is a constant threat. Over the next five years, investors should focus on capital preservation and avoid getting swept up in the inevitable credit-fueled bubbles."
Boeckh Investment Letter, October 30, 2009

An Update on Our Performance

Interest-rate sensitive strategies continue to lead in 2009. Shorting the U.S. dollar and being long high-yield bonds has been the easiest trade of the century. Actively trading government bonds has also rewarded our investors handsomely. In 2008, fixed-income investments were grossly manipulated by the Fed and Treasury, and in 2009, equities seemed to make no sense. No one ever said it would be easy, but they sure didn't say it would be this hard either.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	October	Sharpe
Name	Months	2009	2009	Ratio
Income Builder (IB)	9.50%	13.06%	0.73%	1.47
The Guardian (GRD)	4.33%	9.33%	0.43%	1.73
Harmony Plus (HMY)	0.54%	7.05%	-0.12%	1.46
The Expedition (EXP)	-2.53%	3.67%	-0.60%	1.14
S&P 500 (SP500)	9.80%	17.05%	-1.86%	0.66
Important Performance Disclosure

ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here: http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Dollar Reality Check

Much has been written about the value of the dollar since the stimulus bonanza began in 2007 and before. Pundits have worried that our cheap dollar policy ("Quantitative Easing") has had a clear impact on the dollar, and not in a positive way. As we see from the next chart, they have a point showing the dollar value erosion began in 2000, as the tech bubble began to break in a trend that continues to this day.

Figure 1 - Weekly chart of the US Dollar Index priced in gold. Chart GenesisFT.com

Stocks Priced in Gold
Economic growth that occurred during the 1990s was accompanied by a confidence in the dollar, which led to some very real gains in asset prices, stocks and commodities (that are priced in US dollars). But in real terms using the gold standard, stocks have been significantly hurt by the falling greenback, thanks to a nearly 85% drop in the value of the buck compared to gold. Next let's look at how stocks fared in gold terms.

Figure 2 shows that the Dow, priced in gold, peaked in mid-1999-almost a year before the index peaked in nominal terms and a big part of the more than 80% drop in real stock prices due to dollar weakness. Stocks have been doing well lately in the face of a weakening dollar, but this has had an overall net negative effect in real terms.

Figure 2 - Weekly chart of the Dow Jones Industrial Average priced in gold. Chart GenesisFT.com.

Stocks in a Euro and Canadian Dollar Perspective
The next two charts show the Dow priced in Euros and Canadian dollars to provide a different value perspective. As we see, the Dow peak in 2007. It was well below its 2000 peak and remains more than 50% depressed from a European investor's point of reference. This may explain why dollar denominated assets held by foreigners (as well as the interest in Treasuries) has fallen in the past few years.

Figure 3 - Weekly chart of the Dow Jones Industrial Average priced in Euros. Chart GenesisFT.com.

Figure 4 - Weekly chart of the Dow Jones Industrial Average priced in Canadian dollars. Chart GenesisFT.com.

Stocks and Commodities
Do you think gold has rallied based on hype and speculation, not real demand? To test this idea, let's examine how stocks have fared compared to commodity prices. As we see, compared to a basket of 17 commodities, the Dow Jones Industrial Average is down nearly 65% from its commodity-adjusted price peak in 1999.

Figure 5 - Weekly chart showing the Dow priced in commodities as represented by the CRB Index. Chart GenesisFT.com.

Are Valuations Justified?

Now that we have a more global perspective on how stocks have fared in the new millennium, where are stock valuations in nominal US dollar terms? If they are historically cheap, they will become more attractive to investors looking for long-term value who believe that stocks have the potential to appreciate in real terms, even if the dollar continues to weaken. This of course assumes that economic growth from here will be sustained and that the dollar does not collapse in value compared to other major currencies.

In late October, ContraryInvestor.com performed an interesting comparison between stock values (S&P500), after stocks rallied 60% between the March lows and October highs, with the 60% rallies that occurred in 1972, 1976, 1983, 1994, 2006. As the following table shows, the numbers were interesting. Based on these metrics, stocks are anything but cheap!

Here is a summary of the 10 indicators following past 60% rallies compared to this one.

Year-over-year retail sales: 9.3% average in prior 60% rallies versus -5.3% currently
Consumer Confidence Index: 95.5 average; 53.1 now
Capacity utilization: 79.9% average; 66.6% now
Year-over-year industrial production: 4.1% average; -10.7% now
Institute of Supply Management (manufacturing) : 53.9 average; 52.6 now
Payroll employment gains over period: 2.2% average; -2.0% now
Decline in continued unemployment claims from cycle peak: -26.3 average; -11.6% now
Year-over-year growth in total credit market debt: 9.3% average; 3.0% now
Year-over-year growth in household debt: 8.8% average; -0.1% now
P/E multiple (trailing 10-year earnings): 16.8x average; 20.0x now

Figure 6 - Weekly chart showing prices, average P/E (blue line) and earnings growth (GRT) for 7,995 U.S. stocks tracked by VectorVest. As the chart shows, the average P/E for the broad range of publicly trading companies entered uncharted territory in 2009 and is still well above any previous year's high. Chart VectorVest.com.

But what happens when we examine valuations for a much broader basket of US stocks, like 8000 (see Figure 6) instead of the cherry-picked, and constantly modified, S&P500 or Dow Jones Industrial Average? The results of this exercise were equally interesting.

On June 5, 2009 the average price-to-earnings ratio for the 8,011 US stocks of the VectorVest Composite Index (VVC) hit an all-time high of 155.58, thanks to rising prices, but no increase in average earnings. Earnings had fallen to their lowest level since the VVC was initiated in 1995 of $0.13/share. But then earnings for a broad range of companies began to show their first real signs of improvement since March 2007, rising from $0.13 to $0.15 per share. P/Es have continued to fall, albeit slowly, to just over 100 on October 30, 2009 as earnings rose.

The same can't be said about earnings growth (GRT). After peaking in May 2005 at 11%, earnings growth (GRT) continued to deteriorate falling to 10% in 2006. By the second week in October, earnings growth had fallen to 0% and the average EPS for the roughly 8000 companies had grown to just $0.22/share, still well below their new millennium peak of $1.04/share in January 2007.

How do these numbers compare to the last recovery? As the rally was getting underway in March and April 2003, earning growth (GRT in red) was a much healthier 8%, and earnings growth had begun improving nearly a year before hitting a low of 3%. Within two months of the bottom in stock prices and the beginning of a 56-month bull market, VVC P/Es peaked at 60.51 (May 2003). Looking even further back to the lofty prices in March 2000, we see the P/E, although high, was a much more benign-32 times and earnings growth was running at 11%.

The Mother of All Carry Trades

Since late 2006, the financial world has become all-too-familiar with the carry trade (selling a low-yield currency to buy assets in high-yield currencies). Then, the Japanese yen was the fuel of choice, thanks to basement costs of borrowing. But with the credit crisis and rapid collapse in the values of high-yield currencies, like the Icelandic krona with commensurate losses, the carry trade appeared to go the way of the dodo bird-extinct.

However, the very factors discussed above have given global investors with a penchant for risk a new carry trade target - that's right, the USD. As Figure 3 shows, one popular currency pair, the New Zealand dollar and US dollar (NZD-USD) has helped fuel the recent stock rally. It means that global investors can borrow dollars at record-low rates, sell them to buy New Zealand dollar denominated bonds and other assets, and reap the interest rate difference as profit. A further weakening dollar/strengthening NZD is a bonus. Their major risk is the possibility of a rapid USD appreciation/NZD depreciation.

As Figure 3 shows, this carry trade was somewhat popular before the credit crisis began in late 2007, but has recently surpassed its 2007 peak popularity, as investors sell USD to buy NZD. Currently, the correlation between the two is nearly 0.94 (a correlation of 1 is perfect correlation).

Figure 7 - Weekly chart of the New Zealand dollar - US dollar currency pair in the upper sub-graph, the S&P500 in the mid-subgraph and the 20-week correlation between the two (red).

As the economist known as Dr. Doom, Nouriel Roubini, pointed out in an article last week, the conditions that have driven the USD carry trade have created what he believes is the "mother of all carry trades."

Here is how he outlined the power behind the key risks that this trade presents in his Financial Times article, "Mother of All Carry Trades Faces an Inevitable Bust."

"So what is behind this massive [stock/commodity] rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates - as low as negative 10 or 20 per cent annualized - as the fall in the US dollar leads to massive capital gains on short dollar positions."

These conditions, "a zero Fed funds rate, quantitative easing and massive purchase [monetizing] of long-term debt instruments is seemingly making the world safe - for now - for the mother of all carry trades and mother of all highly leveraged global assets."

If Roubini is right (and let's face it, his track record in calling the market leading up to and through this crisis so far is impressive), investors are surfing a global cash tsunami which could still be some time from reaching its zenith. However, any potential for gain is offset by the reality that the bigger this bubble gets, the more destructive its ultimate collapse will be, so caution is a requisite.

But even Dr. Doom is careful about calling the end of the financial world as we know it in his final paragraph.

"This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall."

Market Summary

I will be the first to admit that one of the biggest challenges in the current credit crisis and apparent recovery has been estimating the impact of various policy decisions by the Fed and other central bankers around the globe. Few, including yours truly, appreciated just how powerful this stimulus could be in the face of massive debt. In my defense, job one is to protect principle, and debt creates serious risk, especially when it gets as big as it is today.

As history has taught us, bubbles generally build longer than expected, with the biggest gains coming nearer the end than the beginning. Enter too late or exit too early and you underperform your less risk-averse peers.

We at ProfitScore will continue to take a cautious approach to this market and trade it with great care, with both eyes on money management. We will continue to take profits out of the markets without putting serious capital at risk. This is certainly not a market for the weak of heart!

Based on current economic reality, the U.S. still has some time to go before it can follow nations like Australia and be weaned from the punch bowl. And as long as the punch bowl offers libation, there will be money to be made, as long as one doesn't imbibe to the point of losing an appreciation for what happens when the punch is gone.

Interesting Reading:

International Monetary Fund - Principles for Stimulus Exit
http://www.imf.org/external/np/g20/110709.htm

Detail IMF document - Global Economic Prospects and Principles for Policy Exit
http://www.imf.org/external/np/g20/pdf/110709.pdf

Why Some Countries Are Stopping Their Stimulus
http://www.time.com/time/business/article/0,8599,1936585,00.html

The American Economy in One Chart
http://www.safehaven.com/article-14999.htm

Mother of All Carry Trades Faces Inevitable Bust - Roubini
http://www.ft.com/cms/s/0/9a5b3216-c70b-11de-bb6f-00144feab49a.html?nclick_check=1

Portfolio Performance Analysis

Risk & Reward

Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength. Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

Based on our internal valuation estimates, fair value on the S&P 500 is approximately 850. Our long-term dismal GDP growth calculations over the next five years, combined with the fact that equities are currently 30% overvalued, have our five year forecast on the S&P 500 as a negative return. I have had only limited success forecasting equity markets based on fundamentals because investors simply don't care. Fear and greed drive the markets and they always will. Due to volatility contraction and P/E expansion into nose bleed territory, we remain vigilant in our efforts to carefully manage risk.

Our equity trading accuracy remains above 50%, but our average losing positions during October were larger than our average winning trades, producing small negative returns for equities in October. MTD November, we are currently showing small gains for equities across the board. Interest rate sensitive allocations continue their upward march higher.

Index Advantage:

Trading accuracy has stabilized north of 50%, after our low in July. Large monthly moves seem to find us on the wrong side of trades, which causes us to fight back to pull our returns back into positive territory. November is showing small gains for the month. Managing risk in a hard-charging market can be a difficult job.

For the month, this pillar gained -1.28.

Strategic Balance:

We continue to tread water in this allocation, as our risk-adverse traders patiently wait for higher probability trades to materialize.

For the month, this pillar earned -0.67.

Dynamic Income:

Our interest rate sensitive strategies combined to once again produce positive returns for what is now the 7^th-winning month in a row. Given the over-extended positions in asset classes traded in this allocation, we are growing more cautious about changing dynamics and increasing volatility. If the economy once again falters, I fully expect the government to once again manipulate the long and short end of the yield curve, making our job managing these positions almost impossible. Until then, we plan to make hay while the sun is still shining!

For the month, this pillar earned .98.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

Complete our Private Client Group request form by clicking here: http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Currency Manipulation – Has It Helped Your Net Worth?

2009-10-30T13:08:00Z

Discussion on the Hill
Dollar Crisis Averted, But at What Cost?
The Cost of Global Dollar Reliance
A Year After TARP -- Was It Necessary?
Attaboy Jack!

In this letter, we are going to spend some time digging into the recent volatility of the U.S. dollar. In case you haven't noticed, the U.S. dollar roared back in 2008 only to resume its free fall in 2009. There are advantages and disadvantages to having a strong/weak dollar and some passionate arguments for/against various dollar policies. Historically, every great power in history has used a weak dollar to inflate their way out of paying off large amounts of debt.

Below is a recent discussion between Chairman Bernanke and Congress on the use of currency swaps as an apparent tool of the Fed to manipulate the currency market. It appears that the recent financial crisis and the fact that the U.S. dollar is the reserve currency of the world, gave the Fed a perfect opportunity to have its cake and eat it too. The recent drop and increased volatility in the U.S. dollar may mean that the Fed got more than it bargained for.

Question?
If you are invested in the S&P 500 in 2009 and it goes up 15% in value and at the same time the U.S. Dollar drops 16% in value, has your global net worth increased?

"Swap" Discussion on the Hill

A hearing in Congress on July 21, 2009 provided a unique insight into the Federal Reserve's actions at the beginning of the credit crisis. Here is a noteworthy exchange between Congressman Alan Grayson (D - Florida) and Fed Chair Ben Bernanke.

Grayson:
"Chairman Bernanke, I'm looking at the report you handed out this morning... There's a table on page 26 [of your report] that consists of [the Federal Reserve] balance sheet and one of your entries called central bank liquidity [currency] swaps shows an increase from 2007 from $24 billion to $553 billion ...by the end of 2008. What's that?"

Bernanke:
"Those are swaps (derivatives) done with foreign central banks, many [of which] are short dollars and [that would have had to] come into our markets looking for dollars, drive up interest rates and create volatility in our markets. What we have done... [is to] swap dollars for currencies [of 14 central banks']; they take the dollars and lend it out to banks to bring down interest rates in those jurisdictions." (What he didn't say was that such action also helped keep US interest rates down.)

Grayson:
"We looked at one of the arrangements, [one of which was] $9 billion for New Zealand, which works out to $3,000 per person [New Zealand resident]. Wouldn't it have been better to extend that kind of credit to Americans?"

Bernanke:
"...we are extending that kind of credit to Americans."

Grayson:
"...look at the next page which shows... a 20% increase in the nominal USD exchange rate at exactly the same time that you were handing out a half a trillion dollars to foreigners. Do you think that is a coincidence?"

Bernanke:
"... [Pause]...Yes."

It's an interesting question, despite how Bernanke answered it. Action contradicts his answer but in his defense, strengthening the dollar was probably not the goal of the Federal Reserve in taking this action - it was an unintended consequence.

Dollar Crisis Averted, But at What Cost?

In August, September and October, the US Dollar Index (USDX) appreciated 21% after falling 24% from late 2005 into early 2008. But if taming volatility was a motivator for the Federal Open Market Committee to sell swaps as Mr. Bernanke claimed, the strategy failed abysmally. The dollar shot up from 72 in early August 2008, before peaking at 90 in March 2009, after which it then lost 16%.

And the aftermath isn't pretty. The dollar is still falling and recently broke key support at 75, and there is little on the horizon to indicate that this trend will change anytime soon, especially given the moves by foreign central banks to shift away from the dollar (see articles in Related Reading below). Can anyone blame them? Current Federal Reserve and government policies and responses have been anything but dollar positive.

This month, the Bank of International Settlement (BIS) published a paper that attempted to answer this and other questions surrounding central bank actions entitled "The US Dollar Shortage in Global Banking and the International [read: Federal Reserve] Policy Response."

The paper wasted no time in getting down to brass tacks and asked some probing questions of its own.

The global financial crisis has shown just how unstable banks' sources of funding can become. Throughout the crisis, but particularly following the collapse of Lehman Brothers in September 2008, many banks faced severe difficulties securing short-term US dollar funding. In response, central banks around the world adopted extraordinary policy measures, including international swap arrangements with the US Federal Reserve, to enable them to provide US dollars to commercial banks in their respective jurisdictions. What caused this global shortage of US dollars? Which banking systems have been most affected? How could a shortage develop so quickly after dollar liquidity had been viewed as plentiful?

In a nutshell, when the crisis hit the dollar a shortage was the result caused from a trend that had become popular with foreign banks of taking increasingly larger US dollar positions, thereby creating significant short dollar positions among foreign banks. In Europe's case, "[the] banks' need for short-term US dollar funding was substantial at the onset of the [credit] crisis, at least $1.0 -$1.2 trillion by mid-2007."

And that was just Europe.

The Cost of Global Dollar Reliance

The origins of the US dollar shortage during the crisis are linked to the expansion since 2000 in banks' international balance sheets. The outstanding stock of banks' foreign claims grew from $10 trillion at the beginning of 2000 to $34 trillion by end-2007, a significant expansion even when scaled by global economic activity (Figure 1, left panel). The year-on-year growth in foreign claims approached 30% by mid-2007, up from around 10% in 2001. This acceleration took place during a period of financial innovation, which included the emergence of structured finance, the spread of "universal banking", which combines commercial and investment banking and proprietary trading activities, and significant growth in the hedge fund industry to which banks offer prime brokerage and other services.

So how big was the risk of the credit crisis on these foreign dollar positions?

Were all liabilities to non-banks treated as short-term funding, the upper-bound estimate would be $6.5 trillion.

Many of these dollar short positions held by foreign banks was the result of participation in complex derivatives in a market that had grown to around $600 trillion. This short-term funding liability was little more than one percent of the derivative total.

Figure 1

And it is this amount and potentially more that the Federal Reserve was attempting to cover in the action taken by the FOMC. In other words, the Federal Reserve became the buyer of last resort in an effort to avert further crises with the taxpayer, ultimately being on the hook for the tab!

The BIS paper highlighted just how little was known about the structure and complexities of international bank balance sheets and their dependence on one another thanks to financial globalization. It also exposed the risks that grew from this trend and growing use of foreign exchange swaps and other derivatives.

When the credit crisis hit and Lehman Brothers collapsed, short-term currency funding sources were seriously compromised, which many believe required that a buyer of last resort step into the fray. These problems became most acute in smaller countries like Iceland, that had become heavily reliant on complex derivatives and foreign banks to provide a funding backstop in case something went wrong. And in 2008, that is exactly what happened.

But what happens when the next crisis strikes? Will the Federal Reserve be ready and able to again act as buyer of last resort and provide necessary liquidity? And who assumes the risks of this action? As we have learned in the past year, it will be the US taxpayer.

This was just one event in a series of events that were part of a larger global crisis that some experts would have us believe threatened our financial system.

A Year After TARP - Was It Necessary?

Another quickly improvised solution to the 2008 crisis was the $700 billion Troubled Asset Relief Program (TARP), introduced by Secretary Treasurer Hank Paulson in September 2008. Without it, we were told, the financial fabric of our country would have been irrevocably torn with untold consequences. Given this supposed threat, Congress quickly approved TARP on October 3, 2008.

A year after TARP, what has it accomplished? A paper by Florida State University Professor Randall Holcombe published recently sought to address this question.

Figure 2 - Chart from the Federal Reserve showing the effect of TARP, a reduction in commercial and industrial bank lending by commercial banks, which is the opposite of the intention (we were told at the time) of the program. Based on the amount of money spent to date, this chart should make you sick to your stomach.

So what risks did the credit crisis pose based on these foreign dollar positions?

In his opinion, TARP was neither necessary nor has it worked (see Figure 2).

To look at the first question, consider what TARP was designed to do. Secretary Paulson said interbank lending had dried up because banks had toxic assets (mortgage-backed securities) clogging their portfolios. Because nobody knew what they were worth, banks were uncertain of the financial security of other banks. This uncertainty caused a reluctance to lend and prompted the financial markets to lock up.

The solution, Paulson argued, was to approve TARP and use $700 billion to buy the toxic assets. Replacing the assets with Treasury securities would fortify bank balance sheets and interbank lending would resume.

Dr. Holcombe pulls no punches in his synopsis.

It is easy to say the program wasn't necessary, despite Paulson's arguments, because the TARP money wasn't used to buy toxic assets. TARP money was instead used to buy preferred stock in banks, shoring up their balance sheets by giving the federal government part ownership of the banks.

Nine of the largest banks were forced to issue stock to the Treasury, paid for with TARP money, even though several of the banks tried to opt out. Secretary Paulson said that if some of the big banks participated and others didn't, it would identify their varying levels of weakness, which Paulson believed was undesirable.

Instead of buying up toxic assets, the TARP money was used to partially nationalize the banking industry. It was also used for a federal takeover of AIG (after it was initially rescued by the Fed) and the bailout of Chrysler and General Motors.

He admits that without this sizable taxpayer infusion some banks would have failed, but he believes that wouldn't have been so bad.

When firms take risks, they must balance the potential profits from success against the potential losses from failure, and the TARP support removes the last part of that balancing act. There may have been some dislocations in the short run from bank failures, but in the long run allowing them to go under preserves the incentive structure that fuels a market economy. Banks are financial intermediaries that match up borrowers and lenders. When a bank goes under, it does not reduce the amount of money available to borrowers, or prevent savers from providing money that can be lent. Other financial intermediaries are available to borrowers and lenders to replace the activities that failed banks would have performed.

We contacted Professor Holcombe this week to discuss his article with him. His comments provide an excellent TARP overview and epilog.

As to the stimulus package and bailouts, they are both counterproductive. As the economy now enters a recovery, the "stimulus" spending will divert resources from the private sector into government spending, which will slow the recovery.

In hindsight we can see the folly of the auto industry bailout. The justification was to give them a source of temporary funding so they could avoid bankruptcy, but they went into bankruptcy anyway. Now, GM is 61% owned by the federal government, which will make it harder for the company to survive long-term than if it had just gone through a regular bankruptcy proceeding last December rather than getting its first distribution of bailout money.

His comment that stimulus spending "will divert resources from the private sector (and real jobs creator) into government spending, which will slow recovery" is significant. That is exactly what happened during the Great Depression with FDR's New Deal (and other programs). It has also proven to be true as a result of the official response from the Japanese government following the breaking of its asset bubble in 1990 over the last two decades in Japan.

The huge difference in the economies of the U.S. in the 1930s and Japan in the 1990s is that complex derivative ticking time-bombs did not exist at the time, which will make the next crisis far more "interesting."

Definitions

Currency Swap
A currency swap is a financial derivative and an arrangement in which two parties exchange specific amounts of different currencies initially and a series of interest payments on the initial cash flows are exchanged. Often, one party will pay a fixed interest rate, while another will pay a floating exchange rate (though there may also be fixed-fixed and floating-floating arrangements). At the maturity of the swap, the principal amounts are exchanged back. Unlike an interest rate swap, the principal and interest are both exchanged in full in a currency swap. http://www.investorwords.com/1244/currency_swap.html

Derivatives
Warren Buffett describes them as "financial weapons of mass destruction" for good reason. A derivative is a financial contract whose value is derived from the performance of underlying market factors, such as interest rates, currency exchange rates, and commodity/equity prices. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof.

Related Stories and Links:

Alan Grayson and Ben Bernanke Video
http://www.youtube.com/watch?v=n0NYBTkE1yQ

US Dollar Shortage in Global Banking and the International Policy Response
http://www.bis.org/publ/work291.pdf?noframes=1

How the Federal Reserve Bailed Out the World
http://www.zerohedge.com/article/how-federal-reserve-bailed-out-world

A Year After TARP: $700 Billion Down the Drain - Holcombe
http://blog.mises.org/archives/010873.asp

Economist - Down with the Dollar, Why the Dollar Is Falling
http://ow.ly/15W3ht

Dollar to Hit 50 Yen, Cease as Reserve
http://ow.ly/v6hS

Russia Ready to Abandon Dollar in Oil, Gas Trade with China
http://ow.ly/v5Ru

Iran Joins List of Nations in Moving Away from the Dollar...
http://ow.ly/v5QZ

Attaboy Jack!

I put my dad on a plane back to Tennessee on Monday after enjoying another successful bird hunting trip with him. We had great weather, which made for incredible hunting. We recapped the entire experience with friends and family, while enjoying incredible southern cuisine. My new hunting dog Jack made it all possible by exceeding my wildest expectations and performing like an experienced dog well beyond his years. I owe a special thanks to my good friend Brian King for helping me plan a special pheasant and chukkar hunt for us on his ranch.

On our last day, I took my oldest daughter Sarah so she could share this special time with her Papaw. Below is a picture of Sarah and me as we stop for a rest.

I don't think I could have wiped that smile off her face.

My dad and I have been going on this hunt for 12 years and it seems like I enjoy each hunt more than the last. My father turns 70 in March and I know our bird hunting days are numbered, so I am blessed to spend this special time with my dad. For next year, I am in the planning stages of a two-week hunt across Idaho, Montana, North and South Dakota. If you are a bird hunter and can help me plan some stops along the way, I would welcome your call.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

How Our Home Prices Compare To The Rest Of The World

2009-10-20T16:39:00Z

Global Home Price Comparison
Lessons from the Forgotten Depression
Resisting the Intervention Urge
Chaining the Tiger
More Difficult Than Timing the Market

Quote of the week
"Institutional equity investors fear missing out on the rally. Bond investors fear deflation and the stock market is way overdone and is ripe for a steep correction. The gold bugs fear that the fiscal and monetary largesse globally will lead to inflation and fear that the U.S. dollar is on the verge of collapse. Never before has fear felt so reassuring - pick an asset class, and it's going up in price."
David Rosenberg in a recent newsletter to clients

Global Perspective - What's a Home Worth?

In an effort to address deflating stock prices, the Federal Reserve began lowering interest rates in January 2001. Within 18 months it had dropped to multi-decade lows. The strategy eventually worked, but it also fueled a housing boom, propelling home prices to unprecedented highs even after adjusting for inflation. But the strategy had a high price tag and since 2007 we have suffered the all-too-predictable bubble break and property depression.

But how have home prices fared around the globe? Did prices appreciate as significantly? Have other markets been as severely impacted as those in the U.S. over the past two years?

The answers surprised us. A series of charts recently published by The Economist magazine compared home prices from 1990 to present (Q2-09). In the next chart, we see nominal home price changes for Hong Kong, Britain, Spain, New Zealand, Canada and Japan, as well as two estimates for U.S. home prices - the generous Federal Housing Finance Authority (FHFA) and the more conservative Case-Shiller Home Price Index.

Notice the unique jump for Hong Kong in the late 1990s followed by the major correction and market re-ignition. Every other market in the chart, with the exception of Japan, experienced rapidly rising home prices starting in the early 2000s, with peaks in late 2007. Top of the list was Spain followed then by New Zealand (and Australia which closely tracked the path of its smaller neighbor), then Hong Kong, the U.S. followed by Canada and finally Japan, where home prices dropped over the two-decade period.

The takeaway is that although a lot of press was given to the situation in the U.S., there has been a relative dearth of articles comparing international housing markets on this side of the Atlantic and Pacific. In Spain, where home values jumped nearly 400%, prices are still 350% above where they were two decades ago, suggesting that this market has the greatest potential for further price declines. New Zealand and Australia aren't far behind on the "bubble-scale."

Notice that home prices in Canada significantly underperformed their global counterparts through the 1990s and into the new millennium, which may explain why the housing market there has remained more robust of late. And Japan, where prices are still little more than one-half of what they were two decades ago, continues to experience weak housing demand - a result of a combination of an aging population, punitive government stimulus and bankruptcy prevention policies that have frustrated any lasting recovery chances. These are lessons lost on U.S. policy makers.

Figure 1 - International home price comparisons. Source - Economist.com

One thing is clear from this chart. Chances are that the worst is not over for the countries in which housing prices were launched into the stratosphere. It will take more time before economic gravity pulls them back to earth. And even if U.S. property markets stabilize, what impact will falling prices in other parts of the world have on our economy?

Lessons from the Forgotten Depression

Past issues of the ProfitScore IQ have examined the wisdom of a policy to bailout struggling companies and industries in the face of an economic meltdown in historic terms. And in no period in history is the difference between present and past starker than it is today, compared to the 1920 depression.

Then the government and Federal Reserve stayed out of the way and let free market forces deal with the fallout and recovery. Will it become a blatant example of how failing to learn the lessons of history doom us to re-learn them the hard way?

Analysts and economists continually harken back to the period from 1929 to 1933, at the beginning of the Great Depression to laud the example set by Franklin Roosevelt and how he sought to cure the ills of the period with massive government spending and New Deal programs.

Opinions could not be more polarized. On one side supporters of John Maynard Keynes credit government intervention and deficit spending with saving our nation from economic ruin. On the other, opponents of corporate socialism argue that government intervention only served to prolong the economic pain and recovery which ultimately took the second great war to complete.

Why are other periods of economic contagion so rarely discussed? In a recent paper entitled Warren Harding and the Forgotten Depression of 1920, Thomas E. Woods Jr. of the Von Mises Institute explores the Great Depression of 1920 and examines the official response.

"The economic situation in 1920 was grim. By that year unemployment had jumped from 4 percent to nearly 12 percent, and GNP declined 17 percent. No wonder, then, that Secretary of Commerce Herbert Hoover-falsely characterized as a supporter of laissez-faire economics-urged President Harding to consider an array of interventions to turn the economy around. Hoover was ignored."

From 1920 to 1921, foreign trade was cut in half and prices in the U.S. fell by more than 20%.

Today, Hoover's advice would have been gladly accepted and instituted. But a different ethic prevailed in the Harding Administration in 1920.

"Instead of ‘fiscal stimulus,' Harding cut the government's budget nearly in half between 1920 and 1922. The rest of Harding's approach was equally laissez-faire. Tax rates were slashed for all income groups. The national debt was reduced by one-third. The Federal Reserve's activity, moreover, was hardly noticeable. As one economic historian puts it, "Despite the severity of the contraction, the Fed did not move to use its powers to turn the money supply around and fight the contraction."

Resisting the Intervention Urge

Today, policy makers would denounce such a policy as economic suicide and they'd have the backing of the majority of economists and voters. Tightening the purse strings and letting companies and consumers fend for themselves without the help of government cash would not be politically popular.

But then a strange thing happened.

"By the late summer of 1921, signs of recovery were already visible. The following year, unemployment was back down to 6.7 percent and was only 2.4 percent by 1923," according to Woods.

"In 1920-21," writes economist Benjamin Anderson, "we took our losses, we readjusted our financial structure, we endured our depression, and in August 1921 we started up again. . . . The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good."

As Thomas Woods explains, "The federal government [of 1920-21] did not do what Keynesian economists ever since have urged it to do: run unbalanced budgets and prime the pump through increased expenditures. Rather, there prevailed the old-fashioned view that government should keep spending and taxation low and reduce the public debt."

Even in 1920, Harding's laissez-faire approach attracted significant opposition from economists who believed intervention was the right approach, according to Woods. And few presidents before or since have been subjected to the degree of ridicule that President Warren Harding had to endure. His 1920 Republican Presidential Nomination Acceptance Speech provides some clues as to why.

"We will attempt intelligent and courageous deflation, and strike at government borrowing which enlarges the evil, and we will attack high cost of government with every energy and facility which attend Republican capacity. We promise that relief which will attend the halting of waste and extravagance, and the renewal of the practice of public economy, not alone because it will relieve tax burdens but because it will be an example to stimulate thrift and economy in private life.

Let us call to all the people for thrift and economy, for denial and sacrifice if need be, for a nationwide drive against extravagance and luxury, to a recommittal to simplicity of living, to that prudent and normal plan of life which is the health of the republic. There hasn't been a recovery from the waste and abnormalities of war since the story of mankind was first written, except through work and saving, through industry and denial, while needless spending and heedless extravagance have marked every decay in the history of nations."

Figure 1 - Chart of the 46% drop in stock prices from 1919 through 1921 to the nearly 500% boom that followed over the subsequent eight years. Chart by GenesisFT.com.

Can you imagine a political leader giving a similar speech today? But as much as this approach counters the prevailing conventional wisdom, the recovery that it elicited in the early 1920s was nothing short of phenomenal.

Chaining the Tiger

From 1922 through 1929, the U.S. gross national product rose 40%, from $74.1 billion to $103.1 billion and the federal government ran a surplus budget. Unemployment remained low, between 3 and 4%, and per capita income rose from $641 in 1921 to $847 in 1929. As we see from Figure 1 above, after shedding 46% in value between 1919 and 1920, the Dow managed an incredible 500% gain over the next eight years that dwarfs any subsequent eight-year rally.

Such a recovery was possible only because the market had been allowed to work and the economy cleared of uncompetitive companies run by inept managers and debt levels had been significantly reduced. This created an environment that stimulated new business and economic growth, in addition to generating rapid job growth and fueling consumer confidence.

But there was one undeniable side-effect of this and every other sustainable recovery. While the average per capita income rose 35.3% from 1920 and 1929, it jumped 75% for the top 1% income earners. And it is this reality that present-day policy makers find so intolerable. Today's politicians would rather risk national economic health than allow the rich to benefit unfairly. It is the same intervention ideology that would see the tiger fettered with chains to give the gazelle a better chance during the hunt.

Don't get me wrong, I'm all in favor of helping the poor. But how does keeping moribund companies on government mandated life-support and indenturing our children and children's children with debt to help the poor, especially if it increases their number longer-term? And even if these policies did work, how many would prefer to live in a world dominated by government committees that have the power to decide which businesses should survive and which should fail using your tax dollars to play Santa Claus?

Related Stories and Links:

House Prices Are Creeping Up, But It May Not Last
http://www.economist.com/businessfinance/displaystory.cfm?story_id=14462419

Safe as Houses - Interactive home price graph
http://ow.ly/rSoG

Warren Harding and the Forgotten Depression of 1920 by Thomas E. Woods Jr.
http://www.firstprinciplesjournal.com/articles.aspx?article=1322&theme=home&loc=b

Economy of the 1920s
https://www.wou.edu/las/socsci/kimjensen/ECONOMY%20OF%20THE%20TWENTIES.htm

Former Fannie Chief Credit Officer Says FHA Is $54 Billion Underwater
http://www.zerohedge.com/article/former-fannie-chief-credit-officer-says-fha-54-billion-underwater

Measured in Euros, U.S. Per Capita GDP Is Down 25% Since 2000
http://online.wsj.com/article/SB10001424052748703298004574458923186941870.html

How Currency Devaluation Can Be a Bad Thing
http://www.zerohedge.com/article/how-currency-devaluation-can-be-bad-thing

Foreclosures Mark Pace of Enduring U.S. Housing Crisis
http://www.reuters.com/article/domesticNews/idUSTRE59705J20091008?sp=true

Foreclosure Sales in Limbo Over Title Issue
http://www.boston.com/business/articles/2009/10/09/title_troubles_leave_some_foreclosure_sales_in_limbo/

More Difficult Than Timing the Market

My wife left for a well-deserved vacation to Puerto Rico last Tuesday, so I have been playing both Mom and Dad. My kids are very involved in athletics and love to play basketball and soccer. The month of October is just nuts because Sarah has three different teams that overlap during the month, so she is currently playing on 2 different basketball teams and one soccer team. Annabelle is fortunately only playing on one soccer team at the moment.

The day that my wife left for Puerto Rico, Annabelle began vomiting and running a high fever, so I had a kid at home most of last week. Needless to say, I didn't get a lot done working from home, but have worked the entire weekend trying to catch up. I have no idea how single parent families function. Being a single parent in this day and age makes my job of making money in up and down markets seem like a walk in the park. The next time I complain about how hard it is, please remind me to reread this letter.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Why We Appear To Be On The Down-Hill-Side Of Unemployment

2009-10-13T22:08:00Z

A New Strategic Alliance
Our Monthly Performance Update
Incomes - A Four-Decade Long Report Card
Will the Real Unemployment Rate Please Stand Up?
It's ROC That Matters
Will They Keep Buying Our Bonds?
Rocket-Riding Stimulus Junkies (Part II)
Paying the Piper
Are You in "Old-Man Shape?"

I often write about the facts in this letter with little or no emotion. However, peeling back the layers of the onion of economic data over the past 18 months has brought tears to my eyes. I have close friends that have lost their jobs, houses, and even their families during this great recession. It is a humbling experience to watch it affect real people trying to live real lives.

In this week's IQ, we dig into the unemployment numbers and find some encouraging signs that hopefully point to more jobs. This recession has affected a lot of hard-working people who are desperately looking for a way to put food on their family's dinner table. I hope the recent slowing of unemployment will soon turn into new jobs and provide them to people who need them most.

We sat at this very same place back in the mid 1930s when the economy came stumbling back from the first leg of the depression until bad political decisions of higher taxes and restricted trade sent the economy into another deeper decline. It was this second decline that turned a sever recession into the Great Depression. We are seeing some recent trade spats with China and the Obama Administration. It is still planning on eliminating Bush's tax cuts. Despite these warning signs, I am still cautiously optimistic that cooler heads will prevail and we will not make the same poor decisions that will cripple our economy and send us back into a deep recession.

A New Strategic Alliance

Before jumping into our research, I have some exciting news about an important new strategic alliance. As you are probably aware, ProfitScore Capital Management is in the business of managing money for individual and institutional investors. Institutional investors can take many forms such as Registered Investment Advisors, hedge funds, family offices, broker dealers, corporations, pension funds, etc.

Because of overwhelming regulation, one of the most challenging investors to serve are broker dealers. To better serve this market and to give these important clients the respect and service they deserve, ProfitScore has signed an exclusive distribution relationship with Flexible Plan Investments to serve the broker dealer channel.

In this relationship, ProfitScore will begin offering its portfolios through Flexible Plan Investments and Flexible Plan will set up and oversee the client account and manage the broker dealer relationship. In other words, each firm will concentrate on what they do best. I have known Jerry Wagner, CEO of Flexible Pan Investments, for many years and feel fortunate to partner with Jerry to serve the broker dealer marketplace.

Flexible Plan has served the broker dealer channel for over 25 years and is currently approved at over 500 broker dealers. ProfitScore will benefit by being immediately available at hundreds of broker dealers and thousands of their representatives over night. Flexible Plan and ProfitScore are on track to start offering these portfolios by November 1. I promise to keep you posted as we get closer to making these portfolios available.

If you are a broker dealer or a representative of a broker dealer and are interested in learning more about how ProfitScore and Flexible Plan Investments can help you manage your clients' assets and to provide you with the tools to grow your assets under management, we would love to hear from you by sending us an email to: advisor @ profitscore.com.

An Update on Our Performance

The main reason for writing hundreds of pages of commentary and sharing our research is to keep our current clients updated on our thoughts and to shamelessly promote our investment portfolios to investors that may need our help managing their assets. Below is a brief performance update on our investment portfolios.

Fixed income continues to shine as the bright spot in our performance. I get asked often what this portfolio is comprised of, so I thought I would take this section of the newsletter for the next few monthly letters to describe our portfolios in a little more detail.

The Income Builder portfolio is a multi-manager portfolio that is 100% invested in interest rate sensitive assets. Because we strive to produce absolute returns, this is not your traditional fixed income investment. All of our portfolios are considered absolute return investments because we take both long and short positions in all the assets we trade. Income builder is comprised of high yield bonds, government bonds, and the U.S. dollar, each traded actively to benefit from changing market conditions. The portfolio's assets are currently allocated to six investment managers who are trading eight quantitative-based investment strategies.

The design of this portfolio truly gives an investor an opportunity to earn equity-like returns with fixed income volatility. To see more performance statistics on the Income Builder portfolio or some of our other investment strategies, please click on the blue-lettered links in the performance table below.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	September	Sharpe
Name	Months	2009	2009	Ratio
Income Builder (IB)	9.67%	12.24%	3.84%	1.46
The Guardian (GRD)	4.69%	8.88%	1.62%	1.73
Harmony Plus (HMY)	2.32%	7.18%	0.25%	1.48
The Expedition (EXP)	-0.27%	4.29%	-1.31%	1.16
S&P 500 (SP500)	-6.91%	19.26%	3.73%	0.67
Important Performance Disclosure

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Will the Real Unemployment Rate Please Stand Up?

It is clear that employment is increasingly impacting stocks as investors fret over the ability of our fragile economy to generate jobs and boost consumer confidence.

With a release that was worse than expected, the Bureau of Labor Statistics (BLS) reported that there was a monthly loss of 263,000 jobs in September lifting the official U-3 unemployment rate to 9.8%. And, although the number was depressing, it was a mere flesh wound compared to the BLS household survey that showed a September decline of 710,000 jobs.

Some analysts charged that the household survey "vastly" underestimated the loss of jobs (see article September Unemployment... below). How could two estimates from the same government agency be so different? And, did it mean that the chances for a double-dip recession had just increased? Clearly the market was confused.

The chart below adds more confusion. It shows three different unemployment estimates (not including the household survey). Notice the difference between them. The government uses the most benign unemployment measure (U-3) that removes discouraged workers, or those who have given up looking for work (9.8%). This number also doesn't include those who have been forced to go from full-time to part-time employment as part of job cutbacks.

Next, is the U-6 unemployment number which was 17% in September that includes these two groups. Finally, there is the ShadowStats.com estimate that calculates unemployment, including all the groups that have been removed over the years to make the numbers (and the government) look better, was 21.4% in September. That is as bad as it was during the dirty thirties! Which number was most accurate?

Examine Figure 1 and you will notice that although the numbers are different, they are nearly identical in one respect. The three lines move exactly together - they increase and decrease at about the same rate (rate of change). So, no matter which estimate you believe, the rate at which they are getting better or worse is the same.

Geek Note:
Please keep in mind that because the government has changed the way they calculate unemployment, it is mathematically impossible to compare today's official government unemployment numbers to other times in U.S. history. That is why we use unemployment numbers from Shadowstats.com, who uses the same calculation methodology that was used during the Great Depression.

Figure 1 - Chart showing three different unemployment rates. First, the official U-3 rate (green), generally discussed, which rose to 9.8% in September. Next, the broader U-6 unemployment rate (yellow), which includes discouraged and part-time workers that came in at 17% in September. And, finally the alternate unemployment or Alt rate published by ShadowStats.com, which was 21.4% (red) in September. Shadowstats.com

It's ROC That Matters

In an effort to show the true picture, we have constructed a rate of change (ROC) chart (using the U-6 unemployment number). We also placed vertical dashed lines at the beginning and end of the last recession and at the beginning of the current one. In both cases, the unemployment rate had begun to increase fairly rapidly before the recession was officially declared by the National Bureau of Economic Research (NBER), the agency entrusted to tell us when recessions begin and end. It is interesting to note that the 2002 recession officially ended in November 2001 (although we had to wait until July 2002 to be told that fact by the NBER), a full month before that rate at which jobs were being lost peaked. But December 2001 was also sixteen months before the market ultimately bottomed and the rally began (March 2003).

Figure 2 - Rate of change chart showing the speed at which the U-6 unemployment rate changed between 1995 and September 2009.

Two things stand out in the chart. Not only do we see how unemployment peaked well ahead of the recovery and the fact that the rate jobs were being lost soared much higher this time around, but what becomes clear is the that the rate at which jobs are being lost peaked in April 2009. So unless jobs losses accelerate again, this is more proof that even if this rally proves to be a bear rally and retraces, it has strong potential to be a market bottom. Not only that, if things are more or less the same, there is a good chance that the NBER could eventually declare this recession officially over in March (or thereabouts).

Many economists have voiced their opinion of how unemployment is a lagging indicator. However, take the derivative or rate of change and the rate looks to be a pretty good leading indicator. The important caveat here is something we have all read in investment prospectuses - past performance does not guarantee future results.

There is always the chance that this is just a temporary improvement before the next employment rate decline and one of the most probable catalysts for this kind of reversal is the risk for rapidly rising interest rates.

Will They Keep Buying Our Bonds?

What happens when the government has a bond auction and nobody comes?

In 2006, the world got its first taste of what could happen to an industrialized nation when investors decided, en masse, that the interest rate the government was offering on its bonds simply wasn't worth the risk. It wasn't pretty. Saddled with a current account deficit north of 15% of GDP and fast rising foreign debt, Iceland, an OECD member and one of thirty most-developed countries in the world, desperately needed to sell its bonds.

But government bond auctions failed to attract investors even though the rate was a healthy 8%. Even an increase to 14% wasn't enough to entice investors.

Fast forward to October 2008 - in an effort to stem rapid declines in the value of the Icelandic krona, which had its value cut in half on October 8 alone - the government was forced to raise the nation's overnight lending rate 600 basis-points to 18% in one day!

And now a similar situation is unfolding in EU-member Latvia. Like Iceland, it has been a crisis-in-the-making for a while.

Flash back to June 3, 2009, the day that the Latvian government managed to sell just 5% of the more than 50 million lati (about $100 million in US) in bonds. Like a number of nations around the globe, Latvia is drowning in debt. With a GDP down 18.6% in the past year, its public debt as a percentage of GDP swelled from 19.5% in 2008 to a projected 34.1% in 2009. But this amount of debt pales in comparison to many of its European neighbors. Public debt in Italy, Greece, Belgium, Hungary and Ireland are projected to swell to 113%, 103.4%, 95.7%, 80.8% and 61.2% in 2009.

The failed bond auction reflects growing tensions in the Eurozone. Two other eastern European nations, Lithuania and Estonia, have seen their GDPs drop 10.9% and 15.6%, respectively, over the last year prompting a number of analysts to wonder if they are next.

Figure 3 - Monthly chart showing net Treasury international capital flowing into and out of U.S. Treasuries between 2005 and present.

Ballooning debt and falling economies is not a problem unique to the Eurozone. Federal debt in the United States is projected to be in excess of 100% for 2009 and that is a drop in the bucket compared to unfunded liabilities such as Medicare and Social Security. Our point is that governments in the most industrialized nations around the globe are becoming increasingly reliant on investors to finance rising debt levels.

In our recently updated U.S. Net Treasury International Capital Flows Chart (Figure 3), we see that the net foreign demand for our bonds has been steadily dropping since 2005. From the beginning of this year, there has been only one month in which there was not a net redemption of Treasuries by foreigners and the gap between government budgetary needs every month (red line) and foreign capital has steadily widened. Also notice that the long-term trendline (yellow) fell into negative territory in May.

If you listen to weekly government bond auction results, there continues to be a strong demand for Treasuries even though the rates of interest are near historic lows. This is good news as long as it lasts, but just how long can we expect investors to keep buying bonds and be paid back in dollars that have almost steadily dropped in value over the last year?

Could Iceland and Latvia be early canaries in a global bond contagion? And perhaps even more important, how will it impact us all?

Rocket-Riding Stimulus Junkies (Part II)

"You cannot spend your way out of recession or borrow your way out of debt."
Daniel Hannan, Member of the European Parliament

Back in December we discussed the rate at which the adjusted monetary base or money in circulation in the U.S. had rapidly increased in the past few months. According to the Federal Reserve website, the adjusted monetary base (AMB) is the sum of currency in circulation outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories.

By November, year-over-year growth in the monetary base was an incredible 97%; a rate of growth unprecedented in our history as the next chart shows. You will be interested to know that the printing presses have remained in overdrive since then, hitting another new level of year-over-year growth of 112% in April. If you are looking for the fuel behind both the economic recovery and the stock market rally, look no further.

I like to think of the recovery this way. You know those ceramic fake logs you see in a gas fireplace that start to glow a few minutes after it has been ignited? Comforting isn't it, especially when it's cold outside. However, it isn't so comforting to know that Washington has created a gas fireplace economy and the fuel they are using is freshly printed cash. What happens when the gas to our ceramic log economy is turned off?

The question is, have the trillions in stimulus money fueled real economic growth, started new businesses and allowed existing businesses to become profitable enough to survive on their own once the stimulus gas is turned off? This is one reason for caution and why we need more confirmation before we'll know if the unemployment rate discussed above is truly subsiding or just taking a break before soaring to new heights.

Figure 4 - Data from the Federal Reserve showing the adjusted monetary base or money in circulation going through the roof over the last year. So what happens when the presses get turned off?

Paying the Piper

But the bigger problem lies ahead. When the presses do eventually get turned off, the money still has to be paid for (that is unless the nation files for Chapter 11 bankruptcy). As it stands, this money is simply being added to the books as debt.

An interesting paper written by Kyle Bass, Managing Partner of Hayman Associates, the man who allegedly made billions shorting the subprime market, sheds some more light on the true unemployment and hyperinflation threats.

According to Bass, "There have been 28 episodes of hyperinflation of national economies in the 20^th century, with 20 occurring after 1980... all of which were caused by financing huge public deficits through money creation."

Bass discusses the work of Peter Bernholz, Professor Emeritus of Economics in the Center of Economics and Business at the University of Basel, Switzerland, whose 2003 book Monetary Regimes and Inflation: Historic, Economic and Political Relationships, retraces past episodes of hyperinflation and provides an insightful look into the intertwined worlds of politics and economics, with special attention given to money.

Professor Bernholz studied these failed economies and made a startling conclusion - the hyperinflation tipping point occurred when the government deficit exceeded 40% of its expenditures.

So where does that leave us?

"According to the current Office of Management and Budget (OMB), U.S. federal expenditures are projected to be $3.653 trillion for financial year 2009 and $3.766 trillion for FY 2010 with unified deficits of $1.5802 trillion and $1.5 trillion respectively. These projections imply that the U.S. will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed," a level of debt that Professor Bernholz's research has shown is unsustainable.

Bass believes that, "global currency printing will inevitably lead to high levels of inflation - outright currency debasement. Historically, it has taken 18 months to two years to take hold, but we believe it could be sooner due to the size of both monetary and fiscal stimulus as well as the coordinated global nature of the actions."

How they are investing in anticipation of such a scenario makes it very interesting reading and is available in the first link below. But it is very fascinating to note that Professor Peter Bernholz's conclusions are frighteningly similar to those of Ralph Foster is his 2008 book, Fiat Paper Currency: The History and Evolution of our Currency, which I also highly recommend.

In the meantime, it's a trader's market and riding this rally requires keeping one hand firmly on the exit button.

Interesting Reading

Deep Thoughts from Kyle Bass
http://www.zerohedge.com/article/deep-thoughts-kyle-bass-0

Review of Monetary Regimes and Inflation: Historic, Economic and Political Relationships
http://eh.net/bookreviews/library/0649

September Unemployment: ACTUAL LOSS 995k
http://market-ticker.denninger.net/archives/1485-September-Unemployment-ACTUAL-LOSS-995k.html

Household Survey vs. Non-Farm Payrolls
http://www.bls.gov/web/ces_cps_trends.pdf

BLS News Release Page
http://www.bls.gov/bls/newsrels.htm

A House Regulated Cannot Stand - How regulation helped devastate the housing market
http://mises.org/story/3757

Hotel defaults, foreclosures rise in California - Defaults, foreclosures up five-fold in ‘09
http://www.latimes.com/business/la-fi-hotels-foreclosure7-2009oct07,0,6655066,full.story

Link to Ralph Foster's Fiat Paper Currency: The History and Evolution of Our Money
http://home.pacbell.net/tfdf/

Ailing Fast - Latvia on Life Support
http://www.economist.com/world/europe/displaystory.cfm?story_id=14582771

Iceland, in Nod to IMF, Boosts Rate to Kick-Start Crown
http://www.reuters.com/article/topNews/idUSTRE49R30Q20081028?sp=true

Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength. Commentary found in this newsletter is for informational purposes only and does not effect how our portfolios are traded.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

The S&P 500 continues its momentous climb higher, piling on another 3.73% in September. The S&P 500 is currently priced for perfection, so a negative earning session would almost certainly cause a sharp drop in current prices. As we pointed out above, positive signs in the economy are starting to appear. So, unless something critical happens to the economy, it may start to provide some fundamental justification for stabilizing the market.

Without question, this rally has gotten ahead of itself and will almost certainly have a meaningful correction to stabilize recent gains. If the economy continues to improve, then we should see the second leg of this advance take shape. If not, then there will have been no justification for this advance and equities will get crushed. In other words, if the economy begins to justify this recovery then there is room for more upside. If economic and earnings data begins to fall short of expectations, then there is lots of downside risk.

As I pointed out in last month's letter, our equity trading accuracy fell below 30% in August. The last four weeks have us battling back over 50% and our charts are up and to the right. Since March's low, the market has been steadily shifting from a short term mean reverting market to trending for several days to weeks in a row. It has taken our quantitative models time to adjust to this regime change in the market, but recent improvements in our equity trading accuracy are encouraging.

Our fixed income traders operate and function in a completely different world than our equity traders, so it is common for one equity curve to go up while the others go down. In 2008, equity outperformed fixed income, but our fixed income portfolio has quickly made up for lost ground and now leads all portfolios for the year and past 12 months. Our equity models appear to have stabilized to recent market changes, so I anticipate our equity strategies to take the lead over the next several months.

Index Advantage:

All of the losses experienced in this important allocation occurred in the first two weeks of September. Trading accuracy has steadily improved from what we expect was the equity low for this allocation. October is currently showing small gains and trading accuracy continues to improve.

For the month, this pillar gained -1.71.

Strategic Balance:

We again experienced a small loss trading U.S. sectors and international markets for the month. Our overall investment exposure remains historically low as these traders patiently wait for higher, rewarding, low-risk trades.

For the month, this pillar earned -0.42.

Dynamic Income:

This now makes the 6th winning month in a row for our fixed income allocation. Month-to-date October is also showing green across the board lead by our allocation to government bonds.

For the month, this pillar earned 4.09.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October). For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements. It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis. To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum.

Are You in "Old-Man Shape?"

As I have gotten older, I realized how important it is to stay physically fit. It takes months to get into shape, and only a few weeks to fall off the wagon. My definition of being in shape has changed over the years. When I was in my late teens and early 20s, I thought being in shape meant I needed to bench press 300 pounds. The thought of lifting that kind of weight these days makes every joint in my body ache.

Nowadays being fit means I am in good enough shape to ride my mountain bike in the foothills, hunt for chukkar along the Snake River Canyon, or ski Idaho's many slopes. After a while, my mind's eye actually starts to make me feel like I am in the kind of shape I was in during my early 20s. Well, that is until I do something silly like play a game of soccer against my daughter's soccer team.

I didn't grow up playing soccer, but have grown to have a lot of respect for the game. I am an assistant coach for my oldest daughter's team. Sarah has a great coach named Corey, who makes practices both fun and challenging. During our last practice, Corey wanted the two of us to play on one team against Sarah's entire undefeated team so we could spread the field and teach the girls how important it is to stay in their correct position. In hind sight, let me advise you against doing this when you only have one other person on your team and the field is 100 plus yards long.

What I didn't know until after practice is that Corey is a marathoner and runs between 5 and 18 miles a day. He thought this would be a great way to teach the girls some important fundamentals and good exercise for us.

Corey didn't even have sweat on his brow as he encouraged me to run faster to get open for the pass. For a brief moment, I thought I might actually pass out from a lack of oxygen to my brain caused by my bleeding lungs. It was hard to hear the laughing of the girls zooming by me to steal the ball because of the ringing in my ears. What a wake-up call! There is a big difference between running on a treadmill and running 100-yard sprints up and down a soccer field.

This kind of reality check seems to happen to me about every couple of years. My mind tricks me into thinking that I am in good shape just because I work out on a regular basis. My daughter has coined the phrase as "old-man shape." It is a shame that they wasted all of that strength and agility on the youth.

Halloween is just around the corner and my kids are finalizing what they want their costumes to be. Annabelle was dressed up as an angel last year, but this year she wants to look like a Hershey Bar. Her mom is really struggling on figuring out how to make a costume shaped like a candy bar. Sarah and her buddy have decided to dress up by dressing down to their PJs. I can't wait to take the pictures.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. ProfitScore provides its separately-managed accounts to individuals, advisors and institutional investors. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

So What Is Warren Buffett’s Desert Island Indicator Saying?

2009-10-09T14:58:00Z

Warren's "Desert Island" Indicator
So What Is It Telling Us?
The Weekly Rant - The Rocket-Riding Stimulus Junkies
Moose for Dinner

Last week, we discussed the Baltic Dry Index as a leading economic and market indicator. We showed how it had performed during the recent highs and lows of the market. This week we continue our discussion on leading indicators as we examine the indicator that Warren Buffett would rely on if he were on a desert island and could only use one to make his investment decisions.

Warren's "Desert Island" Indicator

The data that powers Warren Buffett's desert island indicator, or more appropriately, set of indicators, are produced by the Association of American Railroads (AAR). They publish data every Thursday morning (East coast time). These indicators are useful because they show real demand for the raw materials and finished products for a broad spectrum of commodities and merchandise shipped by rail, which is still the most cost-effective way of shipping around the U.S.

In their latest monthly report for August, the AAR reported that total U.S. freight rail traffic was down 16.4% (to 1.116 million freight carloads) from August 2008. In addition to that, intermodal (truck freight trailers on rail cars) was down 16.7% and Canadian rail traffic was down 20.5% (reflecting a drop in commodity demand). Cyclical traffic (autos, steel, lumber, chemicals, etc.) was down even more on a year-over-year basis at 44.6% in Q3-2009.

We examined various data sets provided by the AAR and on a quarterly basis, all figures are down from the same quarter the year before. This next chart of intermodal traffic shows an interesting relationship to the stock market. As we see from the green "V" pattern (Figure 1) in Q1-2002, intermodal traffic hardly suffered during the recession of 2001-2002 and began to recover more than a year before the stock market recovered in March 2003. If there was a recession in transport, you would have never known it from intermodal traffic.

Figure 1 - Quarterly intermodal rail traffic report comparing the impact of the recessions in 2001-2002 and now. TOFC stands for (truck) Trailers On Rail Cars. Data - railfax.transmatch.com

Intermodal traffic also peaked out in Q4-2006 (magenta inverted "V"), well in advance of the stock market peak in Q3-2007. But then something interesting happened. Instead of recovering in advance of the stock market rally, traffic fell in Q4-2008! Traffic dropped 37% between Q3-08 and Q3-09.

According to Drew Robertson of Atlantic Systems, the drop in intermodal traffic demonstrates the decline in U.S. manufacturing (and increase in reliance on foreign imports that don't ship intermodally) combined with the effects of the recession. Atlantic Systems produces proprietary transport and stock indicators for investors. Robertson believes that as the recovery takes root, intermodal traffic will rebuild as U.S. manufacturing picks up again. But that probably won't happen until at least next year.

Figure 2 - Transmatch chart showing year-over-year weekly changes in total rail and intermodal traffic. Both charts show a bottom around the end of June, but total traffic looks to have bottomed first. A positive sign? Source - railfax.transmatch.com

Figure 3 - Another perspective on rail traffic showing a rolling four-week average of both total and intermodal rail traffic showing a bottom in Q1-2009. Source - railfax.transmatch.com

So what is Warren's desert-island indicator saying?

There is little doubt that this time is most certainly different than past recessions when it comes to rail traffic, and especially intermodal truck/trailer rail traffic. Down by more than one-third in the past year, traffic will have to increase by nearly 60% just to get back to where it was last year. Given the trend of increases in imports, that won't happen anytime soon. But is a recovery in U.S. manufacturing back to prior recession levels necessary before the economy can recover this time around? Probably not, however an increasing dependence on imports is certainly not positive for long-term national prosperity.

This does not mean that the current rally can't continue for a few more months. More importantly. from a shorter term investment perspective, the latest weekly data suggests we have seen a bottom of sorts in rail demand and that is positive for both markets and the economy as long as it persists...which brings us to our next topic.

The Weekly Rant - Rocket-Riding Stimulus Junkies

"Our nation is suffering from ‘stimulus addiction,' and the path of least resistance is to continue feeding the habit." - Dr. Chris Martenson in a September 28, 2009 report

Last week, a friend of mine told me that a Canadian bank was offering five-year variable-rate mortgages at 2.25%. I checked and sure enough, rates for our pampered neighbors to the north are at their lowest in more than 30 years, according to the ad. A five-year fixed rate was advertised at 3.89%. Is it any wonder that the Canadian real estate market is again rising faster than a Roman candle on Canada Day? And a number of sectors of the U.S. market are enjoying a similar resurgence if the latest real estate statistics are any indication.

ProfitScore readers are by now familiar with the forces that drove real estate prices to unheard of heights (even after adjusting for inflation). And as discussed in our last monthly report, this growth was certainly not due to any measurable rise in real wages or household incomes. It was made possible thanks to a seemingly endless supply of cheap money. No one seems too concerned about the rather unpleasant side-effect of rapidly rising debt levels (see Figure 8 in last month's report).

It could be argued that the availability of cheap money created demand that spread like wildfire and eventually enveloped the nation. But was this demand real or artificially created?

In a "normal" market, no matter what the product, demand is driven by the ability of potential customers to buy it. That means that they must have a job and the disposable income necessary to pay for the product.

But as we all know, unemployment is still rising and the average work-week was just one-tenth of an hour above its all-time low at 33.1 hours in August (see Figure 1). Real unemployment measured by the more realistic all-inclusive BLS U6 unemployment rate hit a six-decade high of 16.8% in August.

And as we also learned last month in Figure 2, real wages are still lower than they were in 1982.

So, if real wages are lower than they were 27 years ago, unemployment is at a multi-decade high (and rising) and the number of hours worked per week is near an all-time low, just how are people buying homes?

In his latest weekly newsletter, Chris Martenson makes an interesting case for the argument that in an effort to re-inflate the housing bubble, the federal government and Federal Reserve now have become the housing market. Is this possible and if so, how?

Thanks to Federal Reserve "generosity," interest rates are at or near a half-century low, but that alone was not enough to re-ignite this housing market without a bigger push. The next step was trillions in stimulus that included programs to take over and refloat[O1] the failed GSE mortgage giants Fannie Mae and Freddie Mac with billions in new cash; agencies that failed because they had too many non-performing loans. So what does the government do? Instead of decreasing the size of the amount of loans it issued as would be the responsible thing to do, they increased the maximum loan limit! The plan also included forcing banks to "renegotiate" billions in risky mortgages, instead placing this risk squarely on the shoulders of the taxpayer.

The latest federal housing stimulus program is a credit of up to $8,000 (or 10% of the value of the home whichever is less). This allows new home buyers to purchase their first home (in three years) and get a tax refund. A total of 1.8 million buyers are expected to take advantage of the program. There is now a bill (introduced by Senator and former realtor Isakson) before the Senate that would raise this credit to $15,000.

Martenson calculates that through August 2009, a total of $686 billion in new mortgages were issued. Compare that to mortgage-backed securities (MBS) purchased by the Federal Reserve over the same period totaling $624 billion, plus another $98 billion of agency debt for a total of $722 billion injected into the housing market through Fannie Mae, Freddie Mac and the Federal Home Loan Bank (FHLB).

"In other words, the Federal Reserve alone bought $722 billion of mortgages and agency debt when only $686 billion in new mortgages were issued. So, through August, the Fed bought more than 100% of the entire supply of mortgages in 2009," according to Martenson (emphasis are mine not his).

Here is the obvious conclusion. National demand has created a political machine that is doing the voters' bidding. That overriding demand is to cure economic and housing ills, no matter what the cost and no matter who has to pay for it. Put in simple terms, we have become a nation of debt junkies who demand our fix no matter what the cost and the majority of our politicians are only too happy to comply.

But, as any junkie who has recovered and lived through it will tell you, the bigger and more deep-rooted the habit, the more painful and costly it is to cure. I wonder how long it will take our nation of debt junkies to figure out that we can't live beyond our means. That will be a tab left to our children and children's children to pay.

Some legacy!

Related Stories and Links

Warren Buffett's "Desert Island" Economic Indicator
http://manualofideas.com/blog/2009/09/warren_buffetts_desert_island.html

American Association of Railroads Monthly Report
http://www.aar.org/NewsAndEvents/~/media/AAR/RailTimeIndicators/Rail%20Time%20Indicators%20September%202009.ashx

Atlantic Systems Weekly Railfax Report
http://railfax.transmatch.com/

Chris Martenson's Website
http://www.chrismartenson.com/

First-Time Homebuyer Tax Credit Claims Soaring
http://finance.yahoo.com/news/Firsttime-homebuyer-tax-cnnm-973908072.html?x=0&.v=5

Banks Are Forcing Homeowners to Keep Paying After Short Sales
http://www.businessweek.com/the_thread/hotproperty/archives/2009/09/banks_are_forci.html?ref=patrick.net

U.S. Mortgage Delinquencies Set Record
http://www.reuters.com/article/gc03/idUSTRE58K29E20090922

Almost One-Third of Home Loans Under Water
http://www.marketwatch.com/story/almost-one-third-of-home-loans-are-under-water-2009-08-13

"Banking system like South Sea bubble," says senior Bank of England official
http://www.guardian.co.uk/business/2009/jul/01/bank-england-south-sea-bubble

FDIC Weighs Extraordinary Steps to Shore Up Fund
http://finance.yahoo.com/news/FDIC-weighs-extraordinary-apf-3266069115.html?x=0

FHLB Website
http://www.fhlb.com/

Moose for Dinner

It doesn't get any better than spending time with good friends and family in Idaho's backcountry. Doug's camping accommodations continually get better year after year, and this year was no exception. His new pellet stove burned warm the entire night, knocking the edge off of the cold mountain air. It was a refreshing change to not have to build a fire on a cold, dark morning to warm the tent.

As usual, we got a big snow storm. This storm came on Wednesday and dumped 8 inches in the valley and 12 inches in the higher elevations. I call these big storm days "pancake days" because we normally get a late start and get to enjoy a big country breakfast before braving the cold.

I was fortunate to fill my moose tag on the 2^nd day of our hunt before the snow came, so we were blessed to have filled our freezers with Idaho's finest. Hunting moose in Idaho's backcountry will be one of my all-time fondest memories. As I have aged, it is more about the experience and the special times with friends and family and less about the hunt.

My father is due to visit in a couple of weeks for our annual bird hunt with my new dog, Jack. My wife is a spectacular southern cook, so I can't wait to eat our traditional quail dinner with all the fixings, topped off with homemade pumpkin pie. Talk to you next week.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Are Shipping Rates Trying To Tell Us Something About This Recovery?

2009-09-28T14:02:00Z

www.profitscore.com

Consumer Crush
To Lead or Not to Lead?
Got a Market Headache?
The Weekly Rant-More BLS CPI Sleight of Hand
Idaho's Back Country

In September's ProfitScore IQ, I mentioned that we would begin publishing a smaller, fact-filled weekly newsletter called the ProfitScore Weekly Market Watch. As promised, here is our first publication of that newsletter. I hope you enjoy its content and that it helps you become a better investor.

In last IQ, we discussed household wealth and debt and how the growth rate of debt at all levels has rapidly outpaced both incomes and wages. As debt becomes a larger burden on our economy, it will increasingly strangle consumer spending and that is a problem when we consider that approximately two-thirds of our economy depends on it.

This week we take a final look at the health and financial staying power of the consumer. Then we begin the search for some useful, leading market and economic indicators.

Consumer Crush

This next chart shows just how seriously consumers have cut back their borrowing; cuts that have come for two reasons. First, when there is a real chance that you could lose your job, it is only natural (and financially wise) to curtail your debt load. To put this drop in perspective, the $108.7 billion drop was both the largest on record and the largest percentage drop since the time of the D-Day invasion in 1944 when allied forces were landing in Normandy in the largest military offensive in history.

Unfortunately in economic times like these, what is good for the economy (increasing spending) is simply bad for the consumer. Now squeezed between rising unemployment and tighter bank lending practices, consumers are hunkering down. Savings levels rose to a 14-year high of 6% in May, before dropping back to 4.2% in July, compared to just 1.3% at the beginning of 2008.

Figure 1 - Monthly chart of consumer credit closely tracking the business cycle over the last twenty years, showing the $109 billion drop so far in 2009.

To Lead or Not to Lead?

So will programs like the $3 billion cash-for-clunkers draw shoppers back into stores and get them spending again in an economy that has lost approximately 7 million jobs since the recession officially began in December 2007? As our charts of real time incomes (in 1970 dollars) showed last week, its not as if consumers have access to bigger pay checks to help them ‘grow' the economy.

If anything was clear from those charts, it's that the latest bubbles were not fueled by increasing incomes. Median incomes peaked in 1999 at $50,641 and were still below that level at $50,233 in 2007, according to the latest data available. There is little doubt that median incomes fell again in 2008 and will likely fall in 2009. Spending to fuel these bubbles was made possible by a large jump in debt levels, thanks to central bank cheap-money policies.

So how will we know when the worst is truly behind us? That's the trillion-dollar question.

One approach is try and stay one step ahead of the economic data. And, to accomplish this daunting task, it requires a combination of indicators, some well-known and some that are more obscure.

Got a Market Headache? Take a BDI and Call Me in the Morning...

One of the more widely used indicators is the Baltic Dry Index (BDI). The BDI represents the cost for shipping dry bulk goods like iron ore, coal, grain, etc., by sea around the world (not by tanker or in containers). When international demand for goods is high, shipping rates go up, and when demand is low, they fall and so this is a good leading economic indicator.

What makes the BDI interesting is that there is virtually no speculation and very little opportunity for manipulation, since the price of shipping is not traded on an exchange. It is driven by real demand, so it is therefore not subject to trader fear and emotional greed swings. It also supports the theory that the bubbles in commodity and stock markets were not significantly driven by speculators as many politicians and regulators have charged.

This index climbed from around 4,000 in early 2007 to over 11,000 in May 2008, thanks to strong economic demand in a booming global economy. Last Monday (September 21^st), the index was sliding toward 2,300, down nearly 50% in just three months from its June 2009 high. It is interesting to note that the BDI bottomed on the same day that the 17 commodities of the CRB Index did - December 5.

Figure 2 - Chart of the Baltic Dry Index showing the significant double top in September 2007 and in May 2008 above 10,000, after which the index cratered to a low of 663 on December 5, 2008-lows in the index not seen since August 1986. As this chart shows, the six-year average is just under 4,300. Its most recent peak briefly topped above it in early June, then reversed again. Data - Capital Link Shipping.

So how good is the BDI as a leading market indicator? It took some digging to answer this question. First, we had to match data points for both the S&P500 Index (SPX) and the BDI. As we learned the hard way, both indices had quite a large number of gaps (even though both were supposed to be daily), which means we had to fill them in with the previous daily data, since charting programs don't work well with holes in the data. The Baltic Dry Index dates back to the beginning of 1985, so that is as far back as we could go.

Figure 3 - Daily chart of the S&P500 compared to the Baltic Dry Index showing the BDI peaking later, but bottoming earlier. Is this latest drop a warning of things to come?

The chart revealed an interesting relationship. First, the correlation between the two before 2000 was low, but increased from 2005 into 2009. But as we see from Figure 3, although both peaked around the same time (October 2007), the SPX dropped after putting in a lower high and the BDI rallied again to a higher high in June 2008. However, it then dropped off before hitting bottom in early December, a full four months before the SPX (and a number of other global stock market indices) bottomed.

More importantly, is the recent drop from its 2009 high in June a warning of market trouble ahead? This argument becomes more compelling when we look at China's Shanghai Composite Index that has been in a bear trend since peaking in August and can therefore not be ignored.

Because of its importance in measuring global trade demand, the BDI has the potential to provide advance warning of both increasing and decreasing demand. But, as any good trader knows, one indicator does not a trading (or investment) system make.

Next week we'll take a closer look at the indicator that Warren Buffett would choose if he was stranded on a desert island and could only use one to make his investment decisions.

The Weekly Rant-
More BLS CPI Sleight of Hand

Longer-term PS IQ subscribers are familiar with our views on government-generated statistics. At best, they leave much in the way of impartiality to be desired. At worst, they are little more than propaganda tools to make incumbent governments look better at dealing with economic challenges than they really are and have become crucial aids in keeping governments in power come election time.

In the September 16^th Consumer Price Index (CPI) August news release from the Bureau of Labor Statistics contained the following terse statement:

"In contrast to these increases [in food and other prices], the index for new vehicles fell 1.3 percent in August, partly due to ‘cash for clunkers' incentives." (For the complete report, please see Related Stories below.)

Excuse me? Since the description was very brief, it left a lot of room for interpretation. But, if I understood correctly, it meant that the $3 billion in taxpayer assistance was treated as non-existent. Did the BLS just do what I think it did - reduce the cost of all the cars purchased under the program (which by the way works out to 666,666.66 cars sold if you divide $3 billion by $4,500)?

If so, it sets yet another interesting "moral hazard" precedent. Not only does it make inflation look tamer than it really is because car prices weren't in fact reduced by $4,500, they used your money to help buy them and then treated the cash as non-existent. Since inflation is subtracted from GDP growth to get real economic growth, this sleight of hand also has the effect of making GDP look better than it really is. But that pales in comparison to the $787 billion TARP program and all the trillions in business, bank, mortgage and other bailouts that have been handed out so far.

So how will the statisticians treat all the stimulus cash? Will it also be treated as non-existent? The answer to that question is that the government will treat it pretty much any way it pleases, thanks to hedonics, which gives these minions the ability to treat any statistic any way they please and to make the government look more effective than it really is.

And these methods don't have to be consistent, which means we will likely see a mess in the way this cash turns up on government balance sheets and in the "official" government statistics.

Related Stories

Baltic Dry Index Dives as Chinese Coal, Iron Ore Demand Slumps
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aFnXgNO6O._U

Record Plunge in U.S. Consumer Credit Signals Weakened Spending
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avvF5aNtrCfc

U.S. Economy May See Its Slowest Recovery Since 1945
http://www.bloomberg.com/apps/news?pid=20601068&sid=aBj5AeyQqun8

Is the Government Using Cash for Clunkers to Supress Inflation?
http://www.businessinsider.com/is-the-government-using-cash-for-clunkers-to-suppress-inflation-2009-8

Link to BLS Cash-for-Clunkers September 16 news release
http://www.bls.gov/news.release/pdf/cpi.pdf

Idaho's Back Country

I was notified this summer that my archery hunting buddy Doug Bolen and I were drawn for one of Idaho's special Moose Permits. I say "special" because you have less than a 1% chance of getting drawn and if you are drawn you won't get to put in for this hunt again for the rest of your life. If you grew up enjoying hunting like I did, getting picked for this hunt is the equivalent of winning the lottery.

Doug is one of the most capable guys I know in the woods and the best part is that his camping gear is second-to- none. Camping in Doug's sheep herder's tent is like living in a small, cozy cabin with about every accommodation you could ask for besides indoor plumbing. Being comfortable is a good thing because running around in Idaho's rugged back country is not for the weak of heart.

In a typical day, we will walk 10 to 15 miles, starting our day around 4:30 AM and getting back to camp an hour or so after dark. I wore a device that tracked my calories burned in a day a few years ago hunting elk and I burned around 5,500 calories a day. That is about the same as Navy Seals burn in training camp.

Doug and I have trained hard for this trip, so hopefully our preparation and hard work will reward us by filling our freezer for the year.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Why Are Americans Earning Less Than They Did In 1982?

2009-09-22T19:06:00Z

www.profitscore.com

An Update on Our Performance
Incomes - A Four-Decade Long Report Card
The Incredible Shrinking Work Week
The Curious Case of Hourly Earnings
What a Difference a Week Makes
What's a Buck Worth?
Incomes Just Don't Buy What They Used To
Wow, I Didn't Know That!
Questions and Comments
Definitions
Take My TV Challenge

Tuesday, September 14^th marked the first anniversary of the collapse of Lehman Brothers. This historic event almost brought our financial house down and exposed a multitude of inherent Wall Street vulnerabilities in the process. Only time will tell if the government response of throwing trillions at the problem to bail out industry giants like Fannie Mae, Freddie Mac, Citigroup, Bank of America and AIG, deemed "too big to fail," was the right move.

In this ProfitScore IQ, we will continue our inflation/deflation argument and we will examine real employment incomes, and the growth in household wealth compared to debt growth rates. How have wages fared during the inflationary times of the 1970s, on through the eighties and nineties, and into the new millennium?

What we found astounded us and will surely surprise you!

But first, I have some exciting news for our current subscribers and would like to welcome our new subscribers to the ProfitScore IQ. If this is your first letter, I want you to know how much I appreciate your valuable time and that my staff and I put our heart and soul into publishing this letter. We hope our thoughts help to make you a better and more knowledgeable investor.

Over the past several years, we have gained a large and growing readership. This is in a large part due to our loyal, long-term subscribers. We recently added a new distribution partner for this letter. This new relationship will push our readership over 1 million. Thanks to all of our readers who have made this possible!

Major economic changes are now happening at the speed of light. To keep abreast of these rapidly changing circumstances, we will now start publishing our thoughts weekly. We will call this weekly publication the ProfitScore Weekly Market Watch. You will start receiving this weekly letter on September 28^th. I, of course, will take a few weeks off for holidays, but you can expect to hear from me much more often.

These weekly letters will be shorter, yet focused and full of thought-provoking content. Once a month, we will also produce our traditional ProfitScore IQ containing more details about topics produced for the weekly letters and our regular update on our portfolios and other ProfitScore specific news.

An Update on Our Performance

The only bright spot in last month's performance was once again our fixed income portfolio, which continues to make consistently positive returns and now sits at a new equity high. In the long-term, we will be rewarded for these high probability decisions, but short-term, they can damage our equity curve.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	August
Name	Months	2009	2009
Income Builder (IB)	5.85%	8.09%	0.83%
The Guardian (GRD)	6.32%	7.15%	-2.06%
Harmony Plus (HMY)	9.42%	6.91%	-4.16%
The Expedition (EXP)	9.32%	5.68%	-6.36%
S&P 500 (SP500)	-18.25%	14.97%	3.61%
Important Performance Disclosure

ProfitScore provides separately-managed accounts for individuals, advisors and institutions. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Incomes - A Four-Decade Long Report Card

According to the latest non-farm payrolls data from the Bureau of Labor Statistics (BLS), the number of jobs being lost fell to 216,000 in August. But before celebrating, we need to look more closely at the employment numbers and time spent working. BLS reported that the average hours worked was 33.1 hours in August, up marginally from a multi-decade low of 33 hours in June.

We also learned that the unemployment rate jumped to 9.7% in July, the highest rate since 1983. A statistic not widely discussed was BLS's all-inclusive U6 jobless rate, that includes those working part-time. It showed the loss of 336,000 full-time jobs in August, sending the U6 rate to an all-time high of 16.8% since the data was first recorded (and does not include the Great Depression).

What about incomes? This begs our first question of the week - Are we better off than we were four decades ago? If so, how much better? And have real incomes kept up with the rate of inflation? In order to answer that question, we need to look at a BLS statistic called personal consumption expenditures (PCE), together with changes in average hourly incomes will determine an inflation-adjusted number.

PCE represents the cost of goods and services used for individual personal consumption and are measured differently by each country. This statistic is designed to provide a representation of the cost of living for the individual. (For a more detailed definition, please refer to the end of this newsletter.)

We will then adjust average hourly earnings by both the official and unofficial CPI to figure out how our incomes have changed.

The Incredible Shrinking Work Week

Our next chart shows average hourly earnings since 1970 adjusted for PCE inflation. In January 1970, the average hourly income was $3.31, and by December it had increased to $3.50, according to the U.S. Bureau of Economic Analysis (BEA). Contrast this with an average hourly wage of $18.43 in January 2009 and $18.56 by July in 1970 dollars.

Figure 1 - Chart showing average hours worked with big drops in the past 18 months of multi-decade lows.

In other words, since 1970 wages have increased 430%, which works out to an average annual compound increase of 4.3% per year. Here are my calculations.

Total return (for n years) (TR)                                4.30 or 430.0%
Number of years (n)                                               40.0
Average annual return (AR) =((1+TR^(1/n))-1 =    0.043 or 4.3%

But as we see from our next chart, this growth rate was anything but linear each year. Between 1970 and the early 1980s, PCE inflation-adjusted wages soared from $3.31 to a high of $5.58 by June 1982. However, over the next two decades real average hourly earnings growth stagnated and by July 2005, it had dropped to $4.93/hour, a 12% decline from the peak in the early 1980s.

In other words, real incomes actually dropped during the greatest bull market in history (1982 - 2000)!

The Curious Case of Hourly Earnings

Figure 2 - Monthly chart of real average earnings (1970 dollars) showing a fast rise between 1970 and 1983, after adjusting for PCE inflation. As of the most recent data (July), real earnings are down 0.1% from their 1983 peak. In nominal terms, average hourly earnings were $3.50 versus $18.56 in July 2009.

As the above chart shows, in July 2009 real average hourly earnings were still below where they were in the summer of 1982.

But is this a realistic income picture since monthly incomes are determined by multiplying average hourly incomes by the number of hours worked? To answer that question, we gathered data from both the BLS and BEA to calculate average weekly PCE inflation-adjusted incomes.

This next chart shows our findings.

What a Difference a Week Makes

Figure 3 - Annual chart of real average weekly earnings that factors in the drop in average hours worked in a week. It recently hit an all-time low of 33. Real earnings are down 6.1% since the peak in 1982.

We again see that average weekly earnings rose rapidly during the inflationary years of 1970 through 1982 from $125.80 to a high of $186.93 in 1970 dollars. However, due to a trend of falling hours being worked each week, incomes in 2009 are still 6.1% below where they were when the biggest bull market began in 1982. This is a 6% greater drop than in hourly earnings (Figure 2).

What's a Buck Worth?

Next, we calculate buying power for the average hourly income by deflating nominal hourly earnings by CPI. As a brief review, our next chart from our last monthly newsletter compared three different inflation estimates, the most benign of which is the official government consumer price index (CPI-U). It showed that the dollar is now worth about 18% of what it was in 1970, the alternate CPI (CPI-Alt) that calculates inflation before statistical changes were made post-1982, showing a drop in dollar buying power of 94%. According to the price of gold, the dollar has dropped more than 96% since 1970.

Figure 4 - Chart of three different estimates on how the value of a dollar has changed since 1970. In 1982, government statisticians began making changes to the way inflation was calculated that had the effect of minimizing it. The official CPI (CPI-U) puts the value of a 1970 dollar at $0.18 today compared to $0.059 using the Alt-CPI (original CPI calculation) and $0.04 using gold. Source data - Bureau of Labor Statistics and ShadowStats.com

Next is a chart that adjusts average hourly incomes by both the official CPI (CPI-U) and John Williams' alternate CPI (CPI-Alt) in 1970 dollars. The graph of average weekly earnings adjusted for both CPI-U and CPI-Alt is not included here shows an even greater drop in CPI adjusted earnings!

What also stands out is the difference between the Personal Consumption Expenditures and the Consumer Price Index. As we saw above, wage inflation (the total increase in wages) was 430% between 1970 and 2009. According to the PCE, inflation amounted to 338% over the same period while the official total CPI (CPI-U) was 450%. That's a big difference in inflation!

Incomes Just Don't Buy What They Used To

Figure 5 - Chart of average hourly incomes deflated by both the average annual official consumer price index (CPI-U) and the alternate consumer price index (CPI-Alt), showing the purchasing power of the average wage after adjusting for inflation.

Figure 5 provides us a long-term look at the buying power of the average hourly wage. If you are feeling more poor than you felt in the 1980s, you now know why!

Even before the big plunge in household incomes as a result of the credit crisis that started mid-2007 fueling a record loss of $13.7 trillion in household wealth (see article Shock May Put Global Relapse... below), incomes have failed to keep up with inflation. And if you use the alternate CPI, which calculates inflation as it was before all the changes made to the statistic post 1982, the drop in real incomes has been significant.

Wow, I Didn't Know That!

In 1970, the Dow Jones Industrial Average ended the year at 828.40. On Friday (September 18) it closed 9820.20, an increase of more than 1086% in nominal terms compared to a nominal (non-inflation adjusted) increase in wages of 430%. Why have real wages fallen as the stock market gains so much ground?

Did households become increasingly dependent on stock market gains to provide income or was some other factor responsible for the growth in household wealth over this period?

And through this period, how quickly has debt grown - debt which one day will have to be repaid?

Here is what we found.

First we looked at the growth of household net worth between 1970 and 2009 (green) and then examined the annual change (red line). Net household wealth peaked (annual basis) in 2007 at $63.9 trillion, according to data from the Federal Reserve. By December 2008, it had dropped to $52.9 which was a 17.2% drop before recovering slightly to $53.1 trillion by Q2-2009. That was the biggest percentage dropping by a wide margin since the Fed first began recording the data in 1945 (see Figure 6).

Figure 6 - Annual household net worth and the yearly rate of change.

Figure 7 - Household debt and annual rate of change showing the first year-over-year decline in 2008 of 0.71% followed by a 1.05% drop in 2009 (to Q2-09), which were the first annual declines since 1945 according to the Fed.

Now let's put it all together and compare the overall growth rate in household debt, average wages and the Dow Jones Industrial Average versus three types of debt - household debt, total credit market debt (debt at all levels in the economy) and Federal government between 1970 and 2009. (For a more detailed discussion of Federal government and total credit market debt and a chart showing how quickly each has grown, see Figures 3 and Figure 4 in last month's newsletter.)

Here is what we found. As the chart shows, government and credit market debt have grown more than twice as quickly as household wealth and more than three times faster than the Dow in the 39-year period. Federal government debt grew seven and a half times faster than wages between 1970 and 2009!

Figure 8 - Comparison of the growth rates of wealth, the Dow and average wages compared to three types of debt from 1970 through Q2-2009.

We performed the same calculations for the last decade (1999-2009). Not surprisingly, Fed government debt grew the fastest at 130% over the decade with both credit market and household debt close behind (105% and 108% respectively). Wages were next at 41%, followed by household wealth (24%) then the Dow, which dropped 16% between December 1999 and September 18, 2009.

We watched an interview that featuring perma-bull Ken Fisher. His big message was that he wished we had more debt! Using what we consider rather twisted logic, he said that with an economy of approximately $13 trillion annually and debt where it is today (the latest estimate comes from Sprott Management puts total debt and unfunded liabilities at $118 trillion), means that the country in Fisher's opinion is returning 11% on its debt (investment).

It is important to point out that he made the same claim in June 2007 and also claimed that our economy AND homeowners needed more debt at the time, advice which those who took it to heart probably seriously regret today. Warning - relying on Fisher's logic to run your own financial affairs would be very harmful to your financial well being! However, somehow it's okay for a nation to be reckless in its financial affairs. (See both the recent and June 2007 articles below in Stories of Interest.)

Here is a little known fact. Ken Fisher has a mutual fund called Purisima Total Return (PURIX). You can look it up at Yahoo or any similar website. I calculated how it performed during the current bear market and here is what I came up with:

Equity High was on November 1, 2008 - $23.93 per share
Equity Low was on March 9, 2009 - $9.99 per share
Loss in dollars: $13.94 per share
Loss in percentage terms: -58.25%
Increased required to get back to break even: (100% / 41.75% = 240%)

I will let you be the judge if Ken is a better marketer or a better money manager.

But whether we like it or not, based on the growth rates in debt, Fisher will most certainly get his wish. The current debt level of $118 trillion works out to exactly $1 million per U.S. household, which most economists would argue is completely impossible to pay off anytime soon (more like within the next three or more decades).

Next week we continue with this discussion to see how you can protect yourself and even profit from the challenges we face. Stay tuned!

Questions and comments

Do you have a question or comment? Please email us at info @ profitscore.com. Paste this email address but remove the blanks before sending. (We have to do this to reduce spam emails.)

DEFINITIONS

Personal Consumption Expenditures (PCE)

Personal consumption expenditures (PCE) are all funds spent on goods and services intended for individual consumption or use. It includes such items as food, beverages, clothing, and utilities. The PCE price index takes into account actual prices paid by households for durable goods, as well as non-durables and services. Even though the personal consumption expenditures price index makes constant adjustments for changing consumer spending habits, its conclusions are considered somewhat predictable and therefore has little impact on the markets. Source - InvestorGlossary.com

Consumer Price Index (CPI)

The (official) Consumer Price Index (CPI-U) is released monthly by the US Department of Labor. It measures the price changes in a fixed basket of consumer goods in an attempt to measure economic inflation. A Consumer Price Index reading that excludes volatile food and energy prices (core CPI) is also published monthly. The basket of goods and services used to calculate the Consumer Price Index includes medical services and drugs, food, energy, recreation, clothing, education, housing and communications. The Consumer Price Index is widely viewed as a leading economic indicator. Cost of living adjustments in programs such as Social Security are based on the Consumer Price Index. GDP calculations also use the Consumer Price Index as an input. Because of its wide implications, the Consumer Price Index can affect interest rates and foreign exchange rates. Source - InvestorGlossary.com

Stories of Interest

Too Much Debt? Please. We Need MORE Debt, Says Ken Fisher!!
http://finance.yahoo.com/tech-ticker/article/334648/Too-Much-Debt--Please.--We-Need-MORE-Debt-Says-Ken-Fisher?tickers=tlt,tbt,spy,dia,%5egspc,udn,uup&sec=topStories&pos=8&asset=&ccode

Same sort of funny advice from Fisher in June 2007 with his numeric rationale...
http://globaleconomicanalysis.blogspot.com/2007/06/in-love-with-debt.html

Gain in U.S. Household Wealth Will Help Ease Strain on Spending
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=apwSioYuG_cI

Revealed: The ghost fleet of the recession anchored just east of Singapore
http://www.dailymail.co.uk/home/moslive/article-1212013/Revealed-The-ghost-fleet-recession-anchored-just-east-Singapore.html

Shock May Put Global Relapse Odds as High as 1-in-3, Roach Says
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a9odwc3.kFwM

Poverty Deepens as Recession Cuts U.S. Incomes, Census May Say
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aw6DvG14bU6s

U.S. Economy May See Its Slowest Recovery Since 1945
http://www.bloomberg.com/apps/news?pid=20601068&sid=aBj5AeyQqun8

Global Economic Crisis to Continue: IMF Chief
http://www.reuters.com/article/GCA-Economy/idUSTRE58B0K620090912

Record Plunge in U.S. Consumer Credit Signals Weakened Spending
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avvF5aNtrCfc

U.S. Economy: Trade Deficit Widens Most Since 1999 on Imports
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZcN_BCvBsAE

Consumer Sentiment Improves, Inventories Drop
http://www.reuters.com/article/GCA-Economy/idUSTRE58A3EM20090911?sp=true

Portfolio Performance Analysis

Risk & Reward

Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

I would be lying to you if I could have imagined that the S&P 500 would be 60% above its March lows 6 months later. Then again, the world has never seen so much liquidity pumped into the markets by governments around the globe. During the past six months, the S&P has leaped from 20% below its 200 day moving average to 20% above it. Has it come too far to fast? Yes! Here are some interesting statistics I pulled from Bespoke Investment Group the other day:

"Since 1928, it's happened three times--1932, 1938 and 1975--and each time, the S&P was lower one, three and six months later every time but--and this is a big 'ol but--the average return, one year later, was 13.3%, with positive returns two out of three times."

It is hard to argue against the liquidity effects of trillions of dollars, but I think those dollars are getting tired. At this point, I am not sure how the next six months will play out. With so much government intervention, it is hard to tell. The only thing I am fairly confident in is that volatility is about to be reintroduced back into the equity equation.

The other day I was playing a game called "Trouble" with my oldest daughter, Sarah. The game is pretty simple and fun for younger kids to play. The game has one die in the middle enclosed by a hard plastic see-thru shell. When you press the shell, the spring in the bottom pops the die, which is the equivalent of rolling the die to determine your number. To do well at the game, you need to roll a six. Rolling six gets your man out of home and allows you to travel to your destination. By rolling a six, you also get to roll again. Tolerate me for a moment, because this helps me explain our performance in August.

While Sarah and I were playing, I rolled 12 sixes in a row. It was quite amazing-and boy do I wish I could have had that kind of luck playing craps. I obviously won the game. The very next night, the whole family played the game and unfortunately my luck had changed. In this game, I wasn't able to roll one six. I never got one man out of home before the game was over.

If you flip a coin and it lands on heads 20 times in a row, the chances of it landing on heads on the 21^stflip is still 50%. Unlike investing, with flipping a coin, the chances of lading on heads or tails is always 50%. It is common to experience long winning or losing streaks, but your chances are always 50%. Trading is different in that you can win more than 50% of your trades. Our overall average is around 65%, but in the past 16 months we have seen some months better than 80%.

In August, our equity trading accuracy dropped below 30%. It felt like we couldn't buy a positive equity trade. There are more reasons for this besides just statistics, but probabilities do play a big role in return distribution. This is one of the reasons that we trade so many different asset classes.

Our fixed income models had another impressive month, helping to offset our difficult month trading equities. Month-to-date, we are still a little shy of 50% with our equity trading accuracy, but our distribution is starting to skew back to the positive side of our historical averages.

Below is a performance summary for the indices we track and benchmark our portfolios to:

	Cumulative Return			Average Annual Return
Indexes	Mth.	YTD	1 yr	3 yr	5 yr	10 yr

CSFB L/S *	1.42	13.03	-3.59	3.36	7.30	7.73
CSFB Multi-St. *	1.42	17.03	-5.00	1.52	4.91	7.05
Barclay F-of-F *	1.22	7.04	-10.69	-1.70	2.25	5.15
S&P 500	3.61	14.97	-18.25	-5.78	0.40	-0.79
Barclay HY	1.86	40.94	6.50	3.87	5.27	5.59
Barclay Agg.	1.04	4.63	7.95	6.35	4.96	6.31

* Note:	Estimated monthly performance

Index Advantage:

As explained above, we experienced a larger than normal loss for the month with the majority of our trades experiencing losses.

For the month, this pillar gained -9.94.

Strategic Balance:

We also experienced a small loss trading U.S. sectors and international markets for the month. Our overall investment exposure remained low and thus our losses were muted.

For the month, this pillar earned -0.61.

Dynamic Income:

This makes our 5th winning month in a row for this important diversifying allocation. September is also showing impressive gains currently leading all investment allocations.

For the month, this pillar earned 1.08.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October). For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements. It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis. To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum.

Take My TV Challenge

When I grew up, the only time to watch cartoons was once a week on Saturday morning. There just wasn't much on TV for kids back then, so we did what most kids did - go outside and play. Well that was when my dad gave us time from our farm chores to play with our friends. Remember what your parents used to say when you went outside to play, "Be home by dark." Ah, those were the good old days. Now-a-days there are multiple channels for kids to watch. Some of them are good; Discovery, History Channel, etc. However, many are bad.

After much discussion with my wife, we decided to unplug cable TV about two years ago. I can say today that it has been one of the best family decisions we have made. It has taught my kids how to entertain themselves and they play with each other and their friends all the time. Our neighbor's kids are the same age and they don't allow their kids to watch much TV either, so it has been a perfect situation for both of our families.

In June, we decided to unplug the TV altogether. I have been getting all my news from the internet for years, so I had no business reason other than entertainment to watch TV. In Idaho, there are lots of ways to be entertained without watching TV, so staying busy and entertained is not a problem. I can say for certain that we have grown closer as a family because we simply spend more time together. In America, fathers spend on average 15 minutes a week talking with their daughters. I now spend at least an hour a day. It hasn't been easy missing Monday Night Football or missing my favorite college football team, but it has been one of the most rewarding family decisions we have made.

I encourage you to take my challenge and try turning off the tube. If you are like me, you have grown so addicted to TV that you can't simply turn it off. You'll have to have your cable turned off to kick the habit. My guess is that the thought of turning off your TV is unimaginable, even scary to you. I know because I felt the same way. Sadly, there's no other word for the feeling other than addiction. Your friends will think you are weird because they can't imagine their life without TV. I now enjoy watching the expression on peoples face when they find out I don't have a TV. Now that I have kicked the habit, I actually feel sorry for other people who haven't.

I will make a deal with you if go without watching TV for three months, I will manage your money free of charge for three months (this will apply to new clients only). If you need help kicking the habit, send me an email and I will talk you down off the cliff.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Will This Rally End In Tears?

2009-08-26T19:46:00Z

www.profitscore.com

An Update on Our Performance
The Great Inflation/Deflation Debate, Part II
Getting Real on Inflation (Continued)
Life on a Debt Rocket
A Shakespearian Tragedy
Resisting the Ostrich Urge
Real Estate Update - The Next Two Boots?
Portfolio Performance Analysis
The First Day of School and the Oregon Coast

Last month I clearly spoke my mind about the challenges we face. I was hesitant to do so because I never want to be perceived as a doom and gloom guy. To make money consistently, it is important to objectively evaluate the data and adjust your investment positions accordingly. I am always cautious with my investment ideas because, as a manager of other people's money, it is my job to be nervous about anything that can cause my clients to lose money. Lately, I have felt an overwhelming level of stress about the decisions that are being made and I am not alone.

Here are some facts from Warren Buffett's recent editorial in the New York Times:

Congress is now spending 185% of what it takes in
Our deficit is a post WWII record of 13% of GDP
Our national debt is growing by 1% a month
We are borrowing $1.8 trillion a year
$1.8 trillion is a lot of money. Even if the Chinese lend us $400 billion a year and Americans save a remarkable $500 billion and lend it to the government, we'll still need another $900 billion.

So, where's it going to come from? Most likely the printing press. And, ultimately, Buffett says, "That will destroy the value of the dollar."

I must have struck a nerve with my frank comments in last month's newsletter because I received more feedback on it than any other newsletter I have published. There are clearly a lot of people who are uncomfortable about our future.

This month we will continue our debate about inflation versus deflation and attempt to bring some clarity to the clear as mud government data. I also want to bring your attention to the pain that commercial real estate is about to inflict on our struggling economy. Unlike residential real estate, commercial real estate mortgages are normally held by local and regional banks. Are you aware that the commercial real estate market is actually larger than the residential real estate market?

Commercial real estate rents are plummeting across the nation. Locally, commercial real estate rents in Eagle, Idaho have dropped from $24 per square foot to $13.50. And, to add insult to injury, taxes and utilities have increased. I spoke to an owner of a Class A office property in Eagle a few weeks ago. He bought several beautiful office buildings in 2006 and is now in mortgage remodification discussions with his local bank. Our office is located in a beautiful office park along the Boise River and is considered one of the most modern office parks in the Boise MSA. Vacancy rates in our office park are currently running close to 50%. Based on rents, these buildings no longer generate positive cash flow and prices are dropping fast.

Like residential real estate, commercial real estate is dependent on employment. When businesses are going bankrupt, there aren't opportunities to rent office, retail and manufacturing space. All of the problems we are about to face with commercial real estate are still in front of us. Expect this boot to drop within the next six months. You will soon see a lot of FDIC bank takeovers because of commercial real estate problems. If you currently own bank stocks, this week would be a good time to put in your sell orders. At the very least, purchase some put options to hedge your bets.

The head winds continue to blow at gale force strength. 2010 promises to be another crazy economic year and a stressful year for investors.

An Update on Our Performance

We managed to put green on the board for all our portfolios last month. Fixed income continues to be our shinning star having its second best month since the launch of our multi-manager portfolios. Because we take short positions, we will normally have a difficult time outperforming a market that goes up for continuous days and weeks in a row. Rallies such as these seldom happen, so our models will bet against them occurring. Long-term, we will be rewarded for these high probability decisions, but short-term, they can damage our equity curve.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	July
Name	Months	2009	2009
Income Builder (IB)	4.28%	7.20%	3.00%
The Guardian (GRD)	9.18%	9.40%	1.73%
Harmony Plus (HMY)	16.49%	11.55%	1.11%
The Expedition (EXP)	20.75%	12.85%	0.83%
S&P 500 (SP500)	-19.96%	10.97%	7.56%
Important Performance Disclosure

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

The Great Inflation/Deflation Debate, Part II

In our last ProfitScore IQ, we looked at some examples where hyperinflation got the better of a nation and whether it's a possibility that should worry us. With that in mind, we will take a closer look at the differences between the official and the unofficial Consumer Price Index (CPI) and examine the implications for the economy and market if inflation is greater than the official CPI would have us believe it is.

What will it mean for the future of markets, our economy and your financial well-being? More importantly, what can you do to protect yourself?

Figure 1 - Chart comparing the monthly official Consumer Price Index numbers (CPI-U in green) that shows annual inflation was running at 3.84% in 2008 versus the Alternate CPI estimate (CPI-Alt in red) using the calculation before the changes post 1980, which showed inflation at 11.57% in 2008. Notice how the two estimates have diverged since the statistical changes were first made in the 1980s. Source - Bureau of Labor Statistics and ShadowStats.com.

Getting Real on Inflation (Continued)

If we take the annual CPI numbers from the chart above, we can calculate how inflation has impacted buying power since 1970. First, we'll examine what the official CPI is telling us. According to annual CPI data from the Bureau of Labor Statistics (BLS), inflation averaged 4.68% between 1970 and 2008.

In 1970, a US dollar purchased 100 cents worth of goods. What is a dollar worth today? More precisely, what percentage of the goods that a dollar bought in 1970 would it purchase today? According to the official BLS CPI, in 2009 a dollar buys about $0.18 worth of goods that it did thirty-nine years ago. Put another way, what cost you one dollar in 1970 now costs $5.56 if you believe official inflation figures.

Now let's perform the same exercise for the CPI (CPI-Alt) calculated the way it was before government statisticians began to modify it in the 1980s. According to CPI-Alt, a dollar in 2009 buys less than $0.06 worth of goods that it did in 1970, which means what cost $1 in 1970 now costs $16.95. In other words, the dollar has just one-third the value that the government would have us believe.

Let's look at another measure of value - what did a cup of coffee cost in 1970? According to Wiki.Answers.com, most restaurants charged $0.10 for a cup of coffee with a meal. Today the cost of an average cup of coffee in the U.S. is $1.38. Our rudimentary coffee index says that it now takes $13.80 to buy what cost $1.00 in 1970. Let's forget that you usually got a bottomless cup back then so the comparison isn't perfect. But our coffee index is much closer to the CPI-Alt estimate.

Now let's examine a standard that has been used for thousands of years as a currency-gold. In 1970, while the U.S. was still on the gold standard, an ounce of gold (Englehard gold price) averaged $36.75. In 2009, gold averaged $920.40 which makes the 1970 dollar now worth just $0.04. In other words, it now takes $25 dollars to buy what a buck purchased in 1970 using the gold standard. If we use the linear regression of the price of gold today to remove the big ups and downs, which pegs the present day price of gold at $560/oz, the dollar is now worth $0.06.

Even using this extremely conservative gold price estimate, the present day value of a dollar is still roughly one-third the $0.18 estimate based on the official CPI and nearly identical to the Alt-CPI estimate.

Figure 2 - Chart showing three different estimates on how the value of a dollar has changed since 1970. By 1980, the buying power of a dollar had been more than cut in half. But then in 1982, a strange thing happened. Government statisticians began making changes to the way inflation was calculated that had the effect of minimizing it. The official CPI (CPI-U) puts the value of a 1970 dollar at $0.18 today compared to $0.059 using the Alt-CPI (original CPI calculation) and $0.04 using gold. Source data - Bureau of Labor Statistics and ShadowStats.com.

But, no matter which way you slice it, it is safe to say that the official CPI estimate has underestimated the true rate of inflation and as we see from Figure 1 and from the Fudge Factor Chart in Figure 2 of our last report, this discrepancy is accelerating at an increasing rate. (At the end of this report we'll show you how the Dow Jones Industrial Average priced in gold has performed in the last decade.)

Why would the government mislead us? As long-time ProfitScore IQ readers know, we believe it's at least partly because statistics are just one tool that incumbent governments use to get re-elected. It would seem that the temptation to modify economic statistics to woo voters has been just too powerful for governments to resist.

Just look at the most powerful short-term cycle in markets - the four-year presidential cycle. For those of you not familiar with it, 93% of Dow Jones Industrial gains were earned in the 26 months leading up to each election versus just 7% in the 22 months after each election between 1902 and 2006. So by being invested 54% of the time, the hypothetical investor would have captured 93% of Dow gains using a simple presidential cycle trading system.

But whether or not you agree that official stats paint a biased picture, can we at least agree on the necessity of viewing the financial world as it really is, not as it should be or as someone would like us to see it? Certainly for the investor, that is essential. And no investor is more sensitive to the real rate of inflation than the bond investor.

So why focus on the bond investor? Simple, the fate of the western world now lies in its hands. Bond investors finance debt, and debt in the U.S. has reached gargantuan proportions. As Figure 3 shows, government debt projected to be nearly $13 trillion in 2009 is spiraling out of control. At $53 trillion (Q1-09) total credit market debt (debt at all levels of our economy) is more than four times greater than federal government debt (Gigure 4). Total debt has grown without a break since the 1981 recession, and has doubled in nominal terms since 2000 (see Figure 5).

Who finances a large chunk of the trillions in government debt? You got it, the bond investor. And as we have observed from this year's Treasury auctions, roughly one-half of the bidders have been indirect bidders comprised of foreign central banks. As the largest debtor nation in the world, we rely on the kindness of strangers to finance our debt - the total debt of the rest of the world is dwarfed by U.S. debt as we saw in Figure 3 of last month's report.

Figure 3 - Chart showing annual growth in government debt and the year-to-year growth rate. In 2009, the debt was growing at 29%, based on the estimate of the 2009 budget deficit. Since 1970, government debt has grown at an average annual rate of 8.89%. As this chart shows, since then it has not declined even for a year. Data - Whitehouse.gov.

Bloomberg estimated that the U.S. government will be selling as much as $3.25 trillion worth of Treasuries in 2009 (from 90-day to 30-year notes) to pay the bills for yields (interest rates) that, just last week, ranged from 0.17% at the short end to 4.44% for the 30-year Treasury.

Figure 4 - Historic chart showing total credit market debt to GDP through 2009. In the wake of the stock meltdown in 1933, the ratio hit 265%, but then dropped into the early 1940s. The last year that the total credit debt dropped relative to GDP was 1981. Since 2000, TCMD has grown 35% faster than the economy in a time of economic expansion (if you believe the official GDP growth numbers). Data Source - U.S. Federal Reserve and Gabelli Mathers Fund.

Figure 5 - The function of recessions is supposed to remove the excesses that have built up during the good times so as to reduce debt. But, as this chart shows, total credit market debt has continued to grow unabated since 1981, thanks in large part to the Federal Reserve's accommodative "cheap money" policies. As we see, debt expanded even more rapidly than average in 2008, as the credit crisis took hold, thanks to the Fed quantitative easing. Data - U.S. Federal Reserve.

This is where the inflation argument gets really interesting.

As of July 2009, the official annualized CPI from the Bureau of Labor Statistics was -2.1% showing deflation. This compares to annual inflation of +5.44%, according to the CPI-Alt from ShadowStats.com. A bond investor relying on the official CPI, buying a Treasury bond believes that it will shield him/her from the deemed real drop in prices with a guaranteed return of anywhere from 0.17 to 4.44%. However, if the CPI-Alt is a better reflection of reality, the bond investor is actually losing money, since the rate of return is below the actual inflation rate.

From a longer-term perspective, the second scenario has been the more accurate. The value of 10-year Treasuries lost 4.5% in nominal terms during the first half of 2009, which was the worst performance in 30 years according to Bloomberg (see article Treasuries Drop for First Time in Six Weeks below). If we use the CPI-Alt inflation rate of 5.44% it means investors generated a real annual loss of at least 9.94% (the rate of inflation according to the CPI-Alt was much higher at the beginning of the year)!

Figure 6 - Chart showing monthly changes in Treasury international capital flows (net foreign purchases of U.S. Treasuries) together with the amount required monthly to finance the budget deficit since 2005 (red line). This year's budget deficit estimated by the White House (http://www.whitehouse.gov/) equates to more than $140 billion per month. Also shown is the trend of foreign net Treasury capital flows (yellow line). Source - U.S. Treasury.

Figure 7 - Overview of foreign investments in the U.S. since 1980. Notice the big drop in 2009 indicating net selling of U.S. assets by foreigners. Source - St Louis Federal Reserve.

Life on a Debt Rocket

Is it any wonder foreigners are losing interest in financing our credit needs? Here is a brief summary of the problems we now face.

Problem 1 - Sheer size and growth rate of the debt
The total projected 2009 government debt ($12.9 trillion) works out to more than $42,400 for every man, woman and child, or $112,000 per household in this country. And, this debt has been growing at an average annual rate of nearly 9% since 2000. However, this does not include future unfunded Medicare and Social Security liabilities that taken together with total government debt total more than $50 trillion according to former U.S. Comptroller General, David M. Walker. Today's total credit market debt of $53 trillion (not including future liabilities), works out to nearly $175,000 per person or $460,000 per household (assuming 115 million U.S. households) and is approaching 4 times the size of our total annual economic output or GDP.

If we take David Walker's estimate of future unfunded Medicare, Social Security and other liabilities and add them to current total credit market debt, the total is more than $90 trillion, which works out to total present and future debt obligations of more than $780,000 per U.S. household! (As I write this I am hoping I made a mistake with the math, but I have triple-checked the government and total credit market debt figures.)

Granted our savings rate has been climbing, but it would take far more than total U.S. savings to finance our debt. According to data gathered up until March 31, 2009, the 8,246 financial institutions insured by the FDIC had total assets of $13.54 trillion. So even if we used every penny of the assets of all insured U.S. banks, we would still only have enough to finance federal government debt, but that is just one-quarter of all U.S. debt. We have been clearly living far above our income levels and debt levels tell us that this habit is growing. With foreign interest in our bonds dropping, who is going to finance our growing financial needs?

Problem 2 - Growing Cost of Financing
Over the last thirty years, debt has continued to grow in both booms and recessions, but so far it has been manageable enough to finance. Now, even at current low interest rates, it's getting more expensive due to its sheer size. This year's projected government debt of $12.9 trillion will cost us more than $452 billion per year at an interest rate of 3.5% (approximate yield on a 10-year Treasury). That is roughly equal to the entire cost of the total federal budget deficit just last year in 2008 ($455 billion).

Problem 3 - Interest Rate Risk
Whenever there is a debt, it is accompanied by an interest rate risk-the greater the debt, the greater the risk. Historically speaking, current interest rates are near 50-year lows. If rates rise, so will the cost of the debt. At an interest rate of 8%, the annual interest on government debt rises above $1 trillion. Is this a real threat? This is where the real inflation rate becomes crucial. When (not if) bond investors get tired of financing this debt for the current small rate of return, they will demand a higher return. If the real inflation rate is 5.44%, it means we will have to pay bond investors that, plus a reasonable return of at least two to three percent, which puts the interest on government debt at a minimum of 7.44%. Could it happen? Take another look at Figure 3 above. Government debt has increased at an average annual rate of 9% and at no time since 1970 has government debt declined. It did happen in Iceland a couple of years ago. The government was willing to pay 8% to investors to finance the government debt, but no one was interested. Within fifteen days, the rate jumped to 14% and the government had no choice but to pay it or face default.

The important takeaway for now is to realize how vulnerable we have become due to our high debt levels and just how quickly this habit has spiraled out of control.

As we will see next, history has not been kind to nations that have found themselves in a similar position in the past.

Currency Life Cycle

In last month's report we began with a discussion of Zimbabwe, the latest example of a fiat paper currency that fell prey to the evils of hyperinflation. The overriding question today is, "Could it happen again here in the U.S.?" When I say "again," it is not a typo. This has happened in our country before, and more than just once.

In his 2008 book entitled, Fiat Paper Money: The History and Evolution of Our Currency, bullion and currency specialist, Ralph Foster, discusses Zimbabwe and other national fiat currencies throughout history. And one important lesson stands out. Without exception, every fiat paper currency since the beginning of time has suffered a strikingly similar fate. As we mentioned last month, the U.S. dollar became a fiat paper currency backed by nothing more than the faith and good will of the government following the move by Richard Nixon to take the nation off the gold standard in 1971.

Fiat paper money is currency not backed by gold, silver or other semi-precious metal or tangible asset. Its first recorded use provides valuable insight into the challenges nations employing it have faced throughout history.

According to Foster, fiat currency for general use first appeared in recorded history in the 11^th century AD in Szechwan, China. Following a long period of peace and prosperity, the area around Szechwan endured a shortage of copper, which was used for coinage. Iron was tried, but it proved too heavy and impractical.   Paper had been used in money shops in the exchange of deposit receipts to transact business, so the next logical step was to use it as a currency. In 1024, it made its debut as a national currency for general use by the Sung Empire.

Armed with the best of intentions, bureaucrats for the Imperial Sung Treasury originally intended that the currency be redeemed for coin after three years. However, whenever there is potential for abuse, the temptation becomes unbearable and over time, the Sung Treasury kept printing an increasing number of notes and redeeming fewer at the allotted time. By 1077, only 29 percent of the issue was backed by coin.

But in spite of these abuses, the note called the chiao-tzu, held its value for seven decades. As time went on, the Imperial Sung Treasury gradually and quietly slipped into the practice of issuing series after series of notes with little regard for the regulatory controls. The days of 29 percent backing quietly slipped into oblivion as the state discovered how easy it was to pay its obligations in paper. (Does this sound familiar yet?)

By the first decade of the 12^th century, over 20 times as many notes were circulating as had been originally authorized in 1024 and prices were quickly rising. Then the Sung Empire was attacked and war began, further increasing the need for money by the rulers. Laws were enacted to contain inflation, but it was too late. In 1127, the leaders of the Sung Empire were broke, forced to cede the territory in dispute and flee south by which time the chiao-tzu had become worthless.

This set of events, with different casts, played out four more times over the next two centuries in China. And then, it happened countless times in other parts of the world over the next nine hundred years by just about every civilized nation in the world. Even though the characters and locations changed, the plot remained strikingly similar to that of a Shakespearian tragedy-it could be broken down into five all-too predictable acts, including the death of the play's central character, the currency.

Of Fiat Princes and Paupers (in that order) - A Shakespearian Tragedy

Act 1 - A form of currency, usually a metal, which had been in use, became impractical as the economy grew, causing bureaucrats to adopt a paper replacement due to its light weight, ease of use and versatility. Often, but not always, the new note was initially backed either by gold, silver or copper and would often have a redemption date.

Act 2 - As time progressed and prosperity grew, the temptation to create something from nothing was too great to resist and an increasing number of notes would be printed by those in charge of the treasury. This would not be immediately noticeable, which led to an increasing number of notes being printed to the benefit of those in charge. At this stage, the ruling classes often enjoyed new found prosperity, wealth and status. It was also at this stage of the fiat currency life cycle that Ponzi schemes like Tulip Mania (1637) in the Netherlands or the South Sea Company bubble (1720) took root. Without the availability of large amounts of ready and portable cash, such schemes and bubbles are nearly impossible.

Act 3 - Often a war, attack, military action or other crisis erupted that required huge sums of money from the ruling classes. Debt replaced greed as the primary motivator to print more money. Any checks and balances still in place to curtail money supply would be abandoned and the printing presses were kicked into high gear. Debt continued to mount and inflation rapidly accelerated.

Act 4 - The result was always the same - hyperinflation ensued after attempts to pay off unmanageable levels of debt failed and the currency plunged in value until it became worthless. Act 5 was the unfortunate and inevitable final step.

Act 5 - In the wake of financial collapse, which was often but not always the result of a failed expensive military campaign or war (which the subject country usually lost), economic collapse gripped the nation and economic chaos followed. Citizens stripped of their property struggled to feed themselves and their families. Barter became the primary form of currency. Often laws would be passed banning the use of paper currency again. But in a generation these lessons were forgotten laying the foundation for the next fiat currency cycle.

Foster's Fiat Paper Money is an essential read for anyone concerned about their future financial well-being. In the appendix, Foster lists the instances he found in which national notes became worthless, breaking the list into decade-long periods starting from the beginning of the 20^th Century.

In total, there are 431 examples (pages 216 and 217) in which a national note or currency became worthless between 1900 and 2009, which works out to an average of four fiat money collapses per year. And a number of nations have been repeat offenders.

Foster also discusses four interesting examples of fiat paper money in the U.S. since our nation's beginnings (not including the current dollar), that like every other case of every fiat currency in history, eventually became worthless and had to be taken out of circulation.

Resisting the Ostrich Urge

Granted, our debt appears to be spiraling out of control. It has only been made possible thanks to existence of a fiat paper currency that allows those in control of the Treasury to print as much money as they want when the need arises. But, burying your head in the sand won't make the problem go away.

History tells us that over time, regulatory controls diminish and out-of-control inflation is the unavoidable end result. I am still optimistic that we are not beyond the point of no return to become a Zimbabwe, at least not yet. But the window of opportunity is closing more quickly than most realize. As a friend of mine used to say, plan for the worst and hope for the best. This means taking some steps to protect your assets from potential inflation, which, once it has begun, could escalate to hyperinflation in relatively short order. I will discuss that in more detail at the end of this newsletter.

Figure 8 - Chart showing the parabolic move in the Zimbabwe Industrial Index in the dying days of the Zimbabwe dollar. The problem is that by the time you sold the stock and cashed the check, you had virtually nothing left, thanks to an inflation rate running in the billions of percent.

Real Estate Update - The Next Two Boots?

We have been hearing about the green shoots in the real estate market. Both new and existing home sales have improved, and although median prices haven't responded with much conviction yet, they appear to have stopped falling, at least for the time being. Builder sentiment is also on the mend, if you believe the most recent National Association of Home Builders Sentiment Report.

But according to the Case-Shiller Home Price Index, while existing home prices are falling more slowly than before, they were still falling at an annualized rate of 17% in May. And there are two more clouds on the real estate recovery horizon. The first is foreclosures as another 1.9 million were registered in the first half of 2009. And while existing home sales are gradually improving, the addition of new foreclosures means inventories will remain stubbornly high for the foreseeable future, further depressing prices.

The second cloud is commercial real estate. Based on recent news, the commercial property market may be as much as two years behind its residential counterpart, and this is very bad news for the beleaguered banks that hold the mortgages. Already reeling from residential defaults and soaring foreclosures, the banks are now taking it on the chin as commercial property values plummet and occupancy rates soar. This has led to a new round of bank defaults, which hit 77 for 2009 on August 14, with the failure of Colonial BancGroup, which is the largest failure of 2009 and the most costly since the failure of IndyMac Bancorp in 2008.

Some areas have been harder hit than others. Commercial property sales in Denver dropped 68% in the 12 months ending June 30, 2009, according to a report from LoopNet Inc. Property owners have been increasingly squeezed between falling demand amid the economic slowdown and tightening lending standards by banks desperately attempting to stem the hemorrhaging of red ink from their balance sheets.

Figure 9 - Chart showing delinquency rates at commercial banks for residential and commercial real estate ad credit cards.

According to one industry analyst, "The bottom line: defaults are exploding. It's going to be worse than the early 90s."

The delinquency rate on commercial property loans pooled together into investments, estimated at around $750 billion, hit nearly 3% in Q2-09. This is about triple from where it was at year-end 2008, according to real estate group Reis Inc. In all, there are about $3.5 trillion worth of commercial real estate loans held by banks, tied up in commercial mortgage-backed securities or held by other institutions. More than $2 trillion in commercial mortgages are expected to come due between now and 2013 (see article below Recession and Debt Drag on Commercial Real Estate).

REIT Rally Madness
What I find interesting is the how well the majority of Real Estate Investment Trusts (REITs) have performed since March. The First Trust S&P REIT Index ETF (FRI) is up more than 65%, the REIT Diversified Industrial (MG441) is up 69% since March 6, 2009, which is representative of how well they have performed since the most recent recovery began. Overall, REITs (both equity and mortgage) are up 68% since March 6, 2009, according to the VectorVest Composite REIT Sector Index. According to data from VectorVest.com, per share earnings for the VectorVest REIT Sector Index comprised of 133 equity REITs and 41 mortgage REITs came in at negative $1.08/share, according to the latest data, which is an improvement from the March 18, 2009 low of -$1.35, but a sizable per share loss nonetheless. More importantly, the earnings growth rate is negative 4%.

So are gains approaching 70% justified when REITs are still bleeding significant cash? I'll let you be the judge.

For the broad range of stocks, according to the latest earnings data from VectorVest.com, per share earnings for the more than 8000 U.S. stocks tracked by the VectorVest Composite Index have risen to an average of $0.17 from an all-time low of $0.13 six weeks ago, which hardly justifies the more than 50% gains we have seen in equity prices since March 2009. There is little doubt in our minds that stocks in general have clearly gotten ahead of themselves and REITs are way overvalued given the economic environment.

Finally, the chart by dshort.com (above) compares the most recent rally (blue) with the rally in 1930 (grey). We don't believe that the S&P500 is getting set to drop 83% as happened from 1930 to 1932 (let's face it there is too much stimulus money being pumped into the system for that to happen), but it does suggest that the correction we saw in the third week of August may be the beginning of more to come in the coming weeks.

Suggested Reading:

The Economy Is in Deep, Deep Trouble...
http://globalresearch.ca/index.php?context=va&aid=14759

Toxic Loans Topping 5% May Push 150 Banks to Point of No Return
http://www.bloomberg.com/apps/news?pid=20601109&sid=aTTT9jivRIWE

Recession and Debt Drag on Commercial Real Estate
http://news.yahoo.com/s/ap/20090812/ap_on_bi_ge/us_commercial_real_estate_2

Commercial Mortgage Failure at 20-Year High in U.S.: Report
http://www.reuters.com/article/ousiv/idUSTRE56J1A120090720

Commercial Real Estate Deals Off, Prices Up
http://www.bizjournals.com/denver/stories/2009/08/10/daily88.html?ana=from_rss

Underwater Mortgages May Reach 30% by Mid-2010, Zillow Says
http://www.bloomberg.com/apps/news?pid=20601110&sid=aL3gWFhKRt_w

Treasuries Fall for First Time in Six Weeks as Stocks Advance
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aVIVaL2qqOWY

HSBC Says 2010 European Bond Sales to Approach 1 Trillion Euros
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aEId3R3ePT9s

Fiat Paper Money: The History and Evolution of our Currency by Ralph Foster
http://home.pacbell.net/tfdf/

Money, Bank Credit, and Economic Cycles by Jesus Huerta de Soto
http://mises.org/store/Money-Bank-Credit-and-Economic-Cycles-P290.aspx

In New Phase of Crisis, Securities Sink Banks
http://finance.yahoo.com/news/In-New-Phase-of-Crisis-wallstreet-1020317667.html?x=0&.v=4

Portfolio Performance Analysis

Risk & Reward
Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

The S&P 500 continues to soar higher, adding 7.56% in July and another 3.9% MTD August. From the low on March 5, 2009, the S&P 500 has now rallied 50.3%. Most market analysts expected some kind of bounce from oversold conditions, but few, including your humbled analyst, expected the most powerful rally since the 1930s. During the Great Depression era, the Dow Jones also experienced significant rallies of 122.48%, 100.67%, and 52.16%. Each rally lasting months and each ending in tears.

Will this rally be different? Will the history books list March 5, 2009 as the bottom of the market for the Great Recession? Time will soon tell. I think this rally will likely continue higher, but will likely end in tears after it has sucked every last dollar back into the market.

July was similar to June for our portfolios, with our fixed income investments outperforming our allocations in domestic and international equities. Volatility in government bonds still remains extremely high and equities continue to rise for consecutive days and weeks in a row. Equity markets appear to be gravitating from mean reverting to trend following market behavior. Regime changes such as this keep me up at night anticipating portfolio allocation adjustments.

Below is a performance summary for the indices we track and benchmark our portfolios to:

	Cumulative Return			Average Annual Return
Indexes	Mth.	YTD	1 yr	3 yr	5 yr	10 yr

CSFB L/S *	1.46	9.79	-8.33	2.89	6.69	7.38
CSFB Multi-St. *	2.98	15.64	-7.53	1.24	4.70	7.00
Barclay F-of-F *	1.58	5.91	-13.10	-1.85	2.02	5.09
S&P 500	7.56	10.97	-19.96	-6.16	-0.14	-1.19
Barclay HY	6.09	38.37	4.92	3.79	5.29	5.28
Barclay Agg.	1.61	3.55	7.85	6.52	5.14	6.19

* Note:	Estimated monthly performance

Index Advantage:

Because we will short riskier or low probability trading opportunities, it is difficult for a long/short portfolio to keep pace with equity markets that move higher for consecutive days and weeks in a row.   For the month, this dynamically changing equity allocation managed to capture 15% of the S&P 500 7.56% gain, but keeping pace with our long/short equity benchmarks.

For the month, this pillar gained 1.13%.

Strategic Balance:

Total investment exposure for this nimble allocation remains historically low as our traders patiently wait for higher probability trades to materialize. Because overall investment exposure remains low, our risk-adjusted returns for this allocation are in the stratosphere. On a relative return basis, it has outperformed equity investments with much lower risk dynamics than traditional fixed income investments.

For the month, this pillar earned .62%.

Dynamic Income:

We had so many challenges with our fixed income allocation in our first year of trading, that I now feel like a proud father watching his young son score the winning touchdown. Fixed income clearly continues to lead all allocation in this powerful bull market rally. I am sure there are more bumps in our road ahead, but I am confident in the long-term performance of this very important diversifying allocation.

For the month, this pillar earned 3.25%.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October). For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements. It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis. To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum.

The First Day of School and the Oregon Coast

On Thursday, my daughters, Annabelle and Sarah, started school. Annabelle is in the 2^nd grade and Sarah is now in the 5^th. Can you remember what a big day that was for you? They were so excited to start school that they got up before their alarms went off. Don't get me wrong, they weren't excited about their school work, but rather to see all of their friends. I am sure this will change when they become teenagers.

Before they left for school that morning, I informed them that this was the last day of their life that they would get to experience the first day of 2^nd and 5^th grade. I try to communicate to them how short life really is, but when you live life one day at a time it doesn't have much meaning until you get older. I wish I could have their innocent thoughts for a week. What a joy it is to watch them grow up.

I somehow talked my wife into letting me pull our kids out of school for a week to go to the Oregon Coast. My college roommate and dear friend, Geoff Kittell, moved out west with me to Portland in 1993. He married the girl of his dreams and still lives there with his young and growing family. He invited us to his beach house, so the girls and I are hitting the road for a 9 hour road trip to the most beautiful coast in America. If you have never been to the Oregon Coast, you need to add it to your bucket list!

Does anyone know of a good answer to the two most asked questions by children on long road trips?

Dad, are we there yet?
Dad, how much further is it?

If you have a good answer, please send me your comments.

By the time you receive next month's ProfitScore IQ, summer will be over. You only have a few more precious weeks of summer left and life is short. Please take some time to enjoy your friends and family and take pleasure in the precious few days of summer we have left.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

I Wish I Knew What Was Going To Be On The Other Side

2009-07-27T14:22:00Z

www.profitscore.com

An Update on Our Performance
The Great Inflation/Deflation Debate
Is Inflation Causing a Rippling Effect?
Getting Real on Inflation...
Paper Money Siren Song
Fiat Money Time-bomb?
Portfolio Performance Analysis
The Idaho Back Country

Over the next 20 years, you are going to see significant changes in how we function as a nation. With our back up against the wall, it won't be business as usual for the foreseeable future. I am not sure how it will end, but I am fairly certain that the reset button will be hit. I just wish I knew what was going to be on the other side.

Why am I so certain? Because we simply owe more money than we can afford to pay back, and not paying back your debt or paying back the amount you owe in dollars that have been devalued tends to make people mad at you.

Our current publicized deficit is around $11.4 trillion. The true deficit, or the deficit that accounts for all the United States' financial obligations, is around $60 trillion. These other financial obligations consist of off-balance sheet liabilities-Social Security, Medicare, TARP money and a few other trillion dollar debts. So, in reality the publicized $11.4 trillion national debt is not even close to the real amount of money owed by you and me.

How can this be? The Fair Accounting Standards Board (FASB) considers Social Security and Medicare off-balance sheet obligations because the government can change its mind on how they are paid. Your government has the flexibility to change the retirement age, lower payment amounts, reduce your medical coverage, and numerous other activities to reduce its financial debts. Because of this flexibility, the FASB considers these obligations off-balance sheet items. How many politicians do you know that would vote for a bill to reduce these obligations? I don't know any either.

Historically, there is an incredibly accurate predictor for resetting societal norms. The ancients called this predictive cycle a saeculum, which is the length of a long human life-80 to 100 year time span. According to the authors of the book The Fourth Turning and the founders of the respected think tank Life Course Associates, this repetitive cycle has happened consistently, dating as far back as Roman times.

If you work the math, you'll discover that the last three cycles in the United States have been the Great Depression/World War II, the Civil War and the Revolutionary War. Each event is separated by the length of a long human life. War is a normal part of the cycle but it doesn't always happen in the resetting process. If you are curious about this methodology, I strongly encourage you to get the book and give it a read. The book was published in 1997 and amazingly the authors predicted current events. Thanks to my good friend Joe Barrato for sending me a copy.

Most economists are currently predicting that the economy is in danger of either soaring inflation or spiraling deflation. Since most economists are terribly wrong with their forecasts, I am always looking to take the other side of their trade. In this case, I think they might both be correct and that our economy is at risk of Stagflation. This unique situation would be caused by our enormous national deficit, falling dollar, increasing commodity prices (which are generally tied to the U.S. dollar), and high unemployment.

In this ProfitScore IQ, we are going to discuss the hard facts of soaring inflation. If I had a choice, I would prefer hyper inflation to spiraling deflation. And now, to add insult to injury, we may be faced with suffering through both at the same time.

"The United States debt, foreign and domestic, was the price of liberty."
Author - Alexander Hamilton

An Update on Our Performance

June was case and point for the importance of portfolio diversification. Our fixed income models made significant profits, while our equity models were hammered across the board. It was a very odd month for equity trading because our trading accuracy was north of 60%, but our losses were larger than our gains-causing larger than normal losses for our 100% long/short equity allocation. Given our consistently positive performance lately, I guess I should be thankful for a loss so our readers wouldn't think we were trying to emulate Bernie Madoff.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	June
Name	Months	2009	2009
Income Builder (IB)	0.45%	4.09%	2.42%
The Guardian (GRD)	7.16%	7.54%	-0.72%
Harmony Plus (HMY)	15.91%	10.33%	-2.71%
The Expedition (EXP)	21.49%	11.92%	-4.64%
S&P 500 (SP500)	-26.21%	3.16%	0.20%
Important Performance Disclosure

Complete our Private Client Group request form by clicking here http://profitscore.com/clientgroup.aspx and submitting your contact information. (This is the most preferred method.)
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The Great Inflation/Deflation Debate
You can't afford to get this one wrong!

Anyone who has tuned into the financial news recently has been assaulted with contradictory reports. First, that deflation is the biggest risk, then later that inflation is what we really need to worry about. Why is this so important?

Simple, in a deflationary environment, cash is king. Asset values such as stocks, commodities (including gold and silver), as well as the cost of food, fuel and other everyday necessities fall. Deflation is the result of a drop in demand for goods as the economy slows, unemployment rises and people have less and less money to spend. Money supply, the money in circulation in our financial system, declines.

Stagflation occurs when costs climb but salaries and incomes either remain stagnant or fall. The last time our nation experienced Stagflation was during the 1970s. Squeezed between the cost of necessities and a fall in available cash, consumers spend less. Strikes increase as discontented workers rebel against falling real incomes. Price controls by government exacerbate the situation, causing long lines for food, fuel and other necessities, as the cost to purchase these goods falls below the cost to produce them.

Inflation occurs when an increasing number of dollars chase a limited supply of assets. Consumers rush to trade cash for goods as the price of these goods climbs. Stocks and commodities rise initially as investors increasingly seek refuge as the value of their dollar falls. But this trend is usually short-lived. Rising inflation forces responsible central banks to raise interest rates in an attempt to control the inflation monster-eventually leading to deflation.

Hyperinflation occurs when inflation is left unchecked because central banks are reluctant or unable to raise interest rates or reduce money supply-usually the result of populist government intervention. Instead the government tries to fix the problem by doing more of what got it into trouble in the first place. It prints more and more money until the inflation rate skyrockets. Hyperinflation has occurred periodically throughout history where a fiat paper currency has granted political leaders the freedom to print money as the mood arises.

This next news story is a textbook example of hyperinflation at its destructive worst.

Zimbabwe Abandons Its Currency
BBC News, January 29, 2009
BBC southern Africa correspondent Peter Biles says the Zimbabwean dollar has become a laughing stock. A Z$100 trillion note [equivalent to $30USD] was recently introduced. Our people are now using multiple currencies alongside the Zimbabwean dollar according to Acting Finance Minister. The country is in the grip of world-record hyperinflation which has left the Zimbabwean dollar virtually worthless - 231,000,000% in July 2008, the most recent figure released. Teachers, doctors and civil servants have gone on strike complaining that their salaries - which equal trillions of Zimbabwean dollars - are not even enough to catch the bus to work each day...

Is Inflation Causing a Rippling Effect?

Before the Zimbabwe dollar finally became worthless and had to be taken out of circulation in early 2009, inflation soared to nearly 500-billion percent, according to the International Monetary Fund. It was triggered by a scarcity of foreign currency that caused shortages in just about everything from food to fuel. In April 2009, the Zimbabwe dollar was officially declared dead and completely worthless. Zimbabweans were forced to transact in gold.

Could this situation occur here? The possibility is remote, according to the guardians of our financial system-experts such as Federal Reserve Chairman, Ben Bernanke, a host of Federal Reserve Board members, Treasury Secretary, Tim Geithner, as well as a battalion of economists, bankers and professional money managers. In fact, they have warned us that deflation is the greater threat.

But not everyone agrees.

Here are samples of the contradictory media reports to which we've been exposed to lately.

Fed's Yellen Says Rates May Stay Near Zero for Years
Bloomberg News, July 1, 2009
Federal Reserve Bank of San Francisco President Janet Yellen said the prospect that policy makers will leave the benchmark U.S. interest rate near zero for the next several years is "not outside the realm of possibility. We have a very serious recession, we have a 9.4 percent unemployment rate," and inflation possibly falling further below the Fed's preferred level, she told reporters [June 30] after a speech in San Francisco.

As for inflation, the "predominant risk" is that it will "be too low, not too high, over the next several years," Yellen said. Inflation excluding food and energy may fall to about 1 percent over the next year and remain below 2 percent, with an unlikely possibility of turning into deflation if the economy fails to recover soon, she said.

U.S. Inflation to Approach Zimbabwe Level, Faber Says
Bloomberg News, May 27, 2009
The U.S. economy will enter "hyperinflation" approaching the levels in Zimbabwe because the Federal Reserve will be reluctant to raise interest rates, investor Marc Faber said. Prices may increase at rates "close to" Zimbabwe's gains, Faber said in an interview with Bloomberg Television in Hong Kong. Zimbabwe's inflation rate reached 231 million percent in July, the last annual rate published by the statistics office.

"I am 100 percent sure that the U.S. will go into hyperinflation," Faber said. "The problem with government debt growing so much is that when the time will come and the Fed should increase interest rates, they will be very reluctant to do so and so inflation will start to accelerate.

Federal Reserve Bank of Philadelphia President Charles Plosser said on May 21, inflation may rise to 2.5 percent in 2011. That exceeds the central bank officials' long-run preferred range of 1.7 percent to 2 percent and contrasts with the concerns of some officials and economists that the economic slump may provoke a broad decline in prices.

"There are some concerns of a risk from inflation from all the liquidity injected into the banking system but it's not an immediate threat right now given all the excess capacity in the U.S. economy," said David Cohen, head of Asian economic forecasting at Action Economics in Singapore. "I have a little more confidence that the Fed has an exit strategy for draining all the liquidity at the appropriate time."

Rising National Debt Raises Prospects of Eventual Inflation
USA Today, June 28, 2009
Inflation is as dead as the Wicked Witch of the West in a waterfall. The consumer price index has actually fallen 1.3% in the past 12 months. So why is everyone so worried about soaring prices?

In a word: debt. The government owes the world $11.4 trillion - $37,000 for every person in the U.S. In the next fiscal year, the government will add $1.8 trillion to the deficit.

The government could simply print more dollars to pay off our debts with cheap currency - a tempting but inflationary solution. Politicians wouldn't have to ask citizens to pay for the government's services, and citizens wouldn't have to think about the actual cost of what they demand - until, of course, the currency collapses, interest rates soar and the economy craters.

If you're worried about inflation rearing its ugly head soon, relax. Inflation just isn't going to happen in this economy. "A lot of the worries about immediate inflation are examples of financial illiteracy," says David Wyss, chief economist for Standard & Poor's. "You won't get inflation until the economy gets back, and that's at least five years out.""

So who should we believe?

Getting Real on Inflation...

As the last article points out, the consumer price index has been dropping. In May, the official consumer price index (CPI) registered its worst decline since 1950. But, just how accurate is this modern-day CPI as an inflation meter? As Figure 1 shows, CPI has been substantially altered over the past 25 years.

Here is a comparison of the old and new consumer price indexes - the first (in red) is the alternate CPI calculated pre-1982, before it was first changed during the Reagan administration. The most recent alternate CPI showed an inflation rate of 6.15% in May.

This statistic is in sharp contrast to the official CPI (blue line in Figure 1) published by the Bureau of Labor Statistics (BLS), which showed a 1.28% decline in May. That is a difference of 7.43 percentage points! Is it any wonder that the public is confused?

Figure 1 - Official CPI vs. the SGS alternate CPI (calculated pre-1982) before the modifications by various government statisticians, provided by John Williams of http://www.shadowstats.com/ . In May, the official CPI showed a 1.28% drop vs. May 2008. This compares to a SGS CPI of 6.15%, as it was calculated using the statistical methods pre-1982. SGS Link http://www.shadowstats.com/charts_republish#cpi

In the May report the BLS official CPI number was 213.86. The alternate CPI was 636.48. Take the official CPI 213.86 and add 197.62% and you get the alternate of 636.48-nearly triple the official CPI. As the chart also shows, the rate at which the two estimates are diverging is rapidly increasing as evidenced by the parabolic shape of the curve. It shows that government statisticians are increasingly "fudging" the CPI number to make inflation look more benign than it really is.

Figure 2 below provides another perspective on the difference between the two CPIs and shows how the two estimates of CPI have diverged since the calculation was first changed in 1982. The scale at the left side shows the percentage difference between the official nominal CPI and the traditional calculation - a figure we'll call the CPI "fudge" factor.

Here is a point to ponder. Other than the price of a home and the cost of gas since July 2008 (which was a short-term spike), how much has the everyday cost of living dropped in the past year? Or, does an increase of 6% over the past year seem more realistic?

Paper Money Siren Song

The USA Today article above brings up an interesting point. With U.S. government debt levels climbing at such an alarming rate, wouldn't the government be tempted to simply print its way out of the problem? And just how big is this bill? Perhaps more importantly, just how fast is it growing?

According to Williams of ShadowStats.com, U.S. government debt is at least three times greater than government debt in the rest of the world. As of December 2007, total U.S. government debt and obligations totaled more than $60 trillion and has grown significantly since then (Figure 3).

Figure 2 - Chart showing how much greater real CPI is than reported CPI. In May the Bureau of Labor Statistics reported an inflation rate of 213.86, which was 1.28% lower than the previous May. Real CPI, as calculated before the changes after 1982, was 636.48 nearly 3 times the reported CPI-plus 200% "fudge" factor.

Figure 3 - Chart comparing U.S. government obligations and GDP with the rest of the world. The U.S. government had total obligations (debt) amounting to more than three times that of government in the rest of the world. Source - http://www.shadowstats.com/

If the government is printing dollars to help ease the debt problem, wouldn't this show up in the Fed's official money supply figures? What is the Federal Reserve's money supply data telling us? (For descriptions of the different money supply statistics published by the Federal Reserve, please see Money Supply Definitions at the end of the article.)

Figure 4 - Chart showing M1, M2 and M3 money supply based on data from the Federal Reserve. Data for M3, after the Federal Reserve stopped publishing it in 2006, is provided by ShadowStats.com http://www.shadowstats.com/charts_republish#m3

M1 (blue line in Figure 4), which its currency held outside of bank and government vaults and includes travelers checks and other checkable deposits, rose more than 15% over the past year. M2, which is a larger measure of money supply and includes M1 plus savings deposits and shares in retail money market mutual funds, grew at a slow rate of just under 10% per year.

However, the growth rate of M3, which is a broader money supply measure and includes M2 plus large-denomination deposits, repurchase agreements, Eurodollar deposits, as well as institutional money market mutual funds, fell from above a growth rate of 16% in 2008 to around 7% in 2009.

There is no clear evidence of government printing presses working overtime so far.

However, one money supply metric - Adjusted Monetary Base (AMB) - has shown rapid growth in the last year. Defined as the sum of currency in circulation (outside Federal Reserve Banks and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirements on the quantity of base money held by depositories), the annual AMB growth rate skyrocketed to more than 100% in January 2009, according to Federal Reserve data (see green line in Figure 5). Between June 2008 and June 2009, the AMB soared from $862 billion to $1.7 trillion.

However by definition, AMB does not include deposits in Federal Reserve Banks or the U.S. Treasury or deposits of financial institutions at Federal Reserve Banks, so it does not include the massive increase in Federal Reserve assets from approximately $800 billion last year to nearly $2 trillion this year. Which money supply measure includes those figures?

Figure 5 - Chart from the St Louis Federal Reserve showing changes in the adjusted monetary base. Why is this important? When Ben Bernanke talks about dropping money from helicopters to ease deflation risk, this is where it shows up. (For more money supply definitions see http://research.stlouisfed.org/publications/mt/notes.pdf )

If the government did start printing money in ever larger amounts to pay off its debts, where would this show up in the statistics? And if this data were available, could it be minimized and therefore misleading due to the same sort of statistical manipulation that occurs with the CPI and other government-produced statistics? How can you protect yourself from the inflation wave that many believe is approaching?

Fiat Money Time-bomb?

Next month, we continue exploring the inflation/deflation question as we delve into the role fiat paper money has played. Fiat paper money is a currency that is not backed by a non-renewable precious commodity, such as gold, silver or platinum. Since 1971, when Richard Nixon took the U.S. off the gold standard, the U.S. dollar has met this definition-it is backed by nothing more than the faith and trust in the government to increase money supply in a responsible manner. Is this a realistic expectation?

Unfortunately, this duty has not stopped both Republican and Democratic administrations from spending beyond the ability of the nation to pay its bills. The result is growing budget deficits, a massive debt and an increasing reliance on foreigners to act as our nation's lenders of last resort.

In his last year in power, Bush was responsible for a budget deficit north of $455 billion. But that is nothing compared to what his predecessor accomplished in his first 100 days of his term. So far the projected budget deficit for fiscal 2009 tops $1.85 trillion or almost four times the 2008 deficit.

As a result, the U.S. has accumulated Federal government debt in excess of $11.4 trillion, which amounts to more than $37,300 for every man, woman and child in the country. This debt is projected to grow to more than $23 trillion by 2019. To keep paying the bills this year, the U.S. government will have to sell a total of $3.25 trillion of debt by September 30. Just the interest alone on the $11.4 trillion in debt at 3.5% (current interest rate on 10-year Treasury bond) amounts to an addition $400 billion per year!

But what is more troubling is the rate at which the federal government and Federal Reserve is spending money to address the current credit crisis. Thus far, more than $12.8 trillion (and according to one estimate, more than $14 trillion) has been committed by these two parties in the past two years.

As investor Jim Rogers commented in June, "This policy has never worked. The Americans tried it in the 90s. The policies which have worked let people who make mistakes collapse, let people who are competent take over the assets from the incompetent and start over. Now what's happening is the government is taking the assets from the competent, giving the assets to the incompetent and saying now you compete with the competent. This is not going to work, it's madness."

Is he right? Either way, can we ever hope to repay this huge bill? What happens if we can't? Could the government simply print its way out of this mess? No matter what happens, there are serious economic and financial implications to consider.

Please stay tuned for the answers in our next ProfitScore IQ.

SUGGESTED READING

Hyperinflation in three parts with Ron Paul, Peter Schiff, Jim Rogers, Tom Woods, Marc Faber that is definitely worth watching.
1. http://www.youtube.com/watch?v=Yd0b5XIhCkM
2. http://www.youtube.com/watch?v=1O7jRfCqwSc
3. http://www.youtube.com/watch?v=vvc2GDgkAkQ

Economist Dr. Chris Martenson explains the games government statisticians play http://www.chrismartenson.com/crashcourse/chapter-16-fuzzy-numbers

McCulley Says a New Stimulus Plan Must Show Restraint
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aRhT2ANMiBlw

U.S. Debt Clock
http://www.usdebtclock.org/

Fiat Paper Currency: The History and Evolution of Our Money by Ralph Foster
http://home.pacbell.net/tfdf/

Portfolio Performance Analysis

Risk & Reward

Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

Is this market a replay of 2003? The last 12 days have bears screaming, "Uncle!" The Nasdaq 100 index has now closed higher 12 days in a row. In a quick glance through my data, I could only find a handful of dates that experienced this kind of upward bias. Markets are certainly overextended, but as they have shown many times before, they can remain overextended longer than most trading accounts can withstand to bet against them. Right now the market is doing a good job of inflicting pain to those with short positions.

Something is up with government bonds. While equity volatility continues to decline as prices increase, volatility in government bonds has been extraordinary over the past 12 days. I have always felt that bond traders were better economists or forecasters of the economy than equity traders, so anytime I see something strange, it makes me pay close attention. For the first half of the year, the government lost the battle against interest rates, as traders in these liquid instruments push them lower forcing interest rates higher.

So far in July, rates continue to increase. However, over the past 10 days, trading has been excessively volatile. It once again appears that the Fed may be trying to inject demand back into the government bond equation as they attempt to manipulate the long end of the yield curve. At this point, I am not sure what this all means, but I can almost guarantee that this volatility will soon push back over into the equity markets.

Below is a performance summary for the indices we track and benchmark our portfolios to:

	Cumulative Return			Average Annual Return
Indexes	Mth.	YTD	1 yr	3 yr	5 yr	10 yr

CSFB L/S *	-0.04	8.21	-12.75	2.38	6.08	7.39
CSFB Multi-St. *	1.62	12.29	-12.42	0.31	4.02	6.79
Barclay F-of-F *	0.28	4.35	-16.68	-2.39	1.63	5.03
S&P 500	0.20	3.16	-26.21	-8.22	-2.24	-2.22
Barclay HY	2.86	30.43	-2.41	2.09	4.34	4.70
Barclay Agg.	0.57	1.91	6.06	6.43	5.02	5.98

* Note:	Estimated monthly performance

Index Advantage:

The S&P 500 index was mostly flat in June gaining 20 basis points for the month, while our long/short allocation incurred larger than normal losses. Our trading accuracy has dropped off somewhat over the last 6 weeks and our average trade loss has also increased. In summary, we appear to be at the wrong place at the wrong time, causing us to incur larger than normal losses. And when we were right, we received only small rewards.

For the month, this pillar gained -6.55%.

Strategic Balance:

Our seven-month winning streak for our most consistent allocation incurred a small loss for the month. Total investment exposure for the month was very low, so our losses happened over the course of a few days. So far our exposure for the month of July has been lower than any time over the past 12 months. These traders only take high probability trades, and thus far these trades haven't materialized.

For the month, this pillar earned -1.35%.

Dynamic Income:

Our fixed income traders have clearly been the shining star among our various allocations for the last four months. The contrast between 2009 and 2008 has been 180 degrees, showing the importance of trading different asset classes to diversify your return stream. May's performance took us positive for YTD 2009 and June's performance takes us positive for the last 12 months. As mentioned above, the Fed appears to be applying pressure to the long end of the yield curve, so it is making our job more difficult to trade government bonds. I am closely watching this important allocation and will adjust allocations accordingly.

For the month, this pillar earned 2.67%.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

Complete our Private Client Group request form by clicking here and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

Are You In The Top 5% Or Do You Invest Like Everyone Else?

2009-06-19T15:12:00Z

www.profitscore.com

An Update on Our Performance
A Perfect Timing Model
The U.S. Dollar vs. the Printing Press
Obama's War on Wealth Goes Global
Assessing the Impact
The Corporate Conundrum
Putting Peter Out of Business to Pay Paul?
Manure... A True Story
Portfolio Performance Analysis
Jack Leaves for Birdie School

Is this a new bull market rally? The S&P 500 index recently crossed over its 200 day moving average and has turned positive the for year. The bad news today seems to be getting less bad than it has been over the past 12 months. Optimism and hope about a recovery are flooding the mass media. Are your feelings of "the worst is behind us" misguided? I believe they are.

I am going to point out some hard facts and ask you some painful questions to encourage outside-the-box thinking. If I strike a nerve with you and motivate you to change your investment strategy, then I will consider this ProfitScore IQ to be one of my best.

First, let me point out some of the hard facts:

Fact #1: If you lost money in your account in 2008, it is not the market's fault because there are ways to make money regardless of the market's direction. Blaming the market is what most people do, but successful investors find ways to navigate the storm.
Fact #2: If the person you hired to manage your money lost money in 2008, it is not your manager's fault because you made the decision to hire the manager.

As the Chief Financial Officer (CFO) of your investment assets, how are you doing at your job? I evaluate managers every week at ProfitScore. If you sent me your monthly performance track record for the past 36 months, would I hire you as a manager? If I or someone else wouldn't hire you to manage our money, why have you hired yourself?

Based on every fundamental and longer term technical indicator I know of, there is at least a 50/50 chance that this market will soon drop like a safe. To help bring clarity to this point, let me incorporate the 50/50 odds of this happening into a more meaningful question.

If there was a 50/50 chance that you would get killed as you drove to work over the next two years, would you change the way you got to work?

If your answer is yes, have you changed the way your money is being managed or would you fall into the definition of insanity - doing the same thing over and over and expecting different results? The majority of investors lost significant sums of money during this bear market and they have changed little or nothing about how their money is being managed today. Why?

Not looking at your statement and hoping that everything will get better is not a sound financial decision. Is that how you do your job or how you run your company?    Don't fall in love with any company, industry, or sector and don't have a strong opinion about the market. Your job is to grow your assets every year-period! Not achieving this goal should have you second-guessing what you are doing and adjusting your investment strategy accordingly.

As the CFO of your net worth, I challenge you to think outside the box and not follow the crowd. There are ways to navigate the storm and if you don't have a proven track record of doing this yourself, then I suggest that you hire a manager who has proven that they can.

Remember, 5% of the people in America control 95% of the wealth. In other words, 95 out of every 100 people follow the crowd and generally make poor financial decisions. My attempt with this passionate introduction is to get you to think like the 5% of people who grew the value of their investment assets in 2008.

"If you think nobody cares, try missing a couple of payments."
Author - Larry the Cable Guy

An Update on Our Performance

May was another solid month for all of our portfolios, showing green across the board.   Our fixed income traders produced positive gains for the second month in a row pushing our Income Builder portfolio positive for the year. For the month, we made profits in all asset categories we trade (major U.S. indices, International indices, U.S. equity sectors, gold, energy, high yield bonds, government bonds, and the U.S. dollar). Our trading accuracy remains positively skewed for both long and short trades.

Below are recent performance returns on the four portfolios we currently offer:

	Past 12	YTD	MTD May
Name	Months	2009	2009
Income Builder (IB)	-1.93%	1.62%	2.92%
The Guardian (GRD)	6.24%	8.32%	3.51%
Harmony Plus (HMY)	16.06%	13.40%	4.00%
The Expedition (EXP)	25.30%	19.85%	4.78%
S&P 500 (SP500)	-32.57%	2.96%	5.59%
Important Performance Disclosure

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.

A Perfect Timing Model

I was speaking with a friend of mine the other day and they were inquiring about our performance returns in 2009. They asked me how our most aggressive program was doing for 2009 and I replied about 20%. He stated, "You must be very aggressive in your management in order to produce those kinds of returns." Since my answer was the exact opposite of what he expected, I built the chart below to explain.

Our investment exposure is reduced when volatility is high. Because of recent high levels of volatility, our overall investment exposure has averaged 25% or less for the past 8 months. So how do we generate high returns while investing such small percentages? The answer is trading accuracy and increased opportunity.

Compared to a traditional buy and hold investor who is held hostage by the relative direction of the market, we have roughly twice the opportunity to produce profits. Our profits are determined by our trading accuracy and capital allocation, so regardless of whether the market is up or down, everyday is an opportunity to make money.

This graph represents an equity curve produced by making money every single day in the S&P 500 from 1/1/2009 thru 5/29/2009. This was done by taking the absolute percentage change in the index and compounding the returns for five months. If the index was up 1% or down 3%, I assumed that I made the correct timing decision of being long or short and compounded the theoretical profits that were possible during this time period. Remember, I said possible not probable.

During that five month period, buying and holding the S&P 500 index would have made you a measly 2.96% profit while perfectly timing the S&P 500 index would have produced staggering gains of 532.79%.

Creating the graph was a double-edged sword. It really helped me explain to my friend how it was possible to generate 20% returns and only be exposed to the market 25% or less. On the downside, it made me realize just how poorly we have performed compared to the opportunities to make profits in the first five months of 2009. If anyone has created a perfect timing model that makes money everyday, please call me because you are hired!

The U.S. Dollar vs. the Printing Press

Over the years, you have probably read some very compelling arguments about the good and the bad of eliminating the gold standard from the U.S. dollar. There are some very smart people who present solid arguments for both sides. If the dollar was tied to the gold standard, then 2008 probably would not have occurred. However, being tied to the gold standard tends to limit how fast an economy can grow.

The problem with not having the dollar tied to some kind of discipline or standard is that it allows savvy politicians to indirectly control the printing press. Having the dollar tied to something that can't be manipulated by politicians would be healthy for any economy. One look at our budget deficit clearly removes all doubt at how terrible our politicians are at being prudent with our very hard-earned tax dollars. A friend of mine sent me the best graphical presentation I have ever seen displaying the effects of not having the U.S. dollar tied to the gold standard.

This log scale graph of the purchasing power of the U.S. dollar begins with an index value of 100 at the passage of the Mint Act of 1792. The solid lines present periods when the dollar was convertible into a specific quantity of gold, and the fluctuations represent changes in the purchasing power of gold. The dotted line presents periods when the dollar was not pegged to gold, during and after the War of 1812, the Civil War, World War I, and World War II. There was limited convertibility from 1945 to 1971, and the dollar lost purchasing power during the period. The last link between the U.S. currency and gold was cut in 1971 and the loss of purchasing power accelerated. By 2004, the dollar had lost more than 92% of its original value. This graph and its content was produced by the American Institute of Economic Research http://www.aier.org/.

The chart unfortunately ended in 2004. I contacted the source and they are looking for an updated version. I will include it in next month's letter if they do indeed send it to me. The dollar has dropped like a stone since this chart was produced, so it will be much worse than above.

Considering the $20 trillion deficits we are scheduled to owe by 2020, is it possible that the value of the U.S. dollar will be worth less than the paper it is printed on?

Obama's War on Wealth Goes Global

But just how wise is it?

"Why does a slight tax increase cost you $200 and a substantial tax cut save you thirty cents?"

Author - Peg Bracken

In our last ProfitScore IQ, we discussed the negative impact rising taxes have had on European economies. We also looked at the latest Forbes Tax Misery Index results, where the U.S. is on the scale and what we can look forward to in light of the president's plan for increasing tax revenues.

Not long after President Obama reached his first 100-day milestone, he announced another sweeping tax initiative, this one aimed squarely at multinational corporations and the wealthy, increasing tax revenues by 40% by 2013. It was the second phase of his plan to raise money to pay for his spending initiatives.

Here is an excerpt from the Department of Treasury (May 4, 2009) statement entitled, "Leveling the Playing Field."

Today, President Obama and Secretary Geithner are unveiling two components of the Administration's plan to reform our international tax laws and improve their enforcement. First, they are calling for reforms to ensure that our tax code does not stack the deck against job creation here on our shores. Second, they seek to reduce the amount of taxes lost to tax havens - either through unintended loopholes that allow companies to legally avoid paying billions in taxes, or through the illegal use of hidden accounts by well-off individuals.

A major part of this plan involves changing the deferral rules that allow U.S. companies to "ship jobs overseas" according to the administration. Currently U.S. companies are allowed to defer the taxes they pay on overseas income as long as the money remains invested in overseas operations. This will end as the Obama plan would eliminate deferral provisions and other "loopholes" for offshore subsidiaries.

Is this approach realistic or even practical? Here is how the new Administration's proposals will impact multinational corporations, according to PACE coalition (Promote America's Competitive Edge) Coalition in a May 4, 2009 statement.

The current tax system permits for a temporary tax deferral until those earnings have been paid to the parent corporation. U.S. companies are still subject to taxes in the countries in which they operate. Since 95% of the world's consumers live outside the U.S., overseas operations are essential. All Organization for Economic Cooperation and Development (OECD) nations that tax worldwide earnings, permit some sort of deferral. "Leaving aside the questionable wisdom of raising taxes in the midst of a deep recession, this proposal is a job-killer for American workers," according to John Engler, President of the National Association of Manufacturers. "U.S. corporate rates are already higher than most of the rest of the world. Deferral is essential to the competitive operation of U.S.-owned companies in foreign markets."

American multinational companies directly employ nearly 22 million U.S. workers, support the jobs of 30 million more, and pay wages that are 24% higher than average U.S. private-sector wages. Those 52 million American jobs - 44% of the U.S. workforce - depend, in part, on the competitiveness of U.S.-owned foreign affiliates.

In a nutshell, these proposals amount to a $200 billion tax hike for U.S. companies that the group calls America's most successful job creators.

Assessing the Impact

As we learned in our last newsletter, the first phase of the Obama tax plan, announced in April, is to raise taxes on those individuals and businesses making more than $250,000/year. The second phase, announced in May, specifically targets U.S. multinationals with overseas operations and the wealthy with overseas investments.

Both initiatives are intended to help pay for Obama's spending plan. Initiatives that Professor Michael Hoskins from Stanford University believes can in no way be limited to those making more than $250,000, since it will add $6.5 trillion to the 2010 - 2019 national budgets, not including his planned changes to Medicare or Social Security.

Here is how he explained it in an April 3, 2009 Wall Street Journal article entitled, "The $163,000 Tax Bomb."

If spread evenly over all those paying income taxes (which under Mr. Obama's plan would shrink to a little over 50% of the population), every income-tax paying family would get a tax bill for $163,000. (In ten years, interest would bring the total to well over $200,000, if paid all at once. If paid annually over the succeeding ten years, the tax hike per year would average almost $26,000.) That's in addition to his explicit tax hikes. While the future tax time-bomb is pushed beyond Mr. Obama's budget horizon, and future presidents and Congresses will decide how it will be paid, it is likely to be paid by future income tax hikes as these are general fund deficits.

We can get a rough idea of who is likely to pay them by distributing this $6.5 trillion of future taxes according to the most recent distribution of income-tax burdens. We know the top 1% or 5% of income-taxpayers pay vastly disproportionate shares of taxes, and much larger shares than their shares of income. But it also turns out that Mr. Obama's massive additional debt implies a tax hike, if paid today, of well over $100,000 for people with incomes of $150,000, far below Mr. Obama's tax-hike cut-off of $250,000 (over $130,000 in ten years and over $16,000 a year if paid annually over the following ten years). In other words, a middle-aged two-career couple in New York or California could get a future tax bill as big as their mortgage."

Therefore, hoping that additional taxes on those making in excess of $250,000 per year will pay for this plan is a fabrication according to Hoskins - it will cost all taxpayers more money.

But is it a good idea to target U.S. companies operating overseas? Are claims by PACE and U.S. manufacturers that such a move is counterproductive valid?

The Corporate Conundrum

The following table produced by the Tax Foundation ranks nations according to corporate tax burden. As we see, the U.S. has the highest combined corporate tax rate behind Japan. (As we learned in last month's ProfitScore IQ, companies in New York City have the dubious distinction of paying the highest corporate taxes in the world at a combined rate of 46.2%.)

Rank	Country	Combined
		Corporate
		Income Tax
		Rate 2008
1	Japan	39.54
2	United States	39.25
3	France	34.43
4	Belgium	33.99
5	Canada	33.5
6	Luxembourg	30.38
7	Germany	30.18
8	Australia	30
9	New Zealand	30
10	Spain	30
OECD 30 Average		26.60%
	Source - Tax Foundation

U.S. corporations currently pay a tax rate that is 50% higher than the average for the OECD thirty most industrialized nations. But that isn't the whole story.

Of even greater concern is the fact that of that elite group of 30 nations, the U.S. is the only country that taxes its companies (and citizens) based on citizenship, not residency. That has created a unique problem for US companies with operations abroad and one that has required some rather imaginative solutions to keep them competitive globally.

Back in 1984, the Foreign Sales Corporation program was Congress's way of leveling the playing field for U.S. multinationals due to the fact that the U.S. is the only major industrialized nation (and one of only three countries in the world, namely the Philippines and Eritrea) that taxes based on citizenship. This puts American companies operating in foreign territories at a competitive disadvantage visa vie companies from other countries.

Subsequently, the World Trade Organization in 2000 ruled that the FSC rules were an illegal subsidy and allowed the EU to levy $4 billion in tariffs against U.S. exporters and multinationals unless the rules were replaced. In response, Congress adopted the Extraterritorial Income Exclusion (ETI) Act of 2000, but that was also successfully challenged by the EU.

In response, the ETI was replaced by the American Jobs Creation Act of 2004 signed by President Bush. It provided $140 billion of tax relief to domestic manufacturers and other producers, including several sectors that in the past, never qualified for tax relief. The corporate tax rate for domestic manufacturers dropped from 35% to 32%.

For a one-year period, U.S. multinationals were able to repatriate foreign profits at a 5.25% tax rate. This rate also applied to deemed dividends accumulated by affiliates of controlled foreign corporations that are exempt from current taxation under the Internal Revenue Code Kennedy Amendments of 1962, according to economist and international trade expert Walter Diamond.

Instead of the tax losses predicted by Democrats and even some of the Bush Administration economic advisors, the move caused a flood of overseas cash to be repatriated to the U.S. from more than 800 companies - approximately $362 billion was repatriated from foreign operations, according to the July 1, 2008 Wall Street Journal article "Corporate Tax Cut Windfall."

After the one-year period expired, companies would be taxed at the new corporate rate of 32% on repatriated income. Before the law was enacted, companies had to pay 85%, so this was an improvement. The Act also greatly reduced the double taxation of U.S. exporters and overseas manufacturers. Was it any wonder that more than $600 billion in corporate profits sat overseas?

If overseas corporate earnings had been repatriated under the tax rules Obama has proposed, as much as $510 billion would have gone to taxes. But the reality is that corporations would have permanently kept the income abroad.
Phase two of Obama's plan was made public before the election in his Patriot Employer Act, in which he promised to address these corporate "tax breaks." Promises in a presidential campaign are not unusual and often forgotten once the candidate wins.

Unfortunately, this one wasn't. Even more unfortunate, it is these so called tax breaks for which Congress has fought so hard keep so that U.S. multinationals could remain competitive with their global counterparts. An end to these breaks would force companies with overseas operations to pay the U.S. domestic tax rate (currently a minimum of 35%) on all income-no matter where it is earned-unlike the companies of every other industrialized nation against which American companies compete.

Taxes vs. GDP Growth from 1960 to 1996:

Government Size (Taxes/GDP)	Average Annual Growth Rate of Real GDP
Less than 25%	6.6%
25 - 30%	4.7%
30 - 40%	3.8%
40 - 50%	2.8%
50 - 60%	2.0%
Great than 60%	1.6%
Source: http://www.freetheworld.com/papers/Gwartney_Holcombe_Lawson.pdf

As we this table shows, economic growth was found to be inversely proportional to taxes as a percentage of GDP (tax burden), according to this Cato Institute study.

Putting Peter Out of Business to Pay Paul?

Since 1990, the average tax rate for the 30 developed nations of the Organization for Economic Co-operation and Development has fallen from 40% (what the U.S. corporate tax rate was then) to an average of 26.6%, while the U.S. rate remained more or less static. And, during the 18 intervening years, Congress has been on a continual search to find ways to allow U.S. multinationals to effectively compete, given their unique international tax handicaps. If Obama's latest tax plan is approved by Congress, U.S. competitiveness would greatly diminish.

"Ironically, what the president proposes [increasing taxes for multinationals] will make it more likely that American companies will be bought by their foreign competitors," according to Dave Camp, lead Republican on the House Ways and Means Committee.

According to an article that appeared in The Wall Street Journal after Obama's plan was released in February 2008, "[Obama] has it backwards. The offshore activities of U.S. companies tend to increase rather than reduce domestic business. A 2005 National Bureau of Economic Research study by economists from Harvard and the University of Michigan found that more foreign investment by U.S. companies leads to greater domestic investment, and that U.S. firms' hiring of more offshore workers is positively, not negatively, associated with the number of American workers they hire. That's in part because often what is produced overseas by subsidiaries are component parts to final, higher-value-added products manufactured here."

In a May 6, 2009 article for Tax-News.com, U.S. Chamber of Commerce Chief Economist, Dr. Marty Regalia, warned that deferral has been "mischaracterized" as a tax break when it actually provides a "vital mechanism" for U.S. companies to claim relief from double taxation.

"The United States is the only major industrialized country which double taxes the overseas earnings of our companies. Since other countries don't subject their companies to double taxation, U.S. companies need deferral to stay competitive in the global marketplace," he said.

Who would be affected? According to a Wall Street Journal estimate in April, ten of the biggest U.S. corporations accumulated nearly $58 billion in overseas earnings during 2008, representing about $20 billion in revenue if taxed in the U.S. Since total U.S. corporate tax receipts that year were just over $300 billion, the amount is sizeable. But what would be the offsetting costs?

The challenge to taxing these companies is the type of businesses involved. For example, foreign profits are often highly portable like those in the technology or pharmaceutical sectors that rely on intellectual property, royalties or patents. Such property can easily be moved between entities or to different jurisdictions. Capital is extremely mobile. The problem is once it has moved, it rarely comes back.

Take Microsoft for example. By utilizing Irish patent income rules, the company was able to legally save an estimated $500 million in taxes annually, according to the Wall Street Journal's 2005 Round Island One report. That type of property can easily be moved.

Among the companies affected would be top tech firms such as Hewlett Packard, Cisco, Oracle and Google, as well as global icons like Coca Cola, Pepsi and most of the big pharmaceutical firms. Each of these companies has competitors from other nations that would relish the thought of seeing their U.S. competitors paying higher costs. It doesn't take an accounting genius to appreciate the benefit of buying a company with higher costs and moving it to a lower-tax cost jurisdiction especially when one considers that any other jurisdiction would have lower tax rates on multinationals than the U.S.

"If rules are changed on tax deferral and we are taxed in the U.S. on non-U.S. profit, this significant additional U.S. tax cost would adversely impact our ability to invest and grow our business in the U.S....and to compete against our foreign competitors who are not subject to this U.S. tax," John Earnhardt, a Cisco Systems Inc. spokesman was quoted as saying in a May 4, 2009 WSJ article entitled, "Firms Face New Tax Curbs."

So tell me again how raising tax burdens on our top echelon global companies and making them less competitive is a good idea? Just how vulnerable will it make U.S. companies? How many American jobs will it cost and how likely are they to be buy-out targets or move operations offshore? And if it turns out to be an extremely bad idea, how does the U.S. government go about bringing those companies, their jobs and investment dollars back home again?

The problem is no one, including those in the Obama Administration have provided the answers to these and other pertinent questions.

What are some other solutions? An idea put forward by economists like Nobel Prize winner Robert Lucas is to eliminate multiple taxes on capital gains, interest and dividends, as well as reduce the corporate tax rate. Taxing it once from income and then again when it's earned is not only counter-productive, but it discourages investment and job creation as well.

Isn't it about time the U.S. had a globally competitive corporate tax that encouraged business growth both domestically and abroad instead of penalizing it? Seems to me that the only ones who benefit from new taxes and anti-business regulations are the bureaucrats who create them in the first place.

Suggested Reading

Obama's $163,000 Tax Bomb
http://online.wsj.com/article/SB123871911466984927.html

Forbes 2009 International Tax Misery Index
http://www.forbes.com/global/2009/0413/034-tax-misery-reform-index.html

Obama Announces International Tax Crackdown
http://www.tax-news.com/asp/story/Obama_Announces_International_Tax_Crackdown_xxxx36605.html

Ireland Inc Is Nervous of Obama's Tax Plans
http://www.sbpost.ie/post/pages/p/story.aspx-qqqt=NEWS+FEATURES-qqqm=nav-qqqid=41325-qqqx=1.asp

Obama to Crack Down on Business Taxes
http://www.thetimesonline.com/articles/2009/05/04/ap/headlines/d97vgg581.txt

US Firms Gird For Battle On Obama Foreign Profits Tax
http://forexdaily.org.ru/Dow_Jones/page.htm?id=491499

Congress Approves Chamber-Opposed Budget
http://www.uschambermagazine.com/content/090504x.htm

Manure...A True Story

I got this in an email and then confirmed the story with Google. The author is unknown.

Manure: In the 16th and 17th centuries, everything had to be transported by ship and it was also before commercial fertilizer's invention, so large shipments of manure were common.

It was shipped dry, because in dry form it weighed a lot less than when wet, but once water (at sea) hit it, not only did it become heavier, but the process of fermentation began again, of which a by product is methane gas. As the stuff was stored below decks in bundles you can see what could (and did) happen.

Methane began to build up below decks and the first time someone came below at night with a lantern, BOOOOM!

Several ships were destroyed in this manner before it was determined just what was happening!

After that, the bundles of manure were always stamped with the term "Ship High In Transit" on them, which meant for the sailors to stow it high enough off the lower decks so that any water that came into the hold would not touch this volatile cargo and start the production of methane.

Thus evolved the term "S.H.I.T " , (Ship High In Transport) which has come down through the centuries and is in use to this very day.

And I had always thought it was a golf term!

Portfolio Performance Analysis

Risk & Reward

Each of our portfolios is strategically allocated across one or more of the Investment Pillars of Strength discussed below. Each Pillar is managed by multiple, uncorrelated, absolute-return investment managers to produce a return stream that is consistent, negatively correlated with the major market averages in down markets and non-correlated with each of our core Pillars of Strength.

Managing risk is our most important consideration and it is reflected in the way our portfolios are built and managed each and every day.

The S&P 500 had another positive month in May, pushing toward, and finally crossing the highly watched and arguably over-emphasized 200 day moving average. Since crossing the longer-term moving average on June 1^st, the market has traded sideways and is either consolidating its gains for the next move higher or setting up for a tremendous fall. Extended moves higher off of significant lows are called "climbing the wall of worry" and for good reason.

Bear market rallies are notorious for sucking most investors back into the market because they feel they are getting left behind. Getting left behind is an ingrained fear in all humans for the reason that the pack has traditionally meant safety. In investing, it usually works the opposite, causing pain and anguish, but investors can't shake their carnal fear. Once the move higher pulls most investors back into the market, it will, more often than not, crash from its own weight. Bear market rallies are known for their fast and powerful moves higher. Bear market declines are equally known for the ferocity of their decent.

So which one will it be? Another powerful move higher and the start of a new bull market or the continuation of the current bear market pushing major indexes to new market lows? Since we make our trading decisions daily, we don't really care as long as we are winning more trades than we lose. Like I tried to point out in the introduction to this letter, the ground is littered with dead bodies of investors and investor advisors who think otherwise.

Below is a performance summary for the indices we track and benchmark our portfolios to:

	Cumulative Return			Average Annual Return
Indexes	Mth.	YTD	1 yr	3 yr	5 yr	10 yr

CSFB L/S *	3.87	6.85	-15.00	1.60	5.95	7.75
CSFB Multi-St. *	2.97	9.12	-14.85	0.64	3.44	6.27
Barclay F-of-F *	2.69	3.82	-17.69	-2.75	1.57	5.25
S&P 500	5.59	2.96	-32.57	-8.24	-1.90	-1.71
Barclay HY	6.73	26.80	-7.78	1.02	4.05	4.38
Barclay Agg.	0.73	1.33	5.73	6.30	5.02	5.88

* Note:	Estimated monthly performance

Index Advantage:

The S&P 500 index rallied strongly again in May, tipping the scales with a 5.59% gain. Our long/short traders continue to impress even me as they consistently harvest profits from the daily opportunities that present themselves. Our trading accuracy continues to remain high for both our long and short trades. Our upside and downside capture ratios for this allocation are off the charts.

For the month, this pillar gained 6.13%.

Strategic Balance:

Our overall exposure for the month in this allocation was 17.2%, yet these traders were able to produce gains of 2.91% for the month. In other words, the total exposure to the market in during May was only 3.4 days. Based on a risk-adjusted basis, annualized returns for this allocation would be triple digits. May was the 7^th month in a row this important allocation has made a profit.

For the month, this pillar earned 2.91%.

Dynamic Income:

My frustration for this allocation has turned into pure satisfaction as we continue to fire on all cylinders. The return stream for every asset we trade in this allocation has shown a drastic improvement for trading accuracy, lower volatility, and reduced correlation. This month's performance takes us positive for the year and is now outperforming the S&P 500 for 2009 with a small fraction of the risk versus being exposed to volatile equity assets.

For the month, this pillar earned 3.17%.

Our portfolios are built using varying distributions to the strategic allocations discussed above. To view detailed performance and risk statistics information about our investment portfolios for the month, please click on the links below:

If You Are a Client, Don't Be Confused.
Actual management and performance fees are incurred monthly but are deducted from client accounts in the first month of every quarter (January, April, July, and October). For performance reporting purposes, we deduct fees monthly as they incur and not quarterly, as they are reflected in client statements. It all washes out in the end, but this may cause your account performance to deviate from our published performance reports on a month-to-month basis. To be conservative, we also deduct the maximum fees we charge from our performance reports and your actual overall fees paid may be less than our maximum.

Jack Leaves for Birdie School

Several months ago I wrote about my new dog, Jack. Jack is a Pudlepointer (it is pronounced Poodlepointer) and for you manly men who are rolling their eyes thinking I have lost my mind for owning a bird dog that looks like a Poodle, Jack looks nothing like a Poodle and more like a slimmed down Chocolate Lab. The breed is known for their intelligence, friendly demeanor and athletic ability. I am proud to report that Jack excels in all categories. If you are interested in learning more about the breed, here is a link to my breeder's website: http://cedarwoodgundogs.com/.

My last two dogs were English Setters and we still own both dogs as well. Adding a young pup to our dog family has certainly stirred the pot as Jack wants to play constantly and my older Setters Maggie (11) and Bessie (13) would rather I lock Jack outside so he can't pester them anymore.

My setters are great companions and were exceptional hunting dogs, but due to their age, they can't go bird hunting with me anymore. I have owned a lot of dogs and I have to say that Jack is the smartest dog I have ever owned. I trained my last two dogs and I am at best a marginal trainer. However, Jack's intelligence makes me look like I really know what I am doing.

I am so impressed with Jack's capabilities that I have decided to have him professionally trained. So, yesterday Jack left for birdie school. My Setters welcomed the peace and quiet, but I miss Jack's energy around the house. Jack will be gone for the rest of the summer as he works with an excellent trainer honing his natural-born instincts to point and retrieve birds. I can't wait for my dad's annual bird hunting trip to Idaho this year. Spending time with my dad and watching my new dog work the field will be a special time shared between father and son.

I hope I didn't make anyone mad with my slap in the face introduction to this letter. This bear market has created many real life hardships and I have heard several stories first hand. I just get tired of all the misleading garbage pushed out over the airways and felt I owed it to my readers to tell them like it is.

June is already half over and I hope you are enjoying the summer with friends and family. Talk to you next month.

Working to grow your wealth,

John M. McClure
President & CEO
ProfitScore Capital Management, Inc.

P.S. If you would like to hire us to help you navigate this difficult bear market, below are three ways to contact us:

Complete our Private Client Group request form by clicking here http://profitscore.com/insight.aspx and submitting your contact information. (This is the most preferred method.)
Call us directly at (800) 731-5690.
Simply send us an email to info @ profitscore.com.

Someone will contact you within 24 hours of receiving your information.