ProfitScore IQ : Government Bailout

How Our Home Prices Compare To The Rest Of The World

John M. McClure — Tue, 20 Oct 2009 16:39:00 GMT

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.

The Pollyanna Paradox and A History Lesson Never Learned

John M. McClure — Tue, 20 Jan 2009 19:10:00 GMT

In This Issue:

An Update on Our Performance
Bailout vs. Previous Government Expenditures
A Financial Trap That Catches Millions
Caught In the Trap
Market Rhythms and Rhymes
Bubble Breakdown
Playing Against a Stacked Deck
Practicing Paradox Prevention
Wall Street One-Liners
Portfolio Performance Analysis
Sharing the Sport of Basketball with My Daughters

In this month's newsletter, I will explore some possible explanations for why America and the world are once again in this mess. Our research will not be based on economic reasons but on how human beings continually repeat the same mistakes that they have been making for centuries.

Who's to blame for these mistakes? It can't be the system's fault because the system was created and controlled by people. The ultimate reason could be the fact that human beings are both greedy and fearful. They overreact to positive and negative events just as Pavlov's dogs consistently reacted to the ringing of a bell.

We pride ourselves as being smarter than the last generation. We obviously have more history to learn from than the previous generation, so why do we keep repeating the same mistakes over and over again? Could it be that our emotional wiring is a stronger influence than our intellect? Frankly, there can be no other conclusion.

"The definition of insanity is doing the same thing over and over and expecting different results. Given this definition, the majority of people are stark raving mad."
Author Unknown

An Update on Our Performance

December was our second best month since the launch of our multi-manager portfolios propelling two of our more aggressive portfolios to gains for 2008 while our other two portfolios incurred very small losses. 2008 will go down in the history books as one of the most difficult bear markets of our lifetime. Our performance in the 2008 market places us in the top 1% of all relative or absolute-return money managers in the country.

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

	Past 12	YTD	Dec	MTD Jan
Name	Months	2008	2008	2009
Income Builder (IB)	-3.02%	-3.02%	-0.80%	-0.55%
The Guardian (GRD)	-2.43%	-2.43%	2.16%	0.26%
Harmony Plus (HMY)	1.80%	1.80%	4.60%	0.37%
The Expedition (EXP)	3.75%	3.75%	8.10%	0.19%
S&P 500 (SP500)	-37.00%	-37.00%	1.06%	-5.88%
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 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.

Bailout vs. Previous Government Expenditures

"The budget should be balanced. Public debt should be reduced. The arrogance of officialdom should be tempered and assistance to foreign lands should be curtailed, lest Rome become bankrupt."
Cicero, 43 BC

The bailout numbers are so large that it is hard to comprehend how current events compare to history. Below is a wonderful comparison of recent bailouts compared to previous government expenditures. The data for the graph was compiled by Jim Bianco of Bianco Research and the graph was created by Ockham Research. I estimate that the US government will spend $15 trillion before this mess is over, so this graph is only going to get worse.

It is important to point out that these historic numbers have been adjusted to reflect inflation, so that it is a fair comparison between today's dollars and money spent in the past. No one knows for sure if the government's bailout efforts will work, or if we fall into a soft depression. Regardless of what happens, the scope and scale of the numbers are simply staggering.

A Financial Trap That Catches Millions - Is It Avoidable?

The following is an excerpt from Atlas Shrugged by Ayn Rand: "Watch money. Money is the barometer of a society's virtue. When you see that trading is done not by consent, but by compulsion - when you see that in order to produce, you need to obtain permission from men who produce nothing - when you see that money is flowing to those who deal not in goods, but in favors - when you see that men get rich more easily by graft than by work, and your laws no longer protect you against them, but protect them against you - when you see corruption being rewarded and honesty becoming a self-sacrifice - you may know that your society is doomed.'"

As long-time ProfitScore IQ readers know, we have often railed against television talking-heads, fundamental analysts, politicians and bureaucrats for their inability to recognize or acknowledge the bubbles that formed from 2002-2006, even though there was significant evidence for concern. Shouldn't these so-called experts have had some sort of inkling that there was trouble on the horizon before it hit us like a ton of bricks?

But the challenge has not been limited to a denial that a problem existed before the collapse. Throughout the corrections and bear market over the past fifteen months, every time stock prices stopped declining, these experts could be heard on the business networks proclaiming that now was the time to buy.

Would it be too much to ask for CNBC and other financial networks to qualify anyone giving advice on their show before spewing toxic comments across the airways? How about asking these questions: Mr. Expert, before you give my viewers your advice, what has your performance been during this bear market? How did you perform in the millennium bear market? Have you ever predicted a bear market or advised your clients to sell all of their equity assets and invest in treasuries or go 100% to cash? If an analyst can only give bullish advice about the market, then they should not be allowed to give investment advice!!!

We have discussed the fact in our Equitrend weekly newsletters that although these analysts sounded convincing, spouting terms like "a once in a generational time to buy" and "buying opportunity of the century" (March 2008), the market reversed again and prices continued their march lower. It has been a frustrating time to say the least, especially for investors who have been hearing similar rhetoric from their financial advisors and brokers.

Figure 1 - Historic chart of inflation-adjusted U.S. home prices with building costs, population and interest rates. Orange line on home prices marks previous bubble highs before year 2000. Chart - Robert Shiller.

So should those upon who we rely in the financial and economic world have seen this coming? Let's examine the housing market, which was at the root of the problem.

Caught In the Trap

"The investor's chief problem - and even his worst enemy - is likely to be himself."
Benjamin Graham

Dr. Robert Shiller, economist, Yale economic professor and author of the book Irrational Exuberance, seems to think so. Over the past two hundred years, he has demonstrated how home prices have tracked inflation - rising above the long-term average during boom periods and falling below it during recessions and depressions.

In 2002, it became clear that something significant had changed. Home prices had risen well above any previous highs (see Figure 1) and that unless the traditional ratios of income and rents to home prices had been irrevocably altered, prices were not sustainable. However, prices continued rising leading many, including Ben Bernanke we might add, to determine that the rules had changed.

By 2006, existing home prices had risen to more than double any previous inflation-adjusted high (see Figure 1) even though incomes had not risen significantly and U.S. population growth was unchanged. But according to a vast array of experts, home prices had entered a new economic paradigm and traditional metrics were no longer valid. This idea became the new "conventional wisdom." Market players and economic experts alike all suffered from the same condition - they'd become the latest victims of the Pollyanna Paradox.

However, it soon became clear that they'd been fooled when home prices reversed in early 2007 and then continued to fall. Unfortunately, prices still have a ways to go just to get back to previous bubble highs after correcting for inflation.

Figure 2 - The anatomy of a bubble and bust. The Baltic Dry Index measures the cost of shipping dry goods by ship around the globe. Dropping below 1750 in August 2005, the index peaked above 10,500 not once, but twice in 2008, as the first bubble resulted in an echo bubble hitting an ultimate peak of 11793 in May. Then after hitting a low of 663 in mid-December 2008, the index began to recover, moving back above 900 in mid-January.

Real estate wasn't the only asset class affected. A range of assets from expensive art to commodities also experienced bubbles, and in every case, peak prices proved fleeting.

In almost every single case, and in spite of the fact that such extreme price gains had never before in history proven sustainable, the vast majority of experts denied that a bubble existed. Forecasters with foresight like Peter Schiff, Gary Shilling and David Tice, who warned of the building bubbles in housing and stocks in 2005 through 2007, were routinely ridiculed by experts who towed the conventional wisdom party line (see video clips in Suggested Reading below). It was only when prices fell and losses mounted that the problem became painfully evident to all concerned.

That's not the worst of it. Each time the falling asset prices steadied, pundits emerged from the media woodwork to proclaim that the worst was over. And even as the data deteriorated, calls that we had reached bottom continued to be heard from the majority of talking heads. Those who followed this advice lost their shirts.

This situation has been repeated countless times since financial markets were born. So why do so many get caught each time? How can you prevent being caught in the trap?

Market Rhythms and Rhymes

"Stock market bubbles don't grow out of thin air. They have a solid basis in reality - but reality is distorted by a misconception. Under normal conditions misconceptions are self-correcting, and the markets tend toward some kind of equilibrium. Occasionally, a misconception is reinforced by a trend prevailing in reality, and that is when a boom-bust process gets under way. Eventually the gap between reality and its false interpretation becomes unsustainable, and the bubble bursts."
George Soros

The study of booms and busts and what causes them is not new. In the aftermath of each major bubble throughout history, reams of books have been written about how and where investors went wrong. Much analysis has been published about the biggest bubble and bust (to present day) in the last 120 years - the late 1920s and the Great Depression. But whether it was the 1929 stock market peak, Dutch Tulip Bubble in 1636 (the price of a tulip bulb surpassed that of a luxury home of the day), the South Sea Bubble in Europe in1720 (share prices rose 843% in a 12-month period), the Mississippi Bubble this side of the Atlantic also in 1720 (stock prices soared 3500%), the Florida real estate bubble (lot value jumped from $1,700 to $300,000), or the 1989 stock and property bubble in Japan, each time a bubble formed all past lessons had been forgotten and any warnings from those few, who tried to warn of the impending crash, went unheeded by the masses.

The Pollyanna Paradox is a name designated to describe this phenomenon by analyst Matt Blackman. Where did the name come from? A paradox is defined as a tenet (belief or doctrine) contrary to perceived opinion or common sense in the Merriam Webster Dictionary. Pollyanna was a heroine in the novel of the same name written in 1913 by Eleanor Porter, who was imbued by the author with an irrepressible optimism and tendency to find the good in everything and everyone.

When it comes to financial matters, it is the tendency to follow the crowd and keep buying into a bubble, while ignoring the fact that prices have become unsustainable. It also describes the uncontrollable compulsion to call bottoms in a bear market each time prices temporarily recover in the inevitable bear market that follows. There is little doubt that when it comes to markets, hope springs eternal, no matter how dire the situation or how much contrary evidence there may be.

Bubble Breakdown

"People change when they join crowds. They become more credulous and impulsive, anxiously search for a leader, and react to emotions instead of using their intellect. An individual who becomes involved in a group becomes less capable of thinking for himself."
Alexander Elder

In October 2007, Bespoke Investment Group compared the scope and duration of the NASDAQ (Internet) bubble with those of the Homebuilders and Shanghai Composite. At the time they had been asked by a reader how the first two compared with the last which was up more than 500% from its start in July 2005 (see Figure 3). It is interesting to note that although Bespoke could not have known it at the time, the Shanghai Composite had just hit its peak of 6124.04 on October 16, 2007, two weeks before the chart below was published.

Figure 3 - Comparison of three bubbles to October 2007 by Bespoke Investment Group.

Over the next year, the Shanghai Comp would fall 1664.92, a drop of more than 72%, confirming it as a bubble. So how did Bespoke know it was a bubble at the time? Nothing in economics is certain, but if it walks like a duck and talks like a duck... In other words, any asset that appreciates dramatically in a relatively short time period is probably a bubble.

But what was perhaps more revealing was a comparison of the dynamics of these bubbles and the timing of each. The NASDAQ bubble began June 24, 1996 and peaked March 10, 2000. The S&P1500 Homebuilders bubble began to form March 14, 2000, just four days after the peak in the NASDAQ. Homebuilders peaked on July 20, 2005, just nine days after the Shanghai Composite market began its meteoric rise (July 11, 2005).

Is it a coincidence that new bubbles formed at nearly the exact time that the previous ones were topping out?

Figure 4 - Weekly chart of 30-year Treasury bonds shows the recent price spike to the highest in history as interest rates have dropped to all-time lows. Chart by GenesisFT.com.

It is interesting to note that a few astute observers have commented on the fact that a Treasury bond bubble is now occurring. As we see from the next chart, 30-year Treasuries recently hit an all-time high in December 2008, as interest rates dropped to their lowest levels in history amid recession concerns. As you can see from Figure 4, the Treasury bubble began to form in June 2007, just six months after housing prices started to decline.

Playing Against a Stacked Deck

"Major speculative bubbles, as I argued in Irrational Exuberance, are always supported by some superficially-plausible popular theory that justifies them, and that is widely viewed as having sanction from some authority figures. These may be called new-era theories."
Robert Shiller (2001)

In May 2001, Robert Shiller published a prescient paper entitled Bubbles, Human Judgment and Expert Opinion, in which he discussed some interesting facts at the root of the cause of bubbles. One major reason so many investors fall prey to bubbles, he believes, is the requirement for fiduciaries (like stock brokers, analysts and advisors) to chart a course of action in accordance with conventional wisdom, rather than his or her own judgment.

"Investing for the long term means judging the distant future, judging how history will be made, how society will change, how the world economy will change. With such a confusion of factors, it is hard for anyone to make objective judgments without being influenced by the recent success behavior of the market and the recent success of investments. In making major allocation decisions, one almost inevitably winds up trusting to a common or consensus view about the future. Professionals ultimately must end up generally assuming that what their colleagues believe is true."

According to Shiller, the requirement that fiduciaries follow conventional wisdom (the crowd) is mandated by law in the prudent person standard which he says has a "very long history in common law" and is "enshrined for pension funds in the Employee Retirement Income Security Act (ERISA) of 1974. This act states that investments must be made with "the care, skill, prudence and diligence, under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."

In other words, if a disagreement was to arise between a client and his financial advisor because the advisor lost money, the advisor would be safe if he followed the crowd, but guilty if he acted on his own judgment.

The clear paradox here is that in bubbles and at key market turning points, conventional wisdom is generally wrong. Following the crowd at such times is the best way to lose money. But this course of action is required by law! It goes a long way in explaining why roughly 85% of financial advisors and brokers underperform a simple index like the S&P500 or Dow in a good market or a bad one, and why so much money has been lost in the past year. This legal framework creates a powerful incentive against acting outside the box and taking the chance of investing against conventional wisdom of the times.

And that's not the only legal challenge facing the average investor. In the book Invest by Knowing What Stocks to Buy and What Stocks to Sell by Charlie Kirkpatrick CMT, the author discusses how the goals of the average investor are at odds with that of his advisor. One major conflict is the fact that brokers charge commissions and fees for managing your money and therefore make money whether or not you do. One major conflict is the fact that brokers charge commissions and fees for managing your money and therefore make money whether or not you do. They are prohibited from charging you based on the profitability of your investments under the Investment Act of 1940, according to Kirkpatrick.

This is one major reason for the birth of the hedge fund industry which enabled money managers to act more like partners with their clients, making money when their client did and losing their fees when the account lost money. Unfortunately only sophisticated investors with invest-able assets in excess of $1 million dollars or more qualify for this type of service, leaving the average investor vulnerable to the trials and tribulations of the Pollyanna Paradox.

Practicing Paradox Prevention

"Wishful thinking bias appears to play a role in the propagation of a speculative bubble."
Robert Shiller

Bubbles occur for a number of reasons, the most important of which is easy credit. They are fueled by one factor and that is greed and it is this avarice that makes these phenomena so hard to prevent. Like sharks sensing blood in the water, once profits start to accumulate, investors are magnetically drawn, and in the process, check their capacity for critical thinking and evaluation at the door. It is only when the money evaporates and losses mount that the fiscal feeding frenzy comes to an end. And the longer it lasts, the more painful and protracted the aftermath.

Over the years, politicians have struggled to prevent these manias with rafts of new regulation - but it is this regulation that in many ways has become counterproductive and put the very people it was intended to help at a distinct disadvantage.

For those with a goal of achieving financial independence at some point in their lives, it is essential to avoid the pitfalls and traps that ensnare the average investor. This means they must fight the internal and external urge to follow the crowd and avoid conventional wisdom no matter how right it may feel at the time. It also means steering clear of those financial fiduciaries and advice providers who belong to the conventional wisdom club.

To ultimately survive, it is also essential that you become aware of the signs of a bubble and avoid them at all costs. You will probably leave profits on the table, but will also avoid the painful and debilitating financial collapse that follows along with those who were either too short-sighted or greedy to avoid entrapment in the Pollyanna Paradox.

Suggested Reading

Invest by Knowing What Stocks to Buy and What Stocks to Sell
Charles D. Kirkpatrick II, CMT, 2009, Pearson Education, FT Press

Bubbles, Human Judgment, and Expert Opinion - Robert Shiller
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=275515

Trader6.com Quotes on bubbles
http://trader6.wordpress.com/add-or-update-your-own-quote/bubbles-manias/

South Sea Bubble (1720)
http://www.stern.nyu.edu/eco/seminars/FinHist/Southseabubble.pdf

Mississippi Bubble (1720)
http://www.britannica.com/EBchecked/topic/385600/Mississippi-Bubble

Florida Real Estate Bubble (1920s)
http://floridahistory.org/landboom.htm

The Complete Edition of Murphy's Laws
http://matija.monitor.hr/murphy/0001567/download/edition.htm

Videos

Peter Schiff versus the Pollyanna gang 2006-7
http://www.youtube.com/watch?v=zz_yw0kq3MM

Peter Schiff December 22, 2008
http://www.youtube.com/watch?v=ZHq-D-ya0go&feature=related

Peter Schiff on the auto company and government bailouts December 2008
http://www.youtube.com/watch?v=XXpzMw-e01g&NR=1

What is Peter Schiff saying now? Jan 7/09
http://www.youtube.com/watch?v=9h2x7R8pxUs

Wall Street One-Liners

The news is just so bad these days that I am always looking for something positive to say. Since the tone of this letter continues to have more bad news than good, I thought I would share a few jokes related to our present-day economic mess. I hope they make you laugh like they did for me.

1. Q: What is the one thing Wall Street and the Olympics have in common?
A: Synchronized diving.

2. I went to buy a toaster and it came with a bank.

3. Overheard in a city bar: "This credit crunch is worse than a divorce. I've lost half my net worth and I still have a wife."

4. What's the capital of Iceland?
About $3.50.

5. Q: What is the difference between an investment banker and a pigeon?
A: A pigeon can still make a deposit on a BMW.

6. Q: What is the difference between an investment banker and a large pizza?
A: The pizza can still feed a family of four.

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.

Bear markets are good for absolute-return managers because it reminds investors that the most important thing you can do to significantly grow your wealth is not lose it. This bear market is far from over. I am not sure when it will end and how many head fake rallies are in store between now and the bottom, but I am almost certain that we are not there yet. My range for a bottom on the S&P 500 is between 636 and 400. For everyone's sake, I hope it is the higher end of my prediction. Regardless of what transpires, 2009 is going to be a great year for ProfitScore and our clients.

I call ProfitScore an absolute-return manager, but we are really an opportunistic manager who looks for opportunities on both the long and short side of the assets we trade. If the asset class turns bullish, then we will have a long bias to our trades. If it turns bearish, then our bias will be short. Our bias quickly changes and adjusts to daily and weekly opportunities that present themselves. Because we trade multiple asset classes (equities, precious metals, international markets, government bonds, US dollar, high yield bonds, etc.) our bias can change daily for each asset we trade. To give you an example, at the close of the market on Friday, we were invested as follows:

Short US equities
Long precious metals
Short the US dollar
Short government bonds
Long oil
Short real estate
Short international equities
Long high yield bonds

Our bias and allocations can change daily, but those are the opportunities we felt existed by the close of market Friday.

The S&P 500 is down -5.88% month-to-date January. If you have been invested in an S&P 500 index fund promoted by efficient market pundits, then you have been rewarded with a -1.38% average rate of return over the last 10 years!!! It took 25.2 years for equity investors during the Great Depression to recover from their losses. How long will this super bear market continue to torture the buy and hold, or as I like to say, buy and hope investor? 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 *	1.06	-19.76	-19.76	1.42	5.00	7.87
CSFB Multi-St. *	-1.52	-23.63	-23.63	-1.24	2.18	5.74
Barclay F-of-F *	-0.84	-21.57	-21.57	-2.25	1.26	5.75
S&P 500	1.06	-37.00	-37.00	-8.36	-2.19	-1.38
Barclay HY	7.68	-26.15	-26.15	-5.58	-0.79	2.18
Barclay Agg.	3.73	5.24	5.24	5.51	4.65	5.63

* Note:	Estimated monthly performance

As we pointed out last week, our allocations have been reduced to adjust for the extremely high levels of volatility that currently exist in the markets. We were expecting a reduction in volatility leading up to Obama's inauguration, but volatility still remains historically high.

After getting our pockets picked in November, our traders came rolling back to have our second best month since our launch. Our long/short equity traders lead all allocations, but our government bond traders deserve some credit after recovering form early losses during the month. Our mostly long only Strategic Balance allocation continues to put positive numbers on the board. December was a great month for our portfolios and January is showing strong relative performance for the start of 2009.

Index Advantage:

The most impressive part about our huge gain for the month in this allocation is that we spent most of the month invested in cash. Our average exposure to the market for the month was less than 30%, so the risk our clients were exposed to was a fraction of the overall market. Considering our risk adjusted exposure, our 13.21% gain was staggeringly good.

For the month, this pillar gained 13.21%.

Strategic Balance:

The traders in this allocation continue to impress even me with their ability to harvest profits from practically any market. I can't stress enough how fortunate I am to work with such accomplished absolute-return investment managers.

For the month, this pillar earned 2.49%.

Dynamic Income:

You can probably remember my disappointment in last month's letter discussing the unprecedented government intervention into the credit markets. Portfolios were adjusted mid-month to mitigate this risk and our traders were almost able to recover from losses incurred during the first part of the month. Credit markets appear to be functioning more normally, with smaller levels of manipulation. Due to recent events, fixed income assets are either extremely overvalued or undervalued, so the opportunities to make outsized gains in 2009 are better than normal.

For the month, this pillar earned -.62%.

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.

Sharing the Sport of Basketball with My Daughters

I have always enjoyed playing the game, but I never imagined how much fun it would be to coach my kids.

My first year coaching was last year-I coached Sarah's third grade Y-Ball team. Coaching your kids in basketball and being a parent have a lot in common. The older I get, the more I realize how smart my parents were. I can now say the same thing about my coaches. Yes Coach Rowan, fundamentals are the most important part of the game!

There is a big difference of knowing how to do something well and teaching it to other people, especially young kids. I was more nervous coaching Sarah's first practice than shooting the game winning free throws with 1 second left on the clock. After the first game, I started to get the hang of it and by the second practice it became pure enjoyment. What a joy it was to watch Sarah and her teammates learn the game. The weekly improvement was like watching a puppy grow.

Sarah has embraced the sport and has moved to an advanced league with professional coaches, so I assist when needed. This year, I am coaching the team of my six-year-old, Annabelle, and I am having more fun than anything I have done in a long time. We started scrimmaging last week and it was like watching an amoeba moving up and down the court. I am glad that the refs aren't strict on calling double dribbling violations. I am going to teach them their first play on Wednesday. With a little luck, we may be able to run it successfully by the end of the season.

I hope each of you has big plans for 2009. Don't let this terrible economy bring you down. Long term we will work our way out of this mess. We will continue to hit bumps in the road short term, but in the end, we will be stronger and more resilient. In the long run, no one has ever prospered by betting against America.

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 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.