Thoughts From The Frontline : Interest Rate

2010 Forecast: The Year of Uncertainty

John Mauldin — Sat, 09 Jan 2010 05:04:00 GMT

2010: A Year of Uncertainty
"Rocking Even Me"
Prisoners of Our Preconceptions
The Statistical Recovery
The Great Experiment
Whither the Fed?
London, Monte Carlo, Zurich, and Stocks

"Lying here, during all this time after my own small fall, it has become my conviction that things mean pretty much what we want them to mean. We'll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cosily comforting belief; we are blindest to precisely whatever might be most illuminating."

-- from Transition, by Iain M. Banks

Still a man hears what he wants to hear
And disregards the rest

-- The Boxer, by Paul Simon

"They Are Rocking Even Me"

This will be my tenth annual forecast issue. Time has flown by, and I enter a new decade of writing Thoughts from the Frontline. And even as I write about the high level of uncertainty of the current times, I am optimistic that at the opening of the next decade we will look back and realize that there has been an enormous amount of progress made. None of us will want to revisit the pleasures of the past ten years in some nostalgic dream. I am so ready for a new decade. And speaking of Paul Simon (above), reading the lyrics of The Boxer, one of my favorite songs from my youth, another few words seemed to hit home:

...Now the years are rolling by me, they are rockin' even me
...I am older than I once was, and younger than I'll be, that's not unusual
...No it isn't strange, after changes upon changes, we are more or less the same

At the end of the letter I announce the dates for our annual Strategic Investment Conference, tell you about an important conference I will be attending next month for 9 days (a rather large chunk of time for me!), and drop a hint about why I am going to actually buy some stocks this decade.

For new readers (and a lot of you have joined us this last year), let me quickly tell you what it is that I really do. I basically read and think for a living. I read a lot - hundreds of newsletters, articles, papers, magazines, books, essays, emails etc., almost every week. Each Friday I sit down and write about what seems to me to be the most important ideas I have come across, often tying together concepts from multiple sources into what becomes this letter, hoping to piece together a few parts of the puzzle, to help us see the bigger picture. On Mondays I send readers Outside the Box, which is an article by some other writer that I find interesting, and I try to make sure that I disagree with more than a few of them. We need to think, and that is one way of helping us do so.

The letter started out ten years ago as a way for me to put into writing my ideas and thoughts on what I had read, and I sent it out to just 2,000 people. It has grown to where today it goes to around 1.5 million people and is posted on dozens of web sites. The letter is free. You can subscribe at www.investorsinsight.com simply by giving me your email address. And feel free to forward the letter to friends or put a link to it on your web site. And there are Chinese and Spanish translations of the letter each week as well.

2010: A Year of Uncertainty

I read and research more for the annual forecast issue than any other letter during the year. And having had the luxury of not writing for the last two Fridays, I've had even more time. It seemed to me that the volume of forecasts out this year was greater than ever. But even I was amazed when Birinyi Associates, Inc. showed a picture of annual forecasts they had come across and printed out. It was a stack almost two feet tall and comprising over 3,500 pages. They helpfully summarized the projections for the major investment banks and compared them.

Their work confirmed my own reading. The projections they cited and those I have read were all over the board and more divergent than I can ever remember. But as I read the tea leaves, there is a lot of uncertainty and caveats with these forecasts. And too many are based on assumptions that the future will turn out largely looking like the past. It has been my contention for a long time that we are in a period that looks nothing like the past, and to use backward-looking data to project the immediate future carries the risk of being very misleading.

Thus, before we get into my projections, I think we need to take a survey of where we are. That means this annual issue may turn into a two-week project (I generally try to stop writing at eight pages); but if you don't know where you are, how can you figure out where you're going?

This is a challenging time, and I am going to challenge a lot of people's ideas over the next two weeks. So, as we start, let's look at why we need to very carefully assess our belief systems. The two quotes at the start of the letter point out how difficult it is for us to accept an idea that challenges our belief system, or would have negative consequences for our lives. If we are long some investment, we look for good news that tells us our investments are going up, and gloss over the negatives.

Last month, I found out I was just a few thousand miles from becoming executive platinum on American Airlines. I have never attained that level, and there are some major benefits. So, the flight which was the least expensive and gave me the required miles was a two-hour hop to Tampa, where ironically I had been the week before. I flew back on the same plane 30 minutes later.

However, the time was put to very good use. I read a pre-publication manuscript of a book by my good friend James Montier, called The Little Book of Behavioral Investing. I was asked to write the preface. I have to say that this book will become one of those that I read at least once a year, as it just so pointedly reminds me of all the ways we make investment (and life!) mistakes because of the ways our brains are hard-wired.

One of the real problems is that we "hear what we want to hear." Our beliefs or personal interests lead us to conclusions or actions that may or may not be helpful. Let's take a page excerpt from James' book:

Prisoners of Our Preconceptions

"For instance, a group of people were asked to read randomly selected studies on the deterrent efficacy of the death sentence (and criticisms of those studies). Subjects were also asked to rate the studies in terms of the impact they had had on their views on capital punishment and deterrence. Half of the people were pro-death penalty and half were anti-death penalty.

"Those who started with a pro-death sentence stance thought the studies that supported capital punishment were well argued, sound and important. They also thought that the studies that argued against the death penalty were all deeply flawed. Those who held the opposite point of view at the outset reached exactly the opposite conclusion.

"As the psychologists concluded: ‘Asked for their final attitudes relative to the experiment's start, proponents reported they were more in favor of capital punishment, whereas opponents reported that they were less in favor of capital punishment.' In effect each participant's views polarized, becoming much more extreme than before the experiment.

"In another study of biased assimilation (accepting all evidence as supporting your case) participants were told a soldier at Abu Ghraib prison was charged with torturing prisoners. He wanted the right to subpoena senior administration officials. He claimed he'd been informed that the administration had suspended the Geneva Convention.

"The psychologists gave different people different amounts of evidence supporting the soldier's claims. For some, the evidence was minimal; for others, it was overwhelming. Unfortunately the amount of evidence was essentially irrelevant in assessing people's behavior. For 84% of the time, it was possible to predict whether people believed the evidence was sufficient to subpoena Donald Rumsfeld based on just three things:

1. The extent to which they liked Republicans

2. The extent to which they liked the US military

3. The extent to which they liked human rights groups like Amnesty International.

"Adding the evidence into the equation allowed the researchers to increase the prediction accuracy from 84% to 85%. Time and time again, psychologists have found that confidence and biased assimilation perform a strange tango. It appears the more sure people were that they have the correct view, the more they distorted new evidence to suit their existing preference, which in turns made them even more confident!"

"We'll pluck significance from the least consequential happenstance if it suits us and happily ignore the most flagrantly obvious symmetry between separate aspects of our lives if it threatens some cherished prejudice or cozily comforting belief; we are blindest to precisely whatever might be most illuminating," wrote Ian Banks, of the protagonist in the science fiction novel Transition I am currently reading.

(By the way, if you are a sci-fi reader and have not yet become addicted to the writing of Banks, start with his early work and move through the decades. He is one of the best hard sci-fi writers alive.)

Those who are invested in the idea of a "V"-shaped recovery became excited over the jobs report last month. Unemployment rose by only 11,000 jobs, if you did not look at the underlying numbers or ignored the household survey. And the consumer confidence surveys have begun to rise. The Index of Leading Economic Indicators has now risen for six months in a row. Productivity is up. And surveys indicate that consumer spending is up. GDP growth in the fourth quarter looks to be in the 3%-plus range.

All reasons to be bullish, if you are looking for a reason to be bullish. If you don't examine the underlying data, you can feel good. The problem is that when we look deeper into the data than just the headlines, there are concerns.

For instance, take the contention that consumer spending is rising. I called Philippa Dunne at The Liscio Report. They survey the various states about taxes, among other things. "Sales taxes are not up and the current survey we are doing is pretty bad." She used the word "horrified" when commenting on some of the respondees' replies at the various state tax offices. Further, today we find that credit card lending dropped $17 billion last month, the largest drop in history. And this was during Christmas!

Savings are up. Credit is down. Where did the rise in consumer spending come from? Remember, these are mostly surveys and/or comparisons with a disastrous 2008. And they compare same-store sales for chains like Best Buy, which no longer competes with the bankrupt Circuit City, or for chains that closed stores, forcing buyers to the remaining stores. The key to watch is sales taxes. When they are rising, consumer spending is rising.

Consumer confidence is rising, but from truly awful levels. The levels are still well below any level in previous recessions and certainly do not indicate a robust economic rebound.

A challenged consumer confidence survey is not surprising, given the fact that roughly 8% of the working population is getting some form of unemployment assisance. One in eight children in this country is living on food stamps. By the way, the total number of people on unemployment is about 300,000 worse than most media accounts report. The Extended (and Emergency) unemployment claims for those out of work more than 26 weeks are not seasonally adjusted. To get the total number of people on unemployment insurance of all kinds, you have to add the non-seasonally adjusted number of continuing claims, which is currently about 300,000 higher than the seasonal adjustment. Here is a chart from Philippa, at www.theliscioreport.com.

She explained, "For the week ended 12/19, 10.42 million Americans were receiving unemployment benefits, With 5.44 million Extended claims (week ended 12/19) and 4.98 million Continuing claims.

"But NSA jobless claims show a far different story. The advance number of actual initial claims under state programs, unadjusted, totaled 645,571 in the week ending Jan. 2, an increase of 88,000 from the previous week. There were 731,958 Initial claims in the comparable week in 2009... The advance unadjusted number for persons claiming UI benefits in state programs totaled 5,479,110, an increase of 388,729 from the preceding week. A year earlier, the rate was 4.0 percent and the volume was 5,317,388.

"So the actual, the real benefits paid (Initial, Continuing, and EUC claims) hit another record of 11.268 million." (source: The Big Picture)

Today's employment report was just terrible. The headline said we lost 85,000 jobs. That is from the establishment survey, where they call up larger businesses and ask them about their employment. They also do a household survey, where they survey about 400,000 households. That report reveals a much worse situation.

Last month, single women who are heads of households saw their unemployment ranks rise by a massive 127,000. The number of employed men fell by 214,000. The total number of unemployed in the survey rose by an enormous 589,000. Those classified as not in the work force (due to the fact that they did not look for jobs) rose by 843,000! That now means that in 2009 3.5 million people were dropped from the potential labor force count because they were discouraged.

If you add those to the 15.3 million who are unemployed, you get a much higher unemployment number than 10%. Getting that exact number is tricky, because if you are back in school (as some of my friends are) you are not looking for a job but are going to want one soon. And if the economy does rebound and jobs start to become available, then it is likely a large number of the discouraged 3.5 million will start looking for jobs and therefore be listed in the work force. Ironically, a recovering economy could see the unemployment number rise. During the recovery, it will be important to look at the total number of employed and not just at the unemployment rate.

Sidebar: As noted above, a large number of people were dropped from the official labor force. What that means is that even though the number of employed people fell, the unemployment rate did not. It will be interesting to see if a lot of those people just decided that December was not a good time to be looking, spent time with families, or decided it was too cold to get out. How many will start looking as we get into the new year? We could see a rise in the unemployment rate next month if a large number do look for work.

Look at the chart below from my friend Greg Weldon. (It just hit my inbox.) It shows the percentage of people who are participating in the work force. (www.weldononline.com) It is sadly dropping, which means that incomes to families are dropping. The number of people I know who are looking for work or are struggling increases each week. It truly saddens me.

The Statistical Recovery

So why, if the employment picture looks so bad, are we getting positive GDP numbers? I coined the term "Statistical Recovery" last summer to describe an economy where the statistics are positive but it certainly doesn't "feel" like a recovery. So, how is it that we see a rise in the statistics?

First, year-over-year comparisons are looking better, since 2008 was horrific. Second, inventory levels are about as low as they will go. In the way GDP is figured, a reduction in inventory reduces GDP. That was a negative figure for most of this recession. Simply because inventories not falling any more, it is easier to get a positive GDP.

Second, as I have written, there are one-time benefits for GDP from the federal stimulus. Roughly 90% of the 2.2% growth in GDP in the third quarter was attributable to the stimulus, and we will see a similar affect in the 4^th-quarter numbers and at least through the first half of next year.

A reduction in imports is also a positive for GDP. We are buying less "stuff" from abroad, so that helps statistically.

Martin Feldstein, one of the great economists of our time, was quoted last week as saying that the recession is not over. Indeed, it you look at past recessions, it is not all that unusual (8 out of 11 times) for there to be positive GDP quarters in the midst of an ongoing recession.

The Great Experiment

So this is the backdrop as we look into the future. Unemployment is rising and is likely to remain stubbornly high (over 10%) for some time, except for the few months this coming summer when the Labor Department will hire hundreds of thousands of temporary census workers. The savings rate is rising, and consumer spending is at the very least challenged. The stimulus starts to drop sharply in the latter half of the year. States, counties, and cities are short about $260 billion and will either have to cut services (and thus jobs) or increase taxes. Housing is likely to get weaker, as there are large numbers of defaults coming because of mortgage-rate resets this year and next (more on that in a few weeks). Valuations on stocks are in the high range, and do not portend well for long-term returns.

Further - and this is the most important item to me - Congress is likely to allow the Bush tax cuts to expire and to add insult to injury with some form of large tax increase for heath care. Between the local, state, and federal tax increases, we could see a massive increase in taxes of perhaps $500 billion in a $13-trillion economy, or about 4% of GDP.

Think about that for a moment. It is likely we will begin 2011 with close to 10% unemployment, if not higher. Christina Romer's work shows that tax cuts have a three-times benefit to GDP. Tax increases presumably have a similar negative effect. (Ms. Romer, by the way, is President Obama's Chairwoman of the Council of Economic Advisors. This is not a partisan idea.)

This is the great experiment to which we are going to be subjected. There are those who agree with Art Laffer and company that tax cuts are a positive for the economy (that would include your humble analyst). And there are those who contend that the economy did just fine in the Clinton years before the Bush tax cuts and that we will do just as well if we take them away. And further, taxing the rich a little more is not really going to change their behavior.

My contention is that if such a tax increase is enacted all at once, the economy will at a minimum dip back into a nasty recession. If I am wrong, then I will have to abandon one of my long-cherished beliefs. I will have to stop arguing that tax cuts are as important as I think. Right now, when I read the data and studies, they confirm my tax-cutting bias. But I have to be willing to change my mind if The Great Experiment proves me wrong.

But if you think unemployment is high now, you will really not like what happens if we dip back into recession. It could go a lot higher. They are truly risking a great deal if they decide to pursue this experiment.

Thus, I am faced with a great deal of uncertainty as I look into the future with my forecasts - and we will get into the bulk of the actual forecasts next week. I almost titled this letter "The Year of Waiting," because there are so many important developments we are waiting on. Will they actually raise taxes in such a soft economy, or will cooler heads prevail and the increases be postponed, or at least phased in over 4-5 years? What will the health-care bill look like? There are so many things that could significantly change any predictions.

As I have written for years, the stock market drops an average of over 40% during a recession. If we go into a recession in 2011, it is highly unlikely that there will be an exception to the bear market rule. But this market seemingly wants to go higher. Smart people like my partner Steve Blumenthal argue with me that the technicals say we could go a lot higher in the short term. And he may very well be (and probably is) right.

This is a trader's market. It is not time to buy and hold large indexes or high-beta stocks and expect to be made whole over the next ten years. Hope is not a strategy. But waiting for the "shoe to drop" is frustrating, I know. However, that is the situation we find ourselves in.

We will go into this next week, but the current environment is quite different than 1982, when the last bull market started. Rates were falling; they are now likely to rise over time. Taxes were going down. Valuations were at historical lows, not high and rising. Inflation was coming down. And on and on. The current environment is not one in which bull markets are born.

Whither the Fed?

The futures market is pricing in rate hikes from the Fed beginning this fall. I highly doubt a politicized Fed will hike rates with unemployment over 10%, ahead of a November election. We are going to have a very easy monetary policy for longer than most observers think.

The Fed has painted itself into a very tough corner. Raising rates in a high-unemployment environment is risky. Bernanke knows what happened in 1937 and does not want a repeat. But by keeping rates too low for too long, they risk an asset bubble or two. And the federal fiscal deficit of over $1.5 trillion is not making their situation any easier.

The Fed has announced it is ending many of their various and sundry programs in the first quarter. They have essentially been the mortgage market. What will happen to rates? I think that is one of the reasons why Geithner has essentially lifted any limit on explicit guarantees for Fannie and Freddie. It will be seen as higher-paying government debt. It will also cost you, Mr. and Ms. Taxpayer, hundreds of billions in increased deficits, as they are telling those entities to eat the losses from large numbers of loan modifications. This is outrageous on so many levels. Congress should at least have to approve this.

It's getting close to my eight pages, so let me end by saying that, as we face the next crisis - and we will (there is always another crisis) - we will find we have not fixed the causes of the last one. We still have banks too big to fail, we have not put the credit default swaps on an exchange, we have not reinstated Glass-Steagall, Barney Frank's bill (which was not the one that came out of committee) now makes it exceedingly more difficult to short stocks, we keep in power the same people who missed the problems the last time, and the list of bad policies bought (typo intended) to you by bank lobbyists grows ever longer. If the current bill looks like it was written by the bank lobby, that's because it was. But it means we will have to face the same problems all over again. But that is another story for another day. Next week we look at the dollar and other currencies, gold, commodities, bonds, emerging markets, and more.

London, Monte Carlo, Zurich, and Stocks

Tomorrow I head to Santa Barbara for the annual business planning session with my partners at Altegris Investments. Let me quickly note that our annual Strategic Investment Conference will be April 22-24 in La Jolla. The speaker lineup is powerful. Already committed are David Rosenberg, Dr. Lacy Hunt, Dr. Niall Ferguson, and George Friedman, as well as your humble analyst. We are talking with several other equally exciting speakers. This conference sells out every year, and you do not want to miss it. We will have an announcement soon.

Secondly, I am going to go to the Singularity University's 9-day Executive Program from February 26 through March 6. As for how I feel about it, the fact that I would devote nine days to it basically says it all. They have a very powerful faculty brief a rather small group about how the future of a variety of technologies will impact all aspects of business and the economy. It is not cheap, at $15,000, but I think it will be worth my time. They have had more applications than they have slots, but they have said they will give my readers special preference (as far as possible). You can go to www.singularityu.org and click on the link to the conference to find out more. I have been told who some of my fellow attendees will be, and let me say that the list is impressive. I am really looking forward to it. Hope to see some of you there.

I will be in London January 20-23, then a few days in Monte Carlo, and then Zurich and Geneva mid-week. I do have some times open, and will be speaking in London with my European partners, Absolute Return Partners. Drop me a note if you would like to meet, and I will see what we can do.

Finally, next Monday's Outside the Box will be very unusual. I have not bought a stock for over ten years, preferring managers and funds. But starting in the next few weeks, I am going to begin buying stocks in a particular asset class, and intend to accumulate a portfolio over the next five years. Even in the face of what I think will be a recession. If you are interested in my thinking on this, be sure and read the letter.

I am so ready for 2010 and the next decade! As I look back, every decade has been better for me, and I think this decade will keep that trend intact. As Tiffani comes back from maternity leave (kind of), we have a lot of ideas for ways to serve you better. And we are going to be looking for suggestions. We are excited.

I am going to the Cowboys game tomorrow night, and hope we can beat our post-season jinx. This is going to be a very busy year for me, but I have to admit I am having more fun than I ever had. Thank you for being a part of it all.

Your more optimistic than this letter sounds analyst,

John Mauldin

Where the Wild Things Are

John Mauldin — Sat, 21 Nov 2009 05:49:00 GMT

Where the Wild Things Are
It Is Not Just Japan
The Euro-Yen Cross and the Dollar Carry Trade
New York, London, and Switzerland

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.

It Is Not Just Japan

Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can't make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China's Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) -- The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government's indication, that in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has 'seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.'

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve's policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"'I'm scared and leaders should look out,' Tsang said in Singapore Nov. 13. 'America is doing exactly what Japan did last time,' he said, adding that Japan's zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration's willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron's just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

New York, London, and Switzerland

I am going to hit the send button on what may be the shortest e-letter I have ever done. The travel is catching up with me and I need some rest.

I am looking forward to Thanksgiving next week. It may be my favorite holiday. Family, friends, food, and football. My usual pattern is to get up very early Thursday and start the prime slow-cooking, and then turn to the side dishes. It will be no different this year. My brother will bring the smoked turkeys, which he has down to an art form. And then there are the over-the-top wines I was so graciously given this past birthday by so many friends. I will bring a few of those bottles out.

The next weekend I am in New York for Festivus with the crowd from Minyanville, and then I am home for over a month before I go to London and Switzerland in late January. Then not much is currently scheduled until April, although it always does seem to change. After the recent hectic schedule (15 cities and even more speeches in just a little over three weeks), I look forward to some home time.

I wish those of you in the US the best of Thanksgivings, and the rest of you a great week. And thanks for all the very kind words of late about Tiffani. She seems to be doing better. She is due in a month, so she is still moving slowly, but you can sense the excitement in her and Ryan. I find it all very pleasant.

Your "there's no place like home" analyst,

John Mauldin

Further Thoughts on the Continuing Crisis

John Mauldin — Sat, 07 Feb 2009 05:56:53 GMT

Thoughts on the Continuing Crisis
The Right Direction, At Least
The Jobs Will Come
Can We Have a Little Inflation, Please?
Those Wild and Crazy Analysts
La Jolla, Conversations, and Richard Russell

When confronted about an apparent change of his opinions, John Maynard Keynes is reported to have said, "When the facts change, I change my mind. What do you do, sir?" The earnings season for the 4^th quarter is almost 80% complete, and the facts are dismal. It is worse than the current data shows, and could get uglier. Unemployment is increasing, and consumers are both saving more and spending less as incomes are not keeping pace with what little inflation there is. All in all, a very different set of facts than a few quarters ago. This week we examine some of the new facts, and start out by analyzing how Thoughts from the Frontline has done over the past two years with some of the more important predictions. It should make for an interesting letter.

At the end of the letter, I have a few notes on my upcoming Strategic Investment Conference in La Jolla, April 2-4 (which looks like it will sell out), information on the Richard Russell Tribute Dinner, a mention of my new Conversations service (which is getting very good reviews), and the need for one or two part-time editors.

The Right Direction, At Least

Over the last year, I have become increasingly more bearish on the economy than I was in January of 2007. In my 2007 annual forecast issue, I said that we would be in a recession by the end of the year (we were), and that it would be a long but not too deep recession, with a multi-year below-trend Muddle Through period to follow. I was thinking GDP would maybe be down 2-3%. As I have repeatedly written in this letter and said in speeches, the US stock market drops by an average of 43% in recessions. I saw no reason to be in the stock market, as there was just too much risk of a serious bear market. Further, since international markets now have close to a full correlation with the US markets, foreign stock indexes would be in trouble as well. I also said interest rates would be coming down and deflation would be a problem before we got through this recession.

(As an aside, there are a lot of very well-known perma-bearish analysts who called the recession, but were very bearish on the US dollar and positioned their clients in emerging-market stocks or other markets. Their clients have been mauled. Just because you get the economy call right doesn't necessarily mean you can call the right investment shots. Before you invest with a manager because he seems to have been right about something, look to see what his actual investment strategy has done. And that includes me or my partners.)

I also predicted the bursting of the housing bubble and the subprime credit crisis in late 2006 and 2007. While I was completely wrong about the severity of the current recession, at least I got the direction right. My advice would have been the same, which was avoid long-only stock portfolios and mutual funds, be long bonds, and access active, absolute-return managers and funds.

But the facts have changed. The reality is that we are in a much worse recession than I thought it would be two years ago. And as I wrote last month, we will probably be in recession for the full calendar year 2009, with the same lengthy multi-year Muddle Through Economy I originally envisioned, albeit from a lower base. So, what does that look like? Let's look at a likely set of facts, in no particular order.

1. Consumers are going to save more and spend less. It is likely that US consumers are going to push the savings rate back up to 6% (or more). Total US net worth decreased by $7.1 trillion through the third quarter of 2008, from housing and stock market losses. The trend suggests that could easily be up another $6-7 trillion by the end of this quarter. Greg Weldon speculates that is could easily be $15 trillion by the end of the cycle. That is a massive amount of wealth destruction. And while the absolute numbers are not as large in the rest of the world, the relative magnitudes are. This is a truly global recession. Economists say that anything below 2.5% in world growth is a global recession. We are down to 0.5% and falling.

2. The stimulus package is simply a pork-laden, misguided piece of legislation. The nonpartisan Congressional Budget Office released a report (I think yesterday) that says "CBO estimates that this Senate legislation would raise output and lower unemployment for several yearsÉ In the longer run, the legislation would result in a slight decrease in gross domestic product (GDP)." There is way too much spending on items that have very little current effect on the economy.

I am in principle in favor of a deep and large stimulus package. We need one, but what is on tap is not what will stimulate real job growth. All it does is create more debt that will have to be paid later by our kids. What else could we do? For instance, US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act. (Sent to me by Louis Gave of GaveKal, whose work will be highlighted in next Monday's Outside the Box)

Why not set a 10% tax rate to simply bring the money home, and a 5% rate if they use it for capital spending or to create jobs? Now that is stimulus that would actually result in more taxable income! And that money did help to create a boom in 2004. On an aside, this just goes to show how out of balance the US corporate tax system is.

What little real stimulus is in the bill will not hit all that much in the first half of this year. The fourth quarter of 2009 is likely to look better than the first quarter, but it is also likely to have a negative sign in front of it. I hope I am forced by the facts to change that prediction.

3. I am somewhat more hopeful about the Federal Reserve and Treasury programs, although all they really do is buy time for financial corporations to heal themselves. That is not all a bad thing, though. Volker did it in the early 1980s by allowing banks to carry debt from Latin American countries that was in default at full loan value. Otherwise every major bank in America would have been bankrupt.

And I agree that a lot of the process will be wasteful and unproductive. But such is the nature of crisis planning. Hopefully, they will not put into service the notion of a large "bad bank," but rather go ahead and put the zombie banks to sleep and help the healthy ones survive. But if US taxpayer money is involved, then shareholders should be wiped out first. If the rest of us have to lose on our stock investments, then bank investors should not be in a special protected class.

The downgrades by Moody's today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow.

"Moody's warned in a report last week that loss assumptions would be increased for RMBS and that downgrades could be expected. Moody's is projecting that alt-A deals originated in the second half of 2007 will experience 25.5% losses of original balance, compared to 23.9% of 1H07 deals, 22.1% for H206 deals and 17.1% for 1H06 deals. The rating agency in May expected average losses for 2006 and 2007 vintage deals to reach 11.2% and 14.7%, respectively." (The Big Picture)

These losses are just going to keep coming. Commercial mortgage paper will soon be written down as well. Banks will likely need at least $1.5 trillion in private investment and government funding.

4. As I have noted for almost two years, it will take until at least 2011 for the housing market in the US (and bubbles elsewhere, as in England and Spain, etc.) to stabilize. It will take several years for the creation of a new credit system to rationally replace the old "shadow banking system." This is why the recovery will take so long.

For an economy to grow over time, you need some combination of increasing population, productivity increases, and credit creation. We have destroyed a large part of our credit creation model (which was deeply flawed, even though for awhile it seemingly worked well) here in the developed world, and simply have to build a new one. That is why I believe we are going to see the creation of a massive new Private Credit Market that will compete with banks. You can see this developing here and there, but it is going to take time. The Fed is stepping in now and buying mortgages, credit card debt, student loans, etc., which is useful in the interim, but they need to make sure they do it at rates that will attract private capital and capital formation. We do not want to turn the Fed or Treasury into a national mortgage bank subject to political whim. That would be worse than what we have now. As an example, the government is now nearly the only source for student loans, as they set prices which just did not allow private companies to compete. We must not do that with mortgages.

5. The US government will run multi-trillion-dollar deficits for at least two years. As noted above, I think the current stimulus package will not be deemed sufficient by the third quarter, and the compelling need politicians will feel to do more will be almost uncontrollable.

Interestingly, the increase in federal spending is going to be accompanied by a substantial decrease in state and local spending, as almost all nonfederal entities must balance their budgets, and tax receipts are way down. If consumers are spending 5% less, it stands to reason sales taxes are down by 5%. Property taxes will be down, as will the state portion of income taxes. Increasing taxes will bring about local voter rebellion, so spending cuts will be the order of the day. As an example, state employees in California have every other Friday off, which cuts their pay by 10%. Expect more such cuts everywhere and on everything.

And while I am on the subject, state, county, and municipal pension plans are woefully underfunded. As in by trillions of dollars -- much as I wrote in Bull's Eye Investing in 2003. The signs were so there, and in a few years governments are going to have to figure out how to deal with major shortfalls in funding, as many municipal pension plans will be technically bankrupt.

Accompanying the increase in federal spending will be a real decrease in federal tax receipts, which will make the deficits worse.

6. The main driver in the economic world is deflation, as I have been writing for a long time. Yes, we had a brief whiff of inflation last year, but that was primarily commodity-driven, and that force is now spent. Commodities are likely to rise in price again, but not in the near future.

This is going to give the Fed the room to print money to monetize the federal deficit, and indications are that Bernanke will do it with a vengeance. He will do everything in his power to keep the US economy from catching "Japanese Disease," that is, descending into a deflationary spiral. I fully expect them to "move out the yield curve" and set longer rates at some lower number as well.

All of the above leads me to the following conclusions.

We are going to some new lower level of GDP and consumer spending, maybe as much as 5% lower, which is a serious recession. And the "recovery" is going to be slow. We don't get back to 3% GDP growth in 2010. Let me once again print a graph I have used several times, but it is just so important. You need to think about this one. This shows what the US economy would have been without mortgage equity withdrawals from 2001 to 2006.

Notice that the US economy would have grown less than 1% a year for five years, and barely that by 2006. And that is with consumers saving less than 1-2%! Now, let's imagine a world with savings going to 6% (or more), because shell-shocked US consumers now realize they may actually have to save to be able to retire. And what is it going to feel like when housing drops another 10-15%? Or more?!?!? And what if we have a repeat of a major summer bear market – which I make the case for in a few pages?

The Jobs Will Come

We could see well-below-trend growth for several years. I spoke this week to a small group of entrepreneurs that my daughter is involved with. (It is a business development/mentoring program called Vistage. I know several people who have seen their businesses really take off because of what they learned. If you are running your own business, I highly recommend it. I can see the differences it is making in my business because of Tiffani and other people I know who are involved. Their web site is www.vistage.com)

What I told them is that for those businesses which are dependent on the US consumer, their world is going to be smaller for a long time. We are in a period where the economy is going through what economists call rationalization. We are going to have to reduce the number of retail stores, coffee shops, automobile plants, fast food restaurants, car dealerships, etc., until we get to a level that makes rational sense for the size of the economy. We just built too much stuff, launched too many stores, and created too much capacity for almost everything.

The idea for the business person today is to still be standing when we get through this, as we will. That is what free market economies do. The day will come when we get back to 3-4% GDP growth. But it will be a rational growth based in real fundamentals, one that will last a long time. So hope is not a business strategy. You need to be planning for a lengthy recession and a slow recovery.

And if your business is one that helps producers cut costs? Or improve production? Then this is your time to shine. It is not clear what the stimulus plan will be, but look at it to see if there is something you can do to get in the flow of that money. There are opportunities out there.

We were in a similar period of malaise in the late 1970s. Everyone wondered where the new jobs would come from. The correct answer was, "I don't know, but they will." As it turned out, we saw the creation of whole new industries, which the government had little to do with. It is still the right answer. The new industries that we will see next decade? Biotech? Energy? A new wireless telecom build-out? Something out of left field? The correct stance is to be cautiously optimistic.

I am seeing some amazing private equity deals and new ventures. It is really a great time if you have capital, as you can pick among some very nice opportunities.

Can We Have a Little Inflation, Please?

Getting back to the Fed and deflation, there will come a point (I hope) when the Fed will actually bring about some inflation. That means they will have to tap on the brakes to keep from letting that get out of hand. That of course will slow any recovery, which is another reason I think the recovery from the current recession will be a lengthy one. It is asking too much for them to get it "just right." There is no formula here. They really do have to make it up as they go.

And while I don't think it is the likely case, it is quite possible that we could see a repeat of '70s-style stagflation. We could also slip into Japanese-style deflation, as the Fed may be pushing on a string. There is just no way of truly knowing. You have to stay nimble and go with the facts as they come down the road.

As investors, your goal is also to be standing when we get through this. There is another bull market in our future, as hard as that may be to imagine now. But it is several years off. Now is still a time for absolute returns and active management. You want to arrive at the dawn of the next bull with as much of your assets as possible. How will we know when we are there? Because valuations will be low. Which is a perfect time to segue into an analysis of current market valuations, as we close the letter.

Those Wild and Crazy Analysts

I have been writing about analyst earnings forecasts for some time. Earnings forecasts just keep dropping. I talked with the very interesting and gentlemanly Howard Silverblat from Standard & Poors, who is in charge of assembling the data for the S&P earnings. When I went to the web site, I noticed that "core" earnings were not on the spreadsheet. Core earnings take into account pension fund commitments and other items that sometimes do not make it into reported or operating earnings. During the last bear market, core earnings were a lot lower than reported earnings, as companies adjusted their pension commitments to make things look better than they were. I was wondering if we would see the same thing happening now.

I asked Howard about that, and he said they were having some issues in calculating them but expected the core earnings numbers to be back up in a month or so. And he quoted sources that suggested S&P companies were underfunded by $250 billion in their defined-benefit pension plans. Late last year, the Bush administration waived the requirement that companies fund their pensions to at least 92% of needed capital. It is now down to 80%. That leaves companies some room to play with on their balance sheets.

I commented on how bad earnings were last quarter. The web site shows earnings were a negative $3.14 a share, the first time they have ever been negative for a quarter. Ever! That was with 65% of companies reporting. He commented that it was worse than that. They don't have it up yet, but with 78% of companies reporting, losses are now a staggering -$8.56 a share. And it could get worse. The write-offs this quarter are just huge.

As he wrote, companies are not only throwing in the kitchen sink, but the refrigerator, washer, and anything else they can find as they seek to write off everything they can, to get it over with and start the new year fresh. They need to do a kitchen remodel, but there is no financing available.

So, how does that affect total earnings for 2008? The table above shows analyst projections from March of 2007 through today. Notice how they kept falling over time. They are now down 70% from what was expected two years ago. Earnings for 2008 are a paltry $29.57 and dropping. The S&P 500 closed at 868.60. That makes the P/E (price to earnings) ratio 29.4. (I use a decimal to show I have a sense of humor.)

So, what are they projecting for 2009? Let's take a look. Notice that they too have been falling over time.

If the S&P 500 were to close where it is today, and using the estimates for the first two quarters of 2009, the P/E ratio would be 36.4 on July 1.

But what if earnings merely fall to where they were in the last recession, or about 55-60% of where the projections are today? That would drop the 12-month trailing earnings for the four quarters ending June 30 to $15.90 and result in a nose-bleed P/E of 54.7 by the middle of the year.

If earnings don't come in dramatically better for the first quarter as opposed to last quarter, we could be setting up for a nasty summer bear market. Even in the bear market of 2001-2, the P/E did not get above 47. Which, by the way, at a 47 multiple would correspond to a range for the S&P of either 1111 if the earnings come in as projected or 731 if they come in at the lower range.

I see nothing on the horizon which suggests the economy is going to get manifestly stronger in the next two quarters. The real risk is that earnings come in weak for both quarters and investors simply despair this summer, throwing in the towel and bringing about a vicious bear market. I would seriously consider hedging any long positions you have before earnings season this next April. If they come in stronger, then we will see.

La Jolla, Conversations, and Richard Russell

As I mentioned at the beginning of this letter, along with my partners Altegris Investments, I will be co-hosting our 6th annual Strategic Investment Conference in La Jolla, California, April 2-4. I have invited some of the top economic minds in the country to come and address us, giving us their views on what seems to be a continuing crisis. It will be a mix of economic theory and practical investment advice. WE WILL SELL OUT, so do not procrastinate if you intend to register.

Already committed to speak are Martin Barnes, Woody Brock, Dennis Gartman, Louis Gave, George Friedman (of Stratfor), and Paul McCulley. I anticipate adding another stellar name or two, as a lot of very famous people are coming for the Richard Russell Tribute Dinner (see below). This is as strong a lineup as we have ever had, and on par with any conference I know of anywhere. And as a special bonus, we have invited Fredrik Haren from Sweden. I heard him speak at a conference in Stockholm last year and was blown away. You can click on the link below to learn more about the speakers.

Due to securities regulations, attendance is limited to qualified high-net-worth investors and/or institutional investors, because we will be showcasing a select number of commodity fund managers and other alternative strategies. Early registrants will get a discount. Last year we had to close registration, and I anticipate we will run out of room again, so I would not procrastinate. Click this link to find out more and register: https://hedge-fund-conference.com/register.aspx. And if you cut and paste this link, make sure you copy the "https:" so you go to the secure site.

And the first of the "Conversations with John Mauldin" is up! We recorded it last week, with Ed Easterling and Dr. Lacy Hunt. I thought it went very well for an inaugural talk. The complete audio and transcript are in the Membership Library already. For those who have subscribed, you should have received an email and be able to log in and listen or read the transcript. We are getting very favorable reviews. Multiple readers have let us know that the first Conversation was worth their entire year membership. I am quite pleased with the first transcript and the response to it. My next Conversation is in two weeks, with Nouriel Roubini; and then after the release of banking data in early March, I will do a Conversation with good buddy Chris Whalen and a few real banking experts, on where the US banking system really is. I will offer it as a bonus to those that have already subscribed, as it will be more me asking questions than a real Conversation. I expect it to be very informative.

The regular price for a yearly subscription is $199, but you can subscribe now for $109, and still get access to the timely Conversation with Ed and Lacy. Don't wait, as I am sure my staff will only keep raising the price. To find out more, just click on the link and put in code JM77, which will give you the discounted price. https://www.johnmauldin.com/newsletters2.html

Now, about the Richard Russell Tribute Dinner on Saturday, April 4. It will be at the Hyatt in San Diego. We are going to be sending out invitations early next week to everyone who has responded so far, which is well over 500 people. If you have already responded, you will get a chance to register first, before we open it up again. Next week we will have a page where you can sign up; but when you get the invitation, I suggest you act quickly, as it really could sell out. This is going to be a very special night. If you are one of Richard's many thousands of fans you will not want to miss this. As I said, there are going to be a lot of well-known names there. We are still planning the program, but it will be special. (Note: to those who are attending my conference, noted above, this is a separate event, with separate tickets, in a different Hyatt.)

If you would like to attend, just contact us and we will get you an invitation. The cost will be $195.

And finally, Tiffani and I need an editor or two to help us in the process of editing our taped interviews with millionaires. Drop us a note.

It is time to hit the send button. Have a great week!

Your really optimistic for the long run analyst,

John Mauldin

I Meant to Do That

John Mauldin — Sat, 20 Dec 2008 02:28:02 GMT

I Meant to Do That
The Lights of Myanmar
Some Good News for Borrowers
Madoff May Give Us a Sell-Off
Conversations with John Mauldin
New Orleans, La Jolla, and Merry Christmas

The Fed has taken interest rates to zero. They have clearly started a program of quantitative easing. What exactly does that mean? Are we all now Japanese? Is the Fed pushing on a string, as Japan has done for almost two decades? The quick answer is no, but the quick answer doesn't tell us much. We may not be in for a two-decades-long Japanese malaise, but we will experience a whole new set of circumstances. In what will hopefully be a shorter holiday version of the e-letter, I will tackle these questions and more.

The Lights of Myanmar

Most of us are familiar with the devastating hurricane that hit Myanmar (Burma) this last year, and the difficulty in getting aid to those who were suffering. My friends and colleagues at Knightsbridge were able to get in and help where others couldn't.

Knightsbridge International is a small group of volunteers who go to places that are definitely not safe but where the need for help is critical. Like the knights of old, who ran hospitals and relief efforts, these modern-day knights go to where the need is greatest. They took food and medicine to northern Afghanistan before the troops went in (very dangerous!). They went to rebel-held territory in Sri Lanka after the tsunami, when no one else could get medicine and other aid in. Whether it's driving in to rescue nuns in Rwanda (fascinating story!) or taking solar power to clinics in Myanmar, or water purification units and medicine to Darfur, they go where other groups fear to tread. They have no political or religious agendas, just the drive to get aid to where it can do the most good.

Last year an award-wining documentary was made about three of the Knightsbridge men, Ed Artis, Dr. Jim Laws, and Walt Ratterman. It was shown on PBS and viewed all over the world. These men are the real deal, heroes who like to do good deeds but get an adrenaline rush at the same time. Some of the things they do I cannot write about, as it would put them and others in serious danger. They are a little bit crazy, but then you'd have to be to accomplish everything they do.

Last year you generously supported missions to both Darfur and Myanmar, where a team led by Walt Ratterman (a leading expert on solar power) put into place solar power systems that help power clinics. Walt once showed me a photo of a doctor in Myanmar who had to do an amputation on a child (as a result of a land mine) in the dark, holding a flashlight in his teeth. You can bet that doctor was very happy about getting solar power.

For the past few years your generosity has helped provide solar power for health clinics for refugees in Thailand, as well as in villages in Myanmar. Walt wrote me about the project he recently finished:

"The project we just completed provided solar power for a medical and training facility in the Karen State that is operated by the Free Burma Rangers (www.freeburmarangers.org) The project started with a 4-day journey on foot to get into the area. Equipment for the solar systems had to be carried in by over 100 people prior to our arrival. After we all got in place, and completed the training for the solar installers, we installed twelve 2-panel solar systems. These systems provided electricity for the central communications center, the medical training center, the human rights training center, and other miscellaneous buildings. Once the work was done, we had to take the same 4-day hike back out of the area."

This is not an easy hike. It is through very dense, mountainous jungles, over rivers, and through deep valleys. The Free Burma Rangers have trained over 110 multi-ethnic relief teams, and there are 43 full-time teams active in the Karen, Karenni, Shan, Arakan, and Lahu areas of Burma. Seven more teams have been formed recently in the Chin area on the Indian Border. The teams have conducted over 350 humanitarian missions of one to two months into the war zones of Burma. On average, between 1,000 and 2,000 patients are treated per mission. You can see more about this last project at www.sunepi.org/SunEPI/Burma_files/PP_FBR.pdf

Partially due to your generosity, there are literally thousands of people (many of them young children) who are alive today. This year Walt wants to complete another clinic on the Thai border and then one on the India border with Myanmar. It will take approximately $75,000 to do both.

We are grateful for any donations to this year's project. Donations can be made at the website, www.sunepi.org or by directly going to our Funding Burma page, www.sunepi.org/SunEPI/Funding_Burma.html. Checks can be made out to SunEnergy Power International and sent to 11 Laurel Lane South, Washougal, WA 98671.

As I said, these guys are the real deal. They are helping people who the world has mostly forgotten yet who work hard day in and day out to keep their families alive. I know we are in a recession, but when you compare what is happening here to the devastation in Myanmar, our plight does not seem so bad. Please give generously.

By the way, Walt is in Palestine right now, installing more solar power for clinics. I can't mention where some of the other teams are, but a little extra prayer wouldn't hurt. (Did I mention that none of these guys take any money, and pay their own way? And if you too are a little crazy and are in decent shape and you want to join in some of the projects, drop them a line.)

I Meant to Do That

In my house, when someone stumbles or does something odd, they quickly say, "I meant to do that." It's a running joke, and we all have fun with it. This week the Fed did something rather interesting. Quoting from the release after their two-day meeting:

"The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent."

Normally they have a specific rate and not a range. But for the last few weeks the market has pushed the Fed's fund rate close to zero, making the Fed look like they were behind the curve at the then-official rate of 1%.

Now the Fed, with a range rather than a specific rate, will be able to say, "I meant to do that." They can keep the Fed funds rate from rising over 0.25%. And if it stays near zero? Well, now they can say it is within the target.

And with Fed funds at an effective zero, it is having the effect of bringing down other rates as well. I wrote in 1998, and have repeatedly made the point over the past five years, that deflation will be the primary force that must be dealt with, rather than inflation, before we are done with the current credit cycle. Over the last year, when CPI (Consumer Price Index) inflation was high and rising, I kept insisting that the problem would be deflation in 2009. (That brought more than a few letters telling me I was wrong.) Because of my view about deflation, I have long held that, ultimately, interest rates on the US 30-year bond would fall below 3%. That was rather bold in 1998, or even last year.

Now, that prediction seems rather tame. We went right through 3% this week, and as I write we are at an astounding 2.54% on the 30-year and 2.1% on the 10-year!

Note that the 3-month is at zero. Indeed, to get even 1% you have to go all the way out to a 3-year maturity. This is going to make it very hard on money market funds to offer any type of yield. Indeed, several large firms have closed their Treasury money market funds, as it costs more to operate the fund than the interest paid on the bills, notes, and bonds.

And this is precisely what the Fed wants to see. Investors are going to have to start looking to other avenues to get yield. If you can't get a return on your money market, why not put it in a bank certificate of deposit? You can get a federally insured CD for one year at over 3% at many institutions, and 4% if you want to tie your money up for three years. Making the competition - money market funds – less profitable is one way to recapitalize banks.

The Federal Reserve, as noted last week, has significantly increased the monetary base, but the money supply has not risen in concert. I failed to explain why last week. It is because banks have not taken those reserves and lent them out. Until that happens, the Fed is not really "printing money," they are just making it available. At some point, let's hope the banks decide to use it.

This week's FOMC statement was rather remarkable, in that it was very clear. Normally, and especially under Greenspan, you had to take each sentence apart to try and divine the meaning of the release and what that meant for the future. And the statements are typically short. Not this one. Let's look at three paragraphs from it (emphasis mine).

"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

"Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The Fed expects inflation to fall well into next year. They have noted their concern. They have also said they will hold the Fed funds rate at these low levels for a long period of time. This is to encourage longer-term lending at low rates.

How serious are they? Richard Fisher is the President of the Federal Reserve Bank in Dallas (just down the road from my new office). Over the past few years, he has been the most outspoken "hawk" on inflation of all the Fed governors and presidents. He spoke yesterday at the Dallas chapter of the World Affairs Council. Let me quote a paragraph:

"Price pressures now are in the other direction...[and] we have to do everything we can to lift the economy up and prevent deflation from taking [hold].... We are well aware that at some point, God willing, we'll have to tighten and we'll have to act; and I'm here to tell you that my voice will be very loud at that juncture, but right now that's not the issue."

That is a rather remarkable statement for Fisher. I don't ever recall him talking about preventing deflation. The FOMC meeting this week (where he is currently a voting member) must have been a real eye-opener for him.

The Fed has already committed to buying mortgages and consumer loan securities. In Ben Bernanke's famous "helicopter speech" in November of 2002, he stated that one of the ways the Fed could fight deflation would be to "move out the yield curve" and set target rates for longer-dated securities, like 2- or 3-year US notes. In the FOMC release, the Fed noted that they might indeed use that tool. That is one of the reasons interest rates are falling, as the market must sense that the Fed is prepared to do just that. This meeting simply put the market "on notice" that at some future meeting it is quite possible for them to set a target rate on longer-dated securities.

Some Good News for Borrowers

Remember that ARMs (Adjustable Rate Mortgage) reset problem I was writing about late last year? This includes all the alphabet of ARM mortgages, interest-rate-only mortgages, pay-option ARMs, etc. Resetting the rates has been a problem up until now, as the rates which are the usual base for the resetting have been high, forcing mortgagees to pay a much higher monthly mortgage when the rates reset. However, given the current environment, that may no longer be a problem in the near future.

The large majority of ARMs are linked to either 1-year LIBOR or 1-year Treasuries. We saw above that 1-year Treasuries are 0.39%, and 1-year LIBOR is 2.09. Both were at 4.5% in 2006. Those getting ready to reset in the near future are actually going to catch a break and see their payments go lower!

Fellow analyst Mish Shedlock writes that he has an interest-only mortgage tied to 1-month LIBOR, and his annual rate is going to drop to 1.75%.

You can bet that between the Fed and the incoming administration they are going to pull out all the stops to get 30-year fixed-rate mortgages to drop along with the 10-year US bond, with which mortgages normally move in tandem. The spread is now as wide as I can remember, at well over 3%. Not all that long ago it was 1%. It is quite possible that we will see mortgage rates below 5% and approaching 4% in the next year, at least for conforming mortgages. Since I have two kids that have bought homes this year, I hope they will be able to get refinancing at lower rates with whatever new program the administration introduces.

Madoff May Give Us a Sell-Off

Much of the selling pressure that has come in the stock and credit markets has been rightly attributed to forced selling by hedge funds in an effort to meet redemptions for January 1. I wrote a few weeks ago that this could be the kicker for a powerful rally in the first quarter. Most of those redemptions will show up in the last two weeks of January, with the rest by the middle of February. Institutions, which are the bulk of redemptions, are going to have to put that money to work. Do you put it into bonds at 2%? That is not going to get you to the target returns that you need for the future if you are a pension or insurance company.

Much of that money is going to go back into either the stock market or into other hedge funds. This could be the fuel for a real rally. However, that was before Madoff. I have no hard evidence, but I know a lot of funds of funds had exposure to Madoff. Those funds are likely to see further redemption requests and face the need to further liquidate underlying hedge fund positions. Also, a lot of people who did have investments with Madoff are now going to need to get their liquidity somewhere else.

This all has the potential to put more selling pressure into the market. Enough to overcome the tsunami of money that is coming back into the market? I don't know, but I think it could put a damper on the rally I was predicting. The actual redemptions for most funds of funds will be next April 1, as only a few offer monthly liquidity, but the selling will have to be in the months before. This will need to be closely watched in March.

Conversations with John Mauldin

Yesterday, some of you got a special email from me talking about a new subscription service that we will be offering beginning next month, called "Conversations with John Mauldin." One of my "secrets" is that I have a very powerful rolodex (or, for the younger crowd, my contacts list). Each month, I will call up one of my special contacts in the investment and economic world and hold a conversation with them about the important topics of the day - how we should be investing, what opportunities and pitfalls are out there in the world, etc. Some will be names you recognize, and others you should. You will get to listen in, download to your computer, or read a transcript, whichever you prefer.

Right now, we are offering a subscription for $99, half off the regular $199 price. This is only available for the Holiday season. You can click here and subscribe, if you haven't already. Insert code JM44 for this special offer.

And for those of you who experienced errors signing up, please email eu@2000wave.com and we will let you know whether your subscription and credit card went through.

If you like my regular e-letter (and it will still come to you each week), then you are really going to like this new service. This letter will not change at all. This new service is to let you look over my shoulder as I talk things over with colleagues who are in the know. I hope you join in and get to hear the January conversation, where we will discuss the forecast for 2009. You won't want to miss it.

New Orleans, La Jolla, and Merry Christmas

It is time to hit the send button, as I am off to New Orleans, where I'll spend the next four days with Tiffani, working on our new book, Eavesdropping on Millionaires. I really am looking forward to getting out of the office and focusing on the project. It's a lot of fun to interview millionaires and get their stories. There are just so many ways to achieve wealth, and so many interesting paths and personal insights that we have come across.

Tiffani and I will be in La Jolla in mid-January to have our annual planning meeting with my partners at Altegris Investments. I always look forward to meeting with Jon Sundt and his team, and feel they do an excellent job for our mutual clients. After that, I have a few trips planned in the US, but no trips lined up yet outside the country. That means I will have to get my travel "kicks" by reading International Living. It is an inexpensive way to learn about traveling and living outside your home country. For me, it is cheap fantasy about that beach home in Paradise. You can get your own subscription at http://web-purchases.com/ILV2008/WILVJC04/

The move into the new offices has been rather hectic, to say the least. Getting used to a new phone system, trying to unpack boxes, traveling to Phoenix (where it was rainy and cold), getting Trey ready for a new school, and more than the usual number of distractions has all made life more interesting. But then I have so many blessings that complaining about the small hassles seems out of line this season.

I am not sure if I will write another letter between now and January 9, when I will do my annual forecast issue. Let me take the time to wish you, gentle reader, a heartfelt Merry Christmas and the best ever New Year. While the economy may be a tad bumpy, the important things like family, friends, and health are where our real wealth is. Enjoy this season and all that it means.

Your still having to pack analyst,

John Mauldin

Some Things That Just Should Not Be

John Mauldin — Sat, 13 Dec 2008 05:01:52 GMT

Things That Should Not Be
I'll Pay You to Hold My Cash
Pushing on a String
Free Money with that Credit Default Swap?
Oil Does a Strange Contango Dance
The Tragedy of Bernie Madoff
Goodbye to the Ballpark

There are things in today's markets that are simply astounding. They should not exist, yet they do. Why should US bills trade at negative interest? How can oil be trading at all-time highs in terms of spreads over the next year? Bank debt and bonds are trading at discounts not to be believed. Want some free money? I show you a trade that gives you (almost) just that. Fed funds at zero? Are we starting to push on a string? We'll cover all this and more in this week's letter.

But first a quick commercial. Not all money managers and funds have had losses this year, even though it may seem like it. My partners around the world can introduce you to some alternative funds, commodity funds, and managers which you might find of interest as you rebalance your portfolio at the end of this year. You owe it to yourself to check them out.

If you are an accredited investor (net worth over roughly $1.5 million), you should check out my partners in the US, Altegris Investments (based in La Jolla) and my London partners (covering Europe), Absolute Return Partners. If you are in South Africa my partner there is Plexus Asset Management. You can go to www.accreditedinvestor.ws and fill out the form, and someone from their firms will be in touch. All three shops specialize in alternative investments like hedge funds and commodity funds, on a very selective basis. We will soon be announcing new partners in other parts of the world. And if you are an advisor or broker, you should call them (or fill out the form) and find out how you can plug your clients into their network of managers.

If your net worth is less than $1.5 million, I work with Steve Blumenthal and his team at CMG. I suggest you go to his website, register, and then let them show you what the blend of active managers on his platform would have done over the past few months and years. These are primarily managers who will trade a managed account (using various proprietary styles) in your name, and are quite liquid. Again, if you are an advisor or broker and would like to see the managers on the CMG platform and how you can access them for your clients, sign up and let Steve and his team know you are in the business. The link is http://www.cmgfunds.net/public/mauldin_questionnaire.asp. And now back to the letter.

I'll Pay You to Hold My Cash

In the last few weeks we have seen 30- and 90-day US Treasury bills trade every now and then at a rate of negative interest. That means someone is willing to pay for the privilege of having their cash in US Treasuries. This simply should not be. Why would anyone want to do this? Is this a sign the system is broken? Are we that scared?

Not really. There are some explanations for this seemingly bizarre behavior. First, banks are driving down the interest rates toward zero. Because their audits come at the end of the year, they want to be able to show a very liquid and pristine balance sheet. And what better way to do that than short-term US Treasuries? But that gets us near zero, not below. (And as noted below, the effective Fed funds rate is at zero, not the posted 1%.)

As David Kotok of Cumberland Advisors noted in a post: "We cannot find a single investor or institution or organization that would volitionally buy this T-bill at zero interest, let alone a negative yield. We have polled firms and agents and portfolio managers. We've asked people who range from sophisticated, high-net-worth individuals to multi-billion-dollar institutions. None would do it. We have asked professionals and skilled and trained consultants. All answer 'not me.' Foreign currency traders would not do this trade; they have other ways to hedge or structure without buying a negative yield.

Another possibility is market manipulation or a pricing error. Not this time. All evidence points to the negative yield as seeming to be a market-driven price. This is a real puzzle on the surface."

I have spent more than a little time over the years looking at alternative fund prospectuses and back-room operations, and have been involved in a consulting role for a few funds. Let me tell you how I think interest can get below zero in a perfectly rational market.

Let's say you are trading futures or other leveraged products. You don't need to put up all the money in order to buy a futures contract on oil or the S&P 500. You simply have to have a typically small amount of margin money at the clearing broker, depending on the nature of the contract. Many funds are required by their organizational documents to hold their cash in short-term Treasuries for liquidity purposes. They have no choice but to buy Treasuries. Some of these funds are quite large, and when they come to the market they come, as we say, "in size."

If you are a trader on the other side of the trade and can make a little extra for scalping such a fund, then you do it. It doesn't happen often, but it can and does happen when the demand for liquidity is as high as it is today.

I also called my long-time friend Art Bell, whose eponymous firm Arthur Bell and Associates audits a rather large number of commodity and hedge funds. He is one of the best in the business. He confirmed that he knew of at least one fund that had bought Treasuries at a negative interest rate, not because they were forced to but because they wanted instantaneous liquidity in case they got margin calls on some of their trades. They did not want to be forced to sell something at a larger loss than they would normally take, just because they did not have the cash. The very small negative interest was the price they willingly paid not to be put in the position of taking larger losses on a trade in a forced sale. Sounds like smart risk management to me.

I bet if we checked around we would find more than a few funds and managers who for one reason or another are willing (or forced to) buy Treasuries at negative interest rates. Such is the way in today's surreal investment world. Art says that if this current environment persists, funds will find an alternative, such as third-party collateral deposits, rather than leaving deposits at a brokerage firm.

Pushing on a String

Speaking of zero interest rates, the posted Fed funds rate may be at 1%, but the actual market is trading at very close to zero. That means that banks can get money that is effectively free. The Fed meets next week in what was supposed to be a one-day meeting but which has now been scheduled for two. Guess they think there is a little more to talk about.

The Fed will cut rates next week. But with the effective real market rate now at zero, what difference does a cut make? I hope they do the right thing and go ahead and cut at least 75 basis points, if not more. That would stop the speculation and let them move on to quantitative easing and other allied policies, which we will explore in some future letter. Whether they should pursue some of the more radical policies is open for debate, but it is more important today for us to figure out what they are going to do and adjust our portfolios correctly than to debate policy.

As an aside, if it looks like Bernanke and Paulson are making all their policy moves "on the fly," it is because that is exactly what they are doing. As would any person in their respective offices. There is no playbook with a set of standard policies and procedures that can be used in case of a credit crisis. They have to make up the plays as the game progresses, much as we did in pick-up football games as kids. "John, go long and make a left cut at the trashcan. And try not to drop it this time."

There are very few real rules and laws, and Bernanke and Paulson have shown a willingness to ignore them if they seem to get in the way. This is a very pragmatic group that is trying to keep the economy from imploding. They only have a few theories and some loose analogies to what happened in Japan and maybe the US in the 1930s as guidelines. But those times had such major significant differences that it is hard to make a direct inference as to what did and did not work. As Yogi Berra is alleged to have said, "In theory, there is no difference between practice and theory. In practice, there is." And when theories meet the rough hand of the market, they will be changed.

We are getting to ready to run a grand experiment on many theories in the world of economics. Will Ben and Hank (soon to be Tim) get it precisely right? And what is precisely right? Does the avoidance of a second Great Depression mean success? Will anyone be grateful? We all have seen pictures of Paulson looking so very tired and worn. I actually feel sorry for him. Who would want that job? I know this will not sit well with many readers, but I think he has done about as well as could be expected given the circumstances. Look at the previous Treasury secretaries under Bush. No disrespect to Mr. O'Neill or Mr. Snow, but would you really want someone with so little exposure to the capital markets in the current position? Compared to so many Treasury secretaries over the past 30 years, we are lucky to have Paulson at this time.

In any event, Paulson is pouring water on the fire as fast as he can. I doubt that Tim Geithner will do any different. If Geithner has a play book for avoiding deflation and depressions, he has not shared it with anyone. They will still be making the plays up as they go along next year. I just hope they call the right plays.

Free Money with that Credit Default Swap?

Today there are bonds you can buy and get the interest coupon, and then purchase a credit default swap (insurance) on the loan that is less than the interest you will get on the loan. Assuming you have a creditworthy seller of the credit default swap, it is risk-free money. You can make almost 1% on the spread! Lever that up a few times and it becomes interesting. (Except that you can no longer get money to really leverage it enough.) This should not be. Then why is it?

Because "... assets everywhere are being dumped in favor of cash, and corporate bonds are no exception. Second, corporate bonds are no longer that attractive as collateral for funding because counterparts are demanding more onerous terms in exchange for lending out cash in return." (The Financial Times)

The corporate bond market is assuming an Armageddon Scenario. Barclays Capital writes that one would have to assume that US GDP will contract by 15% to make sense of the current bond spreads.

My friend and partner Nick Rees at Absolute Return Partners in London dropped me this note (emphasis mine):

"Leveraged loans had a particularly rough month with the average senior secured loan losing over 20 points in value and now trading in the mid 60s. The sell-off was largely driven by forced liquidations as hedge funds face substantial redemptions in the run-in to New Year. This is how crazy the loan market is: The worst ever default rate for senior secured loans is about 8%. If you assume a 35% annual default rate and a 50% recovery rate, your IRR to maturity is now in excess of 22%, using no leverage whatsoever. Either this is the investment opportunity of the century, or equity markets have seriously underestimated the economic downturn, and things are likely to get a whole lot worse for equity investors."

Formerly stable credit funds that are mark-to-market are posting horrific numbers. Many of them have closed redemptions until the market comes back. Selling a fully secured loan at 60 cents on the dollar makes no sense; and many investors are happy the funds have closed, as forced selling by other investors would lock in their losses when the loans will surely recover much of the current markdowns over time. But forced selling by some funds mean that all funds have to mark down the loans to today's value. Mark-to-market in this context is appropriate but it is still hard on your psychology while you wait, and especially as loans seem to keep dropping in value.

Oil Does a Strange Contango Dance

The oil market is said to be in contango. The definition of contango is: "A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. It is the opposite of backwardation."

This morning West Texas Intermediate January oil futures prices were (courtesy of Dennis Gartman) $45.80. This rises to $52.28 by just April. A few day's ago, Dennis reports, the spread between the first and fifth futures months had risen to $8.06, the highest ever. When oil was at $147, the spread was an average of $3.25, or about 2.5%. You can buy January 09 crude futures at a stunning 34.5% lower than January 2010.

That means if you could find a place to store that oil, you could lock in a guaranteed 34% profit, less the cost of storage. Sounds like easy money. This is just something that shouldn't be. But what this tells us is that storage for oil is very tight. Oil producers are leasing very large ships to store excess oil, as they cannot find places to store it on land. Storing oil on ships is expensive, so that cost of storage gets figured into the price of oil a year out.

The OPEC nations are not cutting back by any significant amount. Oil is backing up in the system. It is quite possible that oil could go a lot lower in the next few months as the world reels from a global recession, and that means the demand for energy will be down. Oil below $30? Without production cuts that is certainly in the realm of possibility.

As an example, let's look at how shipping is holding up. The graphs below picture a rapidly deteriorating shipping business. Korean exports fell by 18% and Taiwan's by 23% year-over-year ending in October. China's shipping is rumored to be down by 3% on a valuation basis and by 7-8% on a volume basis. Prices in China are actually starting to fall, and Chinese authorities may soon have to deal with deflation.

China is in a situation eerily reminiscent of the US in the very early 1930s. A large trade surplus, far too much production capacity, and falling exports with a whiff of deflation. Hopefully they have studied what we did wrong and will not copy it. But we should pay attention.

This is not a world economic environment that is friendly to oil producers. Could oil fall below $30? It could if producing countries do not start to cut back on production. But many of the larger producers need as much money as they can to keep the lid on civil unrest.

Deutsche Bank and a private consulting firm called PFC, based in Washington, have determined that Venezuela needs the price of oil to average $97 a barrel to balance its accounts, while in 2000 that South American country only required the price to be $34. Look at this chart, courtesy of Dennis Gartman. It shows the price of oil that various countries need to balance their budgets.

Russia will need $70 oil. These countries are going to need to produce and sell what they can, which is in conflict with the need to control production and move prices higher.

So far, the OPEC nations are not cutting back any significant amount of production compared with the destruction in demand. Oil is backing up in the system. Energy economist Philip Verleger suggests that OPEC should execute an "astounding 7.7 million barrels per day" just to restore market balance today. Global demand is down by over 5 million barrels a day to 81.6 million barrels a day. Non-OPEC countries produce almost 50 million barrels of oil. OPEC produces roughly 31 million, plus there are some other OPEC sources of about 5 million barrels equivalent in natural gas liquids. Thus, Verleger says OPEC oil production needs to drop by almost 25%, to somewhere under 24 million barrels a day. Think Iran or Venezuela will cut that much, given their need for cash to fund their regimes? Will Russia join OPEC and cut production? It will be interesting to watch Iran and Venezuela in the coming year scramble to maintain power.

It is quite possible that oil could go a lot lower in the next few months. Demand could fall further. If we are truly producing an extra 5 million barrels a day, the excess supply could be at all-time highs within a few months. Longer term, I still think oil is going higher; but it could be wild ride, and the longer term is now a lot further off. I would not want to be long oil for the next few quarters, until there is some serious growth in demand and some cuts in production.

The Tragedy of Bernie Madoff

And speaking of things that should not be, yesterday I was talking with a few fellow money mangers on a conference call when the news came that Bernie Madoff had been arrested and his fund was missing at least $17 billion, and maybe losses were as much as $50 billion. This is so very, very tragic, as it is not just large investors with well-diversified portfolios who lost here. Many smaller investors around the world had significant sums of money with Madoff. Far too many were not as diversified as they should have been. Some of the stories already surfacing are of horrific personal losses to investors and retirees who have no way to come back from such losses.

The fact that Madoff will spend the rest of his life in jail in no way compensates for the loss of so many people whose lives have been seriously impacted. It is just so terribly sad.

Madoff is a topic that comes up very often in alternative investment circles. I have been talking about his fund with friends at various conferences for almost a decade. "How does he do it?" we wondered. His fund posted steady 1-1.5% monthly returns since 1996, with only a few losing months in all that time. Supposedly he was doing something called split strike conversions. Some speculated that he was actually front-running trades in his market-making business. (Interestingly, regulators who looked at his market-making business never investigated the fund to see if he was doing just that, although I believe there were suggestions and other hints to them.) But arbitrage traders in the same arena could never figure out how he did it, and many were openly sceptical. Everyone, even the smartest trading shops, had losing months and quarters. But not Madoff. The fund was a complete black box and no one knew exactly what he did. Oddly, I have never met or known of anyone who has ever met a trader who came out of Madoff's shop. I run into resumes of ex-traders at various other funds all the time. No one knew what he did, even employees in his (what seems to be legitimate) market-making business, which was walled off from his investment funds. This was a man who was once chairman of the Nasdaq Stock Market. He was trusted and looked up to.

There were signs if you looked for them. The lack of transparency, for starters. The fact that he did his own trades with his own firm and made commissions on them. There was no prime broker where the real assets could be seen. How do you run a $17 billion fund without a room full of traders? I have been on the trading floors of smaller funds, and there are scores of people. A fund that size should have a football field-sized trading floor. Even if it was computerized, there had to be programmers. And lots of them. And where were the geniuses who designed these programs? Jim Simons at Renaissance has hundreds of support staff for his operation. He is one of the best, and he has losing periods. The "auditors" of the Madoff fund was a firm that was located in one 13x18-foot room. For a $17 billion dollar fund? Really? Real audits take lots of manpower.

That being said, a lot of smart people invested in the fund. They trusted Bernie. And anyone who looked at those returns had to be a little tempted. After all, weren't regulators looking at it? (The answer is no.)

Now we know how he made those returns. It was a Ponzi. Except this may have been larger than Enron and ultimately more damaging to more people than any scandal in the past. I remember writing a few years ago, in response to an article in Forbes about some minor hedge fund frauds, that all the losses of all the hedge fund frauds combined did not equal an Enron or WorldCom or just the plain old loss in a few larger companies in the Nasdaq in 2000-2002. I can't say that now.

Note to my fellow alternative industry participants: There is going to be a rush by Congress to regulate hedge funds. The SEC tried to regulate hedge funds a few years ago but had to back away when the Supreme Court said they did not have the authority. When the stories come out over the next few weeks (and I have heard some that really cause me heartache), there will be hearings in Congress. Rules will be passed. Quickly. And they should be.

Instead of fighting regulation as many did last time, we should recognize that this is a war that cannot be won and bow to the inevitable and at least get a few benefits from regulation, like the ability to publicly post past performance (although given the carnage of late, that is not as attractive as when I suggested it a few years ago!). I am regulated by FINRA, the NFA, and the state of Texas. We have had an average of one audit a year by some regulator for the past five years. My firm is small and it does cost a lot, but it certainly does not keep us from operating and growing our business. And I must (grudgingly) admit it does keep us on our toes. So let's sue for whatever terms we can in what should be recognized as a total surrender. And then move on.

When I was a young man I wanted to grow up to be a science fiction writer. The real world has turned out much stranger than I could dream at that time. There are just so many things which should not be.

Goodbye to the Ballpark

For most of the last 15 years, my office has been in right center field of the Ballpark in Arlington, home of the Texas Rangers, the local professional baseball team. The entire center field in the Ballpark was made into an office complex, which has worked out very well for all. I can walk out on my balcony and watch the games and have as many as 25 friends into my office to watch with me. It has been the ultimate little boy's office, and I have enjoyed it. There have been many good times here.

But tonight we are packing up, and tomorrow we'll move the office to Dallas, where I will work in my home along with my small staff. More and more of what we do is now done elsewhere, so we don't need as much room. Not only do we save a very significant amount of money, Tiffani and I also save over an hour a day in commuting. As we began to think about it, that is about 225 hours a year, or almost five weeks of time. And the one thing we both need is more time. At the end of the day, it was the time savings. The office has been worth the money, I think. (I still have a few months on my lease and control the next five years, so if you are interested I would be glad to show it to you.)

There is a part of me that is a bit nostalgic, as I have spent so many Friday evenings here writing this letter to you, even when games were going on. I shall return, as I have friends in the office complex here. But that being said, I am really looking forward to the walk down the hall being my daily commute.

I am hitting the send button a little early, as they are literally going to take my computer in a few minutes. Monday I enjoy the new office for an hour before flying to Phoenix for a day, but back home Tuesday night. Then Friday I am off to New Orleans for a long working weekend with Tiffani, where we will do some real work on our next book, Eavesdropping on Millionaires. The deadline is rapidly approaching and we need to focus!

Have a great week! And remember to think about all the good times! And believe there will be lots more.

Your turning the page of life one more time analyst,

John Mauldin

Is it a Bull, Bear or Cowardly Lion Market?

John Mauldin — Fri, 11 Apr 2008 21:09:51 GMT

Bull, Bear, and Cowardly Lion Markets Market Cycle Math Where Are We Today? Analyze and Strategize Switzerland and American Airlines Are we in a bull, a bear, or a cowardly lion market? As we will see, the answer can make a huge difference in your investment...(read more)

Where is the Bottom in Housing?

John Mauldin — Fri, 28 Mar 2008 15:10:15 GMT

Housing - Finding the Elusive Bottom Where is the Value in Housing? Bottom Line? There is no Bottom in Sight The Real ARMs Race Cancun, La Jolla, London, and Switzerland Existing home sales rose by 2.9% in February, the first significant rise in home...(read more)

Thoughts on the Continuing Crisis

John Mauldin — Sat, 22 Mar 2008 05:51:46 GMT

Thoughts on the Continuing Crisis Margin Clerks of the World, Unite! Where Do We Find New Sources of Credit? In Defense of Alan Greenspan What Now for Gold, Oil, Etc? Baseball, Mexico, and Travel Costs My essay in Outside the Box last Monday seemed to...(read more)

Should the Fed Cut Interest Rates?

John Mauldin — Fri, 07 Sep 2007 08:10:00 GMT

Should the Fed Cut Interest Rates? The Shocker in the Employment Numbers Should the Federal Reserve Cut Interest Rates? Will A Cut Make Any Difference? How Housing Woes Hurt the Rest of the Economy Home Again, Home Again The unemployment numbers came...(read more)

The Panic of 2007

John Mauldin — Fri, 17 Aug 2007 08:08:00 GMT

The Panic of 2007 Muddle Through or End of the World? An Alphabet Soup of Credit Turning Nuclear Waste Into Gold (and Back Again!) Mrs. Watanabe and the Hedge Fund Connection The Rating Agency Blame Game Where Do We Go From Here? Hedge Funds to the Rescue...(read more)

The Inflation of Expectations

John Mauldin — Fri, 06 Oct 2006 06:58:00 GMT

Introduction This week we had two more Federal Reserve members repeat what has become the theme for their chorus, but not one the market seems to be paying much attention to. It should be. The market believes the Fed will soon start to cut rates, perhaps...(read more)

When Will the Fed Stop?

John Mauldin — Fri, 31 Mar 2006 05:50:00 GMT

Introduction This week the US Federal Reserve raised interest rates once again, for the 15th straight time. As everyone knows by now, the press release at the end of the meeting suggests that they will raise rates at the next meeting. But after that?...(read more)

The Sacrifice Ratio

John Mauldin — Fri, 13 Jan 2006 06:25:00 GMT

Introduction This week we will look at a few very interesting items that did not make it into last week's forecast, as that letter was already overly long. Bernanke's arrival, the importance of the housing market to the economy, the length of...(read more)

Can the Fed Find the Sweet Spot?

John Mauldin — Fri, 03 Jun 2005 05:35:00 GMT

Introduction The questions of the day seemed to revolve around Fed policy, the US trade deficit and the dollar. We look at all of these questions and more in today's letter. Specifically, I want to try to lay out three scenarios involving future Fed...(read more)