Search results matching tag 'Investing Strategies'

Treasury Bonds - The Next "Lost Decade?"

GaryHalbert — Wed, 04 Aug 2010 16:14:00 GMT

IN THIS ISSUE:

1. The Erratic Course of Treasury Bonds

2. The Next “Lost Decade?”

3. How to Capitalize on Rising and Falling Yields

4. Attend Our Free Long-Term T-Bond Webinar

Introduction

Should you invest in long-term US Treasury bonds now? It’s a good question since many investors are flocking into these and other bonds in a big way, and have been ever since the financial crisis in 2008. According to data from the Investment Company Institute, mutual fund investors have continued to pour tens of billions of dollars per month into taxable bond funds, much of it in Treasury bond funds. With interest rates at or near all-time lows, it would seem that bond prices would have to fall in the future, making long-term Treasury bonds a very risky bet right now.

However, long-term Treasury bonds have a tendency to confound even the most knowledgeable experts. A little over a year ago, I wrote about how long-term Treasury bonds had outperformed stocks over the last 30 to 40 years, a fact that surprises many investors. In that E-Letter, I cited studies that turned Wall Street’s conventional wisdom on its ear by showing how Treasury bonds, the safest investment around when held to maturity, had actually outperformed stocks over an extended period of time.

The experts tell us that Treasury bonds aren’t supposed to outperform stocks over long periods of time but, for the most part, they have. Perhaps the status of US Treasury securities as one of the safest (if not THE safest) investments, especially during times of global turmoil, explains why Treasury bonds have been so popular in recent years, thus confounding the “experts.”

In this week’s E-Letter, I’m going to discuss the outlook for Treasury bonds for both the short-term and long-term future. We’ll cover the impact of geopolitical influences, a struggling economic recovery, and the possible effects of continued deficit spending by the US government. We might find that we’d consider ourselves lucky if bonds struggle for only a decade and not much longer.

Finally, I’ll guide you to a way to invest in long-term Treasury bonds that has the potential for gains no matter which way bond yields go in the future. In fact, we’re having an online seminar featuring this innovative investment program this coming Thursday, August 5th at 1:00 PM Eastern Time (10:00 AM Pacific). Someone is going to have the potential to make a lot of money when interest rates turn higher, and it might as well be you. Click on the link below to register for this free, no-obligation learning experience:

https://www1.gotomeeting.com/register/460995961

The Erratic Course of Treasury Bonds

Looking back over the last few years, long-term Treasury bonds have had quite a ride as measured by the Barclays Capital Long-Term Treasury Bond Index. After posting a gain of over 9% in 2007, just as the subprime crisis was beginning to unfold, long-term Treasuries returned over 24% in 2008 as the credit markets seized up. In 2008, the long-term Treasury bond asset class was virtually the only one to post a gain that year as investors sold everything and sought the safety that only US Treasuries can provide.

In 2009, long-term Treasury bonds pulled back, losing almost 13% as investors realized that the global economy wasn’t going to melt down and they gradually regained an appetite for risk assets such as stocks and stock mutual funds. Early in 2010, the experts decided that the good times in bonds were over. In a Bloomberg Radio interview in March, bond guru Bill Gross stated that Treasury bonds had “…seen their best days.”

Yet, long-term Treasury bonds had the highest return of any asset class during the first half of 2010, despite experts’ predictions to the contrary. Many cite the sovereign debt crisis experienced by the “PIIGS” (Portugal, Italy, Ireland, Greece and Spain) as the source of global uncertainty that prompted another “flight to quality.” And looking forward, we see no shortage of potential crises that might prompt yet another shift to Treasury bonds, driving yields down and prices up.

A recent Financial Times article noted that Royal Bank of Scotland analysts had announced a significant downward revision to their US Treasury bond yield forecast, predicting that the yield on 10-year Treasury notes could fall as low as 2.75% during the 4Q of 2010, down from a prediction of 4.4% at the beginning of the year. If accurate, this could mean further downward pressure on bond yields, moving prices upwards.

Since long-term Treasury bonds are also sensitive to inflation expectations, the rate of economic recovery could also affect bond prices in the short-term. Last week’s announcement of only 2.4% GDP growth in the 2Q could actually help to feed an expectation of disinflation (or even full-blown deflation), which could also be good for long-term Treasury bond prices in the short term.

While the above factors may create upward trends in bond prices in the short term, it’s the long-term view that we need to be concerned about. Today’s historically low interest rates have to go up at some point, for a host of reasons. What will happen if foreign buyers of our Treasury debt suddenly demand higher interest? What if one or more of the major ratings firms lowers the US Treasury bond rating? What if inflation rears its ugly head due to out of control spending and trillion-dollar deficits?

Millions of investors who have herded into bonds over the last two years will get hammered when interest rates begin to trend higher, and they will at some point.

A “Lost Decade” in Bonds?

You may recall many articles, including in this E-Letter, about the “lost decade” in stocks. This term refers to a 10-year period during 2000-2009 in which stocks had a negative return. While most of the articles came out at the end of the first full decade of the new millennium, a review of recent data indicates that the phenomenon in stocks is still going on. As of the end of June 2010, the rolling 10-year annualized return for the S&P 500 Index is a loss of 1.59%.

In light of historically low interest rates, some analysts are now predicting that bonds, and especially long-term Treasury bonds, may be in for a lost decade of their own. After a significant multi-decade run of favorable returns, I guess it’s not unreasonable to assume that the situation could reverse.

Don’t get me wrong, I’m not trying to talk down US Treasury bonds. It’s just that much of the attractiveness of these bonds to global investors has been that the US is less troubled than some of the other developed economies across the globe. Being the least bad in a gathering of global economies may make you the best choice as a safe harbor, but it doesn’t mean that your economy is suddenly healthy.

With interest rates at or near historic lows, there seems to be nowhere for them to go but up. Sure, we might see some periodic spikes in bond prices due to global uncertainty, but it’s important to remember that interest rates are the true determinant of bond prices. When interest rates eventually begin to rise, and they will, the situation in bonds won’t be pretty.

If we are, indeed, in store for a lost decade in bonds, then the money flowing into bond mutual funds from retail investors may be setting these people up for another big disappointment. In the good old days, we used to think of bonds as less risky and volatile than stocks. However, in an environment of rising interest rates and possible inflation, long-term Treasury bonds could be just as risky as stocks, if not more so.

Unfortunately, many of these retail investors are looking in the rear-view mirror when making their investment decisions. The last 10 years have been good for bonds, while stocks have continued to suffer. Using this backwards-looking approach, investors are obviously choosing the asset class that did best over the last decade without thinking about what might happen in the years to come.

How to Capitalize on Rising and Falling Yields

I think it’s pretty clear from the above discussion that the “experts” have no idea which way bonds will move in the near term. While continued out-of-control deficit spending will almost certainly create upward pressure on yields eventually, no one knows exactly when this might happen. I don’t have a crystal ball to tell you how long-term Treasury bonds will continue to perform well, but I can tell you about an investment strategy that has the potential to make money no matter which way Treasury bond yields go in the future.

Since our AdvisorLink® Program began in 1995, we had searched for a strategy that actively manages US Treasury bonds, and especially those with long-term maturities. However, it wasn’t until 2007 that we met the principals of Hg Capital Advisors and were introduced to their Long/Short Government Bond (“LSGB”) strategy. Byron Haven, Ted Lundgren and Dennis Shaw teamed up to create this active management strategy that seeks to capitalize on both rising and falling yield trends.

Since we have previously introduced the Hg Capital Long/Short Government Bond (LSGB) program in the past, I’m not going to repeat much of the background information. However, in light of the various forces affecting trends in long-term Treasury bond yields right now, I think that our more aggressive readers may want to consider allocating a portion of their risk capital to this program now. One big reason is performance.

Hg Capital’s LSGB program has delivered an average annualized return of over 16% this year as of June 30. The LSGB program also posted a whopping gain of 60.4% in 2009 as interest rates went back up temporarily. These are actual returns in real accounts, including my own account, net of all fees and expenses. As always, past performance is no guarantee of future success.

Compare Hg’s returns to the Barclays LT Treasury Index that posted a 12.93% loss in 2009, which illustrates the value of having a strategy that can “short” the Treasury bond market. Of course, Hg Capital’s LSGB program is not without risk, having posted a worst drawdown of -25% during the worst of the credit crisis in 2008.

I’ll discuss performance in more detail below, but let’s first talk about Hg’s proprietary strategy.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

The Long/Short Government Bond Trading Model

Hg Capital’s bond trading model is a 100% mechanical, quantitative approach based on actual observations of market activity. From these observations, Hg’s portfolio managers have identified a number of what they call “rules” and have incorporated them into the LSGB strategy. It is important to note that these rules are actual observations of historical market activity, as opposed to conceptual ideas of how it “might work” or “should have worked.” Hg also stresses that their rules are not developed by optimizing or “curve fitting” to historical data, since optimized models often fail to produce favorable ongoing results.

Each day, Hg Capital enters current market data into their computer system, and their software analyzes the various bond yield rules in order to determine which single rule is the most likely, from a statistical standpoint, to be indicative of the market’s action during the next trading day. As you might imagine, the computing power necessary to run this analysis is extensive.

The trading model can produce one of three alternative signals: 1) invest on the long side of the long-term Treasury market; 2) short the Treasury market using a specialized “inverse” mutual fund; or 3) go to a cash position (money market fund). All positions use 100% of the account and there are never any partial or staged positions. The LSGB Program uses specialized mutual funds sponsored by the Rydex family of mutual funds that provide a long and short exposure to Treasury bond price fluctuations. The long side also has a moderate 1.2X leverage, but there is no leverage available in the short (inverse) fund.

The primary emphasis of the LSGB model is to identify the position with the highest probability of gain during the next day’s market action. If there is no clear trend, the strategy remains in the Rydex US Government Money Market Fund. The strategy does not attempt to predict what the market may do over the next week, month or year. All it is concerned with is the next day’s market action. If the model is long 20 days in a row, this means that it got 20 independent signals on 20 consecutive trading days that all said the program should be long.

The Hg trading model is 100% mechanical, and Hg will not override a signal, even in the case of a national emergency. Hg has, however, modified the model as necessary to adapt to changing market conditions. For example, when we first offered the LSGB program, it did not have a way to go to cash and was always either long or short. In 2008, this proved to be problematic, so Hg’s principals went to work and developed a way for the strategy to be neutral using a money market fund.

Hg’s own statistical analysis indicates that their systems have been right approximately 60% of the time, based on daily historical data. Our month-end performance analysis shows the bond program has had a positive monthly return approximately 67% of the time, but remember that past performance can’t guarantee future results.

Hg’s methodology does not employ any formal stop-loss techniques. However, since no signal lasts for more than one trading day, the effect of a bad trade may be limited by its short duration. Hg is quick to point out that the Long/Short Government Bond Program is aggressive, and should not be seen as an option for investors who want are looking for a traditional buy-and-hold Treasury bond exposure.

Performance Evaluation

The detailed performance information linked below shows that the LSGB Program compares very well to equity and bond benchmarks, both on an inception-to-date and year-to-date basis. The LSGB Program is also virtually non-correlated to the broad stock and bond markets, as well as to the other investment programs offered by Halbert Wealth Management, as I will discuss in more detail later on.

Since its inception in December of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an annualized return of 16.77% as of the end of June, net of all fees and expenses. The worst-ever drawdown (peak to valley losing period) was –25.01%, which occurred during the recent subprime meltdown at a time when the model did not allow for a move to a neutral position in the money market.

Click on the link below to see the actual performance history and analytical data for more comparisons along with detailed monthly returns. Past performance does not guarantee future success. Also be sure to read additional important disclosures at the end of this E-Letter.

Hg Capital Long/Short Government Bond Performance Data

Correlation is the Key

As I have previously noted, the Hg Capital LSGB Program seeks capital gains from frequent trading of long bond index mutual funds based on the movement of interest rates. With that being the case, you may be wondering why you should consider this program, since it is so much like actively managed equity investments. After all, if the Advisor is managing the asset for capital gains, what does it matter whether it’s a stock or bond?

That’s a very good question. The answer is that the potential for capital gains in bonds, both long and short, generally occur independently from those of equity investments. As a result, successful trading activities can produce a return that has little or no correlation with both equity and bond indexes. By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

Non-correlated investments are often preferred because they have the potential for gain without respect to how any other investment in the portfolio may perform.

The chart below will illustrate this concept. It shows the extent to which Hg Capital’s LSGB Program’s performance is correlated to major stock and Treasury bond market indexes. A value of 0.700 to 1.000 is indicative of a high correlation, values between 0.400 and 0.700 indicate a moderate correlation, and values below 0.400 indicate little or no correlation.

Market Index:	Hg LSGB Program R-Squared Correlation
S&P 500 Index	0.04
Barclays Long-Term Treasury Index	0.04

The above R-Squared correlation analysis covers a period of time from the inception of the Hg LSGB Program in December 2004 through June 30, 2010. Past R-Squared Correlation of the Hg LSGB Program to these indexes is not necessarily indicative of future correlation, and there is no guarantee that these numbers will not change significantly over time. Be sure to read the Important Notes at the end of this E-Letter.

As you see from the chart, the LSGB Program has had virtually no correlation with the major stock market index in the past. It even goes one better by not having a high historical correlation to the Barclays Long-Term Treasury Bond Index, which is what a buy-and-hold position in the Treasury bonds would have produced.

What does this mean to you? It means that you can add an uncorrelated asset to your portfolio for additional diversification and potential for gains. If the LSGB Program continues to identify trends in bonds as it has in the past, it could provide a degree of risk management to virtually any portfolio.

Other ways to use the Long/Short Government Bond Program include:

As a long-term bond allocation for aggressive investors.
As a non-correlated hedge for your bond or equity allocations.
As a long/short strategy within an alternative investment allocation.
As a replacement for aggressive long-only equity strategies in uncertain or declining markets.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusions

Investors have been herding into US Treasury bonds ever since the financial crisis in 2008. Treasury bond yields are now the lowest in the last 50 years. Meanwhile the government is racking up trillion-dollar deficits. At some point, T-bond yields are going to turn higher, perhaps significantly higher. When that happens, millions of bond investors are going to get hurt.

When interest rates do turn higher, the only people that will make money in Treasury bonds are those who are SHORT. Hg Capital has the potential to do just that, plus it also seeks to make money on the long side should we experience any additional “flights to quality.” Now may be an excellent time to consider Hg's LSGB program as part of your portfolio. As I said earlier, someone is going to have the potential to make a lot of money when interest rates turn higher, and it might as well be you.

I think Hg Capital’s Long/Short Government Bond Program may be an excellent way to include an actively managed Treasury bond exposure in a diversified portfolio. It offers the potential to make money in both rising and falling interest rate environments, by trading long and short, which is attractive to many investors.

However, it should not be viewed as a conservative bond investment. Many investors include Treasury bonds in their portfolios for the safety and security of the asset class. While that’s generally true if you buy and hold individual bonds to maturity, it is important to note that this is not the case when bonds (or bond mutual funds) are frequently traded, and especially not when long and short positions are taken.

Another aggressive factor of the LSGB Program is that it employs 1.2X leverage on the long side. Thus, you should consider the LSGB Program only if you can tolerate a significant amount of performance volatility as well as the potential for double-digit drawdowns from time to time.

I encourage you to check out Hg Capital Advisor’s Long/Short Government Bond Program and see how it fits with your other investments. As I noted above, we’re going to be presenting an online seminar (webinar) this coming Thursday, August 12 at 1:00 PM Eastern Time (10:00 AM Pacific) featuring Hg Capital. In this presentation, you’ll be able to hear directly from Byron Haven and Ted Lundgren about how the LSGB trading model works.

You’ll also have the opportunity to ask them questions about their strategy to better evaluate it for your own portfolio. Just click on the link below to register for this upcoming event, I think you’ll be glad you did:

https://www1.gotomeeting.com/register/460995961

(Note: A recording of the webinar will be available on the Halbert Wealth Management website shortly after the event for those who can’t sit in on the live presentation.)

If you would like to request materials or discuss the features of the LSGB Program prior to Thursday’s webinar, feel free to call one of our Investment Consultants at 800-348-3601 or e-mail us at info@halbertwealth.com and we’ll be happy to help you. You can also obtain additional information and contact us via our website at www.halbertwealth.com.

Hoping to avoid another lost decade,

Gary D. Halbert

IMPORTANT NOTES: Halbert Wealth Management, Inc. (HWM), Hg Capital Advisors, LLC, and Purcell Advisory Services, LLC (PAS) are Investment Advisors registered with the SEC and/or their respective states. Any opinions stated are intended as general observations, not specific or personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors. HWM receives compensation from PAS in exchange for introducing client accounts to the Advisors. For more information on HWM or PAS, please consult Form ADV Part II, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index (which includes dividends) and the Barclays Long U.S. Treasury Index represent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Hg Capital Long/Short Government Bond trading program since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index and the Barclays Long U.S. Treasury Index is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index or the US Treasury securities with a remaining maturity of 10 plus years that comprise the Barclays Long U.S. Treasury Index.

Historical performance data from 2007 to present represents the composite returns of representative accounts managed by Purcell, called the Purcell Dynamic US Government Bond. It reflects the reinvestment of dividends and other earnings, and is net of all transaction, custodial and Purcell’s maximum management fee of 2.50%. Performance prior to 2007 represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC. These results reflect actual trades in a proprietary account of the Advisor, managed to mimic the Advisor’s trading signals. The results may not reflect the performance of actual client accounts due to contributions and withdrawals from client accounts, tax loss sales, client-imposed investment restrictions and other factors. These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program. The Program’s objective is to capitalize on the up and down movements in the price of the 30-year Treasury bond. Purcell Advisory Services utilizes research signals purchased from Hg Capital Advisors, an unaffiliated investment advisor. The signals are generated by the use of proprietary software developed by Hg Capital Advisors. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Mutual funds carry their own expenses which are outlined in the fund’s prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results. The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Hg Capital LSGB trading program.

In addition, you should be aware that (i) the Hg Capital LSGB trading program is speculative and involves a high degree of risk; (ii) the Hg Capital LSGB trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell Advisory Services will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) Hg Capital LSGB trading program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. Management fees are deducted from the account on a quarterly basis, and are not accrued monthly. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Dividends and capital gains have been reinvested. No adjustment has been made for income tax liability. Consult your tax advisor. “Annualized” returns take into account compounding of earnings over the course of an investment’s track record. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

Running through a minefield, backwards

JohnMauldin — Tue, 27 Jul 2010 15:02:15 GMT

Before we get into today's Outside the Box I want to clear up a few ideas from this weekend's letter. There have been posts on various websites equating my piece on deflation with Paul Krugman. They say I am advocating kicking the can down the road and not reducing the deficit.

Wrong. What I have been trying to point out for several years is that we have no good choices. We are down to bad and very bad choices. The very bad choice (leading to disastrous - think Greece) is to continue to run massive deficits. The merely bad choice is to reduce the deficits gradually over time. As I try to point out, reducing the deficits has consequences in the short term. It WILL affect GDP in the short term. Krugman and the neo-Keynesians are right about that. To deny that is to ignore basic arithmetic.

I am not for kicking the can down the road. Not to begin to deal with the deficits, and soon, risks an even worse problem. But - and this is a big but - I don't want to stomp on the can, either.

Now, let's get into this week's Outside the Box. I offer you a very intriguing essay by those friendly guys from Bedlam Asset Management in London. They argue that Belgium's sovereign debt should be suspect, and is the country that could be a "sleeper" problem. This is a very interesting read, with a lot of history. It is not too long and very interesting. Enjoy. (www.bedlamplc.com)

Your thinking sovereign debt is the biggest bubble of all analyst,

John Mauldin, Editor
Outside the Box

Running through a minefield, backwards
Part II - farewell Flanonia?

The last issue concentrated on sure sovereign default by Greece, Spain and Portugal - partly due to hopeless economic numbers but more because of various 'soft' issues. For, just as the numbers in a company's balance sheet theoretically provide all that is required to understand and value it, the reality is that squishy issues, such as the quality of management, staff morale or even simple luck can make a mockery of these numbers. Part I also emphasised the futility of gnawing at the bone of the de facto bankruptcy of these three countries. Backward looking investment never makes money; better surely to recognise the sovereign default cycle has further to go, and so spend time identifying the next unexpected candidate.

On the numbers alone, the most likely casualties are the UK and US in that order, but both have good odds of escaping. Many hard issues help. In America, one such is the dollar's currently irreplaceable role as the world's reserve currency. In the UK, the relatively excellent debt duration (i.e. it is spread over many years rather than near-term) is a plus. Each also has good soft issues: the market likes the new British government's tax and slash policies so is a willing buyer of UK debt, whilst the Asian central banks have so many US bonds they simply self destruct if they refuse to keep buying.

The standout surprise candidate for sovereign default by end-2012 is Belgium. A decent country; civilised, at peace, wealthy and globally competitive in several areas. Moreover, first glance at the numbers gives no particular reason to expect Belgium to default. Its potential financial problems have been on the radar screen for so long that we have grown used to them, rather like those many parents who fail to recognise the repulsiveness of their offspring. With net government debt of €400bn, it is hardly a huge world borrower in absolute terms. Yet default could occur almost entirely by accident and the ripples be far greater than its size warrants, because of its position as the de facto federal capital of the EU. Belgium's hastening car crash is not in current bond prices or exchange rates.

The glue has dissolved

There are five reasons why Belgium has hung together for the last 180 years: Britain, God, the King, fear and most importantly, money. Before addressing these, it is necessary to understand why Belgium exists at all. When in 1815 Britain was the Big Beluga after the battle of Waterloo, it wanted a buffer state to contain France. The easy solution was to give the area now known as Belgium to one of its staunchest allies, Holland. Unfortunately, King William I of the now-renamed United Netherlands was not, even according to Dutch history books, the smartest primate in the zoo, and he suffered from the diplomatic skills of a water buffalo. Holland (or the Kingdom of the Netherlands to give it its official name) had a long history of Calvinism. This was unpopular with the newly acquired Dutch and French Catholic subjects alike. Moreover, by deliberately ensuring the French were under-represented in all parts of government, yet overtaxed, the embers of resentment smouldered. These grew hotter in 1823 after an attempt to make Dutch the official language for the whole population. Surprisingly, full rebellion was ignited by the staging of a sentimental patriotic opera in Brussels in 1830. The crowds poured out of the theatre and went on the rampage. As Britain still wanted a buffer state, and was still the world superpower, it quickly moved to ensure the creation of a new country called Belgium, uniting Flanders and Wallonia (hence Flanonia might have been more appropriate).

The people, having suddenly been rebranded, opted for a French king. Britain growled, ever mindful of France's latent imperial ambitions, thus a minor German duke's second son was chosen instead. After nine years' skirmishing, as Holland held onto a few strong points, and a minor invasion by France, Holland withdrew to sulk.

The Dutch king's alienation of his many Dutch speaking but Catholic subjects in Belgium united them with their French counterparts, providing a powerful glue to hold society together well into the late twentieth century. Now, like most of Western Europe, society has rapidly turned secular. In 1967, 43% of the population attended Catholic mass every Sunday. By 1998 (the last year in which the Roman Catholic Church produced data) this was down to 11%. It is estimated to have fallen by 0.5% p.a. ever since, possibly accelerating given the latest sex-scandal investigations. (The Bishop of Bruges confessed to an unpleasant 20-year history and resigned; the police then raided and sealed off the Archbishop's palace, also the national catholic HQ on similar charges. The investigation continues.)

In line with this trend, reverence for the monarchy has also waned, although most of the country's kings have done a good job given they have forever walked the high wire over ferocious political and linguistic divisions. Little needs to be said of the fear quotient. Belgium has suffered from three highly aggressive neighbours: Germany, France and the Netherlands. It was a popular sport for each to routinely stomp all over the area. They have all changed their ways. Leaving aside a lack of clout, the British are now wholly ignorant of how or why they created Belgium at all.

The language chasm

Belgium is a federation of three states: Flanders in the North, where Dutch (Flemish) is spoken by the native Flemings; Wallonia in the South where the official language is French; and thirdly the all-important region of Brussels. This is surrounded by Flanders although the majority of the region speaks French. The linguistic divide is well-known, but this is not of the Mandarin vs. Cantonese or Castilian vs. Catalan spat variety. It is aggressive. Ten metres either side of the official linguistic border, the other language does not exist. Municipalities can and often do insist official documents and meetings only take place in their local language. This draconian legal divide was foolishly legislated into place in 1980 and has become more intolerant every since. Belgian politics are so culturally divided that all 12 of the major parties break down on linguistic lines and cannot stand in the other language area.

A shifting balance of power

Post-independence the balance of power shifted to the French speakers. The richer Flemish Belgians were highly dependent on Holland's colonial trade and capital. Post independence, this stagnated and so they concentrated on successfully out-breeding the French over the next 150 years. Meanwhile the French speaking south boomed. The development of iron, steel, coal and heavy industry - funded by French, and to a lesser extent German, capital and supplied by the major mineral deposits nearby - put all the financial and industrial power into Walloon hands. Like their previous masters in Holland, this was gradually abused. Almost all higher education was in French; plump political posts always went to French-speakers.

Meanwhile, the Flemish-speakers developed into a distinct but majority underclass. By the early 1970s, the wheel had again turned. Today, 75% of GDP is accounted for by the service sector as industry withers. The majority Flemings now sit in the financial chairs and have not hesitated to embark on a little light payback, such as splitting up key universities into Flemish and French speaking sections from 1968 onwards. The relative wealth of the Flemings is simply overwhelming. Their income per head is 118% of the EU average - the French-speakers 85%. Per capita productivity is 20% higher. They make up over 70% of the skilled labour force. French unemployment is twice that of the Flemish speakers.

Per capita, subsidies for French speakers are 50% more than for the Flemish. In short, Flanders funds and props up Wallonia.

This has not been lost on the ever chaotic voting system. Recent headlines have screamed that the independence parties have taken over. A slight exaggeration. True, the Flemish speaking, free market and pro-independence Vlaams Belang (VB) party won the most seats in the 150- member lower house, with an increase from 17 to 27 (in line with the wealth divide, the second largest party with 26 seats is the French-speaking Socialist "welfare" party). But this does not ensure separation, even though in those areas where it was allowed to stand, VB and its sympathisers won over 40% of the votes. Belgian law requires that at least four of the 12 "major" parties (seven Flemish and five French) form a government with at least one from each state. Hence, once again various caretakers are manning the desk. There is no elected government.

The most heated and longest debates in parliament concern two issues: language superiority and the French speakers demanding, and to date getting, an ever greater and disproportionate share of the welfare pie. Up north, not surprisingly this is unpopular. The result is net government borrowing equal to 100% of GDP. Not quite as bad as Greece and a few other miscreants, but add a budget deficit of 6% of GDP and a too-high a structural deficit, and Belgium is in the top fifth of over-borrowed nations globally, a position it has steadfastly maintained for the last 30 years. It has even been worse. Throughout most of the late 1980s and 1990s net government debt averaged 114% of GDP.

As with several Mediterranean countries, Belgium was a huge beneficiary of joining the euro (it was the first to do so) because the implicit German guarantee allowed heavy borrowing at much lower interest rates. Before joining the euro zone, general government net interest payments in 1992 absorbed a whopping 10.3% of GDP. In 2009, even after the collapse and necessary bailing out of its banks, especially the big two of Fortis and Dexia, interest payments were only 3.6%.

Follow the money

High debt and gradual linguistic separation have been a constant for 30 years. The recent elections confirm the trend of accelerating separatism. Yet these are likely to morph faster than expected into a financial problem because of Brussels.

Much to the dislike of most politicians across Europe, Brussels is the de facto Federal Capital. A small city; and only 1.1m people live within the "Brussels region". It is wealthy, with income per head 233% above the EU average. Moreover, despite being only a tenth of the Belgian population, it accounts for over a fifth of GDP. The reasons are well-known. Since the early 1950s treaties presaging the European Union, money has poured into Brussels. The EU Commission alone employs 25,000 people, the EU parliament another 7,000. There are over 10,000 registered lobbyists and more diplomats and countries represented in Brussels than in Washington. Then there are 1,200 accredited journalists (which may explain why expenditure on expenses accounts alone was €800m in Brussels in 2009). Just for direct running costs (i.e. rentals and electricity), the EU pumps $1bn into Brussels every year. Yet this money fountain is not only the EU. 40% of the population comes from outside Belgium, as it is headquarters to a range of other organisations which have developed into an administrative cluster. The better known includes groups like NATO, where Brussels is the European HQ with 5,000 employees. The range includes the weird, such as the heavily funded, big employing World Customs Organisation or EURATOM.

All these foreigners, usually funded by their overseas governments, are amongst the very highest earners in Europe, creating a major multiplier effect on schools, restaurants, cleaners, auto sales or house building. Originally majority Flemish-speaking, now most locally born Brussels residents speak French, the result of policies introduced when they were at the top of the economic tree. Yet Flemings - residents and commuters - still dominate the better paid and skilled jobs, hence Brussels is the only part of Belgium where both languages must co-exist by law. Some local French speaking politicians have been muttering darkly about doing to Flanders what Flanders wants to do to Wallonia, i.e. spin out of Flanders or even Belgium itself. This is because the money spigot is about to jam.

Turning off the taps

As the third richest region in Europe (after Luxembourg and London) it could in theory exist as a wealthy city-state cum federal capital, but such a dream is a chimera. Derided eurocrats live a life apart. Even Brussels-born residents who benefit from their largesse often complain that the many organisations have created rich ghettos from which they are excluded. That these eurocrats are out of touch has been demonstrated both by pay and expenses enough to make a third world dictator blink, and recent demands for pay rises.

There is a commonsense test to apply to the financial future of Brussels. Most European countries are net recipients of aid from the EU. Of the minority putting money in, Germany dominates. Other small contributors such as Scandinavia or the UK are co-joined triplets with Germany. Forced to slash their own capital, social, and welfare budgets following the financial crash, they will not put more into Brussels. It is a matter of time before each country decides to reduce its net or gross cheques written out to various Brussels organisations; hence the second most important engine of Belgium's economy (after the wider economy of Flanders) suffers its first ever post-war squeeze. This means it has less largesse to spread around - particularly in Wallonia

Moreover, Brussels is no longer so logical a geographic centre for a federal capital since the EU expanded eastwards. This has not been lost on the Germans (Brussels' most significant honey provider). Its press and politicians have suggested for example that NATO be moved from a largely neutral country with minimal military capability to one with a little more vim, such as Germany. France would murder to get its hands on more EU institutions. Even the UK, ever-equivocal about what it really wants form the EU, and outside the euro zone, would like a few pointless but foreign funded pork barrels like EURATOM. Such major political changes will take time. Turning off the money spigot is easier and will happen sooner.

How it plays out?

What is evolving in Belgium is old news. The problem now, as for divorcing couples, is how to divide up the assets, or more precisely in Belgium's case, its sovereign debt. It is noteworthy that the government is chary in producing full data on how much Brussels and Flanders subsidise the minority Walloons, but roughly speaking the national debt should probably be split about 35:65 Dutch:French. Yet relatively poor Wallonia simply could not service nearly €260bn of national debt (€175,000 per person in employment). Meanwhile, wealthy Flanders would emerge with a budget surplus, a minute structural deficit and debt to GDP the lower than any EU nation outside of Scandinavia. The imperative for Flanders, along with the scope for argument, is clear.

There is a growing risk of a faster than expected dissolution of Belgium which will result in sovereign default; this is based on a belief in the inability of the individual nations within the euro zone, let alone the EU institutions themselves, to realise that as nations unravel, speed is of the essence. To repeat, the net €400bn national debt is chicken feed - less than half the loss racked up by America's AIG in 2007-8. And in wealthier times, the dream then shared by most of its members, of a politically united Europe would have ensured a quick bailout led by Germany. Mrs Merkel has already discovered that small cash subsidies to the profligate, such as Greece, are very expensive electorally. So foot dragging and evasion are sure to be the political order of the day. As the divorce commences, little is gained in double guessing the next phase. Whether Flanders goes alone as a fabulously rich small state or joins up with Holland (now the religious issue is moribund) is a moot point. Equally, whether France chooses to absorb Wallonia into greater France (Sarkozy's wild card to escape likely electoral defenestration?) or to subsidise Wallonia as a client state again, is also an unknown. On every topic, there is no agreement on how these regions should evolve, nor who is responsible for the debts, further ensuring delay.

Investment conclusions

If markets have re-learned one lesson recently, it is that small events have disproportionate results. Belgium ranks as the world's 20th economy by size, accounting for 0.8% of world GDP. Greece before the fall was No. 28, with 0.6%; its problems continue to shake markets, both because they were unexpected and because of the risk of a domino effect. So too would be the problem with Belgium. It is yet another reason why government bonds are toxic and why at some stage their yields will blow out, thus capital values fall.

Obviously, not holding Belgian shares on a medium term basis is sensible unless valuation work has fully taken account of these unexpected risks (clients have zero exposure). Once again the euro would fall and the German export machine boom. Equity markets would rattle around for a while but then absorb the key lesson. For Belgium is yet another example, as if one was needed, that the supply of government bonds over coming years will continue to soar to unprecedented levels even. All commodity prices tumble when the supply is perceived as infinite. Meanwhile, equities would benefit.

Regards
Bedlam Asset Management plc

A Closer Look at the Second Leg Down in Housing

JohnMauldin — Mon, 28 Jun 2010 21:53:00 GMT

Quickly, I will be on Larry Kudlow's show tonight (Tuesday, June 28), which is at 7 pm Eastern. Larry has promised that we will spend some quality time on some of the current issues facing us. See you there! And now, let's jump in to this week's Outside the Box.

Last January 2009, the Outside the Box featured FusionIQ's quant models that blend both fundamental and technical metrics to determine the strength of 8,000 equities as well as the overall markets (Trading With the Big Boys).

You may recall that CEO Barry Ritholtz, (and good friend and Maine fishing buddy) had been bearish throughout 2008, and was still negative on stocks back in January 2009. Relying mostly on the FusionIQ metrics, Ritholtz flipped bullish on March 2009, and stayed bullish the rest of the year. The firm began raising cash in Q1 of 2010, and by the time the first quarter was over, was only 50% long. They sold more stock in April, and in a bit of good timing that Ritholtz will tell you was "dumb lucky" went to 100% cash on May 5, 2010 – the day before the 1,000 point flash crash.

Some economists see the world from a 30,000 foot overview (that would be me); other analysts work bottoms up. The quants – mathematical analysts whose world view consists of granular data –crunch numbers to reveal what it may about markets and economies. Ritholtz is one of the few that combines all three. This has led to prescient economic and market calls that made his clients and readers money, and kept them out of harm's way when things got ugly. Indeed,Dow Jones noted that "many market observers predict tops and bottoms, but few successfully get their timing right. Jeremy Grantham and Barry Ritholtz sit in the latter category. . ." heady company indeed.

Regarding the market calls, Ritholtz said "We cheat. We use everything that we know works. Macro economics, technicals, fundamentals, valuation, quantitative – it all goes into the mix. That's our secret sauce." Ritholtz added "I don't know why other people limit themselves to just one discipline – the value guys never look at technicals, the fundamental analysts ignore macro cycles. It creates blind spots in their analyses. When we go over other research reports, they are obvious to see."

I have been intrigued by the Fusion system's ability to warn investors to get out of the way of dangerous stocks sectors, even the entire market – before trouble hit.

Dumb lucky or not, I have found over the last year and a half, looking over Barry's shoulder, that this system does seem to (in general) give some very interesting signals about the market. I wanted to catch up with Barry to see what the FusionIQ system was saying these days – about Energy Stocks, about Housing and anything else that he thought noteworthy. As you can imagine if you know Barry, I got an opinionated earful. (Barry is like me, often wrong, but seldom in doubt.) I asked him to put it in a letter for this week's Outside the Box.

What follows is his explanation as to why Housing fall still has further to fall. He included some charts that explain what stocks and sectors to look at and avoid.

His application of both the macro and micro views, combined with using FusionIQ "to cheat," as he puts it, is why institutions and high net worth individuals seek out the firm's investment advice.

As is my custom, I will give you a link to where you can find out more about their services. Visit their site to learn more about FusionIQ. Watch their demo. Outside the Box subscribers are eligible for a discounted rate (less 20%) on the monthly subscription. http://www.fusioniqrank.com/signup.php?a=1

One caveat. This system is for serious traders. Most of you shouldn't be trading. It takes discipline and time. That is not a knock on anyone. I don't trade or have any business trading, either. A man's got to know his limitations. So I find what Barry writes about below interesting and informative. But some few of you who trade should explore his system as another arrow in your quiver.

Your writing away on his book analyst,

John Mauldin
Editor, Outside the Box

A Closer Look at the Second Leg Down in Housing

Our story so far:

Following the 2000-03 DotCom crash, then Fed Chair Alan Greenspan brought Fed Funds rates down to ultra-low levels. Under 2% for 3 years, and at 1% for more than a year.

Rates this low - and for that long - were simply unprecedented. They wreaked havoc with the traditional fixed income market. Bond managers were forced to scramble for yield; they found it in investment grade, triple-A rated residential mortgage-backed securities (RMBS). The higher yield was created by securitizing mortgages, using an unhealthy slug of riskier, sub-prime mortgages.

The demand for RMBS paper was nearly insatiable. Wall Street sucked up as much sub-prime paper as could be legitimately, then illegitimately, produced. The Lend-to-securitize-nonbank mortgage writers responded to the demand by abdicating traditional lending standards. These firms handed out 30-year mortgages to people who in no conceivable way could afford to repay them. The mortgage underwriter's hope was for no default over the warranty period of the mortgage – typically, just 90 or 180 days. After that, the loans were Wall Street's problem.

The Greenspan Fed, in charge of supervising financial lending institutions, looked the other way.

The net result was a massive national credit bubble, and a housing boom. (A true housing bubble only formed in a handful of regions). The credit bubble allowed tens of millions of Americans to become, however temporarily, home-owners.

Consider: In 1992, some 4 million homes per year were being purchased. A decade later, that number had risen 25% to annual sales of five million. A mere three years later, annual sales were over 7 million units - a 40% increase.

From 2002 to 2007, the abdication of lending standards - who cares about credit scores, incomes, debt load, assets, even a job! - helped to create millions of new homeowners. And thanks to the ultra low rates, prices had exploded. The combination of new, unsophisticated buyers and rapidly rising prices was a dangerous combination.

Buyers of limited financial means – who en masse overpaid for their houses at historically low rates – were recipes for disaster. As the Fed began its cyclical tightening, price appreciation slowed, than reversed. As sales plummeted, prices fell. Since 2006, five million of those buyers were foreclosed upon, with another 4-5 million likely to come.

Which more or less brings you up to date.

Today, residential real estate confronts numerous headwinds: Credit, once given to anyone who could fog a mirror, is now tight. Today, demand is far below what it was during most of the past decade. Home prices are still unwinding from artificially high levels, and remain over-priced. Inventory is elevated. A huge supply of shadow inventory is out there: Speculators and flippers who overpaid but have held onto their properties await modestly higher prices to sell. Bank owned real estate (REOs) continues to increase. That's before we get to the fact that unemployment remains high, and is unlikely to improve anytime soon. Oh, and wages have been flat for a decade.

This are not encouraging factors about housing.

This is known, or at least should be by those who have looked at the data. I cannot explain why some economists still have not figured this out.

In my analysis, price stands out as being the prime mover of the next leg down. High unemployment, and a decade of flat wages aren't helping to create any new housing demand. And the millions in homes they cannot afford will eventually add more pressure to inventory and prices. Indeed, we are still working

But the bottom line is Home prices remain too high: There can be no doubt that home prices have moved way down from the 2005-06 peaks. How did I reach the conclusion that, even after a 33% decrease in prices, home prices are high?

By using traditional metrics: Whether we are looking at US housing stock as a percentage of GDP or Median income versus home prices or even ownership versus renting costs, prices remain elevated. Indeed, we see prices remain above historic means.

Consider price relative to income. From 1977 to 2010, the median US home price was 4.1 times median household income. But as the chart below shows, Home prices are still above that mean. Oh, and that mean is artificially elevated due to the 2002-07 boom. It's the same with home prices relative to rentals, or housing value as percentage of GDP.

Further, we should not assume that prices merely mean revert back to historic levels. What usually happens when markets get wildly overvalued – and a ~3 standard deviation price move sure qualifies -- is they get resolved not by reverting to the mean, but by careening far beyond it.

We can look at numerous other factors. Employment, inventory, REOs, credit, another wave of foreclosures. etc. But the bottom line remains that prices must revert to a sustainable level, and we simply aren't there - yet.

Yes, government policies temporarily stopped prices from finding their natural levels. Now that the tax credit has ended, and most mortgage modifications are failing, the prior downtrend in price is likely to now resume.

Neither the Bush nor the Obama White House understood this. The assumption has been that if we can modify mortgages or voluntarily refrain from foreclosures, the residential RE market will stabilize. Through a combination of mortgage mods and buyers tax credits, the government has managed to create artificial demand and keep more supply off of the markets for a short time. But as we have seen, that fix was at best temporary.

One of the things that Markets are best at is price discovery - the determination of a price for a specific item through basic supply and demand factors. Without the heavy hand of the government intervening, the residential real estate market is about to experience what price discovery is all about . . .

~~~

Understanding this and applying it to trading are two different skill sets. That is why we prefer to rely on quantitative tools to help identify opportunities and problem areas before most people are aware of them – before they become front-page news.

The Fusion IQ system generates buy, sell and neutral signals based upon algorithms developed over many years. It is designed so that unemotional, objective criteria determine what is worth keeping or selling. We don't create these signals, the system does.

Let's put our Housing conversation above into some context. Consider from a Trader's perspective the opportunity for a downside trade in the Home Builders. Our quantitative rankings flashed a warning sign on the Residential Construction Group several weeks ago.

You can see the sector went to a Sell signal early in June:

As the charts below reveal, two of the major homebuilders look particularly weak: both Toll Brothers (TOL) and KB Homes (KBH) gave good tradable Sell signals some time ago that traders acted upon.

If you look at a long term chart of these two, they could revisit their lows from March 2009. That would be a huge round trip.

Let's look at another company that is in the News: BP. It flipped from a Buy to a Neutral in mid-April, around $59 dollars. On April 20, it went to a Sell Signal – at $52. Numerous clients have inquired about it. It is still on a sell signal, and we have advised clients to do no more than put a toe in the water. It is better to wait for more positive signals before jumping in with both feet. Wait for the stock to be above its 20 or 50 day moving average – or for a new Buy Signal to be issued.

Retail stocks have been getting hammered lately. But BJs is holding up well. Think of it as the best house in a bad neighborhood. We bought some when it went to buy signal in march of this year. Despite the market pulling back, BJs is still holding up well. It is ranked 85 (out of a 100) and is currently on a neutral signal. (That means don't add to it, but don't sell it yet either).

The flip side of the BP spill are companies that are needed to help clean up the Gulf of Mexico oil spill. Clean Harbors is one such firm. It went to a Buy Signal back on April 29, 2010 at about $57 dollars. The stock is now approaching $70, has a technical ranking of 94 out of 100, and is still on a Buy signal. (Note to traders -- CLH, which has a market cap of $1.8 billion dollars, has a 10 day average volume of 250k -- its not very liquid, so tread lightly).

Lastly, let's look at our entire universe of stocks to see what we can learn about the recent changes in timing signals and score rankings.

The first chart below shows a modest number of Buy signals and increasing numbers of new Sell signals. However, both are dominated by Neutrals. Often, this is a sign of a range-bound market. That is reflected in the 75% cash position in our managed accounts.

The Technical scores tell a similar story. Three months ago, there were more than 4000 stocks ranked greater than 70 (out of a 100). That number has dropped to below 3,000. The lowest ranked group has ticked up from 2500 to just under 3000. This also reflects a modest balance, and has not reached any extremes.

Both charts reflect a market lacking in direction and institutional conviction.

Until the picture clears up, we remain uncommitted, keeping a healthy amount of cash in our accounts. We advise readers do the same . . .

JM here. Have a great week!

What's the point of macro?

JohnMauldin — Mon, 21 Jun 2010 17:17:00 GMT

I am back in Tuscany and will head to Milan tomorrow early, give a speech at the Bloomberg offices and then back home. But it is Monday and that means it is time for another Outside the Box. And I have found a most excellent offering. Dylan Grice from Societe Generale in London wrote on value for an OTB a few weeks ago, and he follows that up with more thoughts on the use of macro trends versus value investing. This is a real think piece, and worthy of more than one read.

I have to hit the send button, as my last dinner in Italy awaits (and real Italian food has been a revelation, and the wines! I am something of a chardonnay snob, and usually turn my nose up at Italian and French whites, but I found some local Tuscan chardonnays that were up to the best in California. And at reasonable costs.).

Your not wanting to leave Tuscany analyst,

John Mauldin, Editor
Outside the Box

What's the point of macro?

By: Dylan Grice

Most people would see the macro strategist's role as timing macro events ... switching between defensives and cyclicals, adjusting duration, risk-on/risk-off trades, and so on ... the only problem is that most of us are rubbish at seeing macro events coming, let alone timing them, as our evolutionary programming blinds us to events which are forecastable (and many are not even that). Perhaps we should embrace our limitations by accepting that 'outlier events' are actually quite regular, and use macro research to aid in the search for appropriate insurance strategies.

* A few weeks ago I mapped out a strategy that was based on the idea that since global banks' solvency was so dependent on government bond holdings, central banks would have no option but to quantitatively ease in the face of future government funding crises. I argued that such funding crises could provide opportunities to buy cheap risk assets before liquidity/QE-induced rallies and that some value was beginning to emerge, but also that that value still wasn't extreme enough to go all in.¹

* As usual, I received some interesting feedback - some favourable, some not (one pm said my 'deflation-begets-inflation' view was a "dog's leg" forecast). But one client asked why I bothered looking at valuation at all. Surely my extreme macro views trumped such considerations? "I just don't understand how you can separate your ... economic research from your stand-alone valuation tools." I thought this was a brilliant question because it gets to the heart of a permanent tension between macro and micro: what should the relationship between top-down macro and bottom-up valuation be?

* At the risk of oversimplifying what our more macro-focused clients do every day I'd characterize pure macro-focused managers as being less concerned with valuation. For a start, the traditional macro instruments such as commodities and currencies are difficult to value. But by far the biggest macro market - the bond market - is largely priced off central bank perceptions of what the economy is doing, and risk assets tend to be priced off those bond markets. Since mispriced assets can become even more mispriced depending on the macro climate and central banks' reading of it, timing is everything and for such managers an understanding of the 'big picture' is far more important than valuation.

* But at the opposite end, where the pure value hunters reside, Warren Buffett has said that even if he knew the Fed's exact interest rate moves two years in advance it still wouldn't make any difference to how he would invest today. Indeed, most value investors shun macro completely and focus entirely on bottom-up valuations. They view recessions as good times to buy and have little confidence in anyone's ability to predict them. But they don't really care because they know recessions occur frequently enough and they are patient enough to wait. So why bother with macro?

At last year's Value Investing Congress, David Einhorn neatly reconciled the top-down versus bottom-up investment philosophies. He was describing his Damascene conversion following a foray into a high quality US homebuilder just before the housing bubble burst:

"At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about 40% of his investment, instead of the 70% that the homebuilding sector lost.

"I want to revisit this because the loss was not bad luck; it was bad analysis. I downplayed the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct it would be possible to convert such big picture macro-thinking into successful portfolio management. I thought this was particularly tricky since getting both the timing of big macro changes as well as the market's recognition of them correct has proven at best a difficult proposition. Smart investors have been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right there was no way to know when he would be right. This was an expensive error.

"The lesson that I have learned is that it isn't reasonable to be agnostic about the big picture. For years I had believed that I didn't need to take a view on the market or the economy because I considered myself to be a "bottom-up" investor. Having my eyes open to the big picture doesn't mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time."

I think most people would agree with this very reasonable hybrid approach: use macro analysis to avoid economic turbulence by managing your portfolio's "long-short exposure ratio" more, and bottom-up analysis to maintain a value bias to the holdings within your portfolio.

But there is still a problem with the applicability of this philosophy: your ability to 'actively manage' your portfolio's beta is a function of your ability to accurately call the market's shortterm direction correctly on average over time. But just because most of us think we are reasonably competent at calling such short-term moves doesn't mean we are. In fact, the reality is that we're appalling at it.

The future is wild, but our forecasts are mild

One problem is that many of the big moves we're supposed to "trade around" are fundamentally unpredictable (Taleb's Black Swans) and no amount of research will predict such events. Perhaps a more important thought is that we're simply not hardwired to see and act upon the big moves that are predictable (Taleb's Grey Swans).

To see why, it's important first to understand the nature of those big "outlier" moves. Benoit Mandlebrot, the inventor of fractal geometry, distinguished between uncertainty that is "mild" and that which is "wild."² For in a sample from a population that is only mildly random, extreme occurrences won't change the estimated characteristics of the population. To use Taleb and Mandlebrot's example³, imagine taking 1000 men at random and calculating the sample's average weight. Now suppose we add the heaviest man we can find to the sample. Even if he weighed 600kg - which would make him the heaviest man in the world - he'd hardly change the estimated average. If the sample average weight was similar to the American average of 86kg, the addition of the heaviest man in the world (probably the heaviest ever) would only increase the average to 86.5kg.

With mild distributions, extreme outliers are insignificant to our understanding of the likely weight of someone randomly chosen from the population. The insignificance of such outliers makes the uncertainty around people's height, blood pressure or IQ so mild that fairly accurate probabilities can be judged using the well-known Gaussian "bell curve" distribution. The bell curve is usually referred to as the normal distribution because it has known and convenient properties, yielding safe and predictable probabilities, and we like to think that safe and predictable is normal.

But it's not actually that normal. There are plenty of very important variables which are more "wildly" random and in which outliers make a transformative difference. For example, suppose instead of taking the weight of our 1000 American men, we took their wealth. And now, instead of adding to the sample the heaviest man in the world we took one of the wealthiest, Bill Gates. Since he'd represent around 99.9% of all the wealth in the room he'd be massively distorting the measured average so profoundly that our estimates of the population's mean and standard deviation would be meaningless. If wealth distribution was mild this would never happen. But it's not. So it does. If weight was wildly distributed, a person would have to weigh 30,000,000kg to have a similar effect!

The simplest way to see if something is mildly random - if it follows a Gaussian distribution - is through a QQ plot. You plot the variables of the series you're interested in on one axis with manipulations of the same variable (which ensures it is Gaussian by construction) along the other, and if the scatter plots a neat diagonal line, your distributions roughly match and your variable is likely normally distributed. If it doesn't you may have a "wildly" random variable on your hands.

The following chart shows a QQ plot of three-month changes in various dollar exchange rates from mid-2006 to the present. Simply eyeballing the data shows that we can't draw a neat straight line through the scatter plot, suggesting the data is non-Gaussian (more rigorous statistical tests show this to be true) and the "fat tails" are clearly visible. It has been known for some time that financial market variables were not mildly random, but LTCM demonstrated just how dangerous assuming away wild randomness could be.

Now take a look at a similar plot below, only this time of forecast 3m changes (I calculated these using Bloomberg's history of quarterly forecasts relative to the 3m forward rates prevailing at the forecast date). Contrast the near perfect diagonal straight line below to the poorly fitting one above. Forecasts are mildly distributed along Gaussian lines (more formal statistical tests show this to be true). Thus, even though we know changes in financial market variables are non-Gaussian, our expectations of those changes remain Gaussian. We see the world in which we live as mild even though we know it's wild.

Why we all think we're great traders

I was dumbstruck in a recent meeting I did with Albert when one of the attendees, who was a well known tech bull in the late 1990s, dismissively claimed (with a completely straight face) that Albert's call to overweight bonds relative to equities in 1999 was "pretty consensus at the time really." This was a time when the tech mania was in full swing, when adding "dot com" to the end of a company name was enough to double its share price that day, when the Nasdaq was trading at a PE in excess of 50x, and when Jim Cramer was telling investors in his hedge fund that PE ratios were redundant because none of his favourite stocks even had earnings "so we won't have to be constrained by that methodology for quarters to come."⁴ Yet Albert's call to sell stocks and buy government bonds at this time was "pretty consensus"!

Niall Ferguson has given a brilliant example of how such "selective memory" can permeate the collective psyche. In his book "War of the World", his fascinating interpretation of the 20th century's rolling conflicts, he shows that pretty much any narrative of WW1 will painstakingly show how all the warning signs of an impending conflict were there and how inevitable the war must have seemed at the time. Germany and France almost came to blows in 1911 over Morocco in the Agadir crisis, a European arms race was in full swing as Russia committed in 1912 to rebuilding its military, and the Kaiser's determination to surpass Britain's naval supremacy was intensifying the armaments build-up in Germany and the UK. Indeed, at Germany's Imperial War council meeting of 1912, von Molkte even argued (now famously) for an immediate attack on Russia since war with her was "unavoidable, and the sooner the better." The march to war was clearly on, wasn't it ....

Well yes, with hindsight perhaps, but no-one realised it at the time. The now familiar historical notion is that a tension was slowly building up between the European powers and that this reached such a fever-pitch that by 1914, when Archduke Franz Ferdinand was assassinated in the Balkans, Europe was a like a barrel of gunpowder just waiting for a spark. But as Ferguson shows in his book, this notion is in fact highly dubious. It implies that everyone knew how significant the above events were at the time, which they did not.

Or at least, the bond market didn't. The chart below shows German bond prices (which were considerably higher than they had been a year earlier) had barely budged following the assassination of the Archduke, which ultimately triggered the "war to end all wars"!

The classic study on hindsight bias was done by Fischhoff and Beyth⁵ who asked their students to estimate probabilities for possible outcomes during Nixon's visit to China in 1972 before it occurred (for example, "what is the probability that the USA will establish a permanent diplomatic mission in Peking, but not grant diplomatic recognition"). What the subjects didn't know was that they would be later asked to recall those probabilities. But when they did, between two weeks and six months after the visit, they recalled that their estimate of events that did happen was much higher than their actual estimate had been, and likewise that their estimate of events that had not transpired had been much lower.

This hindsight bias helps explain our inability to see outliers. If you were perfectly rational in forecasting returns, an unexpectedly positive or negative number would widen your volatility estimate. But if you "knew it all along" you wouldn't accept that the return was unexpected. Your estimate of potential price volatility would be unchanged and you'd continue to disregard the possible outlier events as too unlikely because your forecast range would remain too narrow. This was actually evident when I put the data together for the QQ charts above. The standard deviation of the actual exchange rate changes was 5.7%; that for the forecasts was only 1.8%.

This over-confidence bias is well documented. In spelling tests, subjects who mark answers they're "100% certain" of are only correct 80% of the time. Where an error of 0% is expected, one of 20% occurs. But hindsight bias contributes to this natural pre-disposition towards overconfidence because if you think you predicted past events accurately, you'll think you can predict future events too.

If you ask a class of students how many expect to finish in the top 50%, come the end of the year around 80% will put their hand up. Similarly, I've been amazed at the number of clients who've told me they think "buy and hold is dead" and that "these markets have to be traded." For traders in the market, the odds are considerably worse than students in exams. Performance data typically show that around 70-80% of active managers underperform the indices⁶ while studies of brokerage accounts show similar odds for individual traders.

There is absolutely nothing wrong with "trading these markets" if that's what you love doing and it's what you're good at. But the evidence clearly shows that the vast majority of us aren't. Worse, the vast majority of those who think they are good at it aren't either, and they will be competing against traders who are. So my advice to anyone about to embark upon Einhorn's path of using macro to "actively manage your long-short exposure." is to think long, hard and honestly about what your sphere of competence actually is. Otherwise, the chances are that you'll be making your broker far happier than your investors.

So what is the point of macro research?

So if our confidence in our forecasting ability is for most of us more likely to be reflecting a cruel trick of our evolutionary development than any real ability, is macro research completely redundant? I don't think so. In fact, I agree with the second part of David Einhorn's conclusion in the excerpt above, of "when appropriate, buying some just-in-case insurance for foreseeable macro risk".

At this year's Berkshire Hathaway conference, Charlie Munger said that while most people and firms do whatever they can to avoid large losses, Berkshire Hathaway is designed to take them. "That's our edge", he said. When asked about his successor at the helm of Berkshire, Buffett said that the most important thing his successor at Berkshire must be able to do is "to think about things which haven't happened before." Most insurance companies lose money on their underwriting operations but make money on the float. Berkshire Hathaway makes profits on both. They haven't been able to do this because they've been better at predicting the future than the competition - they openly admit to not even trying - but because their whole approach is grounded in a) the understanding that "outlier" events happen every few years, and b) being patient enough to hold capital in preparation for deployment when such "outliers" inevitably arise.

There are two broad approaches to a more insurance-based approach. The first and most simple is the avoidance of the purchase of overvalued assets. Ensuring an adequate margin of safety against the unknown and unknowable future - rather than trying to predict it - is the central philosophy behind Ben Graham's concept of value investing and one of the simplest differences between investment and speculation. It's as important today as it has always been and is why a careful and prudent analysis of valuation is so important. This is why I spend what some might think is an unusual amount of time on equity valuation for a macro strategist.

The second approach is to focus on the "grey swans" - the tail risks which are predictable - by devoting time to thinking about them and to finding effective and efficient protective insurance should they happen. Most of the research Albert and I write aims in this direction. It is for most of us, I believe, a more fruitful use of macro research than trying to predict various markets' short-term moves. There is a very big difference. Some have interpreted my work on government solvency as a reason to short government bonds, and JGBs in particular. I've actually never suggested doing this. To get it right you have to get your timing right, and ? well ? see the above on how confident most of us (myself included) should be about that.

But just because you can't predict when something will happen doesn't mean you should act as though it won't happen. If, for example, you are as worried about the implications of what appears to be widespread public sector insolvency in developed markets as I am, there are numerous insurance products worth considering. Popular Delusions is of course a strategy product, and regulatory boundaries preclude me from making too specific recommendations, so I'm going to end by doing something I very rarely do: shamelessly plug my colleagues (look away now if you don't want to be soiled by such unbridled commercialism!).

I think it's fair to say that derivatives is one of SocGen's genuine competitive strengths. We have a world class and award-winning derivatives operation and, as far as I know, compete favourably with any other house on the street. So if you're like most of the clients I talk to and are interested in insuring against any of the scenarios Albert and I have explored in our research (whether an inflation crisis in Japan, the break-up of the euro, a funding crisis in the US, a Chinese hard landing) or indeed any that we haven't, but don't know the best way to do so, let me know and I will put you in contact with the appropriate members of the derivatives team here. Having sat down with them in recent months, seen them work and seen the tailevent hedges that can be squeezed out of the options market I'd be surprised if you weren't impressed at what can be done. I certainly have been.

Footnotes:

1 "Print baby, print ... emerging value and the quest to buy inflation", Popular Delusions, 27/05/2010

2 See "The (Mis)behaviour of markets: A Fractal View of Risk, Ruin and Reward" by Benoit Mandlebrot. In the "Black Swan" Taleb drew a similar distinction between Mediocristan and Extremistan

3 See "Mild vs Wild Randomness: Focusing on those Risks that Matter" by Benoit Mandelbrot and Nassim Taleb

4 "Winners of the New World" by Jim Cramer, speech given at the 6th Annual Internet and Electronic Commerce Conference and Exposition, 29 Feb 2000

5 See "I knew it would happen" Baruch Fischhoff and Ruth Beyth (1975)

6 See for example Standard and Poors SPIVA Scorecard results...

The Ultimate Hedge in Economic Crisis

JohnMauldin — Wed, 02 Jun 2010 13:19:00 GMT

This week we have a really counter-intuitive Outside the Box. I was talking with the editor of Breakthrough Technology Alert, Patrick Cox about health care costs and he made some very interesting observations from new research about health care. It seems healthy people pay more for health care than sick people. I asked him to do a write-up for us. Despite the new health care bill that passed, health care costs are going to go up, not down. And that's a good thing, as Pat explains. You really want to read this.

Some of you may not be aware that a few months ago I wrote that I was buying stocks for the first time in 12 years, and specifically smaller, transformational biotech stocks. As I wrote at the time, I think that we could see a real bubble in biotech in the latter part of this decade, and just once, please God, I want to be at the beginning of a bubble.

Pat is one (and maybe the best) of my "go-to" sources for investment ideas in the biotech space. I have been very pleased with the results of his favorite plays in the last few months. And I am glad that some of my favorite companies have seen their prices come back somewhat in the last month or so, as I plan to be buying them for a long time.

Which brings up a problem and an opportunity. Pat's letter is just getting too big circulation wise for the typically smaller companies he finds and writes about. His publishers (Agora) decided last week to basically double the price (and it is not cheap to begin with!) to reduce the number of subscribers. They did a "final promotion" at the old price with a deadline of last week. I just saw that. I asked them to extend that offer for one week to my readers and they agreed.

So for the next week, you can subscribe at a discounted $699 before it goes to double that. Below is a link to the promotional site for the letter. And yes, I know it is very "hypey." I don't like that type of copy, but that is what sells and Agora is in the business of selling letters. My business is to find you good sources and to write about them. In terms of return on investment, this subscription has been a very good one for me. Find out more here.

If you did not get to read his first Outside the Box on the biotech space (and you really should!), and my rationale on why I think there will be a bubble in biotech, you can read that at this link. http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2010/01/11/the-coming-biotech-bubble.aspx

And without further ado, let's find out why health care costs are going up and why it's a good thing.

Your admittedly a biotech junkie analyst,

John Mauldin, Editor
Outside the Box

The Ultimate Hedge in Economic Crisis

By Patrick Cox

Two factors complicate the task of economic forecasting today – the first I bet you know, the second I bet you don't...

One, obviously, is the financial mess afflicting the world. Simply put, the subprime mortgage crisis, empowered by those attempting to use quasi-governmental agencies to promote homeownership, in combination with unsustainable levels of entitlement spending, have pulled so much capital out of the system that economies are stagnating. This reduces growth and creates unemployment, which adds to the demand for entitlement spending. It's a vicious circle spinning like a tornado from California to Greece.

For some reason, by the way, the British press is providing better coverage of the Yank economy than most U.S. publications. I recommend, for those who want to read more, an excellent article by the economics editor of The Telegraph. In a story about the IMF's analysis of the U.S. economy, he points out that "under the Obama administration's current fiscal plans, the national debt in the U.S. (on a gross basis) will climb to above 100% of GDP by 2015 -- a far steeper increase than almost any other country."

The good news, however, is that voters are learning important lessons. Most people are incapable of changing their minds -- until the pain level is sufficiently high. We've reached that point. Economist Robert Samuelson, who is no raving ideologue, does a good job of summarizing the hard lessons of the 20th century in this piece, titled "The Welfare State's Death Spiral".

The second factor that makes it difficult to keep the big picture in mind is the dizzying rate of scientific progress. Things are changing so fast that most people, including policymakers, are operating using outdated assumptions. I'm not talking simply about new gadgets and medicines -- we are experiencing a global demographic transformation that affects every area of life. It is taking place on an unprecedented scale, due entirely to advances in science and technology.

A Demographic Change for the Ages...

The health care bill is a relevant example of a policy based on premises that are fundamentally obsolete and flawed. Just as government-allocated health care is now being dismantled in Greece, it will fail in America. I'm not just ranting here, by the way. There's a huge financial payoff for those who understand the flaws in the current approach to health care regulation.

The health care bill was, in fact, based on a number of key, but erroneous assumptions. One is that health care costs are out of control. The other assumption is that government can do something about it.

Let's deal with the second assumption first, that government can control costs. This is just so much obvious balderdash, I hardly know where to start. Nothing government does is ever cheaper than the private-sector version. Economists speak of the "Rule of Two." This is a rule of thumb meaning that anything done by government will cost twice what it would if it were done by the private sector.

Sometimes, we choose to pay double because government is recognized as the only legitimate provider of some services. These include courts, police and defense. To pretend that these activities are not more expensive as a result, however, would be absurd. The fact that private-sector schools and prisons, for example, operate at half the cost of government equivalents, while yielding superior results, is sufficient evidence.

Yes, I admit there are things we could do to lower health care costs now if we had the political will. Tort and regulatory reform would result in some pretty significant short-term cost reductions. Ending the disincentive problems caused by third-party payers would also help. Implementing all of these reforms, however, cannot and will not stop the inevitable future increases in health care costs.

This brings us back to the first assumption -- that health care costs are out of control and represent some kind of crisis. The evidence typically given to support that claim is that we are spending more than ever before on health care, both as a percentage of our GDP and personal incomes.

One ought to be skeptical of this argument for obvious reasons. To begin with, our lives have been continually and dramatically improving for a long time. Sure, we're spending more of our total incomes in many different areas. We also are spending more of our total income today on restaurants, travel and personal electronics than we did in the past. Yet this is not viewed as a crisis by social planners.

We've all heard that we're "spending too much" so many times, people tend simply to accept it as a truism. It is not. There is a crisis, but it is not that we are living longer and spending more money on health care. The crisis is that a network of government programs were put in place in the 1930s based on the theory that people would work until their mid 60's. Then, they would retire and society would cover their costs. Those days, few people survived long enough to collect significant benefits. Planners did not foresee life spans increasing rapidly with all the accompanying increases in health care costs.

Today, more and more people are living longer after retirement. Because health care cost rise exponentially as we age, they are consuming far more post-employment medical services that must be paid for by younger people. This is the heart of the problem. Both the defenders and critics of medical transfer payments inevitably focus on poor, unemployed, single mothers or their children when making their cases for reform. This is, fundamentally, a ruse to avoid talking about the biggest recipients of medical welfare, older and often wealthier Americans.

The typical medical welfare recipient is not a single mother living on food stamps. It is a retired person in a sun hat, wintering in Florida or Arizona. Society could easily take care of the legitimate medical needs of disadvantaged younger people. The big, overriding problem is the transfer of money from a shrinking percentage of younger workers to an increasing percentage of older retired people.

Nothing in the health care bill changes that. In fact, it accelerates it by forcing younger, healthier workers into the insurance system earlier than they otherwise would. The inclusion of a new fee tacked onto student loans, to be used for older people's medical services, is a particularly blatant example of the stresses our system is suffering.

There are two solutions to this problem. One is to do away with biological old age entirely. An increasing number of scientists believe that regenerative medicine will eventually give us the ability to restore our bodies to a permanent biological youth, probably equivalent to about 28 years old. That is the point before our cells have started to lose function through loss of telomeres. Unfortunately, we're not there yet and don't know for sure when we will be.

This leaves Plan B. Older people, like me, will have to work longer or invest more wisely so we can afford to buy more of our own health care. It's not complicated economics.

Politically, however, it's extremely complex. Polls show that younger people, whose money is being transferred to pay for older and often wealthier people's health care, support such a change. It may be difficult politically, however, to convince older people to go along with that program. Nevertheless, the problem is going to continue to worsen until the change is made. The recent health care bill cannot and will not fix the problem, as I will demonstrate.

Let me give you some numbers to make my point...

Did you know that only one-sixth of per capita lifetime medical expenditures are accrued in the first third of life, before middle age? One-third of lifetime medical expenditures occur during middle age. Fully one half of medical expenses come during the senior years. For anyone who cares about the truth -- it is blindingly obvious that health care costs are rising because more people are getting older and old age is expensive. And the older you get, the more expensive it gets.

Since 1900, American life expectancy has increased by 19 years. It's gone up a decade since 1950, and the rate of increase is accelerating. We are far wealthier than the previous generation, and we can afford medical options undreamed of only a generation ago. There's a catchphrase we use in Silicon Valley: "That's not a bug, it's a feature."

This longevity effect means, by the way, that the administration's claims that better coverage of the uninsured and more preventative medicine will lower costs is patently false. In fact, it will accomplish the opposite. Better health care for the nonaged actually increases total health care costs because more people reach the expensive years of old age -- not that there's anything wrong with that.

If you doubt me, I refer you to a recently released study by the Center for Retirement Research at Boston College. If you haven't thought about this subject, it may surprise you, but the facts are irrefutable.

Let me quote from the introduction of the brief. The researchers conclude, "Our main finding is that although the current health care costs of healthy retirees are lower than those of the unhealthy, the healthy actually face higher total health care costs over their remaining lifetime. To illustrate, the expected present value of lifetime health care costs for a couple turning 65 in 2009 in which one or both spouses suffer from a chronic disease is $220,000, including insurance premiums and the cost of nursing home care, and 5% can expect to spend more than $465,000. The comparable numbers for couples free of chronic disease are substantially higher, at $260,000 and $570,000, respectively. This brief explains this somewhat counterintuitive finding."

Let me restate their point with less jargon: Sicker people have higher temporary medical costs, but they die earlier, so their total costs are far lower than healthy people's total costs. For the mathematically inclined, this is true even when lifetime health care costs are discounted in terms of current dollars.

This ought to be obvious, but there seems to be some sort of psychological block that keeps people from getting it. So let me say this once again: The study proves that healthier people, because they live longer and need increasingly expensive age-related health care longer, have higher lifetime health care costs.

The researchers even imply that insurance companies are missing that point when they set higher rates for people with serious illnesses. Putting it bluntly, unhealthy people die earlier and spare insurance companies and "the system" significant health care costs. If true actuarial principles were followed, people dying at relatively young ages of rapid untreatable illnesses would be given deep insurance rate discounts, if not refunds.

You may recall that tobacco companies made this very point when they were being accused of raising medical costs. Though it was not great public relations and the media painted them as villainous liars anyway, they accurately pointed out that smokers as a group die at significantly younger ages, and relatively quickly when they do. You tend not to "linger," after all, with heart disease and lung cancer.

Smoking, therefore, actually saves the health care system money in the long run. If cutting health care system costs is truly your goal, then you should encourage smoking. If you're a fan of socialized medicine, you should thank your smoking friends for doing their part to make government health care more affordable. In fact, you might consider promoting hang gliding and extreme sky diving sports for the middle-aged if you want to cut costs.

Cutting costs, however, is decidedly not my goal. My goal is help you, my readers, amass the wealth needed to pay for cutting-edge medical technologies so you can live much longer, happier and healthier lives. My goal, politically, is the same. Wealthy societies take care of their own voluntarily and charitably better than well-meaning, but overtaxed and poorer societies.

Health Care, the Ultimate Hedge

So let me get back to the big picture and the opportunity that increasing life spans and health care costs are creating for smart investors.

I consider health care the ultimate hedge in times of economic crisis. Not only is it the last area that people cut back, it doesn't lose value in good times, as gold does. As a percentage of our economy, health care overshadows sectors that are far more subject to economic fluctuations, such as energy.

Last year, as the economy contracted, health care spending increased by over a percent. As a percentage of the total economy, it accounts for more than 17%, and it will continue to rise. Once again, this is a feature, not a bug.

As I've said so many times, the rate of medical discovery is accelerating rapidly. Mortality rates from major diseases like cardiovascular disease, breast cancer, prostate cancer and stroke have fallen significantly in recent years. Even bigger advances are on the near horizon.

The last few weeks, for example, have seen dueling press releases in RNA interference – RNAi technology is racing forward and will likely cure a lot of the diseases that keep people from getting older.

Other progress is even more immediate.

I'm convinced one small company I've been watching will eliminate the threat of influenza and other virus-born diseases that are particularly hard on older people, as well as infants. The small company I have in mind has announced several incredibly important research collaborations with world-class scientists. Soon, those results will be released and we'll know if killer viruses are on the run for good.

There are also companies that I've researched that have increased the efficacies of cancer therapies – providing various benefits in combination with chemotherapy.

Another company has made real progress in the fight to cure Alzheimer's disease – while other cures fall by the wayside this company seems to be on the leading edge of technology.

Then, of course, there's "the big one." By that, I mean stem cell or regenerative medicine. Regenerative medicine will do more than cure diseases. It will extend the lives of our organs and other body parts. I'm predicting, in fact, that we'll see world-changing therapies come out of stem cell companies within 10 years. Profitable life-altering therapies will come long before then, but I'm talking about the ability to rejuvenate critical organs and thereby extend maximum life spans.

Getting back to the point; despite all of the rhetoric, healthcare costs are going to rise but we're going to pay the bill. Nothing can stop that. This is a vastly unrecognized opportunity for investors.

We're not talking about little blue pills that enhance your libido or a hot new iPhone application, we're talking about life. There's no telling how infinitely-valuable these life-extending therapies will be. But one thing is certain, early investors will profit handsomely.

Yours for transformational profits,

Patrick Cox

US stock market returns – what is in store?

JohnMauldin — Mon, 29 Mar 2010 15:54:00 GMT

It has been some time since we have looked at stock market valuations and expected future returns. I made a large point in Bull's Eye Investing that long term returns are closely correlated with the valuation of the stock market upon entry. In fact, I argue that secular bull and bear markets should be viewed in terms of valuation and not prices. The market clearly goes from high valuations to low and back to high again over very long periods of time. The average length of a secular bull or bear cycle is 17 years.

Based on valuations, we are still in a secular bear market. But clearly we are in a bull phase, which within long term secular bear cycles are quite normal. They make for good trading opportunities. But should you invest now with a view to holding for 10-20 years?

This week's Outside the Box from my friend Prieur du Plessis of Plexus Asset Managment looks at what long term return expectations might be from today's stock market valuations. He offers us a range of expectations which I think should help you in your investment decision making process.

Dr Prieur du Plessis is chairman of Cape Town-based Plexus Asset Management and author of the Investment Postcards from Cape Town blog: http://www.investmentpostcards.com (Subscribe to e-mail updates of new articles by clicking on "Subscribe to Updates" in the top right-hand corner of the blog site and providing an e-mail address.)

I am on my way back to Dallas from a quick trip to Washington DC. The cherry blossoms are beautiful, even if the weather is gray.

John Mauldin, Editor
Outside the Box

US stock market returns – what is in store?

By Dr. Prieur du Plessis

Surging stock markets since the lows of March 2009 have caught most investors by surprise, especially as new pieces of the economics puzzle are not always rosy and do not quite seem to support an overly bullish case. In short, investors are increasingly struggling to make sense of the most likely direction of stock prices.

Are we perhaps nearing the end of a cyclical bull phase in a structural bull market? Or will strong earnings growth ensure the longevity of the bull? Or is a "muddle-through" trading range in store? It seems to be a case of so many pundits, so many views.

It is one thing to trade the market's rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that "it's time in the market, not timing the market" that counts. But "buy-and-hold" investors in the S&P 500 Index are still 25.5% down from the levels of 10 years ago, the Dow Jones Industrial Index a similar 23.5% lower and the Nasdaq Composite Index a massive 52.5% under water.

This gives rise to the all-important question: does one's entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns (considering total returns, i.e. capital movements plus dividends). The study covered the period from 1871 to March 2010 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 7.7 with an average ten-year forward real return of 11.4% per annum, whereas the most expensive quintile had an average PE of 23.4 with an average ten-year forward real return of only 3.8% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see Diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is that the ten-year forward real returns of investments made at PEs between 12 and 17 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analyzed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by Jeremy Grantham's GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in Diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index's current ten-year normalized PE of 20.3 and ten-year normalized dividend yield of 2.1%, investors should be aware of the fact that the market is by historical standards expensive. As far as the market in general is concerned, this argues for unexciting long-term returns, possibly a "muddle-through" trading range for quite a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current ten-year normalized valuation levels. As a matter of fact, there is a distinct possibility of some negative returns off current price levels.

* Dr Prieur du Plessis is chairman of Cape Town-based Plexus Asset Management and author of the Investment Postcards from Cape Town blog: http://www.investmentpostcards.com (Subscribe to e-mail updates of new articles by clicking on "Subscribe to Updates" in the top right-hand corner of the blog site and providing an e-mail address.)

The Fed Blinks, Now What?

GaryHalbert — Tue, 23 Feb 2010 21:29:00 GMT

IN THIS ISSUE:

The Fed Blinks
What's the Outlook for Treasury Bonds
Revisiting the Hg Capital Advisors'
Long/Short Government Bond Program
Performance Evaluation
Is This Program Right For You?

Introduction

The Fed's action last week to raise the discount rate paid by banks that borrow money from the Fed is now old news. However, the reverberations of this action are still being felt in both the stock and bond markets. While the Fed's decision was not necessarily a surprise in light of recent comments by Chairman Bernanke and FOMC minutes, the swiftness with which action was taken did shock the markets somewhat.

Investors want to know where they can invest now to get a return on their money. One likely target is the long-term Treasury bond, or "long bond," since its price is highly sensitive to changes in interest rates. Now that government intervention in the credit markets may be coming to a close, many investors are looking for long Treasury bond prices to fall and are seeking ways to capitalize on this expected price trend. However, there are still other factors, such as the recent Greek sovereign debt situation, that can affect bond prices in the opposite direction, so shorting Treasuries could be a recipe for disaster.

While I can't tell you which way long-term Treasury bond prices are headed in the near term, I can say that there is a way for aggressive investors to potentially take advantage of this market, no matter which way bond prices head. Back in 2007, I first wrote about the Hg Capital Advisors Long/Short Government Bond (LSGB) Program. The LSGB Program is a mutual fund-based strategy that employs a combination of long/short trading and leverage in an attempt to realize capital gains based on price movements of the 30-year Treasury bond.

In the remainder of this week's E-Letter, I'm going to discuss the Fed's latest action and what may lie ahead. In addition, I'll revisit Hg's Long/Short Government Bond Program and tell you why I think it may be a good investment for aggressive investors who want to capitalize on the long bond's price movement. In 2009, the LSGB Program posted a gain of over 60%, net of all fees and expenses. While past performance can't guarantee future results, The LSGB Program may be worth consideration for the aggressive portion of your portfolio.

The Fed Blinks

Late last Thursday, the Fed took what could be the first step in a process to mop up some of the excess money supply and get on the road to raising interest rates. The Fed discount rate, the rate at which banks can borrow money from the Fed, was raised from 0.5% to 0.75%. While this move alone is not all that significant, it's what the Fed may be thinking that will affect the markets.

Many analysts expected the Fed to make such a move after Chairman Ben Bernanke's recent comments about plans to phase out subprime-era lending programs to banks and businesses. The January FOMC meeting minutes also mentioned an increase in the discount rate. Thus, this move was not a surprise and was generally seen to be a symbolic gesture.

Investors, however, took the Fed's move as a signal that it may be phasing in an exit strategy to remove all or most of the excess liquidity it has pumped into the system since the credit crisis began. Accordingly, immediately after the announcement, stock futures began to react negatively to the news, and Treasuries extended their losses. The discount rate hike also boosted the US dollar, which automatically affected gold and other commodities prices. Observers said that the stock and bond markets weren't as surprised by the news as they were by the timing – at 4:30 PM EST on a Thursday afternoon.

Over the course of the subprime debacle and resulting recession, the markets and the Federal Reserve have been engaged in a staring match, each trying to determine the next move of the other. The Fed has blinked and now it's up to investors to decide how to position themselves to ride out the exit strategy.

While few analysts believe that the fed funds rate will be increased anytime soon, the swiftness with which the discount rate was raised after first being mentioned in FOMC minutes makes anything possible. I suspect that the Fed is using the hike in the discount rate as a trial balloon to see how markets react to the thought of tighter monetary policy.

While expectations of the Fed raising interest rates would place negative pressure on 30-year Treasury bond prices, there are still plenty of other forces beyond traditional fundamentals that have the potential to exert up and down pressure on long bond prices, including:

We know that much of the action in Treasury bonds over the past couple of years has been due to massive government intervention in the credit markets. While the Fed is signaling that its easy money policy may be coming to an end, this could abruptly change if we encounter worsening problems with unemployment, foreclosures and/or lower consumer spending. A renewed need for government stimulus and other easy money policies could again affect short-term price trends in Treasuries.
The US economy and markets are also not immune from global contagion, as we recently experienced with the Greek sovereign debt issue. While this crisis may be averted, several other countries' sovereign debt is at risk as this is written. Any major default on sovereign debt could counteract any downward pressure from the Fed on Treasury bond prices.
Most analysts feel that inflation is subdued and will not raise its ugly head for the foreseeable future. I have to say that I tend to agree for the short term, but further out I think that our ballooning deficits and national debt will come home to roost in the form of higher inflation.
Finally, we have the issue of continued financing of our huge government debt. No matter whether you're a conservative or a liberal, you have to agree that the expected doubling of our national debt over the next decade will have an effect on interest rates, and thus bond prices. Will foreign governments continue to buy our bonds at rock-bottom yields, or will they insist on a higher return to compensate for our spendthrift ways?

The bottom line is that there are good reasons for 30-year Treasury bond prices to go up or down as we slowly unwind the unprecedented financial and fiscal stimulus that has been pumped into the economy. As a result, it may make sense to have a small allocation to an aggressive investment that can potentially take advantage of market trends in either direction. The Hg Capital Advisors Long/Short Government Bond Program is such an investment. Read on to learn more about this dynamic investment.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

The Hg Capital Long/Short Government Bond Program

As I noted back in 2007 when I first introduced Hg Capital, we had been searching for an effective program that could actively manage the 30-year T-bond on a long and short basis. Since the long bond price can be subject to significant volatility, it naturally lends itself to a strategy that seeks potential capital gains that these price movements can produce.

The Hg Capital Advisors Long/Short Government Bond Program seeks to provide short-term capital gains by trading the Rydex mutual funds designed to provide a long and short exposure to the price movements of the current US Treasury 30-year bond. The Hg strategy is a proprietary trend-following model with overbought and oversold signals also having an input.

However, Hg Capital's LSGB trading model isn't your run-of-the-mill trend following strategy. Hg has identified a number of what they call "rules" and has incorporated them into their model. In essence, these rules are actual observations of historical market activity, as opposed to conceptual ideas of how it "might work" or "should have worked."

Each day, Hg Capital enters current market data into their computer system, and their software analyzes literally thousands of rules in order to determine which single rule is the most likely, from a statistical standpoint, to be indicative of the market's action during the next trading day. As you might imagine, the computing power necessary to run this analysis is extensive.

The primary emphasis of the bond model is an analysis of interest rate data, or yield. As bond yields indicate a developing trend, the Hg trading model will buy either a long or inverse (short) Rydex long-term Treasury bond mutual fund, depending upon the direction of the move. The model can also trade based on overbought or oversold conditions in the market. If the model cannot detect a tradable trend, it will issue a signal to go to cash (money market). However, cash positions are relatively rare, historically amounting to less than 10% of trading days.

Hg Capital's methodology does not attempt to predict what the market may do over the next week, month or year. All it is concerned with is the next day's market action. If the model happens to be long 20 days in a row, this doesn't mean they got a signal saying the market will go up for 20 days. Instead, it means they got 20 independent signals on 20 consecutive trading days that all said the program should be long. In fact, this string of long trades could have theoretically been caused by 20 different rules gaining prominence on each of the 20 trading days.

The Hg trading model is 100% mechanical, and Hg will not override a signal, even in the case of a national emergency. Hg's statistical analysis indicates that their system is right approximately 58% to 60% of the time, based on daily data. Our historical month-end performance analysis shows the bond program had a positive monthly return approximately 66% of the time, but past performance does not guarantee future results.

Hg's methodology does not employ any formal stop-loss techniques. However, since no signal lasts for more than one trading day, the effect of a bad trade may be limited by its short duration. Hg is quick to point out that the Long/Short Government Bond Program is aggressive, and should not be seen as an option for investors who want only a buy-and-hold Treasury bond exposure or interest income.

Performance Evaluation

The detailed performance information below shows that the LSGB Program compares very well to both equity and bond benchmarks over a variety of time periods. The LSGB Program is also virtually non-correlated to the broad stock and bond markets, as well as to the other investment programs offered by Halbert Wealth Management, as I will discuss in more detail later on.

Since its inception in December of 2004, the Hg Capital Advisors Long/Short Government Bond Program has posted an actual annualized return of 17.27% as of the end of January 2010, net of all fees and expenses. The worst losing period (or "drawdown") was –25.01%, which occurred during the recent subprime meltdown. (See a more detailed discussion about the worst drawdown below.) The charts and tables below show detailed actual performance, net of all fees. Past performance does not guarantee future success. Also be sure to read additional important disclosures at the end of this E-Letter.

(Click to view full image.)

Note that the worst drawdown of -25.01%, measured as of month-end, occurred during the worst of the subprime crisis and credit crunch in 2008. Astute readers may recall my original introduction to the Hg Capital LSGB Program back in 2007 disclosed that the strategy had no cash or "neutral" position at that time. As a result, the model had no way to go to a neutral position when the global credit markets came to a standstill in 2008. Accordingly, we withdrew our recommendation of this investment in January of 2009.

However, as all good money managers do, the principals of Hg Capital monitored their trading model during this period of extreme volatility and found that the lack of a cash option definitely contributed to the depth and severity of the drawdown that occurred in 2008. After considerable research and testing, they implemented a cash position in the model, as well as other changes to enhance the model's ability to manage crisis market conditions.

In mid-2009, we reviewed the changes made by Hg Capital and the corresponding improvement in performance. At that time, we became comfortable that the changes implemented by Hg's principals were effective in reducing the risks when market volatility was high and we reinstated our recommendation.

While Hg's principals feel that the enhancements to their model should keep drawdowns from approaching the -25% level in the future, there is no guarantee that they will do so. Hg Capital co-founder Byron Haven points out that the road to the 60%+ return in 2009 was punctuated by at least four drawdowns of 7% along the way, which indicates that this strategy is still an aggressive approach to trading the 30-year Treasury bond.

For investors with an appetite for aggressive investments that can trade long and short on a partial leveraged basis, this program may be just what you're looking for. Small allocations to this strategy can provide additional diversification to both aggressive investors and moderate risk investors who want to include an aggressive allocation in their portfolios.

Administration

Hg's LSGB program is traded at Rydex Funds using mutual funds that seek to provide daily long and short returns based on the price movements of the current Treasury long bond. The Government Long Bond 1.2X Strategy offers a 120% leveraged long exposure, while the Inverse Government Long Bond Strategy provides an unleveraged short exposure.

The LSGB Program is available to both taxable, IRA and other tax-qualified accounts. Since this program trades frequently it will likely be subject to "wash sale" rules and short-term gains (or losses). Thus, it may be most suitable for IRAs and other tax-qualified retirement accounts, including no-load, low-cost variable annuity products that may also help to negate the tax consequences of frequent trading in a non-retirement account.

The minimum account size for the Hg Capital LSGB Program is $25,000. Management fees are deducted quarterly in advance, based on the following schedule:

First $500,000	2.50% annually
$500,001 to $1 million	2.25% (entire account)
Over $1 million	2.00% (entire account)

(*Note that all of the above performance figures are quoted net of all management fees.)

Non-correlation is the Key to Diversification

That's a very good question. As I discussed above, one answer is that Fed actions and global uncertainty could result in "tradable trends" in the long-term Treasury bond. Tradable trends are price movements of sufficient size and duration to be identified by Hg's trading model as potential opportunities to produce capital gains.

Another answer is that the potential for capital gains in the long bond, both long and short, generally occur independently from those of equity investments. As a result, successful trading activities can produce a return that has little or no correlation with both equity and bond indexes. By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

If two investments go up and down together, they are said to be positively correlated. If one goes up when the other goes down, and vice versa, they are said to be negatively correlated. However, if an investment's gains or losses are independent of others, then it is said to be non-correlated. Non-correlated investments are often preferred because they have the potential for gain or loss without respect to how any other investment in the portfolio may perform.

The chart below illustrates this relationship. It shows the extent to which Hg Capital's LSGB Program's performance is correlated to major market indexes and other investment programs my firm offers. A value of 0.700 to 1.000 is indicative of a high correlation, values between 0.400 and 0.700 indicate a moderate correlation, and values below 0.400 indicate little or no correlation.

Market Indexes:	Hg LSGB Program R-Squared Correlation

S&P 500 Index	0.097
Barclays Long-Term Treasury Index	0.104

Other Investment Programs We Recommend: *

Columbus High-Yield Bond	0.156
Niemann Equity Plus	0.122
Niemann Risk Managed	0.130
Potomac Guardian	0.163
Scotia Growth S&P Plus	0.046
Scotia S&P Moderate Growth	0.014
Select Advisors Conservative	0.053
Select Advisors Moderate	0.027
Third Day Aggressive	0.009
Third Day S&P Plan	0.000
Wellesley Convertible Bond	0.116

The above R-Squared correlation analysis covers a period of time from the inception of the Hg LSGB Program in December 2004 through January 31, 2010. Past R-Squared Correlation of the Hg LSGB Program to these indexes and other investment programs is not necessarily indicative of future correlation, and there is no guarantee that these numbers will not change significantly over time. Be sure to read the Important Notes at the end of this E-Letter.

* For more information on any of our other recommended investment programs, give us a call at 800-348-3601 or click this link to go to the Halbert Wealth Management website.

As you see from the table above, the LSGB Program has had virtually no correlation with the major stock market indexes in the past. It even goes one better by having a low historical correlation to the Barclays Long-Term Treasury Bond index, which is closer to what a buy-and-hold position in Treasury bonds would return. Best of all, the LSGB Program has had virtually no historical correlation to any of the existing AdvisorLink® actively managed investment programs.

What does this mean to you? It means that you can construct a portfolio of actively managed investment programs that may perform independently from each other over time. If the LSGB Program continues to perform as it has in the past, it could provide an additional degree of risk management to virtually any portfolio.

Gary D. Halbert, ProFutures, Inc. and Halbert Wealth Management, Inc.
are not affiliated with nor do they endorse, sponsor or recommend the following product or service.

Conclusion - Not For the Weak or Faint of Heart

I think Hg Capital's Long/Short Government Bond Program may be an excellent way to include an actively managed Treasury bond exposure in a diversified portfolio. While there are no guarantees, the LSGB Program offers the potential to make money in both rising and falling interest rate environments by trading long and short, which is attractive to many investors.

However, it should not be viewed as a conservative bond investment. Many investors include Treasury bonds in their portfolios for the safety and security of the asset class. While that's generally true if you buy and hold individual bonds to maturity, it is important to note that this is not the case when bonds (or bond mutual funds) are frequently traded, and especially not when long and short positions are taken and leverage is employed.

I encourage you to check out Hg Capital Advisor's Long/Short Government Bond Program and see if it fits with your other investments. However, before investing in the LSGB Program, you should review your financial goals and other investments in your portfolio in order to determine if it is in line with your overall risk tolerance.

If you would like to have assistance in this review, feel free to call one of our Investment Consultants at 800-348-3601 or e-mail us at info@halbertwealth.com and we'll be happy to help you. You can also obtain additional information and contact us via our website at www.halbertwealth.com or by completing our online request form.

Wishing you profits,

Gary D. Halbert

As benchmarks for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) and the Barclays Long U.S. Treasury Indexrepresent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of these benchmarks cited may differ materially (more or less) from that of the Hg Capital Long/Short Government Bond trading program since they are unmanaged Indexes which cannot be invested in directly. The performance of the S & P 500 Stock Index and the Barclays Long U.S. Treasury Index is not meant to imply that investors should consider an investment in the Hg Capital Long/Short Government Bond trading program, which is actively managed, as comparable to an investment in the "blue chip" stocks that comprise the S & P 500 Stock Index or the US Treasury securities with a remaining maturity of 10 plus years that comprise the Barclays Long U.S. Treasury Index.

Historical performance data from 2007 to present represents the composite returns of representative accounts managed by Purcell, called the Purcell Dynamic US Government Bond. It reflects the reinvestment of dividends and other earnings, and is net of all transaction, custodial and Purcell's maximum management fee of 2.50%. Performance prior to 2007 represents an actual account in a program named Hg Capital 199Hg-TYX, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC. These results reflect actual trades in a proprietary account of the Advisor, managed to mimic the Advisor's trading signals. The results may not reflect the performance of actual client accounts due to contributions and withdrawals from client accounts, tax loss sales, client-imposed investment restrictions and other factors. These performance numbers have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Since all accounts in the program are managed similarly, the results shown are representative of the majority of participants in the Program. The Program's objective is to capitalize on the up and down movements in the price of the 30-year Treasury bond. Purcell Advisory Services utilizes research signals purchased from Hg Capital Advisors, an unaffiliated investment advisor. The signals are generated by the use of proprietary software developed by Hg Capital Advisors. Statistics for "Worst Drawdown" are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. Mutual funds carry their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

In addition, you should be aware that (i) the Hg Capital LSGB trading program is speculative and involves a high degree of risk; (ii) the Hg Capital LSGB trading program's performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Purcell Advisory Services will have trading authority over an investor's account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) Hg Capital LSGB trading program's fees and expenses (if any) will reduce an investor's trading profits, or increase any trading losses.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. Management fees are deducted from the account on a quarterly basis, and are not accrued monthly. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Dividends and capital gains have been reinvested. No adjustment has been made for income tax liability. Consult your tax advisor. "Annualized" returns take into account compounding of earnings over the course of an investment's track record. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

JohnMauldin — Mon, 18 Jan 2010 18:28:55 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. His track record in this decade has been quite good. I want to thank Gary and his associate Fred Rossi for allowing us to view this smaller version of his latest letter.

If you are interested in his letter, his web site is down being re-designed, but you can write for more information at insight@agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get the full 2010 forecast with price targets, but an extra issue with his 2011 forecast (of course, that one will not come out until the end of the year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

John Mauldin, Editor
Outside the Box

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

(excerpted from the January 2010 edition of A. Gary Shilling's INSIGHT)

Our investment strategies for 2010 follow from our forecast of continued economic weakness and deflation, as discussed earlier in this report and in previous Insights, especially our Dec. 2009 edition. We see the 2010 investment climate dominated by weak economic growth here and abroad, led by U.S. consumer retrenchment. More government fiscal stimulus and continuing Fed policy ease are likely in this setting. So is low inflation or deflation.

INVESTMENTS TO BUY

1. Buy Treasury Bonds. Long-term Insight readers know we started recommending long Treasury bonds back in 1981 when we forecast secular and huge declines in inflation and interest rates. So we declared back then that "we're entering the bond rally of a lifetime." The yield on 30-year Treasurys was 14.7% and our eventual target was 3%. Last year, yields blew through 3% to reach 2.6% at year's end, so in our Jan. 2009 Insight we declared "mission accomplished" and removed Treasury bonds from our recommended list.

But then Treasurys sold off, pushing the yield on the 30-year bond to 4.7% at the end of 2009. So we've reactivated the strategy with our forecast of a return in yields to 3.0% or lower. Treasurys will continue to be a safe haven in a troubled world and benefit from deflation as well as their three sterling features. They are the best credits in the world. They are highly liquid. And they generally can't be called by the Treasury, and calls limit price appreciation when interest rates fall.

A decline in yields from 4.7% at present to 3.0% may not sound like much, but the bond price would appreciate over 34%. If it occurs over two years, then two years' worth of interest is collected, and the total return on the 30-year Treasury would be 44%. On a 30-year zero-coupon Treasury, which pays no interest but is issued at a discount, the total return would be about 64% -- most attractive! Recall that in 2008 when 30-year Treasurys rallied from 4.5% to 2.7%, their total return for the year was 42%..

Treasury bonds way outperformed equities in the 1980s and 1990s in what was the longest and strongest stock bull market on record. The superiority of Treasurys has been even more so since then. Chart 1, our all-time favorite graph, shows the results from investing $100 in a 25-year zero-coupon Treasury bond at its yield high (and price low) in October 1981, and rolling it into another 25-year Treasury annually to maintain that 25year maturity. In November 2009, that $100 was worth $16,972 with a compound annual return of 20.1%. In contrast, $100 invested in the S&P 500 at its low in July 1982 was worth $2,099 in November for an 11.8% annual return including dividend reinvestment. So Treasurys outperformed stocks by 8.1 times!

Doubters

Many believe Treasury yields are headed up, not down. They think that all the bank reserves created by the Fed that have not generated bank loans will do so, flooding the economy with money and then create excess demand and inflation. They also think the continual heavy issuance of Treasurys to fund the nonstop federal deficits will push up yields. In contrast, we don't foresee the rapid economic growth needed to induce chastened banks to lend and cautious creditworthy borrowers to borrow. And if we're wrong, it will take at least several years to eat up global excess capacity during which the ever-inflation-wary Fed will no doubt remove the excess bank reserves, as Fed officials have already indicated.

We do expect large federal deficits for many years, in part because of pressure on government to create jobs and restrain unemployment in a slow growth economy. But those deficits will increasingly be funded by U.S. consumers as their saving spree continues. Although stock market bulls salivate over the prospect that increased saving will mean more equity purchases, we believe most of the money will continue to reduce the immense debt consumers have accumulated in recent decades.

Repaying debt will be attractive to many Americans in 2010 and beyond as they shun many investments after their huge losses in stocks throughout this decade and their shocking setbacks in real estate. A number will want to be less leveraged as slower economic growth makes employment less stable and unemployment more likely. Chastened lenders, pressed by regulators, will be pushing individuals to lower their leverage by repaying debt.

Another concern for Treasury bonds is that continued huge federal deficits and the required Treasury financing will erode confidence in these issues by Americans and foreigners, as noted earlier. This seems unlikely, especially before the end of this year. Also, as U.S. consumers save more and curb spending on domestic products and imports, the trade and current account deficits will continue to shrink. Earlier federal deficits were financed by foreigners as they recycled back to the U.S. the dollars gained from their trade and current account surpluses. The growing U.S. current account deficit measured the increasing gap between domestic saving and investment, or, in effect, and the need for foreigners to not only finance government deficits but also make up for declining U.S. consumer saving.

But now, the current account and trade deficits are shrinking, and further declines will accrue in future years if, as we forecast, exports grow faster than imports. So foreigners will have smaller American current account deficits to finance. At the same time, much more of federal deficits will be financed by rising U.S. consumer saving.

With 3-month treasury bills yielding 0.046%, we've moved out on the yield curve for what is essentially cash positions in some cases. Sure, 5-year obligations are much more volatile than 3-month bills and do have risk of loss if interest rates rise. But we think the direction is down in that part of the interest rate curve, and 2.6% returns vs. 0.046% seem enough to offset the risks.

2. Buy Income-Producing Securities. This includes high-quality corporate and municipal bonds as well as stocks of utilities, consumer product companies, health care firms and others that pay meaningful dividends that are likely to rise. Master Limited Partnerships are also possibilities, but only if their underlying businesses are secure enough to continue significant income flows to limited partners and stockholders. Banks used to pay significant dividends but slashed them when their earnings collapsed. Nevertheless, their deleveraging and reversion to safer but less growth-oriented businesses will probably pressure them to again pay attractive dividends.

Utilities lagged behind the stock market last year, but at the end of November, the dividend yield on utilities averaged 4.5% compared to 2% for the S&P 500 index. That low return compares with 3%, which used to be the floor (Chart 2). Payout ratios recently have been essentially meaningless with the collapse in corporate earnings, but low, 31% in the third quarter of 2009. Under pressure from stockholders, dividend yields are likely to return to 3% or more. The current high level of corporate cash will also encourage dividend paying.. Also, the S&P utility sector has returned 53%, including dividends, since 2000 while the total return on the S&P 500 index has been a minus 11%.

With stocks likely to be weak this year, dividend yields may constitute 100% or more of total returns. Note, however, that although the prices of utility and other defensive stocks sometimes rise in bear markets associated with recessions, that's not always the case. That was clearly true in 2008 when virtually every stock sector went down. Utility and other dividend-paying stocks and ETFs based on them, however, can be hedged against general stock market declines.

3. Buy Consumer Staples and Foods. Items like laundry detergent, bread and toothpaste are basic essentials of life that are purchased in good times and bad. In fact, as we've seen lately, consumers are buying more of their calories in supermarkets and they economize by eating at home rather than in restaurants. Note, however, that they are downgrading from national brands to cheaper house brands, and likely will continue to do so as a weak economy and high unemployment persist. Among retailers, the winners may continue to be discounters. Producers of national brands will need to continue to adapt to consumer downgrading by emphasizing cheaper "value" products.

4. Buy Small Luxuries. This is an investment concept we developed years ago. Consumers, especially when they're hard pressed, tend to buy the very best of what they can afford, even if it's within a low-priced category. We first noticed this tendency years ago, before apartheid ended in South Africa. We read that urban blacks there often carried the elegant, slim and expensive umbrellas typical of investment bankers in London. They couldn't afford cars or maybe even taxi fares, but did achieve status and satisfaction with fine umbrellas. We also learned of a currently unemployed man who enjoyed the status of morning coffee at 7-Eleven six days a week. By reusing his cup and the one he takes home to his wife, he gets a 32-cent discount per $1.37 serving and saves $655 a year on this small luxury.

Companies are adapting to small luxury modes in various ways. Some are offering the same products with lower cost and selling prices. Coach is cutting ladies handbag prices and working with suppliers to reduce costs. Neiman Marcus is pressing suppliers for lower-cost versions of designer styles.

Others are putting their prestigious names on different products. C.F. Martin reintroduced its stripped down 1930s guitar for under $1,000. Average prices were in the $2,000 to $3,000 range and its top of the line guitar sells for $100,000. California winemakers are emphasizing cheaper wines as sales of those over $25 per bottle slump. Consumers are retrenching and dining out less at upscale restaurants where fine wines are sold. Tiffany sales of products over $50,000 are weak, but high-quality small items continue to sell well--always in its trademark blue box. Procter & Gamble has not cut prices on its top of the line products that sell at premiums but carry high-quality images. Consumers still splurge on such small luxuries as Gillette's five-blade Fusion razor and Olay's Pro-X moisturizer. But P&G has introduced cheaper "value" versions of Tide and other products to compete with the growing consumer interest in lower-cost national and house brands.

5. Buy The Dollar. Dumping on the dollar was the favorite sport of investors and the financial media until very recently. The financial meltdown in 2008 drove investors to the dollar as the global safe haven, but in early 2009 that status faded as fears of financial collapse melted. Buck-busters cited the record low short-term interest rates, with the fed funds target rate at 0-0.25%, even lower than in Japan. This made the greenback the preferred funding currency for the carry trade in which it is borrowed and then sold for other higher yielding currencies with rising interest rates. The falling dollar against those currencies enhances the profitability of those trades. Buck dumpers also emphasized the tremendous amount of dollars being pumped out by the Fed and the Treasury 70 in their attempt to revitalize the economy 68 and the Fed's clearly-stated commitment to keep short-term interest rates low for an extended period.

Despite all its drawbacks, however, the dollar remains the world's reserve currency and safe haven, regardless of suggestions by the Chinese and others that the dollar should eventually be replaced by a global currency. This status for the buck appears to be reemerging and will grow if we're right and hopes for a rapid economic recovery are dashed. Furthermore, almost everyone was on the dump-the-dollar side of the boat, a situation similar to early in 2008 that preceded the dollar's jump starting in mid-year (Chart 3). History suggests that when that happens, the winds often shift and all those folks will get tossed into the water as the boat sails in the reverse direction.

We favor selling British sterling since the U.K. economy remains in deep trouble, with even higher external debt than in the U.S.-- a ratio to GDP of 404% in 2008 compared to 95% in this country, which has caused bond rating agencies to threaten a downgrade of U.K. government debt. Also, the troubled British financial sector accounts for 21% of total jobs compared with 14% in the U.S. The U.K. was almost alone among advanced countries in suffering a falling economy in the third quarter of last year.

The euro is vulnerable, in our view, because the eurozone has a one-size-fits-all monetary policy but its economies vary in strength from Germany and the Low Countries at the top to Portugal, Italy, Spain, Greece and Ireland at the bottom. Those lands can't use independent monetary policies to stimulate their economies since that's the providence of the European Central Bank. So they need to resort to fiscal stimuli and increasing government borrowing to finance the resulting deficits. A number have suffered sovereign debt rating downgrades, which increase their borrowing costs, and more are likely. This could spark renewed threats that one or more countries will withdraw from the eurozone and go back to using drachmas, draculas or whatever as their currencies. That probably won't happen as the ECB will do all it can to prevent dissolution, but serious discussion of the likelihood could depress the euro considerably against the dollar.

These concerns are not new for us. Just as the euro was being launched 10 years ago, we wrote in our Dec. 1998 Insight that with a common currency, individual countries would be forced to rely on fiscal policy to deal with local business conditions and "the limit on fiscal stimulus will be default risks. Government bond investors and rating agencies will become the policemen and will blow the whistle.... It's even possible that economic differentials among countries may be so great that the common currency doesn't hold together, especially in the next European recession when unemployment leaps...."

Commodity-driven currencies like the Canadian, Australian and New Zealand dollars are also likely to weaken against the greenback as commodity prices fall. The Japanese economy remains weak and back in deflation, but the yen's involvement I the carry trade makes it a tricky currency for investment.

6. Buy Eurodollar Futures. In most markets, traders want to be where the action is, where liquidity is the greatest even though that's where competition is the strongest. Years ago, a jeweler in New York City complained to us about how fierce the competition was in his location. His shop was on 47th Street between Fifth and Sixth Avenues, the heart of the jewelry district. We asked why he didn't move to a less competitive area. He shrugged and said, "This is where the action is." In the case of short-term credit instruments used in futures trading, eurodollars are where the action is.

Our interest is in eurodollar futures contracts. Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future, and for investors to bet on the future direction of short-term interest rates. Each Eurodollar futures contract has a notional or "face value" of $1 million, though the leverage used in futures allows one contract to be traded with a margin of about $1,000. Trading in Eurodollar futures is extensive, and the market for them tends to be very liquid. The prices of Eurodollars are quite responsive to Fed policy, inflation, and economic indicators. It's ironic that eurodollar futures markets dominate trading, not those for Treasury bills or federal funds on which eurodollars are essentially based.

Eurodollar futures prices are determined by the market's forecast of the 3-month US$ LIBOR interest rate expected to prevail on the settlement date. Eurodollar futures contracts extend out for 40 quarters or 10 years, so they can be used to bet on interest rate movements many quarters ahead.

Long positions in eurodollar futures have been one of our most successful investments in recent years. Earlier, the futures market did not price in the full extent of the Fed-engineered decline in short-term interest rates. With our forecast of the financial crisis and the worst recession since the 1930s, however, we believed that the Fed would ease dramatically. So we reasoned that eurodollar futures prices would rise as they reflected the Fed's action. So far, they have.

Now the futures market assumes that the Fed will raise its target rate in the course of this year, so the LIBOR rate on which eurodollar futures settle will increase by 1.22 percentage points between January and December. We, however, believe that a weak economy will keep the Fed on hold throughout this year, so the interest rate implied by the December 2010 contract will fall by 1.22 percentage points. That would result in a $3,050 profit on a $1 million futures contract. That's a mere 0.3% gain. This is hardly worth the investment without leverage. But with only a $1,000 margin requirement on the futures contract, well, you do the math.

INVESTMENTS TO SELL OR AVOID

We hope these six investment strategies for 2010 that involve buying or being long securities are useful. But given our forecast that, at best, the U.S. and global economies will be sluggish this year, it won't be a surprise that we have a longer list of strategies that involve selling or avoiding various sectors. In fact, there are 11, or nearly twice as many.

7. Sell U.S. Stocks in General. The S&P 500 index in late December was selling at 19 times top-down Wall Street strategists' operating earnings estimate of $60.59 per share for this year, as noted earlier. That's an historically high P/E to start with that makes stocks vulnerable going into the year. Even more so because it assumes a steep economic recovery in 2010. And even more so if our forecast of continuing recession or sluggish recovery at best proves out. Our $50 estimate of operating earnings, down 11% from estimates for 2009, puts the S&P 500 index P/E at a nosebleed 22.5 level, as noted earlier.

Selling stock indices short, either through futures contracts or ETFs, strikes us as a prudent idea. Index shorts can also hedge long positions in utilities or other long strategies we discussed earlier.

Be well aware that our forecast of a declining U.S. stock market is critical to many other strategies we'll discuss later that involve selling or avoiding equity sectors here and abroad. We believe they all will perform worse than the stock market overall, but if we're wrong and the stock market leaps this year, we'll probably also be wrong on many of these other strategies.

8. Sell Homebuilder and Selected Related Stocks. Homebuilder stocks rebounded sharply from their March 2009 lows, along with stocks in general, but peaked in September with a slight downward trend since then. This may be beginning to reflect our forecast of another 10% decline in house prices (Chart 4). Excess inventories of houses for sale, the mortal enemy of prices, remain huge. And inventories may rise, even with housing starts at very low levels, as people foreclosed out of their houses double up with family and friends.

Also, a quarter of homeowners with mortgages are under water, 40% of those who took out mortgages in 2006. Increasing numbers of these people are convinced that they'll never regain positive home equity and are abandoning their abodes in favor of renting other houses at lower monthly costs. Still, the subsequent foreclosures on their mortgages will keep them from qualifying for a government-guaranteed mortgage for three to five years and will stay on their credit records for seven years.

Despite leaping mortgage delinquencies, federally-mandated but mostly unsuccessful mortgage modification programs are keeping many houses, especially middle- and higher-priced homes, from being foreclosed and sold--temporarily. Furthermore, the investment tax credit for new and some existing home buyers, which was extended beyond November 2009, is scheduled to expire in April. The overhang of aging new single-family homes available for sale is huge (Chart 5 ). Also note that new residential mortgages are almost entirely dependent on guarantees from government entities such as Fannie Mae, Freddie Mac and the FHA, and they are tightening their credit standards.

Low mortgage rates are a plus, but are only meaningful to those who qualify for loans as lending standards tighten. Most now need to meet the old conservative standards of 20% down, good credit, full documentation of income and assets, etc. And lower borrowing rates don't help underwater homeowners either refinance or buy other houses. Furthermore, rates on large "jumbo" mortgages remain high. Finally, lower house prices don't induce buyers who expect the downward trend to continue and hold out for even-lower prices.

9. Sell Selected Big-Ticket Consumer Discretionary Equities--for two powerful reasons. First, as consumers persist in their saving spree they'll continue to curtail spending on expensive postponeable items. Second, as widespread price declines persist, they will be anticipated. Prospective buyers will wait for lower prices. As a result, excess inventories and unused capacity will mount, forcing prices lower. That will confirm prospective buyers' suspicions so they'll wait for still-lower prices in a self-feeding downward spiral.

Deflationary expectations are clearly at work in the vehicle market. The cash-for-clunkers program generated one-time sales as buyers viewed it as just one more rebate inducement in a never-ending stream. But who would dare announce to a friend that he paid the full sticker price for any car? Of course, deflationary expectations don't work for small, inexpensive items. Suppose you know for sure that toothpaste will be cheaper next month. If you run out, you won't brush your teeth with Ajax while waiting for lower prices before buying a tube.

Even the rich, normally immune to recessions, are cutting back and downgrading. Note the weak sales at Tiffanys, Nordstrom and Saks Fifth Avenue and the poor auction results for Sotheby's and Christie's. A Merrill Lynch study found that the number of people in the world with $1 million or more in investable assets fell from 10.1 million in 2007 to 8.6 million in 2008. Those assets dropped from $40.7 trillion to $32.8 trillion. Their equity holdings fell in step with the S&P 500, about 40%, and their real estate also dropped in value.

Ever since the data series began in 1967, the share of income of the top 20% has trended up while all other shares fell. Note that these are shares, not income levels--which have grown on balance for all quintiles. Studies have found considerable rotation in and out of the various quintiles, with many of those in the top bracket in a given year absent from it in earlier and later years. Still, the drop in purchasing power for many middle-income people in the last year in addition to the collapse in their homes' values has created considerable anger at those at the top.

The equities of most producers of big-ticket consumer discretionary goods and services collapsed in the 2007-2009 bear market, reflecting consumers' buying strike, but have recovered somewhat since March. With our conviction that American consumers have reached a watershed and switched from a quarter century borrowing-and-spending binge to a decade or longer saving spree, we are very suspicious of the sustainability of any rebound in stocks of producers of major consumer discretionary products such as cruise lines and airlines.

10. Sell Banks and Other Financial Institutions. During the financial free-for-all days, large banks moved well beyond traditional spread lending--taking deposits and then lending them with interest rate spreads to cover their costs, loan risks and reasonable profits. They hyped their leverage--and their risk--as they set up off-balance sheet vehicles, engaged in proprietary trading and in the origination of and investment in derivatives. Regulators stood by under the theory that free markets would discipline excessive risk-taking. Both the big banks and the regulators, however, knew or should have known that those institutions were too big to fail and could take the financial system down with them. So those financial institutions were really playing a game of, heads we win, tails we get bailed out.

And fail they did, and bailed out they have been. Many investors seem to believe that's the end of the unpleasantness and now it's back to business as usual. The recent big trading profits by some financial institutions certainly point in that direction as did the stock rebounds until recently. We doubt it, though. The financial sector expanded its leverage over about three decades and its deleveraging will probably consume most or all of the next decade. Big risk-taking CEOs like Ken Lewis at Bank of America are being forced out, sending a clear message to the senior officers who remain.

Stringent, probably excessive regulation is replacing the laissez faire model. Higher capital requirements and other limits on risk-taking will curb bank profitability. So will the limits on executive pay aimed at reducing the incentive to take big risks.

Weak Loan Demand

Furthermore, with slow economic growth, consumer zeal to save and repay debts, and weak capital spending this year, loan demand will likely be weak. In addition, the present steep yield curve makes borrowing cheap deposits and lending long-term at higher interest rates very profitable. But it will probably flatten as the year progresses and long rates fall. Banks, of course, can increase fees on checking and other accounts, but are limited by competition from money market funds and other alternatives.

Also, banks' costs of borrowing in the bond market is well off its highs relative to Treasurys, but still elevated compared to pre-crisis years. The spread now runs over three percentage points compared to about one in pre-crisis days. Much of the cheap debt banks acquired from private markets in earlier years and the government more recently will mature in the next several years and need to be replaced at much higher costs. The maturities for U.S. banks have dropped from 7.8 to 3.2 years in the past five years.

Regional and community banks are also likely to be unattractive investments this year. Ironically, in the go-go days, many of them were unwilling to virtually abandon their underwriting standards to compete with nonblank residential mortgage lenders. So they lent to the commercial real estate market instead. That's proving to be a jump from the frying pan into the fire, as discussed earlier, and is shown by weak demand, falling prices and rising delinquencies. Regional banks have more than their share of the $1.7 trillion in outstanding commercial real estate owned by all banks. These loans constitute 35% of regional banks; total loans, up from 25% in 2000.

Due to bad commercial as well as residential real estate loans, smaller banks are dropping like flies, 140 so far this year (Chart 6 ). Individually, they aren't too big to fail, but collectively they are since they are the primary financers of smaller businesses. Those businesses don't have access to commercial paper and other credit market vehicles and must rely on their local banks for loans--or on the personal credit cards of their owners.

11. Sell Consumer Lenders' Stocks. Consumer lenders' stocks have also rebounded sharply from their March 2009 lows. We were wrong on our strategy of selling them last year, but believe it will work in 2010.

Consumer lenders had their hey day during the long consumer borrowing-and-spending spree. Consumers were trained--and we use that word deliberately--to believe they deserved instant material gratification. Buy now, put it on the plastic card and pay later-- much later--became the norm. And creditworthiness was no problem for credit card issuers and other consumer lenders. They sliced and diced consumers' financial statuses, used sophisticated models to determine payment risks and charged fees and interest rates to fit any risk category.

But their models and analyses inherently assumed that the borrowing-and-spending binge, as well as the ability to repay, would last indefinitely. But then consumers suddenly switched to a saving spree and started to pay down credit card and other debts. Also, heavy layoffs, leaping unemployment and collapsing house prices and inadequate consumer incomes spiked credit card delinquencies. Congress last year restricted credit card fees and interest charges. Also, consumers went on a buyers strike a year ago and cut back on their use of credit, debit and charge cards.

Recent developments are virtually all negative for the credit card business now and for years to come. The cottage industry to help these people deal with their huge credit card debts is exploding in size. As noted earlier, charge cards and debit cards are replacing credit cards as consumers realize they can't trust themselves to restrain debt and need to pay off monthly or accumulate the money in a bank account before spending it. Layaway plans are replacing the buy now-pay later approach. With the switch from a quarter century consumer borrowing-and-spending binge to a long run saving spree, the credit card business has moved from a growth industry to a laggard.

12. Sell Many Low and Old Tech Capital Equipment Producers. Low and old tech producers will remain depressed in a world of chronic excess capacity. When operating rates are low, producers don't need more capacity and worry that revenues, prices and profits won't be adequate to justify even existing capacity. And note that the volatility of the producers of equipment is much greater than that of the users. Auto sales declined by over 47% from their peak in July 2005, but orders for machine tools, automatic transfer lines and other equipment fell much more as auto assemblers and parts makers almost froze orders. Recall as well how the recession-sired excess capacity in airlines has caused massive cancellations and postponements of orders for Boeing's Dreamliner.

Earlier, we discussed our statistical models that explained capital spending. They show that in accounting for the year-over-year change in the equipment and software or in equipment and software plus nonresidential structures components of GDP, thelevel of operating rates is far and away the most important explanatory variable, even more so for the year-over-year change in operating rates. This indicates that even if capacity utilization is growing rapidly, if it remains at low levels as at present, the growth in capital spending will be subdued.

Other variables, such as the year-over-year changes in cash flow, profits and interest costs, were statistically significant in our models, but much less effective in explaining the change in capital spending. These findings are important because many believe that the negative gap between capital expenditures and internal funds is sure to generate a capital spending surge. But our models, based on history, say that with huge excess capacity, that cash flow won't burn holes in corporate pockets. And our models don't quantify and add in the extra corporate caution spawned by today's recessionary climate and financial crises.

Besides the depressing effects of excess capacity, low and old tech companies suffer from ongoing problems. Foreign competition continues to grow as their technology is transferred to China and other cheap production locales. Some suffer rising cost pressures due to lack of productivity gains. High-cost unionized labor forces are sometimes a problem. And many sell into saturated, slow growth markets.

13. If You Plan to Sell Your House, Second Home or Investment Houses Any Time Soon, Do So Yesterday. This strategy has worked for the last two years and will continue to do so if we're correct and house prices nationwide fall another 10%. Sure, prices have been weakest in states like Florida, Arizona, Nevada and California where the biggest bubbles preceded the collapses. But almost every area of the country has experienced price declines (Chart 7 ).

Many owners have tried to wait out the bear market in housing, a technique that worked in earlier years when any price declines were small and short-lived. But huge excess inventories, a flood of distressed sales after mortgage modification attempts are over, depressed incomes and rising unemployment will probably keep sellers plentiful, buyers reluctant and prices falling throughout 2010 and perhaps beyond. In past regional house price collapses, it's taken homeowners a year-and-a-half to give up and throw their houses on the market for whatever they will bring. After the final bottom is reached, house prices will likely mirror inflation, or in future years, deflation as they have historically.

14. Sell Junk Bonds. During the dark days of the financial crisis, the yields on junk bonds leaped to 19.3 percentage points over Treasurys as investors worried about complete financial collapse and widespread defaults among low-grade issues. Triple-C rated bonds, the lowest junk tier, sold at 42.6 cents on the dollar at the beginning of last year.

But the bailout of the big banks and easing of the financial crisis allayed investor fears and junk spreads narrowed. Institutional investors piled in, followed by individual investors, many of whom sought alternatives to low returns on bank deposits and money market funds. So the spread has dropped to 4.6 percentage points, much closer to where it was before the crisis began. Last year, junk bonds returned over 50%, much more than the 25% gain on the S&P 500 index.

Nevertheless, we believe this rally is way overdone. Default rates on junk bonds normally peak late in recessions or in the year after it ends. Also, the default rate may reach or exceed the previous peak in 2002 if the economy remains weak, suggesting major declines in junk bond prices. Furthermore, the value of bonds after default is likely to go lower if the recession drags on, as we forecast. Slow revenue and cash flow growth will make it difficult if not impossible for a number of financially weak and weakening firms to service their bonds and other debts.

15. Sell Commercial Real Estate. As discussed earlier, excess capacity and big refinancing requirements in coming years will continue to plague hotels, malls, warehouses and office buildings. Moody's/REAL Commercial Property Price Index was down 44% last October from its October 2007 peak. Retailers closed 8,300 stores last year, more than the previous peak of 6,900 in 2001. Businesses will continue to cut costs this year, not only by holding down employment and therefore the need for office space, but also by moving in the partitions to fit the remaining people in less space, as mentioned earlier.

Increasing use of telecommuting will also reduce need for office buildings. And more teleconferencing will cut hotel-utilizing business trips, especially after intensified airport security in reaction to the recent terrorist incident in Detroit on Christmas Day. At the same time, frugal consumers will restrain discretionary travel and the hotel and motel use involved. Weak consumer spending will keep mall and warehouse space under pressure.

Some believe that commercial real estate woes may exceed the residential collapse, and they may be right. Commercial tends to be less leveraged but if refinancing isn't available, it may note make much difference how leveraged it is. Also, distressed commercial real estate owners definitely don't have the political sympathy and bailout prospects enjoyed by troubled homeowners. The Fed has set high standards for bailout loans on commercial real estate. Commercial real estate REITs rebounded last year along with the overall stock market (Chart 8 ), but strike us as vulnerable. These leaps combined with plummeting real estate prices have pushed REIT prices to a 25% premium over their net asset values.

16. Sell Most Commodities. Commodity prices rebounded last year and benefited from cheap and available money. Some live in their own worlds. Petroleum is not only influenced by fundamental supply-demand conditions, but also by OPEC decisions. Natural gas prices in the U.S. weakened last year with the recession, but also because of new production technology that unlocked abundant shale gas. The prices of agriculture commodities, including honey, are highly dependent on weather.

In any event, we believe that economic supply and demand will rule most industrial commodity prices this year and result in weakness due to sluggish global business conditions. Also, investors put a record $50 billion into commodities in 2008 but then retreated last year after prices nosedived. They learned the hard way that commodities aren't an asset class but speculations, and may be cautious this year. And the strengthening dollar should depress the prices of the many commodities traded worldwide in dollar terms. We look for falling commodity prices this year. Also, we believe that many commodity-producing companies and their suppliers of equipment and supplies will be unattractive investments as weak demand, excess capacity and soft prices persist. The same is true for economies such as Persian Gulf sheikdoms that depend heavily on petroleum, as witnessed by the financial collapse of Dubai.

17. Sell Developing Country Stocks and Bonds. As late as the end of 2007, most forecasters believed in decoupling. Even if the U.S. economy suffers a setback, they said, the rest of the world, especially developing countries like China and India, would continue to flourish. Indeed, the strength of those economies could even aid the U.S. as they bought more American exports.

We disagreed. We did a study two years ago that found that China was not yet developed sufficiently to have enough people with discretionary spending to support the economy domestically. She remained export-led, with most of those exports going directly or indirectly to U.S. consumers. So, with our forecast of a major retrenchment by U.S. consumers, we predicted big trouble for China. Our analysis revealed that in China, it takes about $5,000 per capita to have meaningful discretionary spending power. About 110 million Chinese had that much or more, but they constituted only 8% of the population. In India, that class was a mere 5% of the population. In contrast, it takes $26,000 per capita in the U.S. to have discretionary spending power and 80% of Americans have at least that much.

Well, as they say, the rest is history. The Chinese and most other developing Asian countries nosedived as U.S. consumers retrenched. But in the wake of China's huge $585 billion stimulus program last year, massive imports of industrial materials like iron ore and copper, jumps in construction of cement, steel and power plants and other industrial capacity, and a pick up in economic growth, many forecasters again believe in decoupling.

We continue to disagree. Sure, some countries such as Brazil were not hurt too severely by the global recession, at least so far. Still, most developing economies depend on exports for growth, and the U.S. consumer has been the biggest buyer of those exports and far and away the globe's biggest spenders. As the American consumer saving spree continues to shrink the U.S. trade and current account deficits (Chart 9), those developing economies will be subdued.

China's economy looks like a house of cards. Her most recent fiscal stimulus not only went into industrial capacity-building but also bank lending-spawned stock market and real estate speculation. But what will utilize that capacity and justify those speculations? The usual outlet, exports, is curtailed by retrenching U.S. consumers. And, as noted, China is not far enough down the road to industrialization for local consumers to fill the gap.

We doubt that the rebounds in emerging market stocks and bonds correctly forecast robust, decoupled economic growth that is sustainable. While the S&P 500 now trades at 20 times earnings over the last 12 months, normally cheaper emerging markets are more expensive. Recently, the Shanghai Composite Index sported a 32 P/E while South Korea's was at 35 and Indonesia's was at 29. And note that the 65% jump in emerging market stocks in 2009 only offset two-thirds of the 54% drop in 2008.

Furthermore, as was made clear by the universal weakness in security markets in 2008, bond and stock markets around the world are highly correlated. With globalization, the days are gone when a globe-trotting sleuth can discover gems in the remote reaches of Asia or Latin America. The similarity of bond and stock performance is even greater when adjusted for risk. Emerging market stocks and bonds may climb more in bull markets, but have greater falls when the bear arrives, as we believe he is about to. There's no such thing as free lunch.

The Coming BioTech Bubble

JohnMauldin — Tue, 12 Jan 2010 01:45:00 GMT

In last Friday's letter, I said that I had not bought any single stocks in the last decade, preferring funds and managers, and in general I still do. However, I am now going to start buying a specific asset class this month and currently plan to add to those holdings at least every quarter for several years. This is the high risk portion of my portfolio, so it will not be all that large a percentage. (Do not write and ask me what the right percentage is. It will be different for everybody. For some of you the answer will be none, as you need to be taking very little risk. Consult your investment professionals.).

Let me state emphatically that I am not going to become a stock picker. My regular letter will remain focused on the macro economic environment and investments in general. This is not my recommended advice to you but what I am doing as an individual investor. I simply know that many readers are interested in what I am doing personally and in my investment ideas. If this doesn't make sense to you, then by all means hit the delete button later. With that thought, let's dive right in.

In the 70s, we had a bubble in gold and commodity stocks. Some stocks had huge run-ups because of major gold finds coupled with the price of gold going up over 20 times over the period. A gold mine became a hole in the ground with four promoters standing around it telling you a story about why there was gold in the hole. Sometimes there was, but often the "gold" was the stock the promoters sold. I was too young and poor for that bubble, although I did get into a few (sadly too few) later winners.

Then we had the tech bubble. And the internet craze. Obviously, some of those stocks are still around and have been longer term winners, but the number of stocks that went public with crazy offerings, no revenues and valuations from left field eclipsed anything I have ever witnessed. I missed that bubble as well, as I was bearish about the markets in general and tech in particular, as I wrote in my first book (1998).

I think there is a potential for another bubble over the next decade. There will probably be several, but there is one I am particularly interested in and that is biotech, with an emphasis on stem cell and gene therapy and their allied kin. For reasons outlined by my friend Patrick Cox, writer of the newsletter Breakthrough Technology Alert, in today's Outside the Box, I think we are on the cusp of a decade of remarkable breakthroughs which will change the way we do medicine.

While some of these breakthroughs will come via large firms, others will be in smaller companies. Imagine cures for certain types of cancer. Rejuvenation of failing hearts? Livers? Genetic therapies for all types of diseases? The list of potential blockbuster therapies from current research is enormous and growing.

There are going to be some companies which will simply see their stocks explode. Of course, for everyone that has a large run, there will be failures which will go to zero. Or companies that seemingly have "the cure" only to have another company come along with something faster and cheaper, wrecking their share values. (Think of the dawn of the computer age and how many once high flying stocks went to zero. Biotech stocks are not bonds.)

But I think (personal belief here) that what will capture the imagination will be the large winners. Everyone will want to be in at the beginning of a new home run. As the decade goes along, we will see companies go public before they are really ready, just because they have a great story and people will want to fund that story.

It has the classic potential to become a bubble, because there is a deep reality - some substance to the stories of the winners - that will make people look for the next big winner. So far, we as humans have not proven ourselves able to resist bubbles. Maybe this will be the time we all become adults and there will be no bubble. Maybe. But my thought is that it will not be.

And as I have been ending my speeches recently, I have lived through a number of bubbles. I have never gotten to invest in one. This time, dear God, just once please let me be at the beginning of a bubble.

Now, I have no particular expertise in biotech stocks. I go to conferences, read articles and hear amazing stories. They all sound good to me. But for about a year I have been reading Patrick's newsletter, and have spent a lot of time talking with him (and others in the biotech industry). He does have expertise in looking at all types of breakthrough technologies (and not just biotech). He is one of my main sources for ideas in this space, and if you are interested in the tech and biotech world, you might consider subscribing to his letter (I will provide a link later). As an aside, he will be writing the chapter on biotech in my next book.

Starting this month, I will begin to buy some of the stocks in his suggested portfolio. I will start with four stocks and add to those positions and other stocks over the coming years. I think this is a long term play. My best guess is that the coming recession I predicted last Friday may hurt the value of these stocks, but I simply don't know. This is not a trade, nor will I be hedging (at least not for some time). I expect to be adding small positions for years.

Do not write and ask me which stocks I will buy. For lots of reasons, I won't do that, not least of which it is not fair to Patrick for me to use his intellectual work. I am building a portfolio, and I can almost guarantee you that some of those stocks will end up being dogs. Second, Patrick is not going to mention any specific stocks in this week's letter. It would not be fair to his smaller subscriber base to mention a stock to 1 million readers. Third, if you do subscribe and after some time reading and researching on your own, decide to buy a stock or two, do not chase the price. And I would suggest you do not buy all you intend to buy all at once. Space it out over time. These stocks can be very volatile and it is probably better to average in over time.

There are some other letters and analysts that I am going to introduce you to over time. There is no need to rush. Also, if you know of another writer I should be aware of, feel free to drop me a note with their name. Now, if after you read this week's Outside the Box you are interested in subscribing to Patrick's letter, you can do so here. The writing on the web site is fairly typical in it's over the top promotional style, but see through that to his actual work. And they are knocking off $300 off the regular price of $895 for my readers. I am a big fan of Patrick, and admire his thoroughness and work. If you want to invest in this sector, starting off with Patrick is a good way to go. Take your time, read, learn and then invest. Again, no hurry here. But do get started researching.

A couple of caveats. I may be completely wrong about there being a potential bubble in biotechs. Just because there may be similarities to previous bubbles does not mean there will be another. Past performance is not indicative of future results, as I say time and time again. Second, stocks you buy in the near future may really get hit in the next recession. You might consider waiting if that will make a big difference to you. Like I said, there is no rush. Consult with your investment professionals about this, and do not take large positions relative to your total portfolio. A stock that I could be convinced about today can be made obsolete by newer technology. Cautious optimism is always proper, with the emphasis on caution.

Finally, and as a reminder, this is a market and sector call by me. I have no idea on who the real winners will be in ten years, although I hope I get lucky and find a few. And for those of you who don't have enough money (yet) to buy into this concept but still like the idea, consider a small cap biotech mutual fund as a way to start. There are several.

Now, let's see what Patrick has to say about the coming new world of biotech.

John Mauldin, Editor
Outside the Box

The Coming BioTech Bubble

by Patrick Cox

BioTech Overview

In just a few paragraphs, I'm going to tell you something that will, if you are a demographically typical American, extend your healthy life span significantly. Moreover, what I'm going to recommend that you do is essentially free. On top of that, top researchers report it will make you feel better within a few weeks.

Get richer. Live longer. Feel better. Impossible, right? Obviously, some joke or a scam that slipped past your spam catcher. On the contrary, I'm entirely serious and I can site a preponderance of peer-reviewed science from the most prestigious scientific journals to prove it. Within a few years, this information will be common knowledge. Very few people know about it today however.

My purpose for telling you about this scientific breakthrough is not simply to impart the benefits of this new research. It is to make a much more important point. That point is this: the biotech sciences have been leading the discovery race for years now and almost nobody has noticed.

You probably know about 3D television and the newest whiz-bang smart phones. You may know about private orbital launchers and new toys that let kids control objects just by thinking. Virtually no one outside the biological sciences, however, knows about the astonishing biotech progress that has gone on "under the radar."

There are a number of reasons for this. One is that the mainstream media is patently incapable of grasping or reporting complex scientific subjects. This was the case even before major news organizations began slashing news staffs. Moreover, many biotech stories are so technical in their details that few journalists have the background or patience to actually dig in and understand them.

My biologist wife's theory, incidentally, is that biotech breakthroughs just don't make great theater. This is especially true when compared to developments in physics and computer sciences.

You know that IT continues to accelerate. You can touch and hold new computers in your hands. You've personally seen the dramatic improvements in Internet performance and the resultant explosions in social media like Facebook, YouTube and Twitter. Similarly, big physics experiments make big headlines. They require huge budgets and enormous structures, like the Large Hadron Collider.

Biotech advances, however, typically take place in relatively small laboratories. The experiments themselves produce results that can only be observed on a microscopic or sub-microscopic level, and they are measured using the language of careful obtuse statistical analysis. Nevertheless, my message today is that biotech is where the really big breakthroughs and profits will take place in the next few years. Moreover, these advances will ultimately change the world in ways that dwarf the direct impact of computers and the Internet.

So now, I'm going to give you an overview of some of the truly remarkable breakthroughs in biotech, as John Mauldin has asked me to do. First, however, I'll tell you how to live longer, get richer and feel better, as promised.

It is this: Optimal vitamin D serum blood levels, attained through sunlight or supplementation, dramatically reduce the risk of most serious diseases by an astonishing 50 to 80 percent. These diseases include osteoporosis, osteomalacia, hypertension and a range of cancers from breast and colon to deadly melanoma skin cancers.

Yes, that's right. The risk of contracting the really nasty skin cancers can be dramatically lowered by getting moderate, sensible sunshine or through vitamin D supplementation. Non-melanoma skin cancers do increase somewhat with sun exposure, especially with sun burns but they are relatively benign and are easily detected and removed.

This is not the end of the list, though. The big killers and most expensive diseases respond similarly to adequate D. I'm talking about cardiovascular disease and stroke. So do type 1 diabetes, type 2 to a lesser extent, rheumatoid arthritis, peripheral vascular disease, multiple sclerosis, dementia, autoimmune diseases and apparently even viral diseases such as H1N1 and AIDs. I emphases that some of these diseases are not "cured" by sufficient D as some bone diseases are. The risk of developing other diseases and the severity of their symptoms if you do is much lower, however, if you are not vitamin D deficient.

There is, by the way, no simple prescription in terms of sunlight exposure or vitamin D supplementation because age, skin color, body weight and even location play huge factors in your circulating blood levels, which should be at least 40 ng/ml of 25-hydroxyvitamin D. Ideally, you should consult a physician who can prescribe blood tests to see where your D levels are.

This information is not new but the odds are that you are unaware of it unless you read the New England Journal of Medicine or other scientific publications. I'll include links at the end of this article for you to investigate this matter further, including the NEJM paper I just referred to.

This new consensus regarding vitamin D must be viewed as a sign of the biotech revolution on the horizon. Just as new IT and nanotech sensing technologies have shed light on the function of vitamin D, they are leading scientists to entirely unexpected discoveries in other areas as well. More importantly, these discoveries, unlike sunshine, can be patented. You, therefore, can invest in the companies that own the IP and reap transformational profits.

Some of the contributing technologies include supercomputing, without which the human genome could not have been decoded. We now know, by the way, that the activity of about 2000 human genes is moderated by vitamin D. Supercomputing has also enabled an entire new means of biological experimentation called in silico. Simply put, in silico experimentation uses 3D computer models of organic molecules. These models, existing in virtual reality environments, can be manipulated at incredibly high speeds to quickly yield results that once would have taken decades in physical labs.

Incidentally, the reason that I can confidently say that the vitamin D information will make most people wealthier is simply this. Personal wealth is directly correlated to age. As an investor, I can assume that you understand exponential growth. You know, therefore, that diversified portfolios grow faster over time. Every additional year that you live will see, statistically speaking, an increasingly rapid rate of wealth accumulation.

I believe, based on discussions with top scientists, that the impact of attaining optimal vitamin D blood levels for the vast majority of people, whose serum D levels are insufficient, will be an increase in average healthy life spans of 5 to 8 years. This is pretty breathtaking news, frankly, but you have to view it as just one manifestation of accelerating scientific discovery.

Average lifespans have been increasing steadily for hundreds of years but have recently begun to accelerate noticeably. This trend will continue to increase as proven biotechnologies, now in the developmental stage, come to market. These biotechnologies include RNA interference, nanotech biosensors, personalized medicine, nanotech viricides and stem cell technologies among others. Non-medical biotechnologies will not directly impact lifespans but they will create enormous wealth. Notably, I'm talking about cellular engineering.

There is still work to do in all these areas but the science behind them is solid. When they come to market, which will be sooner than almost anyone expects, they will create enormous wealth for those with the foresight to invest in them before the general public has caught on.

Think, for example, back to the birthing days of the computer and software industries. Remember when virtually everybody considered personal computers expensive toys that would never really catch on? Do you remember when financial gurus were saying the Internet was a fad and that e-commerce would never be more than a novelty? This year, by the way, Amazon.com sold more e-books than paper books.

When those technologies were ramping up, it was possible to buy a diversified mix of the best players at bargain prices. When the technology proved itself, people who held such portfolios made immense fortunes despite the fact that many of the original companies failed. You can own a bunch of losers but still makes thousands of percent returns if your portfolio included the big winners like Intel, Apple and Microsoft.

As people catch on to the potential of these new biotechnologies, we will see similar bubbles. John Mauldin, in fact, has predicted just that. Now, therefore, is the time to begin building a diversified portfolio of the most promising transformational biotechs. So just what biotechnologies are we talking about?

Regenerative Medicine

This is numero uno; stem cell technologies. They may not be first to market, but the technology's potential is unparalleled in history for reasons I'll explain. Other huge transformational technologies may treat and prevent currently incurable diseases before regenerative medicine matures. Stem cells, however, are unique in their ability to rejuvenate the human biology. I'm not, by the way, talking about obsolete embryonic stem cells (eSCs). Despite the political rhetoric, the scientific action has moved far beyond eSCs to several other forms of stem cells.

Unless you are reading scientific publications, however, you probably wouldn't know this. In fact, the scientific literature itself is usually outdated because leading stem cell scientists are not working in academia with its "publish or perish" pressures. The last thing that scientists in start-ups and small caps want to do is give away the inside information about their innovations. As a result, almost none of the real breakthrough news in stem cell or other cutting edge science makes it to the mainstream or financial medias. Let me prove my point with a pop quiz.

Q: How long will it be before scientists can duplicate the army of clones scenario that George Lucas portrayed in Star Wars II: Attack of the Clones. In other words, when will scientists be able to swab the inside of your mouth, take a single cell and turn it into an unlimited horde of healthy babies, each with your identical DNA?

A: If you said "several years ago," you are right. This is routine, well-established science at this point. We don't believe anybody has actually used this ability with humans yet, for obvious ethical reasons. Scientists, however, have taken adult skin cells from mice and transformed them into a new kind of stem cell called an induced pluripotent stem (iPS) cells. Those iPS cells have, in turn, been allowed to develop into healthy adult mice.

As dramatic as this ability is, it is not particularly useful outside of agriculture where the technology will be used to produce perfect livestock. The real promise of iPS cells is "potentiation" for specific medical needs. What I'm talking about is taking an iPS cell, which is fundamentally identical to an embryonic stem cell, and programming it to repair aged or damage tissues.

Potentiated iPS cells could be be grown, using your own cells, that would rejuvenate your heart muscles, one of the muscle tissues that cannot regenerate on its own. These cells could be programmed to become fresh cartilage, another cell type that doesn't regenerate, thus giving the aged and arthritis sufferers youthful pain-free joints.

We're looking at non-surgical organ replacement, one cell at a time. An injection or series of injections of these potentiated stem cells would, for example, transform an aged, damaged liver into a healthy youthful organ.

Someone suffering from severe diabetes could get off-the-shelf islet cells that produce insulin, saving their lives and allowing them to live normal lives. People who are blind due to macular degeneration could see again. You name it, these extraordinary cells will do it. In fact, they did do it. Every cell in your body, cartilage, kidney, heart, skin and bones, started out as a stem cell.

So let's have another quiz.

Q: How long will it be before the programming code for cartilage stem cells is cracked.

A: Once again, the answer is that it has already happened. Top private industry scientists have decoded the secrets of hundreds of cell types and are experimenting now with cartilage, nerve and other cell types. Human tests, probably offshore because of the FDA's snail pace, will begin if not this year, then next year. These therapies will be offered initially outside the United States. Many of us believe that, once Americans begin coming back home healed of conditions previously thought incurable, the FDA will bow to public demand. Regenerative medicine will inevitably be fast-tracked.

(Note: there will be lots of scams offering all sorts of purported stem cell therapies offshore offering "cures" for all sorts of diseases. Don't buy them or subject yourself to them. The legitimate players will surface over time, associated with real hospitals and researchers.)

There is one final aspect to the regenerative medicine picture that makes it especially attractive to long-term investors. Let me tell you a story to make this point.

Last year, I was in Canada speaking at a financial conference about emerging biotechnologies. I was privileged to share the forum with Harvard futurist, best-selling author and venture capitalist, Juan Enriquez. Enriquez is a major force in cellular engineering, working closely with the genius ex-surfer Craig Venter who cracked the human genome for a fraction of the cost and in a fraction of the time that the US government had allotted. President Clinton, in fact, issued an emergency executive order denying Venter IP rights to the genome he had decoded.

Today, Venter is applying his genetic genius to the other end of DNA complexity. He is developing the tools to reprogram the genetically simplest life: microorganisms. Venter compares DNA to computer code and scientists following his work say he will create the first artificial life form, probably this year. It will be, in fact, a designer bacteria. More importantly, his next step is engineer algae that secrete high-grade hydrocarbons that can be refined into transportation fuels. ExxonMobil believes him and gave Venter's research firm $300 million to work on the project.

Anyway, I asked Venter's associate, the venture capitalist Enriquez, why his biotech funds weren't invested in stem cells. His answer was straightforward. He said that the IP was already tied up. This is an astonishing fact. The intellectual property, the patents, for this phenomenal rejuvenative technology is already applied for or awarded.

The IP structure of regenerative medicine is unlike most other pharmaceutical or biotech industries, including cellular engineering. Traditional drug discovery, in fact, consists largely of identifying which of many molecules can do a certain thing. Frequently, only a small percentage of possible candidates are identified and then, through an elimination process, one is identified for testing and approval.

Cellular engineering is more dramatic but the potential number of new biofuel-producing algae is theoretically unlimited. Anyone who creates a new breed of algae can patent only that microorganism.

This is not the case with stem cells. There are very few "pluripotent" stem cell types that can become all the other cells. Already, the means of producing these cells and, in many cases, the cells themselves have been patented or applied for.

To invest in algae biofuels, which I probably will do, I will have to pick the most likely winners from a field of players to guarantee owning the big transformational winners. This is possible but it is much riskier than the stem cell space. This is because the number of companies that hold the bulk of the really valuable IP and patent applications can be counted on one hand. If big pharma wants into the regenerative medicine business, and they will, they're going to have to pay these tiny small caps for the right. This reduces the risk of buying losers enormously.

RNA Interference

There are many standalone breakthroughs in biotech and I'll mention a few in a bit. First, I want to tell you about the other big biotechnology industry, RNA interference. RNAi is a perfect fit with regenerative medicine, which has the power to restore damaged and aged tissues but does not attack the causes of diseases. This is where RNA interference fits in.

This field is actually younger even than stem cell sciences. The scientific paper that broke open the field was published in 1998 and the Nobel Prize for medicine was awarded to its authors in just four years ago in 2006. RNAi had one major advantage over regenerative medicine, however. It was not effected by the political and moral controversies that regenerative medicine faced before it moved past embryonic stem cells. As a result, researchers have had no trouble getting government and private funding.

Here is the overview. Our DNA is, in effect, locked and protected in a cellular clean room without a door. DNA communicates with the rest of the body by sending out messages with orders to turn genes on or off. Those messages are RNA, or ribonucleic acid. Therefore, the right RNA sequence can be introduced to the body to mimic those messages, which are then identified as invaders. The provokes the body to treat certain of its own RNA messages as invaders and destroy them.

This is RNA interference and it provides the ability to control any of the genes in our body and the proteins they produce. Those proteins, in turn, are the key to most human diseases. RNAi can both increase and decrease these proteins, providing cures for innumerable diseases. The companies that own those therapies will, in turn, become new pharm giants or they will be acquired by existing pharma.

RNAi researchers are working on drugs that could reduce production of bad cholesterol or increase production of the good form. RNAi could be used to turn off the gene that allows cancers to develop capillary networks. Similarly, it has been demonstrated to turn off the gene that provokes the excess blood delivery that causes wet macular degeneration. It could moderate the ability of the body to store fat or increase muscle mass. In could turn off hypertension or insulin resistance as well as neoplasias such as tumors, infections, and neurodegenerative disorders like Parkinson's and Alzheimer's Disease.

For the first time, science is looking not to treat symptoms, but to actually stop the gene functions that cause diseases. This is truly a revolution. The challenge to this remarkably young science now is the actual delivery of RNAi drugs to cells. We know they work in the lab but RNA molecules are large and fragile, so they don't penetrate cellular membranes under normal circumstances. Additionally, the body tends to clear itself of RNAi drugs through the kidneys or inside the cell itself. Nuclease, which exists inside the cell, also breaks down RNA.

For this reason, a number of delivery mechanisms are being developed to safely transport the RNA as a payload. A handful of small companies with superb talent and IP are racing to perfect their own varying solutions. Each has a different approach to solving the delivery problem but all have demonstrated efficacy. At this point, we don't know which will yield the big solutions. It appears increasingly likely, however, that different platforms will be best suited for different RNAi applications. Each has huge profit potential. RNAi drugs are in trials and big pharm has already snapped up one small cap player.

The Nanotech/IT/Biotech Convergence

I've already mentioned cellular engineering. Craig Venter calls cells hardware and DNA software. He treats DNA like the ones and zeroes in current software. The same IT/biotech convergence is also evident in new in silico experimentation.

Nanotechnologies are contributing indirectly to the explosion in biotech innovation indirectly through new lithographic chip fabrication techniques that increase computer speed and power. The decoding of the stem cell potentiation process relies on this power and would have been impossible only ten years ago. Nanotechnologies are also directly impacting a whole range of biotech applications by allowing increasingly smaller interventions.

I read very recently an editorial in the Wall Street Journal by a writer and research at Ethics and Public Policy Center. In it, he basically declares Richard Feynman's original vision of nanotechnologies a bust. He obviously isn't reading my newsletter because we are currently seeing animal tests of new medicines that combing nanotech polymer structures with biological parts in ways that trick and attack viruses. Already on the market are nanotech sensing systems using submicrosopic biological components married to metal molecules that provide nearly instantaneous diagnoses of a rapidly expanding range of pathogens.

These sensors are going to power an even larger revolution in personalized medicine. For those unfamiliar with the concept, allow me to explain.

Currently, medicine is, to a large degree, a "one size fits all" proposition. Doctors watch for adverse effects and check personal and family histories. Medical technologies, however, are designed for the general population, not individuals.

That's going to change.

We know that many current treatments work on some people, yet not others. Some drugs are safe for many people, but have dangerous side effects for others. Some are just the opposite. This is because all of us have individual differences in our genetic code based on heredity and environment. Even slight differences can lead to very different reactions to medications.

This has created serious regulatory problems. Drugs are denied regulatory approval not because they do not work, but because some fraction of the population suffers adverse effects. As a result, patients are often denied incredibly effective therapies simply because they are not universally effective.

This shockingly primitive state of affairs exists because, until very lately, we simply have not had the tools to get to the genetic roots of disease. Scientists and pharmaceutical companies haven't precisely known how a particular drug's chemical profile interacts with a genetic one. Medical science, in turn, has been unable to tailor drugs to work with a specific genetic makeup. That is rapidly changing.

The Impact of the Genome

With the mapping of the genome, scientists can now identify single genes and their individual expressions. Nanotech biosensors can identify genetic characteristics in individuals so that individual reactions to drugs can be known before they are taken. It is meaningful, from the investor's perspective, that Dr. Francis Collins, the head of the Human Genome Project, now heads the National Institutes of Health. Collins has long been a prominent champion for using the knowledge gained from human genome to accelerate personalized medicine.

Collins has also stated that genomics is currently where the computer industry was back in the 1970s - at the beginning of a technological revolution. While he was speaking in scientific terms, we should remember that the '70s was also the right time to begin investing in a diversified portfolio of breakthrough computer technologies.

I believe this is true across the board for a range of revolutionary biotechnologies. I also like to remind readers that important innovations traditionally do not slow down during economic turn downs. The Great Depression, in fact, is considered by many to be one of the most important periods in the history of innovation.

What I'm hearing now, talking to people who range from Nobel Prize winners to CEOs of biotech start-ups and small caps, is that the world is going to change very soon in ways that no one is prepared for. Our lives are going to be significantly better and longer.

I also like to point out that private investors will not only profit from this revolution, they will power it. This is especially meaningful because one of the most dramatic impacts of these new technologies is longer life spans. By investing in regenerative medicine and other important biotechnologies, you are helping extend your own life. Traditionally, financial analysts have always told us that we should invest more conservatively as we age, with less of our portfolio in speculative higher-risk stocks.

For the first time in history, I believe this is exactly the wrong advice. You don't know how long you are going to live and, with these new therapies, it could be much longer than you've been led to believe. By investing as a younger person, you might actually make it so.

One last thing, here is the link regarding vitamin D that I promised.

http://www.vitamindhealth.org/

John back: Patrick is clearly enthusiastic about the potential for biotech. But that is because he is talking to the guys who are making it happen. He has been introducing them to me over the past year. They have been in my home or we have met on the road. And I have to admit, that enthusiasm is contagious. There is a deep reality here. I am fully cognizant that it will not happen the way we envision, but something large - very large - is on its way. Again, if you are interested in the letter, you can find out more information here.

Reckless Myopia

JohnMauldin — Mon, 30 Nov 2009 20:11:46 GMT

Long time Outside of the Box readers are familiar with John Hussman of the eponymous Hussman Funds. And once again he is my selection for this week's OTB.

This week he touches on several topics, all of which I find interesting. As he notes:

"We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in."

Have a good week.

John Mauldin, Editor
Outside the Box

Reckless Myopia

John P. Hussman, Ph.D.

I was wrong.

Not about the implosion of the credit markets, which I urgently warned about in 2007 and early 2008. Not about the recession, which we shifted to anticipating in November 2007. Not about the plunge in the stock market, which erased the entire 2002-2007 market gain, which was no surprise. Not about the "ebb and flow" of short-term data, which I frequently noted could produce a powerful (though perhaps abruptly terminated) market advance even in the face of dangerous longer-term cross-currents. I expect not even about the "surprising" second wave of credit distress that we can expect as we move into 2010.

From a long-term perspective, my record is very comfortable. But clearly, I was wrong about the extent to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.

I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again.

We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.

Taking the weighted average outcome for the two states of the world still produces a poor average return/risk tradeoff. Taking the weighted average investment position for the two states of the world is somewhat more constructive. As I noted several weeks ago, I have adapted our weightings accordingly. As a result, we have been trading around a modest positive net exposure, increasing it slightly on market weakness, and clipping it on strength, as is our discipline. Currently, the Strategic Growth Fund has a net exposure to market fluctuations of less than 10%, but enough "curvature" (through index options) that our exposure to market risk will automatically become more muted on market weakness and more positive on market advances, allowing us to buy weakness and sell strength without material concern about the (increasing) risk of a market collapse.

There is no chance, even in hindsight ("could have, would have, should have" stuff) that I would have responded to the existing evidence in recent months with more than a moderate exposure to market risk during some portion of the advance since March. But our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.

Still, our stock selections continue to perform well relative to the market, our risks remain well-managed through a substantial (though not full) hedge, and our investment approach has nicely outperformed the S&P 500 over complete market cycles, with substantially less downside risk than a passive investment approach. We have implemented some modest changes to improve our potential to benefit from (even ill-advised) speculative runs, but we've done fine nonetheless, and we can sleep nights.

Whether or not I have focused too much on probable "second-wave" credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a "miss" on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.

Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.

This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate.

Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.

In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.

Our current Fed Chairman's voice literally quivers in response to the phrase "bank failure," even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a "whole bank" entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.

In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the "typical post-war recovery" scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.

As Gluskin Sheff chief economist David Rosenberg noted last week, "Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.

"This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.

"Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully."

Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): "The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued."

In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.

One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies. Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation. A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut. Why is this a surprise? Where else could the money have gone? Labor compensation? It is truly mind-numbing that a moment after a temporary surge of trillions of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of "resilience."

What matters is sustainability, and unfortunately, it is clear that credit continues to collapse. Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow "substantial discretion" with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.

Urgent Policy Implications

From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:

First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear's bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman's disorganized liquidation would have been completely unnecessary. As I've noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a disorganized way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.

Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that automatically converts to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.

Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as "capital" for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate only to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.

Since early 2008, beginning with the provision of non-recourse funding in the Bear Stearns debacle, the Federal Reserve and the Treasury have repeatedly allocated or implicitly obligated public funds to defend the bondholders of mismanaged financial companies. This has included the outright and non-recourse purchase of nearly a trillion dollars in mortgage securities that have no explicit guarantee by the U.S. government. By purchasing these securities outright (rather than through a well-defined repurchase agreement), the Fed is effectively obligating the U.S. government to either guarantee them or to absorb any future losses.

Aside from the fraction of bailout funding that was specifically allocated by Congress through legislation, these actions represent an unconstitutional breach into enumerated spending powers that are the domain of the elected members of Congress alone. The issue here is not whether the Fed should be independent from political influence. The issue is the constitutionality of the Fed's actions. The discretion that it has exerted over the past two years crosses the line into prerogatives reserved for Congress. That line needs to be clarified sooner rather than later.

Emphatically, the trillions of dollars spent over the past year were not in the interest of protecting bank depositors or the general public. They went to protect bank bondholders. Instead of taking appropriate losses on those bonds (which financed reckless mortgage lending), those bonds are happily priced near their face value, for the benefit of private individuals, thanks to an equivalent issuance of U.S. Treasury debt. But that's not enough. Outside of a very narrow set of institutions that are subject to compensation limits, just watch how much of the public's money – which benefitted several major investment banks following a very direct route – gets allocated to Wall Street bonuses in the next few weeks.

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Health Care, the Ultimate Hedge

US stock market returns – what is in store?

US stock market returns – what is in store?

The Fed Blinks, Now What?

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

2010 Investment Strategies: Six Areas To Buy, 11 Areas To Sell

INVESTMENTS TO BUY

Doubters

INVESTMENTS TO SELL OR AVOID

Weak Loan Demand

The Coming BioTech Bubble

The Coming BioTech Bubble

Reckless Myopia

Reckless Myopia

Urgent Policy Implications

Running through a minefield, backwards
Part II - farewell Flanonia?