Search results matching tag 'John Mauldin'

Association of Investor Awareness - Week of 11/06/2008

AIAAdvocate — Thu, 06 Nov 2008 15:55:00 GMT

In This Issue:

The Rally May Have Legs – Or Not!
A Banquet For Value Investors
Dividends Shine In This Market
A Yield Bonus That Few Investors Consider
The Bluest Of The Blue Chips
Love Those Dividend Aristocrats
The Bottom Line This Week

The mid-cycle rebound we have been expecting showed up last week with a spectacular opening. Even though the market on Monday showed a 203 point loss, huge gains over the remaining four days pushed the Dow and the Nasdaq up 11.3% and 10.9% respectively.

This time the gains survived the weekend, but not for long. Monday was a yawn, but the market jumped 305 points on Tuesday as excitement about the presidential election boosted spirits. On Wednesday, however, America suffered a post-election hangover and stocks dropped a whopping 486 points. It looks like Wall Street plans to give President-elect Obama a very short honeymoon.

The Rally May Have Legs – Or Not!

Several analysts who read tea leaves and stock charts are convinced the signs indicate that the rally will run at least through Thanksgiving. The optimistic analysts are joined by many fundamental investors who agree that most stocks are cheaper than they have been since 2002.

We agree with both groups. However, we also continue to think that chasing this rally will prove to be a trap for the unwary. The economy is slipping even further as scared consumers refuse to spend money. Joe & Sally MidAmerica may loosen up a bit during the Holiday Season, but probably not by a lot. Without consumer support, growth can't recover.

Manufacturers, retailers, and even bingo parlors are registering the consumer strike. Automakers are taking such a beating that GM and Chrysler may merge in an effort to survive. Even if they team up, however, the companies may be like two drunks trying to hold each other up.

The good news is that fear may be a stronger emotion than greed, but it doesn't have much staying power. Americans are natural optimists who are not given to remaining down in the dumps very long. It would not take a lot of good news to turn a recession into little more than a period of very weak growth.

For the present, however, good economic news is in short supply. As a result, the stock rebound looks a lot more like a bear rally than it does the start of a new bull market.

A Banquet For Value Investors

Fortunately, the weak outlook for the economy is of little importance to long-term investors who focus on good stocks that are clearly bargains. In fact, today's lower prices can work very much to an investor's advantage. Not only do low prices boost profits down the road, they also increase the number of stocks from which to choose. The severe stock market downturn is creating a veritable cafeteria of excellent investment opportunities.

Taking a long-term view towards profits further increases your odds for success. Numerous studies show that over the long haul, stocks beat bonds, real estate, precious metals, and most other investments.

Dividends Shine In This Market

One type of stock that looks particularly good for current conditions are those which pay attractive dividends. Unfortunately, many investors dismiss dividends without looking closely at their role in boosting long-term returns. According to John Mauldin, author of the popular book Bull's Eye Investing, dividends account for about 40% of the 10% average annual gains returned by the stock market.

Focusing on dividends has another payoff as well. It automatically puts an investor in the strongest stocks that are most likely to rebound when market conditions improve. In fact, when bear markets finally turn around, value investors often see their dividend portfolios become growth stock portfolios, sometimes overnight.

A Yield Bonus That Few Investors Consider

The best dividend stocks of all are those that increase their payouts every year. Because your cost doesn't go up after you buy such stocks, your effective yield (dividend divided by price) will keep rising over time. After several years, your effective returns can be well above those paid by bonds and other fixed income investments.

A little arithmetic shows how it works. If you buy a $50 stock that pays a $1.50 annual dividend, your starting yield will be 3% - a payout that several oversold blue chips now offer.

If a year or so later the dividend rises to $2.50, your effective yield will be 5%. If the dividend eventually goes up to $4, your effective yield will be $8 - and so on. The effective yield on your $50 purchase can get pretty sweet after a few years. That's why retirees who packed their portfolios with dividend-payers aren't being hurt by the sharp interest rate declines that are hammering many of their contemporaries.

The Bluest Of The Blue Chips

In the difficult economy this year, investors might assume that few stocks qualify for S&P's list of Dividend Aristocrats. Such stocks have increased their payouts for more than 25 years. That's an amazing record since the long time period includes several tough recessions.

In fact, 60 companies are now on the list, of which 39 have already announced dividend increases in 2008. Most of the remaining 21 stocks are expected to qualify before the year ends.

A dividend increase doesn't always indicate that a company is having a good year. Some Dividend Aristocrats will dig deep into their pockets even in a slow economy because they wish to maintain their good standing with investors. This year, several banks are in that group.

However, most dividend divas cut nice checks because they are able to keep money rolling in even when times are tough. Not surprisingly, investors will bid their stock prices up even when everything else is falling.

At the Dividend Growth Investor www.dividendgrowthinvestor.com Dobromin Stoyanov identified the five best performing Aristocrats so far in 2008. They are (with their symbols and percent changes): Family Dollar Stores (FDO, 42.6%), Rohm and Haas Company (ROH, 34.8%), BB&T Corporation (BBT, 21.4%), Anheuser-Busch (BUD, 20.5%), and Wal-Mart (WMT, 19.4%). Two of the five –-Anheuser-Busch and Wal-Mart-- are companies that we have recommended in this newsletter.

Love Those Dividend Aristocrats

At this point, we are more interested in Dividend Aristocrats that have not yet performed well. Such stocks should have some catching up to do when investors decide to revalue them. The following companies in that group look especially attractive to us:

Archer Daniels Midland (ADM) is the Exxon of food, the OPEC of agriculture. http://finance.yahoo.com/q/bc?s=ADM It would be difficult to find a company better suited to succeed in today's hungry world. That doesn't mean the stock won't go down. It's well off its high right now. However, ADM should do very well longer term.

Coca-Cola (KO) may be the most recognized brand in the world. http://finance.yahoo.com/q/bc?s=KO Explorers have reported finding Coca-Cola cans in the villages of "undiscovered" tribes in New Guinea and Borneo. The company also produces juices, energy and sports drinks, teas, coffees, and bottled water – plus sweeteners and fountain syrups for retailers and restaurants. KO has a bright future.

Johnson & Johnson (JNJ) needs little introduction to our readers since we wrote about it recently. http://finance.yahoo.com/q/bc?s=JNJ The company is starting to get more press exposure as a top value stock, and may not remain cheap much longer.

Procter & Gamble (PG) is another of our favorite blue chips that is beginning to get noticed. http://finance.yahoo.com/q/bc?s=PG The company's products are not exciting but they are used worldwide by millions of increasingly affluent people in developing nations.

Walgreen Company (WAG) is starting to expand into new areas again. http://finance.yahoo.com/q/bc?s=WAG It's expensive to open new stores which hurts profits. But we think the plan will pay off, particularly when the economy begins to pick up.

The Bottom Line This Week

The stock market made some very good gains over the past ten days, which may be the start of something more significant. However, we caution readers that impressive rebounds are common even in the toughest downturns. When the rallies collapse, they do great damage to investors who followed them up.

A better plan is to focus on oversold value stocks. Those that make the S&P list of Dividend Aristocrats have especially good track records for delivering long-term gains.

Fighting Deflation Instead of Inflation?

ChuckButler — Wed, 09 Jul 2008 14:53:15 GMT

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In This Issue..

* A bounce in the euro overnight...

* Iran tests long range missiles...

* Japan's Machine Orders soar!

* Is Big Ben giving us a hint?

And Now... Today's Pfennig!

Fighting Deflation Instead of Inflation?

Good day... And a Wonderful Wednesday to you! Things settled down a bit yesterday, with the rumors of bailout for Fannie and Freddie Macs fading, and some awful Housing data being swept under the rug. The dollar gained back the ground it had lost to the euro the previous day, and Japan printed a very strong Machine Orders report... And now Iran tests long range missiles... All that and more as we begin our Wednesday...

OK, front and center this morning... The Housing data from yesterday. Since the media decided to sweep this under the rug, I thought I would make certain that at least Pfennig Readers were aware of the rot on the Housing vine. The index of Pending Home resales fell -4.7% in April, a much larger decline than the "experts" forecast. I think what you're seeing here is simply that would be buyers are holding off as they expect further declines in prices...

Before I go on to other things, there's something that's been on my mind for a month now, and I just remembered what it was! Recall when the Existing Home Sales data was strong a month ago, and I said that it must have been the fall in home prices to spur that kind of result? Well... As I thought more about it, I decided to look into a thought I had... The thought was a question... Are foreclosures included in Existing Home Sales data? And, lo and behold, the answer is yes! As long as someone was living in the house when it was foreclosed, which would put the percentage very high, wouldn't you think? Anyway... There you have it! A price drop, and foreclosures spurred that strong Existing Home Sales report... I knew there was something rotten in Denmark when that data printed!

Well... I was all prepared to talk about the $8 fall in Oil prices the past two days this morning, only to come in a see the news story that Iran tested a long range missile overnight, one that would reach Israel... And voila! The price of Oil is climbing again... But since I was loaded for bear this morning on Oil talk, I'll go ahead and give you a bit of what I was prepared to talk about.

I was all prepared to tell you that the $8 fall in Oil prices the past two days were a result of the slowing economy worldwide. It was thought that with slowing economies, that inflation would weaken, and thus reduce the need to buy an inflation hedge like commodities... But I was going to refute that notion, and say that we've seen these drops in the price of Oil several times in the past couple of years, and every time it happens, we get the bugs coming out of the wall boards telling us that the price of Oil has stopped rising and it will now fall back to levels previously seen before the meteoric rise... And to that I would say HOGWASH! Will Oil go up forever? NO! Have we seen the highs? I don't believe we have... If this sell off is anything like the previous ones seen, Traders will simply use this lower level as a new base to move higher once again....

I don't know what's going on with Iran testing the long range missiles, it looks to be saber rattling to me, given Israel's test just a couple of weeks ago... Sooner or later, love is gonna get ya', no wait, sooner or later, I'm afraid that all this saber rattling will escalate to something else... Let's hope my fears are not proven to be true!

So, the euro lost ground yesterday, when the rumors of another risk event (Fannie and Freddie) faded... And I guess the news that another Financial institution was going to cut over half its staff wasn't enough to make people wonder about the U.S. economy, as dollars were bought all day long...

Overnight however, the euro has gained back the ground it lost yesterday... What the heck is going on here? Ahhh grasshopper, this is simply "noise" in the markets... Up one day down the next... As long as the underlying trend, which happens to be a weak dollar trend, remains in place, this is just daily noise... European Central Bank (ECB) President, Trichet, said in an interview overnight that "inflation is worrying"... Don't tell me that Trichet has become the new "Mr. Obvious"! That title has been held by U.S. Treasury Sec. Paulson for some time now... I think I'll give Trichet some slack on this one, since this is his first foray into the world of obvious statements!

Speaking of Mr. Obvious, Hank Paulson... Here's a little ditty that he put out there for us yesterday... Paulson Says... "Many Home Foreclosures Are Inevitable"

Japan captured some magic in a bottle with their Machine Orders posting a 10.4% rise in May... Here's the skinny... Equipment orders which signal capital spending in the next three to six months, rose 10.4 percent from April when they climbed 5.5 percent... The experts had forecast a rise of only 1.1%!

The rumors of the Japanese economy's death have been greatly exaggerated! And I can't point to it and say its just one report, as this is the second consecutive month of a strong posting in this data! Does this mean the Bank of Japan (BOJ) will react with a rate hike? Not hardly... The BOJ are stuck in the mud, just like the Fed and the Bank of England (BOE) ... The BOJ has different problems from the Fed and BOE, who have inflation coming out their ears and no economic growth...

I read my friend John Mauldin's "Out of the Box" letter yesterday, which was written by Van Hoisington and Lacy Hunt. These two analysts put down a lot of good thoughts that inflation isn't going to be our problem going forward, but deflation instead... If that's true, then the Fed's got an even tougher road to hoe than they do now! And if that's true... Forget all the rhetoric about raising interest rates here in the U.S. If that's true, you can take a flyer now on lower interest rates and tons of money supply, and easier credit, and well just about anything else you can throw at deflation. You might as well throw the kitchen sink, because Japan has tried all these things during their decade of deflation... And nothing worked!

The G-8 meeting in Japan ended with a whimper... I tell you this... These G-8 ministers are simply in it for the boondoggle... They did nothing, said nothing, and left without a word... though reports continue to suggest Germany's Merkel, in particular, was dissatisfied with the failure of the final communiqué to address recent currency movements. Merkel is quoted saying "Honestly speaking, we could have imagined one more sentence.that foreign exchange rates must reflect economic fundamentals."

I think the dollar wouldn't fare too well with that statement, given its economic fundamentals, and so, the G-8 decided to leave sleeping dogs alone here...

The Canadian dollar / loonie, has outperformed all currencies overnight, which is about time! The bounce in Oil prices overnight has boosted the loonie higher... But in reality it's a small trading range, so don't get all lathered up just yet!

The Aussie dollar received some not so good economic data last night... Consumer Confidence plunged to a 16 1/2 year low in July, as rising food and fuel prices are hurting the Aussies as well. The data in Australia, which previously, kept pointing to another rate hike by the Reserve Bank of Australia (RBA), has softened in recent prints, and now suggests that the RBA is finished with rate hikes in this cycle... That will cause some softness in the A$, but only while those that were looking for a "quick hit" get out and move to something else... I still believe in the Aussie $ story, and view this as a temporary situation.

The Indian rupee continues to get sold... And this is beginning to get old! I was telling someone yesterday that the flows into India have slowed somewhat, and you had the Reserve Bank selling rupees a couple of months ago to keep it from getting too strong... When you have a Central Bank that demonstrates a willingness to sell their currency, traders and investors can choose to fight them, or go along with the selling... Unfortunately, it looks like the latter of the two choices has been the winner, thus a weaker rupee...

The New Zealand dollar / kiwi has had a difficult time dealing with the fact that the Reserve Bank of New Zealand (RBNZ) has basically called an end to their rate hike cycle... I've said this many times in the past, but for new readers it could be a first, so I'll say it again... Kiwi has had a wonderful, exciting, and most profitable run for the last 6 years, but as the currency was being bought because of the high interest rates that could be had there, the country's Trade Deficit was rising... The Trade Deficit has run well over 7% of GDP for a couple of years now, but as long as interest rates were high, the kiwi benefited... But now, if interest rates aren't going higher any more, or maybe even lowered, the Trade Deficit comes front and center, and is no longer swept under the rug... Be careful here...

The weakness in Oil prices kept Gold subdued yesterday, but as you can imagine, the bounce in Oil prices overnight has allowed Gold to also rebound.

Did you see that Big Ben Bernanke announced yesterday that he is going to continue to allow Financial Institutions the ability to use the Fed's lending facilities? Doesn't that tell you something? Well, it tells me that Big Ben sees the need to keep this option open... And the need is probably the fact that he knows the problems these institutions are experiencing.

Don't you find it strange that the news stations didn't carry that news? I shake my head in disgust of the attempt to make us feel good... When people should be warned of the storm clouds so that they can take appropriate action to protect their investments...

Currencies today 7/9/08: A$ .9525, kiwi .7545, C$ .9845, euro 1.5715, sterling 1.9750, Swiss .9695, ISK 75.44, rand 7.6685, krone 5.12, SEK 6.0125, forint 146.40, zloty 2.0775, koruna 14.94, yen 107.40, baht 33.60, sing 1.3625, HKD 7.80, INR 43.15, China 6.8580, pesos 10.30, BRL 1.61, dollar index 72.80, Oil $137.70, Silver $17.83, and Gold... $920.75

That's it for today... The rain is back... Which left me pretty soaked on my way in today... I'm driving a loaner, so my umbrella isn't in the car, and if you've seen me walk since my surgeries last summer, I don't get along too quickly... So... Soaked! Baseball's All-Star Game is next week, two Cardinals made the team (should have been 3!). The All-Star Game is in St. Louis next year, sure hope there's a way I can find two tickets for me and my little buddy to go! But that's a year away, no sense thinking about it now! Kristin is on her way to Las Vegas to speak at the Freedom Fest, if you're going, make sure to stop by to say hi to her! Hey! About a month ago, I did an interview on a PBS radio show called "On The Money"... Our website will soon have that interview as a part of our great currency pages... So check back often to see when it's available, click on it, and there you go! I hope you have a Wonderful Wednesday!

Chuck Butler

President

EverBank World Markets

1-800-926-4922

1-314-647-3837

How do You Spell Stagflation?

JohnMauldin — Sat, 17 Nov 2007 04:16:26 GMT

In This Issue:

How do You Spell Stagflation?
Cooking the Inflation Books
Gaming the Producer Price Index
Consumer Spending is Up, but then Again, It May Be Down
A Two Dimensional Problem
Saudi Justice
New York, Toronto, Europe and Thanksgiving

This week we look at inflation. Is it just over 2%, giving the Fed room to cut rates, or will it be closer to 4% by the next FOMC meeting, making a rate cut problematic? How do they get those numbers? When and how can two opposite things be true at the same time? The answer depends on how many dimensions you are living in when you are asking the question. The Fed is going to be faced with a very difficult decision at its next meeting, and there results of there deliberations will be felt by you.

But first, an observation about a milestone passed last week. I started this letter 7 years ago with about 2,000 names and it has grown to where it is sent to more than 1,000,000 of my closest friends each week. For the last year, this letter has been translated each week into Chinese and posted on a Chinese version of Thoughts from the Frontline web site by my Chinese assistant Coryne Wei.

This last week we passed 1,000 subscribers that get the Chinese version. I know that is small, but it is a beginning. It will be interesting to see how it grows over the years. If you would like to get this letter in Chinese, you can go to www.frontlinethoughts.cn and subscribe.

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How do You Spell Stagflation?

I wrote this summer that it was likely that we would see inflation as reported in the Consumer Price Index rise dramatically in the fourth quarter. This is due to the very low year over year comparison numbers of last years fourth quarter. We got the CPI numbers yesterday, and we did indeed see a rather uncomfortable rise in inflation, just as I predicted. "Headline" inflation is at 3.5% over the last 12 months, well above anybody's comfort level, and "core" inflation (inflation without food and energy in the numbers) is at 2.1% over the same period.

It is likely to look worse in the coming months, at least in the statistics. To see why, let's go the table below from the Bureau of Labor Statistics who creates the CPI.

The monthly numbers are the index for inflation. Since the base is from 1982-84, we can see that sometime last year prices doubled over the last 25 years. But it certainly feels like it has been more. We will look at how those numbers are created in a minute, and whether we can attach much credulity to them.

Now, here is what to notice in the table. The number for December is the same as the number for October. Since the beginning of this year we have seen a steady rise almost every month. If you assume inflation is running at 2%, this would mean that the November number would yield a 3.8% inflation rate and would be closer yet to 4% for December.

If you extrapolate the inflation of the past two months for the next two months, that would take inflation slightly over 4% as we go into the next two Fed meetings. Yes, we all know the Fed prefers to look at core inflation, but at some point you do have to pay attention to the headline number.

Today, in a speech in New York, Federal Reserve Governor Randall Kroszner said policy makers probably won't need to reduce interest rates further to help the economy weather a "rough patch" in the coming year.

"The current stance of monetary policy should help the economy get through the rough patch during the next year, with growth then likely to return to its longer-run sustainable rate," Kroszner said. Data consistent with such growth "would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate."

The risks are roughly balanced between inflation and growth in his opinion. However, futures prices still suggest that the market expects an 84% chance of a rate cut at the December 11 meeting.

Cooking the Inflation Books

Just for the record, I want to state that I know as does nearly everyone else who pays attention to the CPI statistics that they are bogus. They do not reflect the real world that you and I, gentle reader, live in. So, while it may look like I take them at face value, I do so only because the Fed pays attention to the number, (nod, nod, wink, wink) and makes policy based upon it. So, let's look at how the calculation of the CPI has been politicized and how much of a difference it makes, and then go on to the expectation for statistical inflation in the near future.

John Williams writes an excellent monthly letter on all types of government statistics called the Shadow Government Statistics at www.shadowstats.com. One of the things he points out that during the Clinton administration, the way the BLS calculates inflation was changed. He calculates his own inflation number using the old pre-Clinton inflation model. Using that methodology suggests that inflation is at 7%. And if you use other methods, inflation might even be substantially higher. Look at the chart below.

Since the CPI is used to calculate the increase in Social Security payments and a host of other items, calculating inflation is important. I the early 1990s the arguments in the press was that inflation was over-stated. Michael Boskin, chief economist in the first Bush administration and Alan Greenspan were among the chief proponents for a new methodology of accounting for inflation.

Quoting Williams: "Up until the Boskin/Greenspan agendum surfaced, the CPI was measured using the costs of a fixed basket of goods, a fairly simple and straightforward concept. The identical basket of goods would be priced at prevailing market costs for each period, and the period-to-period change in the cost of that market basket represented the rate of inflation in terms of maintaining a constant standard of living.

"The Boskin/Greenspan argument was that when steak got too expensive, the consumer would substitute hamburger for the steak, and that the inflation measure should reflect the costs tied to buying hamburger versus steak, instead of steak versus steak. Of course, replacing hamburger for steak in the calculations would reduce the inflation rate, but it represented the rate of inflation in terms of maintaining a declining standard of living. Cost of living was being replaced by the cost of survival. The old system told you how much you had to increase your income in order to keep buying steak. The new system promised you hamburger, and then dog food, perhaps, after that.

"The Boskin/Greenspan concept violated the intent and common usage of the inflation index. The CPI was considered sacrosanct within the Department of Labor, given the number of contractual relationships that were anchored to it. The CPI was one number that never was to be revised, given its widespread usage.

"Shortly after Clinton took control of the White House, however, attitudes changed. The BLS initially did not institute a new CPI measurement using a variable-basket of goods that allowed substitution of hamburger for steak, but rather tried to approximate the effect by changing the weighting of goods in the CPI fixed basket. Over a period of several years, straight arithmetic weighting of the CPI components was shifted to a geometric weighting. The Boskin/Greenspan benefit of a geometric weighting was that it automatically gave a lower weighting to CPI components that were rising in price, and a higher weighting to those items dropping in price.

"Once the system had been shifted fully to geometric weighting, the net effect was to reduce reported CPI on an annual, or year-over-year basis, by 2.7% from what it would have been based on the traditional weighting methodology. The results have been dramatic. The compounding effect since the early-1990s has reduced annual cost of living adjustments in social security by more than a third."

Then to confuse the process even more, the BLS uses something called hedonics, from the root word hedonism. Essentially, the adjust the price of an item based on the "pleasure" or increased value you get. Thus, they don't price automobiles based on the sticker price, but on what you get for your money. If the manufacturers load in more items like new electronics or anti-locking brakes that were not standard the year before that means you are getting more value for your dollar, so therefore the price in terms of inflation goes down even though you may be paying the same or even more to get out of the car show room.

The same is true for computers. We clearly get more power every year, so for the BLS the price of computers are going down, although it seems to me that the price I pay for a top of the line computer is about the same as it was five or ten years ago.

If the government mandates an additive to gasoline that costs 10 cents more, that is not included in the inflation numbers, because we get a new, improved gasoline that pollutes less. Supposedly the pleasure of breathing cleaner air reduces the costs to our pocket book, or something like that.

My health insurance costs have tripled over the last ten years, and I know that is the experience of many of my readers. Yet, the BLS has medical costs rising by less than 50% for the last ten years. Their data suggest the cost of housing has risen by about 30% over the last ten years. Again, that is not the experience of many of my readers.

Social Security expenses are $657 billion per year. If Williams is right (and I think he is) that under the old methodology that expenses would have risen by a third, then that means we are spending $200 billion a year less. Add $200 billion to the deficit. And then watch politicians panic.

I am not one to suggest conspiracy, but if the CPI reflected the real world, the US government would be spending far more money on Social Security and a host of other pension programs. The crisis we will be experiencing in about 8 years would have already hit us. Thus, there was an incentive for leaders to find economists who could argue for new, more "progressive" methods for calculating inflation. Notice that this was done by the BLS without any protest from Congress.

None of this was done behind closed doors. The BLS, to its credit, is extremely open about how it calculates CPI, and you can get an enormous amount of detail on their web site about prices of things like tomatoes in very part of the country going back for decades.

But the way we calculate the CPI is not going to change. No administration will want to go back and add in an extra 4-5% a year to Social Security and other government pension programs. So, let's return to the prospects for a rise in the CPI in the near future, which will have policy implications for the Fed.

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Gaming the Producer Price Index

On Wednesday, we got the Producer Price Index. After the above notes on the CPI, it will probably not come as a surprise that there may be some problems with the PPI. The PPI rather oddly has the price of energy going down in October. PPI is important, as it is in indication of the trend of inflation in consumer prices in the future.

As friend Bill King notes:

"Since June, BLS has energy prices declining in all three PPI stages: finished, intermediate and crude. For June finished energy goods the index is 160.9, for October 159.5; the intermediate prices are 179.9 vs. 178; for crude it's 238 vs. 232.9. BLS has energy prices DOWN 3.64% since July!!

"Oil has rallied from ~$75 to the mid-90s since July 9. Over the same period, gasoline has rallied from $1.95 to $2.35; heating oil has rallied from $2.15 to $2.55; natural gas has fallen from $8.50 to $8.25."

That means that inflation in the PPI numbers may be less than the table below, which is bad enough. Notice the increase in the change of year over year inflation in the index over the last 8 months.

Another table shows "core" PPI, without energy and food, and you find that core PPI is flat. Again, we are seeing almost all of the real inflation in food and energy. But with a falling dollar, do we expect food and energy prices in the US to fall as well, since much of the price of food and energy is determined on international markets?

Consumer Spending is Up, but then Again, It May Be Down

Headline consumer spending came in up 5.2% year over year, which suggest a very respectable growing economy. But retail sales were only up 0.2% in October, which is below inflation. In other words, retail sales fell in October in real terms. But digging deeper into the numbers, we find a problem. Remember food and energy. As Greg Weldon points out, it is unlikely that US consumers bought 16% more gasoline than they did last year. The increase in spending for gasoline was all related to price. Ditto for food.

John Williams says the same analysts who want to use core inflation should also use core retail sales. And if you take out food and energy from retail sales, you find consumer spending to be flat in October. There were multiple categories like home furniture, music, electronic games, etc that were in outright declines. Most interestingly, online sales actually dropped last month. Annual sales growth dropped to its lowest number in years.

FedEx warned today that its earnings would be down due to fewer shipments and higher energy costs. The number of containers coming into the US is down. Retailers are expecting a very modest Christmas season.

So, we come to the question: Is the economy slowing and thus the Fed will cut, or is inflation rising which will force the Fed to sit tight?

A Two Dimensional Problem

I recently spent some time with the very brilliant Columbia Professor Graciella Chichilnisky (the economist whose work created the carbon credit markets, among other things). We got to talking about the problems the Fed is facing, and she gave me a very interesting insight from a paper she had written a few years back. I am going to try and re-create it, though I am sure I will take some of the potency away in trying to put it in my simple terms.

Assume that you have an individual living in a two dimensional world. For them there is only length and width, but no height. Then let's draw a line between two exactly opposite points above and below that two dimensional world and connect them with a line. At the precise point where the lines meet in the two dimensional world, to the individual in that world, it appears that both points are exactly the same. Two things which would clearly be opposite to anyone living in a three dimensional world would be equal in a two dimensional world.

The Fed faces a problem something like that. They are living in a two dimensional world, working with two dimensional tools (they can cut rates or raise them) but the problems they face are multi-dimensional.

If they cut rates, the dollar will fall and import prices rise, and it will also likely have negative effects on food and energy prices. If they do not cut rates, the markets will simply throw up as it will interpret that as a Fed which is not concerned about a slowing economy.

Not cutting rates risks an economy that could easily slip into recession due to a growing risk of a credit crisis turning into a credit crunch. Usually, that means that inflation will fall. Usually, but not always.

The Fed is faced with a problem I predicted four years ago in this letter and in Bull's Eye Investing, as the Fed dramatically eased monetary conditions in an effort to fight deflation. In a word, stagflation. That terrible moment in time when an economy slows (is stagnant) yet inflation is high, limiting the monetary authority's ability to act.

With a clearly slowing economy, a credit crisis, and rising inflation, they have no good and clear choices. Whatever they do is likely to create problems in a multi-dimensional real world. I still think they cut, as core inflation is still close to their comfort zone. But if core inflation starts to rise, they will have to act. Or at least should.

Saudi Justice

I usually avoid controversial matters, other than economics and finance, but I came across a story which I think deserves attention. It seems that a 19 year old young lady in Saudi Arabia was gang-raped by six armed men. They got between one and five years in prison. Because she was in a car with a man who was not related to her, she was given a sentence of 90 lashes. Because she appealed and a higher court ordered another trial, the court then more than doubled the sentence to 200 lashes.

"A court source told the English-language Arab News that the judges had decided to punish the woman further for 'her attempt to aggravate and influence the judiciary through the media.'" Her lawyer had his credentials removed for defending her. This is simply barbaric. It is an affront to any civilized thoughtful person. Where are the protests? Are we to believe that the Saudi royalty condones such acts?

http://www.breitbart.com/article.php?id=071115145104.rykb7bub&show_article=1Ifanyone

I hope that other writers will use this in their letters.

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New York, Toronto, Europe and Thanksgiving

This week I had to take a quick one day trip to Toronto. Changing my ticket ended up costing me six times the original round trip ticket. To add insult to injury, I got in a taxi at the Toronto Airport. It used to cost about $50 Canadian dollars to get a ride to downtown. The price has risen to $60 and then throw in a $10 tip. A few years ago, this would cost me about US$35. Today it was $70. I offered the taxi driver 3 twenty dollars bills and a tip, but he pointed out that the exchange rate made my US$60 only worth about Canadian $55. Sigh.

I am going to have to go to New York again in a few weeks to attend the Minyanville BBQ picnic and charity fundraiser. South African business partner Prieur du Plessis will be there, but I am going because his wife Isabel has demanded my attendance. And a European trip late in January is shaping up.

There will be no Thoughts from the Frontline letter next week, as it is Thanksgiving, and I am going to take the day off and spend it with the kids. They are all seven coming back home. I know that it will not be too far into the future when they are going to get scattered and having them all under one roof at the same time is something to be savored. I will make prime and smoke turkey, with mushrooms and all the fixings. I do so love Thanksgiving. Friends and family, food and Cowboys football, great wine and laughter. It just doesn't get any better.

I hope those of me readers in the US have a good Thanksgiving as well. Have a great week.

Your thinking about how the world will change analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

The Return of Muddle Through

JohnMauldin — Fri, 28 Sep 2007 08:13:00 GMT

The Return of Muddle Through

The dollar reaches new lows. The housing market shows no sign of a bottom. Oil almost touches $84 before backing off. Interest rates go up after the Fed cuts. So naturally the stock market keeps climbing. But then, consumer spending came in strong, employment looks like it may be ok, inflation (at least by one measure) came in below 2%. This week we look at the question of whether you could have a continued bull market and a recession. (Maybe.) We look at the bigger picture for the dollar and interest rates and examine the ugly data from the housing sector. Inflation or deflation?

But before we get started into what should be an interesting letter, let me thank those who completed my reader survey last week. Over a thousand of you gave specific comments and I looked at every one. If you didn't take the anonymous survey yet, but would like to, just click this link. All I really know about 99.9% of my readers is an email address. The survey is just a few questions which gives me an idea of the audience I am writing to and some feedback on how I'm doing. And feel free to make comments at the end in the space provided.

As my gift to you for taking the time, when you finish the survey you will be given a link to the audio of a speech by Dr. Mike Roizen, the author of You, The Owner's Manual and a dozen other blockbuster best-sellers. He spoke at my Strategic Investment Conference this spring (co-hosted by Altegris Investments) on "How to Stay Young - Getting Your Body to Give You a Do-over." (If you can't listen when you finish the survey, save the link.) Thanks.

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Inflation is Not a Problem - Until It Is

The Fed cut its fund rate by 50 basis points and the stock market has rejoiced. But the bond vigilantes came out in full force. The last three times the Fed initiated a new easing cycle, ten year bond yields typically dropped 20 basis points or more in the next five days. This time they rose by 20 basis points. Since mortgages rates are typically geared of the yield of the ten year bond, this is a cut that has not helped the consumer as of yet.

Clearly, the bond market is worried about inflation, or worse - stagflation. It's that 70 show all over again. The market should start worrying about something else. Inflation is not a problem in a recession, and certainly one caused by the bursting of the largest housing bubble in US history. Be definition, those are deflationary events.

If we have a simple slowdown I think rates drop to 4% or less. If we see a recession, short term rates will drop below 3%. Van Hoisington, manager of the best performing long term bond fund over the past five years (and frequent Outside the Box contributor), said today that he thinks that yields on 30 year bonds will drop below 4%, from the 4.84% they are positioned at today.

Hoisington thinks that GDP is "going to be very slow in the fourth or first quarter, close to zero in one of the two." The head of Freddie Mac now estimates that there is a 40-45% chance of a recession. And the core PCE (Personal Consumption Expenditures), the Fed's preferred measure of inflation, dropped below 2% for the first time in a long time, down to 1.8%. The Dallas Fed uses sits own version of the PCE, called the trimmed PCE (which includes food and energy), which shows inflation is now edging down below 2%.

That will give the Fed room to cut rates in the last two meetings of the year. And the data that came out on housing suggests they will need to.

The House of Pain

Let's slice and dice the latest housing data and see just how bad it is if you are trying to sell a home. (Most of the data is from data-maven Greg Weldon at www.weldononline.com. I highly recommend his letter. It is one of my favorite sources.)

First the inventory of existing homes rose yet again to 4,581,000, which is an increase of more than 1,000,000 since March alone. It is more than double the supply since the beginning of 2005. In January there was a 6.6 months supply of homes for sale. Now it is 10 months. Over 500,000 homes are in the process of foreclosure and will soon come onto the market. I think that means in the near future we will see a 12 month supply of existing homes for sale.

Remember, that is an average. In some markets, that means there may be a two year supply and a three month supply in areas of higher demand. It is going to become a buyer's market in the middle of next year as sellers

Want to buy a condo? Existing condos for sale have risen by 35% since January to 661,000. That is almost 12 months of supply, and there are a lot of new condos coming onto the market as there are a lot of construction projects that are just now nearing completion.

New home sales in August saw the largest decline in three decades, down 8.3%. Mean new home prices are down 11% in the last five months. The inventory of new homes for sale is up to 8.2 months and rising.

Greg also spotted something which I suspected and hinted about in previous letters. The number of homes above $750,000 which are selling is down by over 35% from last year. Sales of home from $500,000 to $749,000 is down by 25%. Jumbo mortgages are just hard to find at rates that make sense. I think it is likely that Congress will allow Fannie and Freddie to take larger loans onto their books. I would not be shocked to see the number at $600,000, at least temporarily. Right now they are limited to taking $417,000 loans. With a 20% down payment that means about $525,000 for the sales price of the home.

All this means that the fall-out from the housing recession is still in our future. I expect to be able to take out the e-letters I wrote on the problems of deflation back in 2002 and update them sometime next year. Again, recessions and the bursting of bubbles are profoundly deflationary.

The Return of Muddle Through

It is going to take some time for the economy to work itself through the current credit crisis and the collapse of the housing bubble. I suspect the US economy will grow below trend for at least another year. We will work through it, as we always do. But it is the return of the Muddle Through Economy.

How long it takes to work back to a 3% GDP depends on how fast the credit markets can figure out how to create a structured security and a collateralized debt obligation market. Without those structures, all sorts of consumer loans and mortgages will be more expensive and difficult to get.

In the Financial Times today, Jan Krahnen suggested that a new type of mortgage back security be created that kept the first risk of loss with the initial lending institution. In the past, a securitized loan was divided into five different segments called tranches. The lowest rated tranche was called the equity tranche because it took the first losses in the pool of loans.

What Krahnen suggested that instead of letting a mortgage bank sell of 100% of the loan, they have to keep the equity tranche. That way, they suffer the loss if the borrowers don't pay. They are first in line for the moral hazard of losses. That would tend to focus the management of the bank in the direction of making good loans rather than merely taking fees. Investors could have more confidence in the loan making process.

That makes immanent sense to me. Of course, it would mean that larger institutions or more capitalization would be needed on the part of mortgage lenders, but it would get the market going again.

A Bull Market and a Recession?

Changing pace, as most readers know, it has been my contention for almost a year that the bursting of the housing bubble would result in a mild recession or at the least a serious slowdown. And a recession has always meant a full blown bear market in the stock market (an average drop of over 40%). But even if there is a recession, there may be reason to argue that the large cap market indexes will not see as severe a drop as has been the case in the past. Why not?

I ran across an interesting thought by Michael Albert on his blog at www.leadlag.com. We corresponded and he made the following charts for me. Notice that certain sectors of the S&P 500 are on a tear since the first of the year, like energy, material and technology.

The sectors that are outperforming are all large multi-nationals that get as much as 50% of their earnings from outside the US, and the global economy is doing well. Those that are not doing well are tied to US domestic consumer spending and the financials.

Now let's look at the weightings of the various sectors in the S&P 500. Notice that almost 60% of the cap weighting is to industries that get a good portion of their earnings from overseas, or are largely insulated from a slowdown in overall consumer demand (like healthcare which you buy when you need it, not generally as a discretionary item). Utilities should do well in a falling interest rate environment.

If we saw a 30% drop in the 40% domestically impacted sectors (with healthcare and utilities basically flat) and a 10% rise in the rest, that would be an overall drop of only about 7%, which is not much of a bear market in the total index, although there would be sectors that are ugly.

That also argues that large cap multinational stocks will outperform smaller firms. The Dow will beat the Russell 2000, as an example. This may be one reason that legendary fund manager Bill Miller of Legg-Mason, who beat the Standard & Poor's 500 Index for 15 straight years until 2006, is rotating out of mid-caps and into very large caps, to insulate himself from a potential slowdown or recession.

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King Dollar and the Guillotine

In February of 2002 I turned bullish on gold in this letter (after having been a bear for at least 15 years) and in early March of that year I wrote a letter called "King Dollar and the Guillotine" where I outlined the reasons that the dollar was getting ready for a rather long slide. The euro was at $.88 and I suggested that we could see dollar parity by the end of the year, which we did.

In May of the next year, with the euro around $1.07, I suggested that $1.40 was possible. In later letters I suggested that $1.50 is possible, although I admit that when France and the Netherlands rejected the constitution I lowered my "target" back to $1.40, with the euro around $1.20 at the time.

The dollar closed at $1.42 this afternoon. Now $1.50 doesn't seem all that far, just another 5% move. Let's look at a chart of the euro since it was introduced and then I will make some comments.

The euro was introduced January 1, 1999 and had a value of $1.19. It promptly started falling and reached a low of around $.82 shortly before the end of 1999. There were a number of reasons for the drop, but the euro clearly became seriously undervalued.

It has risen over 70% since that low and over 60% since I wrote about it in 2002. That is a very large movement. But if you view it from the introduction in 1999, that is only about a 20% move in almost nine years. It is also only up 10% since the end of 2003, again not all that large a move for almost 4 years. But that is because the euro rose too fast and then went sideways for two years, before once again renewing a very defined upward trend for the last two years.

A little rest for the euro would be in order. It would not surprise me to see the euro drop a little from here before resuming its upward journey. I read that 90% of currency traders are dollar bearish versus the euro. When everyone is on the same side of a trade that is usually when the trend is getting ready to reverse, at least for awhile.

Before we leave the euro, I should note that I expect the euro to go back to parity over a long period of time, maybe a decade or more. But that's a story for another letter.

The Canadian dollar went to parity this week, which I first suggested was possible four years ago. That used to get laughs in Canada, as the audience waited for the punch line. It could easily get stronger.

But where we should be paying attention is Asia and in particular the Chinese yuan. It also made new highs against the dollar. It has risen almost 10% in a little over two years, bouncing off its 50 day moving average with regularity. And I think it is being set up to rise at a faster pace. A $6 yuan is certainly in the realm of possibility, and not too far into the next decade.

The Chinese have a problem. Everyone "knows" that the Chinese yuan is going to rise, probably by another 20% at least. So, what do you do? You invest in China, typically in real estate or manufacturing centers, and watch your investment rise 20% just from currency appreciation. That has created a bubble in certain types of businesses and real estate markets, and threatens to destabilize their economy if it were to continue. The Chinese government is actively trying to discourage property speculation, but an under-valued yuan makes that difficult.

Further, if you allowed the yuan to float, but kept a lock on Chinese business and investors from investing outside of the country, it would put even more serious pressure on the yuan to rise, and it could do so rapidly and destabilize the economy. The Chinese government does not want anything to destabilize the economy.

A controlled currency is also creating inflationary pressures. Plus, the US and other western nations are not happy with the low value of the yuan. Not that the Chinese care all that much about what we think, but a trade war does no one any good.

You may not have read about it yet, but there is a tsunami of money getting ready to come from China into the world. And I am not talking about the large government balances or their new sovereign wealth fund.

This week, the Chinese announced they are going to let one of their larger mutual funds invest outside of China. Local Chinese investors will be able to start to diversify and businesses will start to be able to take their capital and employ it abroad. This is just the start of the process. I expect that in just a few years Chinese will be able to buy a wide range of funds and investments.

This will take off a lot of the market pressure for a stronger yuan, as the Chinese will need to buy dollars and euros and other currencies in order to make those investments. Further, those who have invested in China at some point are going to want to take their profits back home.

I think we will see the Chinese government open up the potential to invest and spend abroad before they float their currency. This will allow them to let them get closer to allowing the yuan to float. It is in their best interest to do so over the next few years.

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Birthdays and the Ground Rush Effect

I will be on a show called Commodity Classics next Thursday from 4:15 to 4:30 central time. It is internet TV hosted by Michael Yorba here in Dallas and is at www.mn1.com. The show is based here in Dallas and the studios are near where I live and it gives me an excuse to leave the office early.

Bill Bonner wrote this week how he is feeling ground rush as he watches his kids grow up. Ground rush is that phenomenon that sky-divers feel as the get closer to the ground. It is one thing to fall 1,000 feet from 10,000 feet. It is another to fall 1,000 feet from only 2,000 feet. The lower you go, the faster the ground seems to rush at you.

That describes how I feel, I thought. Next Thursday, I turn (gasp -how can it be?) 58. For some reasons, that sounds, well, I won't use the "O" word, but advanced comes to mind. Time seems to be rushing at me. This week, the Rangers played the last home game for the season. It was a day game, and I watched as the crowd emptied out and the ground crew was breaking down the field and starting the preparations for winter within a few hours. Didn't we just start the season? I have been in this office for 13 seasons, and the end of each season seems to rush at me faster.

Six of my seven kids are basically adults. I have a thousand pictures I look at from time to time, and I marvel at how much has changed in the 30 years since Tiffani was born. But it seems such a short time. They were all so small and young only a few years ago.

I am getting close to where I will have lived two-thirds of my probable life, if I can avoid getting hit by London cabs when absent-mindedly crossing the streets. That is no longer middle age. The weights at the gym are heavier than they used to be, and recovery time is longer.

But then, I am having more fun than at any time of my life, and can see no reason why it should not go on getting better. I enjoy my family and kids more than ever. I have more good friends than most people I know.

So, what the heck. I think I will just do some more free fall and see how fast this life can really go and enjoy the feeling and the ride. Always time to pull the rip-cord later. For now, one more round all around.

Your 58 is just another number analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Sea Change at the Fed

JohnMauldin — Fri, 21 Sep 2007 08:12:00 GMT

Sea Change at the Fed

"Of his bones are coral made:
Those are pearls that were his eyes:
Nothing of him that doth fade,
But doth suffer a sea change
Into something rich and strange"
(The Tempest - Shakespeare)

The term "sea change" has come to mean a profound transformation ever since Will Shakespeare used it in The Tempest. I think this week we witnessed a true sea change in central bank policy, on both sides of the Atlantic. The stock market rejoiced over a 50 basis point cut from the Fed, assuming that it will stimulate growth and avoid anything more than a slowdown. In this week's letter, we ponder several questions. Why did the Fed decide to cut now when the rhetoric of just a few weeks ago was that of inflation fighting? What do they see? Are more rate cuts coming? Will they make any difference? And who is Frederic (Rick) Mishkin and why is he maybe the most important Fed governor you haven't heard of? There's a lot of ground to cover, and it should make for an interesting letter.

But first, I need to acknowledge an anniversary of sorts. Some seven years ago I put this e-letter on the internet, with (maybe) 2,000 names to send it to. Today, it goes out every week to more than 1,000,000 readers and is posted on scores of web sites and blogs. I have to confess with being a little (well, a lot) amazed by it all. It has changed my business practice in ways that I could not imagine seven years ago, and all for the better. Someone asked me what I will do when I retire. I told them I would read, write, travel and speak, which is pretty much what I do now, along with a few extra duties here and there.

But it is a great life and I want to thank you for allowing me to come into your home or office, and for recommending this letter to friends, which is the way the readership has grown. And because I want to keep writing for a long time and I want to keep you as a reader, I am going to make available to you a speech on how we can all live longer by Dr. Mike Roizen, who wrote You - The Owner's Manual (and You - On a Diet, and the other monster best-sellers in the series). He also appears on Oprah about six times a year. I am lucky enough to call him both friend and my doctor.

Mike spoke at my Strategic Investment Conference last year, telling us that if we don't like the way our bodies are doing, it is ok. We can get a "do-over." Mike is one of the true experts on aging (or anti-aging) and shared how we could all live a lot longer and healthier. It was a great speech.

Just a small catch. Let me ask a favor. Since all I really know about you is an email address, I really don't know a lot about who reads me and why. I want to know more about my readers and what it is that you want. What type of e-letters do you like? What topics? Want a blog? More Outside the Boxes? Less? If you could take the time to fill out a short (and very anonymous!) survey, when you finish you will be taken to a page where you can listen to Mike's fascinating speech. There is also a place for comments and suggestions.

Thanks. Just click on the link http://www.frontlinethoughts.com/survey.htm when you are ready. And if you want to get Mike's books, you can go to www.amazon.com and pick any of his dozen books.

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A Sea Change at the Fed

As everyone knows, the Federal Reserve cut both the fed funds rate and the discount rate by 50 basis points this week. The rate cut was clearly telegraphed and only the amount of the cut was a mystery. And for reasons I lay out later on, I think there will be more cuts. But that is not the interesting thing, at least to me. I think the Fed under Bernanke has clearly taken a new direction in determining monetary policy, one that differs with past deliberations.

At Jackson Hole on August 31, Bernanke addressing the problem of moral hazard faced by Central Banks, Bernanke noted: "It is not the responsibility of the Federal Reserve -- nor would it be appropriate -- to protect lenders and investors from the consequences of their financial decisions." He did acknowledge that if the system as a whole was at risk, then a central bank would have to act even in spite of the moral hazard issue.

That was then and this is now. We got rate cuts September 18. Bernanke in his testimony to Congress this week said the Fed cut rates "to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy. While he gave no hints as to future policy, he did note that the Fed would "keep reassessing our outlook and adjusting policy" as the situation demanded.

Read those words again. "...to try to get out ahead of the situation..." Hello. That is something new. Normally watching the Fed and predicting the next move is about as exciting as watching paint dry. The Fed has always waited until the data suggested (and/or the market demanded) a rate hike or especially a cut. The Fed has been what good friend Paul McCulley calls "opportunistically disinflationary" for the past two-plus decades. They tighten until inflation comes down and only when it is apparent that a recession is in the works, or if there is a crisis like 1987 or 1998 (more on that important distinction later) do they cut rates. They have reacted to the data rather than made forward looking assumptions.

Over time, this has been a good policy, as it dropped inflation down from the mid-teens in 1980 to below 2% a few years ago. There are those who argue (and with some justification) that Greenspan left rates too low for too long and allowed inflation to rise back to an uncomfortable 3%, although it has been tending down of late.

But the point is that inflation is merely tending down. It is not below 2%, and year over year comparisons in the fourth quarter suggest that headline inflation of closer to 3% is quite possible. That being said, the similar comparison numbers for core inflation are not as difficult, but certainly do not suggest - at this time - that we will drop below 2% this year.

Indeed, there may be some concerns that the CPI (Consumer Price Index) number could come under pressure from the housing component. Given that home prices are falling, that may be considered odd by many. But CPI does not measure home prices. It measures something called owner's equivalent rent. And even as house prices rose by 93% in real terms (per Bob Shiller) in the last decade run-up, rent in real terms did not go up all that much, so the cost of a new home was not reflected in the CPI.

Now, we may have the opposite problem. As more and more people cannot get a mortgage coupled with a very precipitous rise in foreclosures, we are seeing more people who need to rent. Rental property availability in many markets is quite tight, which means that rent prices are increasing. If you go to the Bureau of Labor Statistics and look at the housing rent data, it is not too hard to think that the housing component of CPI could easily rise by more than 4% in the fourth quarter given the current trend.

Since the housing component is about 30% of the total CPI, a 4% inflation in housing could be significant. And oil is over $80 and rising. The dollar is falling, meaning that import prices are going to rise. And should we mention that food costs a lot more than this time last year?

Given that the Fed has two mandates, stable prices and full employment, is the Fed abandoning its inflation mandate? Is Bernanke, who argued in academia for explicit inflation targeting, no longer worried about inflation? Is he willing to accept the possibility of 3% inflation? Is inflation getting ready to come back, a la the 1970s? Isn't that what the rise of gold is telling us? And aren't TIPS suggesting the same since the rate cut (a long term 2.64% inflation)?

In general I think the answer is no. I think that the Fed is concerned about other problems, and specifically heading off a recession. And to that topic, we need to turn to a recent speech at Jackson Hole by Fed Governor Fred Mishkin.

Long time readers of this letter should recognize that name. Mishkin was the co-author of a 1996 New York Federal Reserve paper on the predictive power of an inverted yield curve and recessions, which I have written about on several occasions. He was most recently a professor at the Graduate School of Business at Columbia before President Bush nominated him to the Fed Board of Governors which he joined last September, 2006. His resume is long and strong. He is a consummate and well-regarded insider. (http://www.federalreserve.gov/aboutthefed/bios/board/mishkin.htm)

At Jackson Hole in late August, he essentially argued that central bankers should ease monetary policy quickly and aggressively in response to a big fall in housing prices. "Presenting a paper on the final day of the Fed's Jackson Hole symposium, Mr. Mishkin said policymakers should not wait until output falls, but should 'react immediately to the house price decline when they see it.'

"He said the optimal policy response was both quicker and more aggressive than that suggested by a standard policy rule, in which policymakers respond only to deviations in output and inflation.

"He said simulations show that this approach 'can be very successful at counteracting the real effects' of even a large house price slump, because of the long lags from changes in housing wealth to changes in consumer spending." (Financial Times)

Transmission Problems

In a car, the transmission is responsible for taking the power of the engine and transmitting it to wheels. Economists also talk about transmission. How does an opportunity (or problem) in one area affect another seemingly unrelated area? How does a rise in housing prices affect overall consumer spending? What is the mechanism (the transmission) of the Wealth Effect? One obvious answer (among many) would be Mortgage Equity Withdrawals that are possible as home prices double in ten years.

And Mishkin talks about just that transmission in his paper. And he makes it clear that a precipitous drop in home prices would be a negative force. Of course, that is somewhat intuitively obvious. But the interesting thing is that he argues for a pro-active response from the Fed when it becomes clear that housing prices are getting ready to fall. Let's read carefully the following from the closing arguments of his paper. (You can read the speech at http://www.federalreserve.gov/pubs/feds/2007/200740/200740pap.pdf)

"My discussion so far argues against a special emphasis on house prices in the conduct of monetary policy. This argument does not extend to a recommendation that central banks stand by idly when house prices climb steeply. To the contrary, central banks can take steps to reduce the negative consequences for aggregate economic activity of sharp movements in house prices. But rather than try to preemptively deal with the bubble--which I have argued is almost impossible to do--a prudent central bank would be better advised to deal with adverse macroeconomic consequences as they emerge in the wake of any substantial decline in asset prices. One way a central bank can prepare itself to react quickly is to explore various scenarios as a normal part of its business to assess how it might respond to a variety of shocks, including a drop in house prices, to achieve maximum sustainable employment and price stability.

"Indeed, the exploration of different scenarios by the central bank can be thought of as stress testing similar to that regularly conducted by commercial financial institutions and banking supervisors. They see how financial institutions will be affected by particular scenarios and then propose plans to ensure that the banks can withstand the negative effects. By conducting similar exercises, in this case for monetary policy, a central bank can mitigate the effects of a drop in house prices without having to judge that a bubble may be in progress or predict when a bubble might burst.

"One objection to an easing of monetary policy following the collapse of an asset bubble is that it might lead market participants to believe that the central bank will always act to prop up asset prices, a belief that can make a bubble more likely. The central bank can mitigate such an interpretation, however, if it publicly emphasizes that its monetary policy is not directed at stabilizing any particular asset price but is rather focused on achieving price stability and maximum sustainable employment. Making sure that a house-price collapse does not do serious harm to the aggregate economy in no way eliminates sharp declines in house prices and so does not provide insurance against such declines. The same reasoning holds true for stock prices. Indeed, we have seen substantial declines in housing and other asset prices in many countries even when monetary policy has been eased substantially."

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A 50% Drop in Housing Prices

Dr. Robert Shiller of Yale (of Irrational Exuberance fame) also presented at Jackson Hole. He said housing prices could fall as much as 50% in some areas given how home prices have diverged relative to rents.

Let's put the timing in perspective before we get back to housing. At the time of the Jackson Hole conference (my invitation once again seemed to get lost in the mail), the credit markets were in the process of freezing up. The European Central Bank was injecting hundreds of billions of euros into the economy. The Fed was also opening the monetary door. But as noted here often, the problem is not one of available liquidity, but of confidence.

The subprime problem, which everyone assured us last spring would not spread to other markets, clearly had infected the entire world. What should be a US problem was more of a problem for European banks. We were told that the housing markets were bottoming last winter and then last spring and now it is clear that we are no where close to a bottom. (I wrote about this time last year we would see a crash in the housing market in late 2007 and 2008 and this winter that the subprime problems would spread.)

By the end of August, all this had to be clear to the Fed gathering at Jackson Hole. And when Shiller stands up and starts talking about precipitous housing price drops, everyone evidently paid attention. Mishkin argues for a pro-active response, and the FOMC (the Federal Open Market Committee which sets rates) responded.

Let's run through the scenario that the US economy, and thus the world, faces. It is going to be many months before there is a functioning subprime mortgage market in the sense that mortgages can be packaged and sold to investors. We are first going to have to create transparency in the various banks to allow the commercial paper market to function. No one is going to buy commercial paper from a bank unless they are 100% sure they can get their money back. And you can't be sure unless there is transparency into the books of the lending institutions. And that includes all the SIVs or Special Investment Vehicles that allow banks to move liabilities off their books. Kind of. Sort of. Maybe. As long as there is not a problem. And then they come back.

Jumbo mortgages (over $417,000) are difficult to obtain without paying exorbitantly high rates. The only functioning mortgage markets are for conforming loans that can be sold to Fannie Mae or Freddie Mac or with FHA backing. (As an aside, I expect that $417,000 to be raised, and for government intervention in subprime markets.)

In effect, with what will be tighter standards for loans going forward, we are going to remove 10-15% of the home buyers that were in the market in 2005-6. That is a serious drop in potential demand. That in itself argues for a large drop in housing prices. Couple that with the rest of the housing market problems, and it could get ugly. Gary Shilling suggests a 25% drop. Dr. Roubini thinks 15-20%.

The total housing market value in the US is $20 trillion. Knock of $4 trillion, and you have a serious drop in the wealth of homeowners. For may, that completely wipes out equity built up over the years.

Wildness Lies in Wait

"The real trouble with this world of ours is not that it is an unreasonable world, nor even that it is a reasonable one. The commonest kind of trouble is that it is nearly reasonable, but not quite. Life is not an illogicality; yet it is a trap for logicians.

"It looks just a little more mathematical and regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness lies in wait." - G. K. Chesterton

All of the subprime mortgages and CDOs that sit on the books of banks throughout the world are the wildness that lies in wait. We can know with some exactitude that there are going to be $100 billion in losses, give or take. What we cannot know is from what hidden glen the losses will spring up. Where is this paper?

And thus the difference between risk and uncertainty. Risk has a price. You can establish the probability of a loss, and price it. Life insurance, as an example, or the likelihood of defaults in subprime mortgages (at least, before they dropped rational lending practices).

But you cannot price uncertainty. And now the markets are uncertain about subprime debt, and uncertain as to where that debt is. And so how do you price the debt? If you are no longer certain about German banks when two of them go belly up, then do you take any German bank paper? French paper? Commercial paper from Countrywide Mortgage?

You are a central banker. You can see the problem, and you can see that a housing led recession or at the very least a serious slowdown is in the near future. The mortgage credit markets are not functioning and may not for some time. Do you wait? Mishkin argues no.

Even though housing is only 5% of the economy, it is a huge part of the Wealth Effect. $4 trillion is not a small sum in the psychology of the consumer. Slower consumer spending, and consumer spending is clearly slowing, is the transmission which takes us from a housing recession to a general recession.

Slower consumer spending should result in lower inflation and lower prices. If you read Mishkin's paper, the Fed is clearly modeling the economy, and just as clearly their models suggests a problem.

And so we get a sea change. We get a Fed that is pro-active instead of reactive. That makes Fed-watching a whole new ball game.

A couple of side points. In 1998, the Fed cut rates 75 basis points in response to the Russian bond crisis and LTCM. When the crisis subsided, they took those cuts away fairly quickly. While I do not think this crisis subsides in a few months, if it does, and inflation even remotely ticks up, they will take the recent cut, and the ones they are going to make in the future, off the table just as quickly.

And I am running out of room, but the Bank of England's response to NorthRock was also a sea change. They in effect guaranteed all bank deposits in Great Britain. This will take some fleshing out on the part of authorities, but it is a big change.

I Still Think Recession

Even with a proactive Fed, I think we do not avoid a recession.

I think the Fed did the right thing by cutting rates. I think they will cut them more as the economy continues to slow. We will see a Fed funds rate with a "3 handle" before this process is over (meaning that the Fed funds rate starts with a 3 from the current 4.75%). The Fed did not start down this road with the thought 50 basis points would be enough.

The point is to try and drop rates enough to make mortgages (when that market finally rights itself) low enough that home buyers can afford to buy homes. While that will help some individuals, the more important concern from a central bankers perspective is the total economy. You do not allow the housing market to implode on your watch and do nothing.

And yes, it will help business with lower funding costs and encourage deals and risk taking. Which is what you want when an economy is on the verge of recession.

But home construction, even with lower rates, is not going to turn around fast. At the peak of the market, we were building 2,000,000 new homes a year in the US. As the following chart from the Conference Board shows (thanks to Dennis Gartman), it is not unusual for housing starts to drop below 1,000,000, and this typically precedes a recession.

This of course is not helped by all the homes that are coming back onto the market via foreclosures. Mortgage delinquencies are rising, especially in the variable rate subprime market, as the chart below indicates.

And all this puts pressure on consumer spending. Hugh Moore of Guerite Advisors writes:

"Consumer spending accounts for two-thirds of the U.S. economy. Total Household Debt is particularly important in supporting the growth of consumer spending. This indicator includes mortgage debt due to the important role that Home Equity Withdrawal (HEW) has played in sustaining the growth in consumption since the beginning of the decade.

"As shown in the graph below, each time the year-over-year increase in Total Household Debt has dropped more than 40% below its recent peak, a recession (or in the case of 1967, a mini-recession) has occurred. The mid-1980's slowdown touched this level, but did not exceed it. The current -38.9% level is approaching this boundary and, based on recent credit tightening by financial institutions, is likely to drop significantly below the -40% level.

And quickly, a preview from next week's Outside the Box, courtesy of my friends at GaveKal (this actually written by Louis Gave). They track the velocity of money. As they note, central banks are pushing money into the system. But is it going anywhere?

"Which brings us to today. Following the recent central bank actions in the US, Europe and the UK, most commentators seem to expect a sharp acceleration of either inflation, economic activity, or asset prices (or all three). As a result, gold is making new highs, the US$ is plunging to new depths, etc.... But aren't the recent buyers of gold focusing solely on likely changes in the money supply (M), while forgetting why central banks are set to dump money into the system in the first place? Isn't the reason behind the loosening of monetary policies the fact that the velocity of money (V) has been plummeting?

"As in 2001, the question investors should thus ask themselves is whether velocity is set to rebound? If it is, then investors are right to position themselves for an ample liquidity environment (long gold, long commodities, long deep cyclicals).

"But if it isn't, then the investment environment could start getting a lot trickier." (emphasis mine).

We do live in interesting times. Next week I will try and look at the currency markets. The dollar is going to continue to be under pressure.

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It's Good to be Home

I must admit I do love to travel and see the world. But I have been doing a lot of travel this year, and it feels good to be home for the next three months. I am sure that something will come along and necessitate a trip, but right now re-acquainting myself with my home is a pleasant exercise. And even more fun in my new digs.

As many of you know, I moved my residence this spring to a high rise in an area of downtown Dallas called Uptown, as a personal experiment in urban living. It also puts me rather close to my two older girls. I find that I like it a great deal, at least so far. Being able to walk to restaurants, entertainment, shops and more is quite convenient, and the area is more fun than the suburbs I have haunted all my life. And I leased. I would have to pay almost two and a half times more a month to buy the equivalent space. That suggests there may be a buying opportunity at some point in the future.

I did my bit for the economy this week. I helped my daughter Abigail buy a car in Tulsa, where she goes to school. I must confess to not looking at a smaller car for a long time. I drive larger SUVs and have done so for decades. Abigail is 4'10" on a good day, so she was looking for a smaller car. We ended up with a Nissan Sentra. I was quite impressed with all the features and luxury that you can buy for $17,000. I know Bill King and others hate hedonic adjustments in the CPI, but this was a massively better car than I bought when I was 22, for about a third the nominal dollars, and used at that. Safer, more reliable. Airbags everywhere. 30 MPG. Blue tooth. 100,000 miles before the first tune-up. I used to change my plugs every 6,000 miles.

And best of all? "Dad, I have been looking at jobs in the paper here. There are just none for public relations, and I want to work for a sports team. I think I might move to Dallas when I graduate." Mark Cuban, are you reading? I'll be glad to drop you a resume at the season opener.

Life is so very good, even with all the bumps here and there. Once again, thanks from the bottom of my heart for letting me send you my musings each week. Your support and comments mean a lot, and I do appreciate it.

Your ready for the Mavericks to start playing again analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

The Black Swan

JohnMauldin — Fri, 14 Sep 2007 08:11:00 GMT

The Black Swan

"A similar effect is taking place in economic life. I spoke about globalization in Chapter 3; it is here, but it is not all for the good: it creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial institutions have been merging into a smaller number of very large banks. Almost all banks are now interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks (often Gaussianized [bell curve] in their risk measurement)-when one falls, they all fall.

The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur...I shiver at the thought. I rephrase here: we will have fewer but more severe crises. The rarer the event, the less we know about its odds. It means that we know less and less about the possibility of a crisis." (Nicholas Nassim Taleb, The Black Swan, p. 225, probably and presciently written last year.)

How predictable was the current turmoil in the market one year ago? Six months ago? On one level, it was not all that hard to see that that there were going to be problems in the subprime mortgage market, especially in the BBB tranches (or portions) of Mortgage Backed Securities which were rolled up together into Collateralized Debt Obligations and given AAA ratings. Saying that there would be massive losses distributed throughout thousands of institutional portfolios was almost a given. I was not the only one writing about the problems that awaited us.

But it is one thing to predict a problem, and quite another thing to understand its full implications in the market. This week we talk about how these events in general come about and end up speculating how we get back to "normal" market conditions. Plus I look at the probability of the Fed cutting rates and speculate that they will eventually lower them much more than we now think.

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The Black Swan

Last week, seemingly so long ago and so far away, I was wondering through St. James Park in London. It was a perfect afternoon in a perfect park, with willow trees reflecting on the pond and the Eye of London in the distant background. And then there it was. It swam into my vision. A black swan. A rather inelegant bird when compared to its august white brethren, but recognizable as a swan nonetheless. Seeing a black swan seemed to cap off the day, as I had just finished reading a book whose title was inspired by the dark fowl.

Just because all the data says that there are only white swans does not prove that black swans do not exist. All we can confidently assert is that no one has seen one - yet. To prove that a black swan does not exist would take an infinite number of observations, and yet only one observation is needed to prove they exist. And thus philosophers debated the black swan issue and showed that by induction you could reason they did not exist.

And that was the case until explorers did indeed find a black swan in Australia. The term "black swan" has come to mean an event or discovery whose existence was not predictable from the available data, and whose effect on society or the markets yields surprising and unexpected results. (And just to note at the beginning, not all black swans are bad. Sometimes they are very good, even if a surprise.)

I had been saving Nassim Taleb's latest book, "The Black Swan - The Impact of the Highly Improbable," to read on my summer vacation. Glancing through the book when I first got it assured me that I wanted to give the book more than a quick read. I was not disappointed. You can quibble over various points in the book (and I may at some point), or not like his confrontational style, but this is a book that demands to be consumed slowly and thoughtfully.

The Black Swan took me several times longer to read than normal. Not because it is not easy or fun to read (Taleb can be quite humorous), but because I had to regularly stop and think (and often to re-read several times) about what he was saying. I rarely read a book twice. So many books, so little time. Generally, I mark it up and return to important sections if I need to. This is one book that I will definitely read more than once. Let me strongly suggest you get the book and set aside some time to read it. You can get it at www.amazon.com.

Mediocristan versus Extremistan

Taleb attacks (the correct word) the social sciences (in particular economics) which uses standard Gaussian bell curves to "prove" their points. Everything has to fit within the curve. There is little room in the neat world of the bell curve for events that are far from the center. He creates a world he calls Mediocristan which is the world of white swans, bell curves and predictability. He contrasts this with Extremistan which is the world of chaos, fractal geometry, power laws, black swans and where the unpredictable happens.

There are parts of our lives which inhabit Mediocristan and parts which dwell in Extremistan. Not knowing the difference can be problematic, if not fatal. And it is difficult to know where one country starts and the other ends. If you are in Mediocristan, then you can use your bell curve assumptions without fear. But if you wander into the murky border areas, you are no longer safe in your assumptions. And yet, the longer and deeper you go into Extremistan without a problem, thinking you are safe in Mediocristan, the larger the disruption is likely to be. Let look at a few quotes and some of his ideas here and there before we look the most recent eruption of a black swan:

"To summarize, in this (personal) essay, I stick my neck and make a claim, against many of our habits of thought, that our world is dominated by the extreme, the unknown, and the very improbable (improbable according our current knowledge) - and all the while we spend our time engaged in small talk, focusing on the known, and the repeated. This implies the need to use the extreme event as a starting point and not treat it as an exception to be pushed under the rug. I also make the bolder (and more annoying) claim that in spite of our progress and the growth, the future will be increasingly less predictable, while both human nature and social "science" seem to conspire to hide the idea from us. (Prologue xxvii)

"When I ask people to name three recently implemented technologies that most impact our world today, they usually propose the computer, the Internet, and the laser. All three were unplanned, unpredicted, and unappreciated upon their discovery, and remained unappreciated well after their initial use. They were consequential. They were Black Swans. Of course, we have this retrospective illusion of their partaking in some master plan. You can create your own lists with similar results, whether you use political events, wars, or intellectual epidemics.

"You would expect our record of prediction to be horrible: the world is far, far more complicated than we think, which is not a problem, except when most of us don't know it. We tend to "tunnel" while looking into the future, making it business as usual, Black Swan-free, when in fact there is nothing usual about the future. It is not a Platonic category!" (p. 135)

I think there is a physical reason that Taleb is right in that we will see more unpredictability I the future than we saw only a few hundred years ago, or even last century, as wild as that century was. I wrote a few years ago of Ray Kurzweil's book, The Singularity is Near. (Also very highly recommended - www.amazon.com). Ray wrote (in 2000) that the pace of change as encompassed by technology is accelerating.

"The first technological steps - sharp edges, fire, the wheel - took tens of thousands of years. For people living in this era, there was little noticeable technological change in even a thousand years. By 1000 A.D., progress was much faster and a paradigm shift required only a century or two. In the nineteenth century, we saw more technological change than in the nine centuries preceding it. Then in the first twenty years of the twentieth century, we saw more advancement than in all of the nineteenth century. Now, paradigm shifts occur in only a few years time. The World Wide Web did not exist in anything like its present form just a few years ago; it didn't exist at all a decade ago.

"The paradigm shift rate (i.e., the overall rate of technical progress) is currently doubling (approximately) every decade; that is, paradigm shift times are halving every decade (and the rate of acceleration is itself growing exponentially). So, the technological progress in the twenty-first century will be equivalent to what would require (in the linear view) on the order of 200 centuries. In contrast, the twentieth century saw only about 25 years of progress (again at today's rate of progress) since we have been speeding up to current rates. So the twenty-first century will see almost a thousand times greater technological change than its predecessor."

What Ray is saying is that most people project future growth in technology at today's rate of change. But the rate of change is accelerating, so that more and more change is packed into smaller and smaller amounts of time. While the vast majority of the thousand times greater technological change Ray is talking about happens in the last part of this century, some of it happens in the next twenty years. How much change are we talking about? Well, from when he first penned those words, the pace of change has picked up. At current levels, that means the 20th century was equivalent to about 20 years of progress at today's rate of change. That pace will continue to increase the amount of innovation we pack into just a few years. From his book Fantastic Voyage:

"...And we'll make another 20 years of progress at today's rate [of growth], equivalent to that of the entire 20th century, in the next fourteen years. And then we'll do it again in just seven years."

That means in the next 21 years we will see double the technological change that we saw in the entire 20th century. At that pace, we will see almost four times the rate of change within 25 years.

But that is just technology. There are also profound and rapid changes happening in the world of finance. Only a few decades ago, there was only a relatively small amount of derivatives in the world as compared to the totality of human commerce. Today we have a reported $450 trillion in derivatives. For us to think that such a thing can come about and not add to the unpredictable nature of the world is not realistic.

George Friedman of Stratfor points out (in a manuscript I just read for his new book, due out soon, we hope) that as humans we are dismal at projecting the future in a geo-political sense. Think about the beginning of every decade of the last century. Then move forward 20 years. Who got any prediction right? Did anyone see World War 1 in 1900 or even 1910? The rise of Germany and Hitler in 1920? The collapse of Russia in 1980? The rise of radical Islam in 1987? A war in Iraq in 2000?

And yet, we assume that the world of 2017 or 2027 will be not all that much different than today. But the only truly safe bet is that it will be radically different in ways that we cannot imagine.

As an illustration of the wildly unpredictable, I read this week (via Bill King) of a new discovery. "An Erie cancer researcher has found a way to burn salt water, a novel invention that is being touted by one chemist as the 'most remarkable' water science discovery in a century. John Kanzius happened upon the discovery accidentally when he tried to desalinate seawater with a radio-frequency generator he developed to treat cancer. He discovered that as long as the salt water was exposed to the radio frequencies, it would burn." http://www.breitbart.com/article.php?id=D8RIRI600&show_article=1

Dr. Roy Rostrum, a Penn State University chemist with a serious pedigree, reproduced the experiment. The process seems to release hydrogen. Apparently it takes more energy to do so than is released, so it is not perpetual motion. Will this lead to anything? Who knows? But there are scores of such random discoveries each year, all with wild unpredictability attached to theme. And as we increase the number of researchers and scientists and garage tinkers in the world, we should expect and will have even more unpredictability.

But this is all hard for us to get our head around. Living in such a rapidly changing world is psychologically difficult. So we resort to trying to simplify things. Returning to Taleb:

"We, members of the human variety of primates, have a hunger for rules because we need to reduce the dimension of matters so they can get into our heads. Or, rather, sadly, so we can squeeze them into our heads. The more random information is, the greater the dimensionality, and thus the more difficult to summarize. The more you summarize, the more order you put in, the less randomness. Hence the same condition that makes us simplify pushes us to think that the world is less random than it actually is." (p.69)

And that tendency lulls us into complacency. And that eventually results in a "Minsky Moment." Hyman Minsky famously stated that stability produces instability, and that the longer things are stable, the greater the instability that will result, precisely because we are unprepared for it.

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When "Because" Isn't Enough

Having seven kids, I have answered more than a few hundred questions with the brilliant "because such and such." The younger kids will sometimes even accept such answers, when a true skepticism would be more in order.

I admit to sometimes giving in to such a rationale today. I, along with my fellow humans, like causality. B happens because of A. And it is tempting to ascribe a simple because to today's black swan in the credit markets. It is all the fault of the subprime mortgage lenders. If they had not made bad loans we would not have the problem.

I would suggest that the problem is more systemic than that. Assume that we had the rational laws in place five years ago that we will enact next year preventing bad mortgage underwriting. Then there would have been excess and a bubble in some other part of the markets at some other point in time. As humans, that is what we do. We push the limits of greed, especially when accompanied by the illusion of stability, until the bubble bursts.

Sometimes the "because" is a synergy of multiple events. The internet is not possible without multiple inventions. It was around for 20 years before it began its rather meteoric rise in the late 80s. There is no simple because, but the implications and the unpredictability of the results were not clear in 1987 to all but a few wild-eyed, and generally considered crazy, individuals.

"This in itself greatly weakens the notion of "because" that is often propounded by scientists, and almost always misused by historians. We have to accept the fuzziness of the familiar "because" no matter how queasy it makes us feel (and it does make us queasy to remove the analgesic illusion of causality). I repeat that we are explanation-seeking animals who tend to think that everything has an identifiable cause and grab the most apparent one as the explanation. Yet there may not be a visible because; to the contrary, frequently there is nothing, not even a spectrum of possible explanations. (p. 119)

Gliding Into Disorder

But all is not that bad. We tend to think of Black Swans as bad events. But as noted above, there are good black swans which positively impact human existence. And Taleb himself sees a glimmer of the positive:

"We are gliding into disorder, but not necessarily bad disorder. This implies that we will see more periods of calm and stability, with most problems concentrated into a small number of Black Swans." (p. 225)

It is easy to take the credit disruptions of today and straight line the present into the future. But it might be more useful to see how the previous black swans of financial disruptions were dealt with.

Let's look at 1987, 1998 and 2000. All three periods had rather solid US economies. All three had rather significant disruptions. And all three saw the Fed open the liquidity flood gates.

You can expect the same today. As I have often written, when the Fed embarks upon a new course, they will go further and the course will last longer than anyone thought at the beginning of the process. Who thought when the Fed began to loosen monetary policy in early 2001, when rates were 6.25%, that we would see 1% within a short period of time? And who thought it would stay that way for so long? And when they began tightening again? Who thought it would get to 5.25%? Back then, 4% seemed like a very high rate.

Right now, the market is pricing in rate cuts of 75 basis points by the end of the year and another 25 basis points within 12 months. I think that is low. If the Fed is cutting, it is because they see the economy weakening. And I think that means they will cut more than anyone expects. What is the end number? I don't know. But I bet it is a lot lower than 4.5%.

Why? Because the credit markets are going to take a lot longer to sort out the mortgage problems than we might think. And that means that a lot of homes are not going to move for some time, which is not good for consumer sentiment or spending. And there will be substantially less mortgage equity withdrawal. As home prices drop 10% and then 15% and then 20%, boomers are going to realize that a large part of what they thought they had for retirement in the equity of their homes is not there. That means they need to spend less and save more. While that is good as an individual policy, it is rough on the economy at large. I still think this process ends in a recession.

But John, (I hear you ask) if the Fed cuts rates, won't that make mortgages cheaper? The answer is that for conforming loans it will. But right now, if you want a home with a loan larger than $417,000, you are looking at interest rates as high as 9%, even with excellent credit. And if you have poor credit? There are no subprime loans for you, without substantial down payments.

The problem, as I repeat, is not the availability of liquidity. It is the lack of credibility. No one is buying paper they are not absolutely 100% sure about. And until a new mechanism is developed that will allow for transparency in the mortgage markets which will then allow for the securitization process to being again, it is going to be tough to get a mortgage for someone who does not fall with the confines of conforming loans (for foreign readers, those are agency loans made by quasi government agencies like Fannie Mae which have the implicit backing of the US government.)

It will take some time, but the current disorder will again become order and the process will begin again, with a bubble happening in some other market which will eventually come undone and create a new black swan event.

(And yes, the implications of lower rates means a lower dollar and thus higher gold.)

And let's end with a great quote from Taleb, which is not exactly on point, but is a great quote nonetheless.

"We humans are the victims of an asymmetry in the perception of random events. We attribute our success to our skills, and our failures to external events outside our control, namely to randomness. We feel responsible for the good stuff, but not for the bad. This causes us to think that we are better than others at whatever we do for a living. Ninety-four percent of Swedes believe that their driving skills put them in the top 50 percent of Swedish drivers; 84 percent of Frenchmen feel that their lovemaking abilities put them in the top half of French lovers." (p. 152)

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Tulsa and New Orleans

I have a family matter which I have to attend to in Tulsa next Tuesday, so it will be a quick one day trip. But it will give me the chance to help my daughter Abigail find a new car. It seems that the car I gave her only a few years ago (but is closer to 5) now has almost 200,000 miles and is beginning to show signs of serious deterioration.

"Dad, I'm making my own money. I can make payments." This from a girl who has one year left in school. But she does have a great job and Dad is proud of her, and in the interest of letting her think that I am still useful, I will go and help the process.

Behavioral psychologists have a phenomenon called "anchoring." We tend to take recent events and project them into the future in a straight line. We "anchor" our projections on some number or data we have recently seen. Tomorrow will be like today. Future earnings increases will look like recent earning increases. There are a host of studies which demonstrate this all too human characteristic.

And quickly, let me mention that I will be at the venerable New Orleans Investment Conference October 21-25. This is the grand-daddie of all investment conferences and features some of the top investment analyst and minds in the country. Among the many speakers are James Grant, Ann Coulter, Lawrence Lindsey, and good friends Marc Faber, Dennis Gartman, Doug Casey. Click on the link and then click on faculty to see what is one of the highest quality gatherings of top-notch speakers at any conference anywhere. You should check it out, especially if you have an interest in gold and natural resources, as some of the top investment analysts in that area are always there. If you are there make sure and look me up.

Tiffani is coming back with her fiancee from Peru in about 30 minutes, so I need to hit the send button and go pick them up. Have a great weekend.

Your enjoying life with all its Black Swans analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Should the Fed Cut Interest Rates?

JohnMauldin — Fri, 07 Sep 2007 08:10:00 GMT

Should the Fed Cut Interest Rates?

The Shocker in the Employment Numbers
Should the Federal Reserve Cut Interest Rates?
Will A Cut Make Any Difference?
How Housing Woes Hurt the Rest of the Economy
Home Again, Home Again

The unemployment numbers came in today, and if you look under the hood of the data, it is worse than the headline loss of 4,000 jobs. Should the Fed cut the interest rates in two weeks? Will it make a difference? Are we headed into recession (as predicted here in my January 2007 forecast issue)? When do we see a bottom in the housing market? Are we there yet? We look at all this and more. It should make for an interesting letter, if I can get my jet-lagged body to cooperate.

But first (and quickly) let me mention that I will be at the venerable New Orleans Investment Conference October 21-25. This is the grand-daddie of all investment conferences and features some of the top investment analyst and minds in the country. Among the many speakers are James Grant, Ann Coulter, Lawrence Lindsey, and good friends Marc Faber, Dennis Gartman, Doug Casey. Click on the link and then click on faculty to see what is one of the highest quality gatherings of top-notch speakers at any conference anywhere. You should check it out, especially if you have an interest in gold and natural resources, as some of the top investment analysts in that area are always there. If you are there make sure and look me up.

And quickly, speaking of gold, it is soaring. It closed at over $700 today, in partial reaction to the awful employment numbers, which was not good for the dollar. But there is another interesting story going on in the background, pointed out to me earlier this week by that South African gold maven Prieur du Plessis. He points out there is a massive build-up of call options in the October and December Comex gold contracts, similar to a period in November 2005 prior to the gold price surging by more than 50%. Smart money? Maybe. But the recent 6% move or so may not be all there is in the "barbarous relic."

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The Shocker in the Employment Numbers

Economists surveyed by Bloomberg expected that payrolls would increase by 100,000. Instead they dropped by 4,000. That is the first drop since August of 2003. The weakness was broad based and payrolls for both June and July were revised down, from 92,000 to 68,000 in July and from 126,000 to 69,000 in June. That is an average of less than 46,000 a month for the last three months. The economy needs to create 150,000 jobs a month in order for employment not to rise.

Technically, there was a drop of 35,000 in September of 2005, but it was later revised upward to 105,000, a rather large swing. But that brings up a point. The employment numbers are subject to large revisions, especially at major turning points in the economy. The employment data is based on a survey of businesses called the establishment survey. It tends to miss jobs created at small businesses at the economy expands. Thus, the jobless recovery of 2002-2005 was not really jobless at all when the revisions came in over the next few years. The Bureau of Labor Statistics (BLS) makes the survey and then based on past data trends, heavily influenced by recent trends, makes an estimate as to the number of new jobs.

A large part of the unemployment figure is from the so called "birth/death ratio." They estimate the numbers of new jobs created or destroyed each month based on past history. This is the main source of the "under" during the recovery phase, but the converse is also true. It will almost always overestimate the number of new jobs as the economy slows, and especially before a recession.

This month the BLS estimated 120,000 new jobs in the birth/death column. These jobs may not in fact be there if the economy is slowing as it seems to be. There are good reasons to suspect that the August number will be revised down at a later date, as were June and July.

But it may be worse. The BLS conducts two surveys. One is the "establishment survey" mentioned above. The second is the "household survey" where they phone households and ask how many people in the household are employed, are seeking employment or are not in the market for a job.

I reprint the table from their website below (www.bls.gov). The number of unemployed people in this survey actually fell slightly, but notice that it also shows a drop of 316,000 jobs last month. Further, they show a rise of 592,000 people who are no longer considered to be in the work force! That is a total swing of over 900,000 workers, or about 0.5% of the labor force. That is a rather large swing in this series.

Finally, and in the "it's probably just a coincidence category," all the research that shows that employment for low wage jobs, especially among teenagers, actually decreases, especially initially, as the minimum wage rises. The new minimum wage kicked in starting July 24, with the rate rising from $5.15 to $5.85. And teenage unemployment rose by almost 6% from July to August. Got to be coincidence. Congress wouldn't do anything to hurt teenage employment, would they?

Should the Federal Reserve Cut Interest Rates?

Looking at the chart below, notice that 2 year rates on US government is at 3.9%. The rate on the ten year bond is at 4.38%. The spread on TIPS (the markets best guess on inflation) is hovering just above 2%. And Fed funds are at 5.25%. The market is screaming for a rate cut.

As I have noted in previous letters, getting an inflation number lower than 2% in the next few months is going to be hard because of the rather low year over year comparison numbers of the latter part of 2006. And the various Fed governors have been telling us that inflation is their primary concern in speech after speech. Cutting rates before we see a lower inflation number is something they have clearly indicated that they are not interested in.

Bernanke and others have made it clear that they do not see it as their job to bail out borrowers who took out home loans they could not pay, or lenders who made risky loans or investors who bought the loans. The fact that the Fed helped create the low interest rate environment which fostered such excessive risk taking is not something they have yet acknowledged.

After today's unemployment number, the futures market is pricing in a rate cut for the September FOMC meeting. If they do not get it, their will be lynch mobs forming. You do not want to be long the S&P of there is no rate cut. It will be ugly. The arguments I have heard and read (not necessarily mine) go like this:

The economy is slowing down. We may even be looking at the possibility of a recession. Recessions are by definition deflationary, so whatever concerns you have about inflation will go away. If the Fed waits until the backward looking inflation data comes in, it almost guarantees a recession.

Further, the credits markets are in the worst crisis in decades. Financial institutions do not trust each other, as there is not transparency. The commercial paper market is in the process of imploding. Mortgages, except for government back agency paper, are not being written or is being done is at very high rates. Want a jumbo loan today? It could cost you 9%, if you can find it, even with good credit. Please, Chairman Bernanke, could we have at least 50 basis points to make the problem go away?

Finally, the housing market is on the verge of a collapse. Foreclosures are high and rising. We need lower rates to help homeowners and jump start the housing market so it can recover.

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Will A Cut Make Any Difference?

Now, for what it's worth, here's my view. I think the Fed should cut rates in September. The economy is indeed in the process of slowing down and I think, for the reasons I outline below, is on the verge of a recession. The Fed policy is now clearly quite tight. A 50 basis point cut will still leave real rates at around 2.75%, which is not exactly an easy monetary policy.

But let's be clear. A fed cut is not going to solve, or even help much, the current credit crisis. The problem, as I have repeatedly said, is not a liquidity problem but a credibility problem. There is plenty of cash, and central banks around the world are adding to it daily.

The problem is that no one wants to buy debt that they do not completely understand. If you are a bond buyer for an institution, it is a career ending decision to buy an asset backed investment grade bond even rated AAA if it goes bad. You might be able to explain buying such assets last spring. Buying a problem bond today and it is now your fault, not to mention your job.

And commercial paper from another financial institution? How much subprime debt do they have hidden on off-balance sheet vehicles? Why loan anyone money for just a few extra basis points when you can't be 100% sure? Especially if you are looking at your own exposure and you see how easy it might be to hide a few problems here or there.

These problems are going to be worked through. I have personally talked to more than a few managers who are raising money to create distressed debt funds to buy this paper at discounts, as there are going to be lots of funds and institutions that will be forced to sell asset backed paper. For instance, if you are a pension fund, bank or insurance company that by law can only hold rated paper, and when the ratings agencies mark the subprime paper that you own down below investment grade, you will be forced to sell.

But the question is who will buy? Those who own these bonds and are forced to sell are going to take large losses. The hedge funds that buy them will have the potential for some very good profits. That helps the markets in general, as it helps "clear" the market and allows things to get back to normal more quickly. But the losses for those who are forced to sell will be larger than for those who can sit it out. (It might help for regulators to relax the holding period for those assets as long as they are properly priced in the portfolio.)

A lower Fed funds rate might make the bonds slightly more valuable. But if your A-rated subprime paper is selling for 50 cents on the dollar (and some are), the extra value that even a 150 basis point Fed funds cut would make is only a few points in value. Small consolation.

On a side note, the higher rated asset backed paper is bouncing back rather significantly from the lows of mid-August, although still at steep discounts. The lower rated (BBB and below) is still near their lows. The market is starting to make the distinction between various types of debt, and that is good. The first part of the process, which is to establish some realistic pricing, is at least starting.

Second, a lower fed funds rate is not going to bail out the housing market. It will of course help some, but again, it is not the interest rates that are the problem. The problem is that we are talking about the 20% plus of the home buyers in the last two years that were able to buy homes because of poor lending practices on the part of mortgage companies. Those home buyers are not going to be there to support the market.

Further, let's say that we could wave a magic wand and allow the millions of home buyers who bought homes on adjustable rate and teaser rate mortgages to somehow refinance their homes at reasonable rates, even though their homes are going down in value. For those who qualified on 2% teaser rates, even if they could get a 7% mortgage, the payment might be too much.

Goldman Sachs suggests home values could drop as much as 20%. Gary Shilling has been saying 25%. We don't have time and space this week to go into housing prices, but many of the mortgages sold in the past two years only made sense in a housing market that was rising by 10-15% a year. A market that is dropping 10-15% a year, as it may do in the next 12 months, is only marginally be helped by a Fed funds cut.

But that does not mean they should not cut. They should, simply because the economy is clearly slowing, and the risks are now to the downside.

How Housing Woes Hurt the Rest of the Economy

I have maintained for a long time that the bursting of the housing bubble would cause a serious slowdown or a recession in the economy. My critics would counter that housing is only 5-7% of the economy and a housing recession would not be enough to drag the whole economy down.

They are wrong for the following reasons. First, rising home values have allowed homeowners to use their homes as an ATM through mortgage equity withdrawals, which have added almost 2% to GDP annually over the last five years. That is now evaporating.

Secondly, falling home construction and lower home sales means fewer jobs not just in the direct home building market, but in the parts of the economy related to the home building markets, like mortgage brokers, real estate agents, hardware and furniture, etc. As an example, Countrywide announced a planned 10-12,000 person lay-off, when just a few weeks ago they were thinking of expansion, as they now think new mortgages may drop 25% in 2008. Fewer jobs mean lower consumer spending.

Consumers are not going to spend as much due to the wealth effect. If you feel your house was going to be a major part of your retirement, and now the value is going down, you are going to be more cautious and actually think about saving. This has been a dangerous prediction for 50 years, but I think consumer spending, some 71% of the US economy, is due to slow down. Year over year growth could drop below inflation later this year.

Further, with all the additional homes coming onto the market due to foreclosures, hone values are going to drop even more, and new home construction, which peaked at an annual run rate of 2,000,000 homes per year, is likely to fall to less than 1,000,000. We are currently at a level of 1,400,000, so we are not yet close to the bottom.

Rising unemployment. A housing market looking at the deepest recession in values since the Great Depression. A consumer under siege. A visibly slowing economy.

The Fed should cut rates. It will not be enough, but it will be something.

The Bush administration needs to augment those cuts with programs to help those who could make their mortgage payments if they could get a reasonable rate to be able to do so. Not a bailout of lenders, but help to those caught in the whiplash of a mortgage market that is rapidly freezing up for many.

Further, the rating agencies need to quickly move to increase transparency on the ratings of structured vehicles, investment banks need to figure out how to create credible structured products, etc.

But that is another story for another letter. For now, the Fed needs to cut. And at least 50 basis points, please.

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Home Again, Home Again

I rather enjoyed my vacation, but now I need to rest up. As usual for me, I tried to do too much in too little time, but it was fun. I want to thank Tom Fischer at Jyske Bank in Denmark for being such a perfect host in Denmark. Rarely have I been treated so well. Warsaw was interesting. I loved Krakow, and Prague is beautiful. I met so many new friends.

I had dinner in London Wednesday night with old friend Bill Bonner of Daily Reckoning fame, but he and I met almost 25 years ago as (then young and struggling) publishers of investment newsletters. He went on to build one of the largest investment publishing businesses in the world, and I left the business five years later for the investment management side of the business, but we have stayed close all these years. We have seen a lot of changes over that time, and I trust we will see a few more over the decades.

He brought me his new book, Mobs, Messiahs and Markets, which will go to the top of my reading list. I love the way Bill writes. Interestingly, I looked at this book on Amazon, and noted that they have his book paired with Alan Greenspan's new book.

I am not certain what it says about the world, but I note that Bill's book is at #10 on Amazon and Greenspan's is at 265. I intend to review the book in the near future, but you can get it at Amazon.com.

It is good to be home. I look forward to being here for awhile. And while I have had major writer's block on the book I am supposed to be writing, I think I worked my way through my problems these past two weeks. Trying to convey the nature of the changes we will be facing in the next 20 years has been a much more daunting task than I had first supposed. But then most things that are worthwhile, it seems, end up taking more effort than we first thought. It is good to be somewhat overly-optimistic, at least for me, for if I was a realist, I would start way fewer projects and end up accomplishing less.

We celebrate my oldest son Henry's birthday tomorrow. It was actually last week while I was on vacation, but nearly everyone, including me, was gone. The twins are down from Tulsa and Henry wants sushi, although that may be tough for me as I did have some bad sushi at the Park Plaza in London on Tuesday and have been sick since then, although I am getting better.

Here's to old and new friends and family. Have a great week.

Your thinking a lot about life analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Hope Is Not a Strategy

JohnMauldin — Fri, 31 Aug 2007 08:09:00 GMT

Introduction

Investors are constantly seeking "alpha," that elusive substance which yields returns in excess of a simple market portfolio. While I am flying today to Prague, this week good friend Rob Arnott teams up with associate John West to show that it is just as important to eliminate negative alpha. In fact, you could find an extra 2-4% in your returns just by doing so!

Rob starts with showing us what type of returns one can expect over the next ten years from the typical US market fund, and then shows how to remove some of the drags of negative alpha which hurt those returns. This is a very important piece and one I think you will want to read more than once.

Rob is the founder and head of Research Affiliates. He has published scores of articles in various financial journals, won four Graham and Dodd Scrolls for his writing, travels and is the keynote speaker at too many conferences to mention and is recognized as one of the top financial minds in the world. He wrote a chapter in my book, Just One Thing.

He is also the creator of the Fundamental Index (patent pending) which is exploding onto the market. When I first wrote about it three (maybe four? Time flies.) years ago, I said that fundamental indexes would be the fastest new investing concept to grow from zero to $100 billion in history. Today there is almost $20 billion invested in various kinds of fundamental indexes all over the world, and the number is growing rapidly, as some of the largest pension and institutional investors in the world are adopting the concept to replace their traditional index investing. At the end of this letter, I mention a few places where you can find funds and information.

But first, let me mention that I will be speaking at the New Orleans Investment Conference October 21-25. This is the grand-daddie of all investment conferences and features some of the top investment analyst and minds in the country. You should check it out and if you are there make sure and look me up.

Now, let's turn it over to Rob and John.

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Past is Not Prologue, and Hope Is Not a Strategy

Guest Column by Rob Arnott and John West, of Research Affiliates, LLC

The capital markets of the last quarter century have been incredibly generous to us. Since mid-1982, the S&P 500 index has advanced at a solid 13.9% annual clip, while 10-year Treasury bonds have posted annualized returns of 9.8%. With annual inflation averaging just over 3%, this means that investors have seen their real wealth double every seven years in stocks and every 11 years in bonds. But, past is not prologue.

Would a bond investor, looking at 25-year returns of 10% and current long bond yields of 5% be foolish enough to expect the next 25 years to deliver 10%? Of course not. They'd recognize that yields started in 1982 at 14% and had plunged to 5% over the next 25 years, earning hefty capital gains on top of a yield averaging 7% over this span. With current yields of 5%, they'd expect 5%.

So, if stocks were yielding 6% in 1982, and are now yielding 1.8%, should we expect to repeat the 13.9% of the past quarter-century? Of course not. On average, 5% a year came from capital gains attributable to multiple expansion - over and above what growing earnings and dividends contributed. Take that away, and we're at 9%. After all, that's what we'd have earned if dividend yields still matched the average yield of the quarter century. But, even that's too aggressive. Dividend yields are 2% lower than their average during this span and 4% lower than the starting yield of 1982. Take 2-4% away, and we should expect 5-7% from our stocks in the years ahead.

Over the past century, dividends have provided over two-thirds of the real returns earned in US stocks. Today, they hover well under 2%, while nominal bond yields are in the 5% range. Simple arithmetic points to 5% returns for bonds and 5-7% for stocks - if their respective yields don't rise in the years ahead! Rising yields and shrinking P/E ratios would mean capital losses which would reduce returns below these levels, much as falling yields and rising multiples fueled the wonderful returns of the past 25 years.

A lot of investors, even professional institutional investors, aided and abetted by their consultants and actuaries, don't like this arithmetic. So, they dismiss it, preferring to forecast the future by extrapolating the past. This is perhaps the worst possible way to construct expectations. It led actuaries to assign very low return assumptions (6% was typical) for pension funds in 1982, at a time when 14% could be locked in with government bonds, and when stocks were producing that same 6% in dividend yield alone, without even allowing for any growth, capital appreciation or inflation, all of which could, and did, add mightily atop that 6% yield. Why such low expectations? Because returns from 1965 to 1982 had been wretched.

Extrapolating the past similarly led to 10% and higher return assumptions at the peak of the bubble in 2000, at a time when bond yields were 6% and stocks were offering a scant 1% yield. Why such high expectations in a world of low yields? Because returns from 1982 to 1999 had been truly extraordinary. In 2000, I wrote a short paper entitled "Death of the Risk Premium," with Ron Ryan, which was received with widespread derision, but ultimately proved correct: plain old 10-year government bonds have produced higher returns than stocks since then, by a cumulative margin of over 30%, despite the durable bull market since 2002. And, even if we include the bubble of 1998-2000, stocks have beaten bonds by well under 1% per year over the past decade.

Today, no matter how fuzzy the arithmetic, it is difficult to justify long-term returns from conventional stock and bond balanced portfolios exceeding 5-7%. We can decry the math and its conclusions, but investors can only dismiss it outright at their peril. Since most plan on 8-10% returns (if not more!), the vast majority of long-term investors are confronted with a large shortfall between likely portfolio returns and what they hope to achieve.

Worse, if inflation drains off 2-3% a year - it would be awfully dangerous to count on a more benign long-term inflation outcome than this - and if taxes take away one-third of our 5-7% total return, we're left with pretty close to zero real return, net of taxes and inflation. Yikes.

Many, with spending plans that require 8-9% returns, hope such seemingly-bleak expectations prove off the mark. But hope is not a strategy. Rationally-inclined investors are grudgingly beginning to accept this likely reality. They recognize that it's far more sensible to take an alternative view: 5-7% returns aren't really all that bad, and so perhaps we should hope for more, aspire for more, develop strategies aimed at achieving more, but accept 5-7% as the base case scenario.

Eliminating Negative Alpha

Noting the gap between expected and required returns, many investors increasingly turn to "alpha" (value added from investor skill) as the elixir to cure their long term ailment. Meander through just about any industry publication and it is impossible to avoid the cascade of references on all things alpha - the quest for alpha, bids to increase alpha, alpha overlays, currency alpha, loosening constraints for alpha and the list goes on. It is almost as if manager skill is an assured and harvestable commodity. The very word "alpha" triggers feel-good pheromones in investors, as reliably as chocolate truffles or love. Few people bother to discuss the fact that alpha is a zero-sum game, with an average alpha of zero - less the costs associated with the quest for alpha. This means that most alpha is negative!

In investing, what is comfortable is rarely profitable. If the crowd is hell-bent on unearthing positive alpha, our own contrarian inclination points us in a different direction - very few of today's market participants are focusing as aggressively on eliminating negative alpha. Seeking, identifying and eliminating negative alpha is as profitable as seeking, identifying and employing sources of positive alpha.

We define negative alpha as the slippage investors unnecessarily incur in the ongoing management of their portfolios. A fancier term would be implementation shortfall. Eliminating all these various mistakes is not only profitable, it's vastly easier than competing with the crowd of alpha chasers.

Four major sources of negative alpha will be covered in today's discussion. No doubt, there are countless more that deserve additional consideration. Certainly, cost is an obvious example: all other things equal, the lower fee alternative will outperform; but, I think that is fairly self-evident. These four require a little more discussion as avoiding them requires considerable more effort than simply lining up expense ratios. They are:

1. Equity Concentration
2. Ignoring Rebalancing Opportunities
3. Chasing Winners
4. Cap Weighting in Stocks

Equity Concentration. Holding equities for the long run is a nearly universal mantra in our industry but there are many markets that appear to offer a "risk premium," ranging from commodities to emerging markets bonds, from real estate to timberland. Reliance on significant equity allocations, while ignoring these other markets, limits our ability to reduce portfolio risk through diversification. One of the best kept secrets in investing is the miniscule diversification achieved in the classic 60/40 traditional balanced portfolio. Due to their significantly higher volatility, sizable equity declines overwhelm bonds in this supposedly "balanced" construct. For this reason, the 60/40 mix has very nearly a 99% correlation with the S&P 500! If we use other "risky" markets selectively, opportunistically when they're offering premium yields, and on a scale large enough to matter, we can earn equity-like returns at far lower risk.

Not many recall the current decade as an easy time to make solid profits. Even the bull market from late-2002 until mid-2007 barely recovered the 2000-02 equity market losses for most investors. But as Figure 1 illustrates, for those who were not invested in an equity-dominated portfolio, especially those willing to stray outside of both mainstream stocks and bonds, many asset classes have delivered lofty returns. Indeed, most people would be surprised to learn that the average return of this list of markets was essentially the same: 9.3% per year in the first six years and 8.7% in the more recent six years!

Figure 1. Comparing Fifteen Markets from 1995-2006

Nearly every category produced meaningful positive returns except stocks and equity-centric balanced accounts. In contrast, all the equity indexes were down and a 60/40 passive mix provided a measly 4 percent cumulative return. The problem with 2000-2002 was not a lack of return opportunities but that one asset category (equities) performed poorly and practically everyone was wedded to an equity-centric portfolio with over-promised diversification benefits from small allocations to bonds and trivial allocations to other assets.

How much does this over-investment in equities lead to negative alpha? If we compare the 60/40 portfolio to an equally weighted portfolio of additional- REIT's, commodities, emerging market bonds, TIPS, etc. - asset classes, we find this new True Diversified Portfolio exceeds the 60/40 Portfolio by X.XX% annually over the last XX years with a significant reduction in standard deviation. Adjusting both portfolios for risk, the True Diversified portfolio's Sharpe Ratio of X.X trounces the 60/40's X.X. Which return stream would a rational investor desire? In widening the opportunity set to include meaningful allocations to alternative strategies, we can avoid the negative alpha due to an over-reliance on equities and likely earn meaningful excess returns.

Rebalancing. Buying low and selling high - through rebalancing - is a perennially underrated investment choice. Neglecting this simple exercise is an almost universal source of negative alpha, especially when we take account of risk. The strong tendency of the capital markets to mean revert translates to incremental profits, for those willing to sell their long-term winners and buy their long-term losers.

Still, it's not an easy discipline to embrace. Consider Figure 1 again. Imagine the courage required to sell the S&P 500 and buy Emerging Markets at the start of our current decade, after six years in which US stocks had risen 219% and Emerging Market Stocks had lost one-fourth of their value.

A disciplined rebalancing policy adds about a half-percent to risk-adjusted returns for a well-diversified portfolio. [I have written a couple of articles demonstrating this result, over long spans, which I will send to John and he will post in the future.] Suppose we started in 1995, with $100 in each of the fifteen asset classes listed above. By the end of the 12 years, our $1500 would have grown to $4412. If we did just one rebalance, halfway through the 12 years, putting one-fifteenth of our money in each of these markets, we'd have boosted our final wealth by $165, or 11% of our starting portfolio value! Remarkably, this result required one set of trades totaling just 12% of the portfolio, effectively an average of 1% turnover per year.

Of course, these excess returns solely accrue to those willing to look uncertainty in the eye and follow through. Indeed, eliminating the slippage is far easier said than done. The more comfortable course, "waiting for things to settle down," allows the asset mix to drift with the whims of the capital markets. In so doing, rebalancing opportunities are squandered with the portfolio suffering the associated negative alpha.

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Chasing winners. Chasing the latest investment craze is incredibly easy, as we are bombarded with success stories at every turn - the neighbor who got in on the hot IPO, our brother-in-law with his 30% hedge fund return last year, and the advertising campaigns of the top mutual fund companies, proclaiming their latest star performers (how often does a mutual fund company take out ads listing their best and worst five funds?!). Collectively, these stimuli lure us like a siren's song to chase the latest winners, be they asset classes, managed portfolios, or individual stocks. In the case of funds, the investment is often then sold at the bottom of its performance cycle, after it's become a "proven" loser. Inevitably, it is replaced with a "good manager" who has experienced strong results recently. Of course, these replacement firms' performance is near high tide and begins to recede not long after retention.

This practice is the equivalent of selling low and buying high and its damage to investor wealth is devastating. To quantify this negative alpha, we turn to a 2005 study by Russel Kinnel of Morningstar that dramatically illustrates the consequences of chasing winners ("Mind the Gap: How Good Funds Can Yield Bad Results," Morningstar Fund Investor, July). In 17 equity mutual fund categories, the average dollar weighted returns (return to the investors) were compared with time weighted returns (return to the fund) over the previous 10 years. Kinnel found every single category's dollar return trailed its time weighted return with the average slippage amounting to 2.8% annually- a damning indictment of investors' tendency to chase recent performance.

An example is probably in order, to illustrate the simple but nasty mathematics behind this shortfall. A small fund with $100 million of assets produces an excellent three-year return of 21% per year. Investors take note and, consistent with history, move money into this hot new portfolio so that over the next three years the fund's asset base swells to $1 billion. Meanwhile, the strong performance evaporates and the fund finishes with a 0% return in the next three years. On a time weighted basis, the fund delivered an average of 10% per year, compounded. But on a dollar weighted basis the fund earned a scant 1.9%, indicating a slippage of 8.1% per year. Kinnel's study showed annual slippage of over 11% for the average investor in Technology funds. Talk about impatient investors!

The urge to act upon recent successes and abandon yesterday's laggards is so incredibly powerful that most investors, individual and institutional alike, lose the requisite patience and throw away a sizeable portion of the equity market's return.

Cap-Weighting in Stocks. The last source of negative alpha happens to occur in the asset class where most investors have their greatest exposure - equities. As we will see, the indexes that we rely upon, by their very construction, fail to enjoy both of the previous sources of alpha. They do not rebalance when any stocks advance well ahead of - or retreat far below - their fundamentals. And they chase winners, by adding stocks to the portfolio after they've been on a roll and dropping them after they've faltered badly.

The shortfall from traditional active management in stocks is well-known: the combined handicaps of management fees and trading costs cause the average fund to underperform the S&P 500 by 1-2% per year over long periods of time. A revolutionary concept thirty years ago, this is common knowledge today and so investors have been increasingly driven towards index funds.

But stock index funds also incur slippage. Virtually all traditional indexes, and their associated index funds and ETF's, use market capitalization, essentially the total value that Wall Street assigns to the enterprise, to determine the weight each security receives. Those shares priced above their eventual intrinsic value (think AOL in 1999) will have an erroneously high capitalization and, therefore, a high index weighting. An indexed portfolio, weighted by capitalization, will invest most of our money in these stocks, each of which will eventually underperform as the market seeks out the intrinsic value. Stocks priced below eventual intrinsic value will have an erroneously low capitalization, hence index weighting, and will offer a performance boost. However, the relative losses of the overpriced stocks overwhelm the relative gains of the underpriced stocks because the underpriced stocks comprise less of the portfolio. In this manner, linking portfolio weight to security price - so that more than half of a capitalization-weighted portfolio will be in overpriced stocks - introduces a return drag.

Investors on both sides of the active/passive debate should be incredibly frustrated by this phenomenon. Some know there are mispriced stocks and so they seek out well-managed mutual funds to identify underpriced companies. Their hopes are, of course, dashed when these funds fail to perform despite an environment that provides numerous opportunities. Seeing these failures, the indexers eschew the performance game and invest in their cap-weighted market proxies. Their confidence shrinks when over time they see their reliable index reliably load up on shares of companies that are later proven to be dramatically overpriced.

The Fundamental Index concept was developed to address this structural return drag. By weighting securities on fundamental metrics of company size like sales or earnings, we sever the link between our allocation to a stock and its over- or under-valuation. Using a valuation-indifferent weighting scheme should leave the resulting portfolio with roughly equal parts overpriced and underpriced securities, even without knowing which ones are which! As these pricing errors are corrected, the relative gains and losses cancel each other out.

The construction is a relatively simple exercise. For example, if Microsoft's sales represented 4% of the top 1000 sales companies, it would receive a 4% weight in a sales index. In the Research Affiliates Fundamental Index (RAFI®), we repeat the same exercise for Microsoft with dividends paid, book value, and free cash flow. Taking a simple average of each company's relative scale in these four financial measures gives us a pretty good indication of its economic footprint. Market capitalization, in contrast, measures Wall Street's estimate of a company's long-term future growth prospects and future economic footprint, for which the market prepays as if that future is a fait accompli!

John Maynard Keynes was not only one of the most important economists ever, he was also a legendary investor. He said that he chose not to invest in speculations and expectations, preferring to invest in what companies own and produce. What better reflects the market's consensus for expectations and speculations than market capitalization weighting? What better reflects what companies own, produce, and deliver to their shareholders, than weighting our portfolio by companies' sales, profits, net assets (book value) and dividends?

In using such "Main Street" size metrics, the resulting Fundamental Index portfolio is largely representative of today's economy. To reflect the changing economy, the index is rebalanced annually. Furthermore, it retains virtually all of the positive attributes normally associated with passive investing - massive diversification, liquidity, transparency, and low turnover.

But most importantly, the structural negative alpha of overweighting overpriced securities and underweighting undervalued shares is gone. What's that worth? Over the forty-five year evaluation period in the US, the Fundamental Index concept produced excess returns of 2% with less volatility than similar cap-weighted indices in large company equities. Interestingly, it makes comparatively little difference which fundamental metric one chooses. Selecting and weighting companies by sales, by profits, by book value, by dividends, even by the number of employees, all produce results within 50 basis points per year of the RAFI composite. The sole outlier, capitalization-weighting, falls 220 basis points per year behind the average Fundamental Index result. That's enough to make the difference between making 80 times our money versus making 200 times our money, over the last 45 years. What an outlier!

Nomura Securities replicated this work in all 23 countries in the MSCI and FTSE developed world indexes, and found that it outpaced capitalization weighting in 23 countries out of 23, with no exceptions, by an average of 2.6% per annum over the span from 1988 to mid-2005. The Fundamental Index portfolio even outpaces capitalization-weighting in all ten of the global market sectors tracked by FTSE (technology, health care, capital goods, etc.), with no exceptions, from 1990 to date.

The Fundamental Index advantage only widens in inefficient markets like small companies and emerging markets. These markets have diminished coverage by Wall Street and institutional managers leading to a greater likelihood of pricing errors. The cap-weighted index suffers a greater return drag as the frequency and magnitude of mispricings proliferate - even more money is allocated to the overvalued and even less is allocated to the undervalued. Imagine a passive strategy outperforming standard benchmarks by 3.5% in small companies and nearly 10% in emerging markets; these are the historical results in these markets! This turns the whole notion of index investing upside down - no longer is the index fund an inferior choice in inefficient markets where the potential returns from active management are greatest.

Practicing What We Preach

Most wealth advisors have seen their clients drawn into the first three errors, the first three sources of negative alpha. Significant positive returns in equities, or any investment category for that matter, tempt clients to forgo proper diversification. Rebalancing often implies adding assets to the worst performers, what many refer to as "watering the weeds." But, as any gardener knows, weeds can grow like crazy! The stellar results of recent winners make them irresistible.

For this reason, investment policies are developed to mitigate these behaviors. The resulting stable asset allocation structures, automatic rebalancing procedures and long-term performance criteria are time-tested and theoretically sound investment practices. One of the main contributions that the best wealth advisors make to their clients' success is to effect these policies and, in so doing, to help their clients avoid simple and costly errors. They ensure patience, discipline, and commitment - three traits vital to long-term investment success.

The return drag associated with cap-weighting, however, is a relatively new concept in portfolio slippage. It has stirred massive controversy in the practitioner and academic communities, because it calls into question some of the core precepts of modern finance and challenges some of the best-respected (and largest) product areas in the investment world. But a sizable portion of the advantage of the Fundamental Index concept, is attributable to the fact that traditional indexes ignore the simple Investing 101 tactics we just reviewed.

The S&P 500 Index chases performance and allocates more of our money to recent winners. A stock that doubles in price gets double the weight solely because it doubled in price. How else to explain Cisco's weight in the index increasing from 0.4% to 4.0% in the last two years of the bubble? Did its weight rise ten-fold because it had become vastly more attractive, as its P/E rose from 30 to 130? Of course not. It's weight rose ten-fold because its price had risen ten-fold relative to the rest of the market. Ironically, as its stock price cratered, the company continued to deliver growth well ahead of the broad economy, but not enough to justify its astronomical multiples at that time.

The cap-weighted index doesn't practice periodic rebalancing, preferring to not buy low and sell high. The only time transactions occur is when new stocks are added and old ones deleted. Very often new stocks will be ones that have done well recently, not necessarily those that will do well in the future. And the deletions, unless they're takeovers, are inevitably companies that have fallen badly relative to the rest of the market.

Combined, the tendency to allocate more to recent darlings and bypassing rebalancing can lead to a relatively less diversified equity portfolio in times of bubbles and fads. As economic sectors surge in price, a natural side effect is a more heavily concentrated cap-weighted index portfolio. In extreme instances like the TMT bubble of 1998-2000, the outstanding diversification typical of traditional index funds is severely compromised. In the past half century, no economic sector that exceeded 25% of the S&P 500 ever delivered enough future success to justify that immense allocation. Technology in 2000 was the latest victim of this pattern.

Why emphasize these time tested methods - diversification, rebalancing and avoiding chasing winners - to asset classes and managers, and then turn around and invest in an index fund that largely ignores them in the cross section of the equity market?

The Fundamental Index concept meanwhile avoids returns chasing behavior, practices rebalancing, and achieves sizeable diversification even when it is out of favor. Stocks that double in price aren't automatically given twice the weight. The annual rebalance ensures discipline and, unlike traditional cap-weighted indexes, forces the portfolio to buy low and sell high. Outperformers are rebalanced back to their economic size with these proceeds invested in shares that have recently fared poorly. As most enterprises' share prices loosely follow their economic scale, annual turnover remains very low - almost as low as with capitalization-weighting. Weighting by fundamental metrics also bypasses the pricing bubbles that occasionally pop up in the equity market. All of this is accomplished in a formulaic and easily replicated manner.

Update - Fundamental Index™ Today

The Fundamental Index concept isn't just theory - it is being used by individual equity investors today in a variety of structures. With each passing month, the RAFI methodology is stirring up considerable debate and, we might add, tremendous flows of equity assets. I've never had the privilege to develop an idea which stirred so much controversy and comment, from both practitioners and academics, so quickly. Total RAFI-related assets have grown from less than $1 billion eighteen months ago to nearly $20 billion today (here, I include assets of others' products that we believe may infringe our pending patents).

The Retrospectives below show a handful of Fundamental Index applications, including US large and small, International, Pan-European, Japan, to name a few. There are other indexes, not shown, covering all 23 countries in the FTSE and MSCI developed world indices, NASDAQ companies, international small companies and 12 of the largest Emerging Markets. These are simple, passive index results, not the results for managed funds. RAFI strategies are distributed through our affiliates, who can provide the results on their own products. The Inception-to-Date results go back as far as FTSE, the global index provider has ratified these results; there are longer-term results, not yet confirmed by a major index provider, going back as far as 1940 in the US and 1984 elsewhere, which suggest similar long-term results.

This year, for instance, the RAFI™ indexes are ahead in all areas except US large companies. Even in US large companies, they lag by only 0.4%, despite what one hedge fund manager characterized as "the largest de-leveraging in history," which led many quant-value managers to underperform by sometimes immense margins. This small shortfall occurs after outperforming by over 5% cumulatively in the prior two years. The FTSE RAFI 1500 is ahead of the Russell 2000 by 150 basis points despite a nearly 900 basis point edge of small cap growth over small cap value. The diversified overseas variant, the FTSE RAFI Global ex-US Index, also is showing solid value-added amidst the year's volatility and value underperformance.

We think these results are compelling to any but the most committed advocates of efficient markets and conventional indexing. Keep in mind as you review this material that this is not stock picking, nor is it a quantitative active management model. It's just a "fundamentally" different sort of broad market index!

Conclusion

Getting Fundamental

(Back to John.) Thanks, Rob, for such a great article. As I mentioned at the beginning of the e-letter, I am a big fan of Rob and the concept of fundamental indexing. It is an idea that just makes sense. I think that we will look back in ten years and wonder why we used cap-weighted index funds. For those of you that have some of your portfolio in index funds, you should seriously consider switching to a fund that is a fundamental index style. You can get US large and small cap funds (and ETFs), European, Asian, Japanese, international, South Africa, various sector funds and more through ETFs and funds offered by Schwab, Powershares (ETFs), PIMCO, and AssetMark, all of which use Rob's fundamental analysis.

I can't get a lot more specific, as everyone has different needs and what may be the right approach for one person would be wrong for others, but in general, I would prefer to substitute a large cap US Fundamental Index fund or ETF for an S&P 500 index fund, as an example. Check with your investment advisor about what is right for you.

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New Orleans, London and South Africa

I know it sounds like I travel a lot, and I do, but for whatever reason, it seems to run in spurts. I will spend the weekend being tourist in Prague, then on to London. When I get back next Thursday, I have very little on my schedule for the next 9 months. I will be in New Orleans in October (as noted above), in La Jolla for my annual Strategic Investment Conference in April (co-hosted with Altegris Investments), and it now appears that I will be going to South Africa in May. I am sure things will come up, but for right now, my calendar is quite bare. I know my publisher will encourage me to use the time to finish my book, and I should.

I am literally on the plane as I write this, flying from Krakow to Prague. Krakow is a lovely city. I took a tour of the Wieliczka salt mine (http://www.krakow-info.com/wielicz.htm) that has been in operation for 700 years. We went down 135 meters (there is a sanatorium at 200 meters), and some 2,000 different man-made chambers, some of which are huge. An excellent tour, all around. Watching how they mined from medieval times was most fascinating, and gives you an appreciation for not only how truly difficult it was to live and work in another era, but the level of ingenuity of those times.

Earlier in the week I was in Warsaw, which has its own charms, but going through the maze that is the Warsaw Historical Museum and being confronted with the utter devastation of the city by the Germans in retaliation for the uprising in 1944 is sobering. Half of the 1.3 million residents of Warsaw, some 650,000 souls, did not make it to the end of the war. 90% of the city was simply rubble. It says something for the national personality of the Poles that they re-built the city.

I can hear the engines slowing down, so it is time to put the computer up, get to my hotel, find an internet connection and hit the send button. And maybe I can get another chapter of The Black Swan read. It is a most thought provoking book. Have a great Labor Day weekend.

Your enjoying the luxury of time to think analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

The Panic of 2007

JohnMauldin — Fri, 17 Aug 2007 08:08:00 GMT

The Panic of 2007

Muddle Through or End of the World?
An Alphabet Soup of Credit
Turning Nuclear Waste Into Gold (and Back Again!)
Mrs. Watanabe and the Hedge Fund Connection
The Rating Agency Blame Game
Where Do We Go From Here?
Hedge Funds to the Rescue!
Warren Buffett Needs to Take Over Moody's
Will a Fed Rate Cut Make a Difference?
Vacation, Europe, and Reading

End of the World or Muddle Through? This week I try to explain in simple terms the very complicated story of how we went from some bad mortgage loan practices in the US to the point of world credit markets freezing up. There is a connection between the retirement plans of Mr. and Mrs. Watanabe in Japan and the subprime problems of Mr. and Mrs. Smith in California. We find the relationship between European banks and problematic hedge funds. And finally, we try and see how we get out of this mess. Oddly, I think it is hedge funds (and maybe Warren Buffett) to the rescue, but not in the way you would think. It is a lot to cover, so let's jump right in. (And there are a lot of charts, so while this will print out long, it is only a little longer than the usual in word length.)

But first, since this letter is likely to be forwarded a lot, if you get this and would like your own free weekly subscription, you can go to www.investorsinsight.com and simply put in your email address. You can be one of my 1,000,000 closest friends who get this letter for free. We will send my Thoughts from the Frontline to you each Saturday morning, along with my Outside the Box, which features the writing of other analysts and comes out on Tuesday.

To say the credit markets are frozen is an understatement. Talking to any number of people who have been in the markets for decades, this is the worst in their memory. Ironically, it is the 100-year anniversary of the Panic of 1907, when one banker (J. P. Morgan) stepped in and provided liquidity to the markets. The central banks of the world are providing liquidity; but as we will see, it is not mere liquidity that is needed.

You cannot explain the problems with just one or two items. A perfect storm of this sort takes a number of factors all coming together to work its mischief. Bad mortgage underwriting practices, bad rating agency practices, a destruction of confidence, excessive leverage and then the withdrawal of that leverage, the need for yield, greed, and complacency which then in a Minsky moment (explained below) becomes paralyzing fear - all play their part.

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An Alphabet Soup of Credit

But let's start at the beginning. In the early '90s, investment banks created a new type of security called an Asset Backed Security (ABS). And it was a very good thing. Essentially, investment banks would take a thousand mortgages or car loans or commercial mortgages or bank loans and put them into a security. You could have a Residential Mortgage Backed Security (RMBS) or Commercial Mortgage Backed Security (CMBS) or a Collateralized Loan Obligation (CLO) and then a Collateralized Debt Obligation (CDO).

I am going to grossly oversimplify the following description, but the principle is correct. Let's take a look at how a Commercial Mortgage Backed Security is created. If you are a bank or institution, when you make a loan on a mall or office building, you incur a certain amount of risk. If you hold 100 such loans, you can almost be certain that some of those loans are going to be bad. Further, you are limited in the amount of loans you can make by the capital you have in your company. But what if you could package up those loans and sell them? You get your cash back, and then you can keep the servicing fees and make more loans. But who would want to take the risk of your loans?

Through a form of financial alchemy, you can take your loans and increase the quality of them to potential investors. Let's say you have $100 million in commercial mortgage loans. You take this pool and divide it up into 5-7 (or maybe more!) groups called tranches. The first group gets the first (as an example) 60% of the principal which gets repaid. That means that 80% of the loans would have to default and lose 50% (80% of the loans times 50% loss is 40% total portfolio losses) of their value before your money would be at risk. If the bank originating the loan is not completely asleep at the wheel, your risk of an actual loss is quite small.

So, an investment bank goes to a rating agency (Moody's, Standard and Poor's, or Fitch) and pays them a fee to rate that tranche in terms of risk. Since the level of risk is small, that first tranche gets an AAA rating. Then the agency goes to the next group. Maybe it is 10% of the pool. It would get all the principal repayments after the first group. In this case, 60% of the loans would have to default and lose 50% of their value before your group lost money. The ratings agency might give this group an AA rating.

This process goes on until you get to the lowest-rated tranches. There is typically an "equity" tranche which is about 2-4%. That tranche is the last group to get its money repaid. In our example, if 8% of the loans went bad and lost 50% (8% times 50% is 4%) of their value, the equity tranche would lose all their money.

Let's assume the average interest rate on the loans was 10%. Because of the lower risk, the investment bank putting the CMBS together might decide to pay the AAA-rated tranche only 7%. Each successive tranche would get a higher rate, as they were taking more risk. The equity tranche is priced to pay in the mid-teens (or more) if all the loans are paid off.

Now, insurance companies, pension funds, and other institutions can buy this security that pays an interest rate higher than they could get from a similar government bond. This difference is called the spread. And in the beginning, spreads were high, as not everyone was comfortable with these new-fangled investments.

To see what I am talking about, you can look at the chart below, taken from the open education source at MIT. You can see the whole chapter here.

Let's also notice something. In order to get someone to buy the lower tranches you have to pay them more. So, the more of the loans you can get the ratings agency to classify as AAA, the more interest you can pay to the buyers of the lower tranches to entice them to buy. This is going to become an important point. (I should note that it also means you can charge higher fees for putting the deal together and selling it to your clients.)

Now, this financial engineering is a very good thing. It is one of the reasons for the worldwide economic boom, as it allows capital to invest in all sorts of loans that would normally be considered too risky. And for the vast majority of all these various alphabet securities, the ratings are going to be just about right. AAA CMBS or CLO paper is where it should be. Even AAA-rated prime mortgage paper, which is now selling for a discount, will (in my opinion) turn out to be just fine.

Investment banks put together all types of asset-backed paper. Car loans, mortgages, business loans, credit card debt, etc. are all fair game. And you can mix and match risk if you like. The combinations are endless. So it can be quite a complex task to analyze what you are buying. And to a very great extent, that analysis was delegated to the rating agencies. For all practical purposes, institutional buyers would look at the general classification of the security and then at the rating. It was on the screen, so they hit the bid. If you can't trust your friendly neighborhood rating agency, then who can you trust? And most of these securities had ratings from at least two if not three agencies.

But (and you know there is a but) there is a problem with subprime-rated paper. In the beginning, subprime loans were made the old-fashioned way. You had to have 80% loan to value and show you had a job and could actually pay back the money. And these loans were packaged up into a subprime Residential Mortgage Backed Security. Eventually, 80% of those loans would get an AAA rating. Now, this means that 40% of those subprime loans would have to go bad and the value of those homes drop 50% before the holders of that tranche of debt lost money. Even with today's loose lending practices, that is unlikely. I think any rating agency is going to be able to justify that initial AAA rating.

But then in 2004 loan practices began to change and had got completely out of hand by 2006. In 2005-6, about 80% of subprime mortgages were adjustable-rate mortgages, or ARMs, also called "exploding ARMs." These loans are so-named because they carry low teaser rates that often reset dramatically higher, increasing the borrower's monthly mortgage payments by 25% or more. Let's look back at what I wrote in March in this space.

"Let's say I want to buy a $200,000 home. I can qualify for an option Adjustable Rate Mortgage (ARM) with a starter rate of 2%. I can pay interest only for the first year, and then the rate goes to 5%. So, I have an interest payment of $4,000 a year, or $333 a month. But starting the second month, the interest is actually at 5%, so the real interest amount is almost $10,000, and the amount on my mortgage grows by roughly $6,000 the first year. I now owe $206,000 on the home. If I put down just 5% as a down payment, I now owe more than I paid for the house, if you take out 6% realtor fees when I sell! But as the interest rate resets in the second or third year, it can go up to 8%. I am now paying $16,500 in interest, and my monthly payment for just the interest is $1,375.

"According to reports from loan counseling agencies across the nation, the main reason homeowners give for falling behind on their mortgage payments is not a change in personal circumstances (such as a job loss), but instead, they are not able to make the increased payments on their ARMs.

"The loan application and review process for 'no-doc' loans was so lax that such loans are referred to as 'liar loans.' In a recent report by Mortgage Asset Research Institute, of the 100 loans surveyed for which borrowers merely stated their incomes on loan documents, IRS documents obtained indicated that 60% (!) of these borrowers overstated their incomes by more than half.

"The newer mortgage products, such as 'piggyback,' 'liar loans' and 'no doc loans' accounted for 47% of total loans issued last year. At the start of the decade, they were estimated to be less than two percent of total mortgage loans. As a result, homeowners have never been more leveraged: the average amount of debt as a percentage of a property's value has increased to 86.5 percent in 2006 from 78 percent in 2000."

Ok, let's run the math. Almost 50% of the loans made last year were made with little or no documentation check, and 60% of those people overstated their incomes by more than half!!! That means 30% of the loans made were to people who were stretching to buy a home and whose actual income would not qualify them for a home anywhere close to what they bought.

The following chart from RBS Greenwich shows the amount of mortgages hitting the reset button in the next two years.

Research by RBS Greenwich (assuming I read it right) suggests that 20-23% of the subprime loans made in 2006 will go into default and foreclosure. I talked with one head of a mortgage brokerage business in California this week (he has over 800 brokers who work for him) and he thinks that home values in certain areas he services could drop by as much as 50%. Others in my area (Texas) think these defaulting home values will drop by as much as 20%. No one can be sure, as the supply of homes for sale is already very high and likely to get worse.

But let's look at what that can mean for a buyer of a lower-rated tranche of a 2005-6 vintage in a subprime RMBS. If 20% of the loans default and lose 30% of their value, the loan portfolio would be out a total of 6%. If defaults were higher, the losses could be more. 8% would not be a stretch. The problem is that the lower-rated tranches comprise as much as 8% of the total pool.

And that may be optimistic. The study done by RBS Greenwich reads: "Our cumulative default projection would translate to a cumulative loss of 10%-11.5%."

As I showed last week, there are already some 2006-vintage subprime RMBS's that have over 50% of their loans at 60 days past due, with over 25% already in foreclosure or having been repossessed. That is in less than a year, and the interest-rate mortgage resets have not even really kicked in! (To see those charts, you can go here.)

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Turning Nuclear Waste Into Gold (and Back Again!)

But that's not really where the problem is. Let's go to a great chart from good friend Gary Shilling (www.agaryshilling.com). In an effort to make it easier to sell the lower-rated tranches, the investment banks put together a Collateralized Debt Obligation (CDO) composed of just the BBB-rated paper. And then got the rating agencies to give 75% of that paper an AAA rating! So we have turned 75% of BBB waste into gold with the alchemy of ratings.

That means that if those RMBS lose just 5% of their value, everything but the AAA portion of the CDO is wiped out. Any losses beyond that start eating into the value of what a rating agency said was AAA! If the Greenwich projections are right (and these are very serious analysts), then all 2006-vintage CDO's will lose their AAA rating when the rating agencies look at them again. The new rating becomes "toast."

Who owns this stuff? According to Inside MBS, foreign investors own as much as 16% of the total mortgage securities. Mutual funds have about 16%. Oddly, for all the publicity, hedge funds probably have less than 5%. But they were leveraged, so the losses are magnified.

Mrs. Watanabe and the Hedge Fund Connection

If you live in Japan and are retired, investing in bonds is not all that exciting at rates that are barely 1%. But you can exchange your yen into all sorts of currencies that have investments that pay much higher rates. And of course, that makes the yen go lower, which increases your yield. You notice your neighbor is making very nice returns, and you open a retail currency account and start trading. 25% of Japanese currency trading is from small retail accounts.

If you are a hedge fund, you borrow massive amounts of Japanese yen at 1% and invest in higher-yielding investments and make the spread. Life is good. The trade goes on and on.

Hyman Minsky famously said that stability breeds instability. The longer things are stable, the more likely investors are to become complacent and risk premiums drop. Because of the lower yields, investors tend to over-leverage to try and keep up their returns. The markets are then likely to have a "Minsky Moment" of instability, and then risk premiums rise and all sorts of assets are repriced.

And that is exactly what has happened. The markets are de-leveraging. The yen carry trade is going away, and hedge funds and Mrs. Watanabe are driving the yen back up in as violent a move as I can ever recall. Look at the chart below of the euro-yen cross.

Notice the steady move up in recent months of the euro against the yen, and then a 12% correction in just two weeks! Ouch. Whether it was the Canadian or Aussie dollar, you were down big. And that is forcing a lot of funds to sell anything they can in order to meet margin calls. And since they can't sell their CDOs, they sell stocks, commodities, and anything that is high-quality. That means that assets that do not normally correlate with each now all move together. And the movement is down.

Groundhog Day For Hedge Funds

One of my all-time favorite movies is Groundhog Day, featuring Bill Murray, where the main character keeps living the same day over and over. One hedge fund manager I know in the credit sector says this whole credit cycle has been like Groundhog Day for certain types of hedge funds.

In February some of the lenders began to notice that the credit quality of some of the CDOs they were lending on might not be as good as that rating they had. So they went to the hedge funds and banks and said, "We are not going to offer you as much leverage as before and are going to make you take an extra 5% haircut on those bonds."

So the funds sold collateral to make the margin calls. And guess what? They had to take less than face value. And that lowered the value of those bonds on everyone's books. Which means the banks went to anyone holding those bonds and demanded more margin money and gave less credit, which created more selling and fewer buyers. The cost of hedging became expensive. It started a vicious cycle. In May, the Bear Stearns fund blew up, and the rout began in full earnest. The chart below is from www.markit.com. You can look at any of the scores of indices they track, and see that the problems began in February.

The above chart is of a BBB RMBS CDO (enough alphabet soup for you?) issued early this year! It is now down to $.33 on the dollar, and it may well go lower. Pools of senior bank loans are selling by as much as a 10% discount. All manner of debt is selling at significant discounts to what it was just 7 months ago.

The problem is, quite bluntly, that no one knows what the values of some of the mortgage-backed securities are. And if you don't know, you don't buy. And today, even very well-designed CDOs with no subprime exposure are selling at discounts, if they are selling at all. Senior bank loans are selling at an apparent discount to subordinated debt (which is not selling, so no one knows the value, so the "price" is the last trade).

And what about the banks that bought those CDOs? What exposure do they have? Are they in a fund or part of the bank capital? Do you want to lend them money on the overnight markets, for a few basis points more than government securities? The commercial paper market for many banks has simply evaporated. These banks depend on this market for their financing.

Last week, the Germans had to completely rescue an older, venerable bank which had a great deal of commercial paper and some off-balance-sheet funds which essentially made the bank's balance sheet negative. If you can't trust a German bank, who can you trust?

This has consequences. As of today, the largest mortgage lender in the US, Countrywide, is now only doing "agency" loans (Fannie Mae and Freddie Mac). Even the best of firms, like Thornburg, are having problems. If you want a nonconforming loan this week to buy a home, either subprime or over $417,000, you may have a very hard time.

The Rating Agency Blame Game

The ratings agencies have put 101 different CDOs on "watch," which is market speak for "we are probably going to change our rating." But that's a little too late.

In 2006, nearly $850 million or 44% (up from 37% in 2002) of Moody's Investors Service total revenue came from the rarefied business known as structured finance. In 1995, its revenue from such transactions was a paltry $50 million. Moody's took in around $3 billion from 2002 through 2006 for rating securities built from loans and other debt pools. The same pattern holds for Standard and Poor's and Fitch.

In short, the ratings agencies were making huge amounts of money from the investment banks for rating these structured products. And let's make no mistake about it, they were selling their name and credibility. Everyone knew what a AAA rating meant when it came to a corporation or a country. And even though there were disclaimers in the 500-page documents accompanying the CDO sales material, the investment banks were clearly pointing to the ratings as they sold that paper.

The entire process hinged on the credibility of the rating agencies. Somehow, no one seemed to think that the default rates from "no-documentation" and "liar" loans would possibly be different. I am sure you can find a paragraph in the offering documents which will make that contention, at least obliquely. Lawyers are good at that stuff. But that is entirely beside the point.

Credit markets function because there is the belief that if you lend money you will get it back. Ratings are the grease for those markets. Now they have become sand in the gears. If you are a bond buyer on an institutional desk, do you want to risk a career-ending move and buy a bond that you are not ABSOLUTELY sure it is what you think it is? Do you want to buy 3-month commercial paper for a few points of spread from a bank or corporation about which you are not 100% sure? Just how solvent is that bank? So, you wait and go to US government bonds in the meantime.

If you are in Europe, you worry about your money market fund. In the US, you think about your CD at Countrywide if it is over $100,000. Everyone gets nervous, and central banks everywhere have to step in and offer massive amounts of liquidity, as they should.

Where Do We Go From Here?
Hedge Funds to the Rescue!

This is not the end of the world. I actually think things should sort themselves out by October or so, given no new major surprises. But how do we get back to normal markets?

It might be helpful to look at how we got out of the savings and loan crisis in the late '80s. As everyone now knows, Congress changed the rules and allowed local savings and loan thrifts to finance all types of debt. They jumped in with both feet. Many were very bad at assessing risk and went bankrupt. The government had to step in and bail out the depositors. The assets of the collapsed savings and loans went into the Resolution Trust Corporation (RTC).

I had friends who made a great deal of money in that market. They would walk into the RTC offices. There would be two-foot stacks of manila folders, each folder representing a loan. You could go through the files and then make a bid for the whole stack.

Quite often, in the file there would be checks from good borrowers who kept sending in their check for the car or boat. Since the S&L was gone, there was no one to cash them. People were paying $.15 cents on the dollar for good loans, and working out the rest. Now, some of the loans were indeed 100% write-offs. But a lot were not. But there were so many that the RTC simply took high bid and went on to the next pile.

I also had a friend (whom I have lost touch with) that bought half a dozen older apartment complexes that needed work. He got them for very little cash, put his own work into fixing them up, got them certified as lower-income housing and then got government-guaranteed rent. He was able to retire in a few years.

The same process needs to happen in the credit markets. First, we need someone to step in and actually make a market for the downgraded credits. Who is that going to be? Mutual funds? Investment banks? The Fed? No, no, and no.

The answer is that it will largely be distressed-debt hedge funds, both those that exist today and the scores that are being formed as I write. There are bonds and loans, various CDO securities, CLO funds, etc. that are seriously mispriced because of the lack of liquidity and transparency. When you can buy a loan today for $.94 that has a 99.9% chance of being good, you simply take the interest and get the extra return for allowing the loan to go back to par. Even modest leverage produces very nice returns.

Savvy distressed-debt managers will go in, look at the paper, and buy it. This time, instead of manila folders it will be electronic files. But with a lot of work, someone will be able to assess the value. Of course, the bad paper needs to be written down and off the books. There will be little appetite for a lot of the riskier paper.

Also, the structure of many CLOs will help. Most CLOs are formed and have a finite life. But for the first 5-7 years, they take the principal repayments and reinvest those dollars in other loans. CLOs that are getting cash today are finding good values.

Warren Buffett Needs to Take Over Moody's

Second, the rating agencies need to restore their credibility. Warren Buffett's Berkshire Hathaway owns about 19% of Moody's. I would suggest that Mr. Buffett step in take over the company (much as he did with Salomon years ago) and put his not inconsiderable credibility on the line for all future ratings and the inevitable re-ratings that are going to be done.

The Panic of 1907 was solved by the credibility of one man, J. P. Morgan, who stepped in to provide liquidity. The Panic of 2007 is not a problem caused by lack of liquidity. It is a problem caused by lack of credibility. Morgan could (and did) provide liquidity. Buffett can (and should) provide credibility.

And someone of similar stature needs to step in at S&P and Fitch. (Can Volker be summoned into the trenches yet one more time?) This is not about whether some person or group at the ratings agencies necessarily did anything wrong, although more than a few lawyers will suggest just that. This is about restoring credibility to the ratings and markets as soon as possible. Without someone new at the head, future ratings are likely to be viewed with the skeptical (and correct) question, "Is this from the same group of people who rated that bond that I bought just a few months ago that is down 50%? Why are they right now? Where is the adult supervision? Who has made sure the process is now working?"

The SEC has announced that they will allow mortgage lenders to work out resetting mortgages with borrowers in cases where there is an obvious default about to happen. In many cases, that will mean extending the lower coupon rate another year. That may just put off the problem, but it will keep a home off the market and allow for a more orderly solution.

Will a Fed Rate Cut Make a Difference?

A rate cut will not make a difference as to the credibility of the ratings, nor will it transform bad debts into good ones. But my view has been for a year that the economy is heading for a recession due to the housing market problems. Given the turmoil in the markets, a rate cut may be in the offing later this year. And given that lower rates will make mortgages cost less, that will help.

The significance of today's cut of the discount rate, and the willingness to look at up to 30 days of loans and high-quality asset-backed paper, is not the actual cut but more the boost to confidence. It is the Fed saying to the market, "Daddy's home. Everything is going to be all right."

Beyond that, let's look at what Nouriel Roubini says today in his blog about the Fed move to cut the discount rate:

"More important than the symbolic 50 basis point cut in the discount rate was the move in today's FOMC statement from the semi-neutral bias of the last few months ('semi' as inflation was still their predominant concern until recently) to a clear easing bias today. Essentially today the Fed telegraphed a certain Fed Funds rate cut at the September meeting and possibly more cuts in the months ahead.

"The statement was very clear in signaling an easing bias and a policy cut ahead: 'Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth forward. The statement also pointed that 'the downside risks to growth have increased appreciably.' And it clearly signaled that the FOMC is 'prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.'

"The stress on the downside risks to growth and the failure of the statement to even mention the 'I' word (Inflation) suggests that, in about a week since the previous FOMC meeting, concerns about inflations as the predominant risk have faded and concerns about growth have sharply increased. For a Fed that until recently was in the soft landing camp (slowdown of growth but still moderate pace of growth) today's statement is a signal that they are starting to worry about a hard landing of the economy.

"For the first time in over a year the Fed is now implicitly admitting that they underestimated the downside growth risk: until now the official Fed view was that the housing recession was contained and bottoming out and not spilling over to other sectors of the economy; and that the sub-prime problems were also a niche and contained problem. The sudden shift to a strong easing bias suggests that the Fed miscalculated until now the damage to the economy and to financial markets of the housing recession and its real and financial spillovers."

While I am not so sure that the Fed will cut in September, they have signaled that they are aware of the problems, as noted above.

As an answer to my opening question, I think we are in for a return of the Muddle Through Economy rather than the End of the World. Credit markets will get back to normal, as there is a lot of money that needs to find a home. It is just looking for a credible home and one that will feature higher risk premiums and spreads.

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Vacation, Europe and Reading

I am off to Europe (London, Denmark, Poland, and the Czech Republic). Other than a speech and a few meetings, I actually intend to take a vacation and do some sight-seeing. In my absence, though, Thoughts from the Frontline will still be coming your way. Next week, it will be written by Barry Ritholtz and the following week by Rob Arnott, so you are in better hands than mine. And Michael Hewitt is going to do the Outside the Box on September 4, about how the credit markets are doing.

And thanks to the hundreds of readers who sent in suggestions as to what books to read on my vacation. I made a new folder to save them, as many of you suggested books that I have always intended to read but not gotten around to.

Tonight I have to hurry home, as I have dinner with friends and then off to The House of Blues. I see margaritas and tacos in my near future, and some much-needed rest in the next few weeks.

All the best, and remember that the world is not in all that bad a shape. We just have to work through a few kinks, and Muddle Through is still moving forward.

Your enjoying the ride analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

The Fugu Ultimatum

JohnMauldin — Fri, 10 Aug 2007 08:07:00 GMT

The Fugu Ultimatum

In the early fall of 1998, I remember being on a flight to Bermuda from New York. I was upgraded and sat next to a very distinguished looking gentleman. He was going to a conference about re-insurance and I was going to speak at a large hedge fund conference. We hit it off, and began a very interesting conversation, one that still burns in my mind today. It turns out that he was vice-chairman of one of the largest insurance firms in the world, and was a real financial insider, seemingly knowing every big name on Wall Street personally. After he had a few drinks (he was clearly somewhat stressed), he began to talk about the Long Term Capital Management fund and the problems in the markets. He had had a ring side seat at the Fed-sponsored bailout proceedings.

"We came to the edge of the abyss in the financial markets this week,' he told me, "and then we looked over. The world does not understand how close we came to a total meltdown of the markets."

This week we look at the similarities and the differences between the credit crisis that is going on today and what happened in 1998, take a quick look at the threat from China to the dollar and see what exotic fish and exotic bonds have in common. There is a lot of ground to cover, so let's jump right in.

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China - Upping the Rhetorical Ante

Early this week the currency markets were roiled as not one but two senior Chinese officials publicly advocated using China's large dollar reserves as a political weapon should the US attempt sanctions on Chinese goods if the renminbi is not valued higher against the dollar. The two were senior officials at Chinese think tanks. Shifts in Chinese policy are often signaled through key think tanks and academics.

He Fan, an official at the Chinese Academy of Social Sciences, used uncharacteristically strong language, letting it be known that Beijing had the power to set off a dollar collapse if it choose to do so.

"China has accumulated a large sum of US dollars. Such a big sum, of which a considerable portion is in US treasury bonds, contributes a great deal to maintaining the position of the dollar as a reserve currency. Russia, Switzerland, and several other countries have reduced their dollar holdings.

"China is unlikely to follow suit as long as the Yuan's exchange rate is stable against the dollar. The Chinese central bank will be forced to sell dollars once the yuan appreciated dramatically, which might lead to a mass depreciation of the dollar," he told China Daily. (London Telegraph)

This comes as the US Congress will consider legislation that will implement tariffs on Chinese goods if China does not revalue its currency. Given the level of rhetoric from both political parties and presidential candidates, it is no wonder that China is finally responding with a little rhetorical shot of its own. After smiling at the editorial cartoon below, let's look at the likelihood of such an event.

China has an estimated $900 billion in US dollar reserves. There is no doubt that if they did decide to sell a few hundred billion here or there, they could push the dollar down against all currencies and not just the renminbi. That would also have the effect of increasing US interest rates on not just government bonds, but mortgages, car loans and all sorts of consumer credit.

Given the current state of the credit markets, that is not something that would be welcome. But it is not likely for several reasons. First, it is not in their best interests to do so. It would hurt the Chinese as much as the US, as it would devalue their entire dollar portfolio and clearly do damage to their number one export market - the US consumer.

Secondly, it is unlikely that the US will actually be able to get such legislation passed into law. Even if such legislation passed Congress (an admitted possibility) it would be vetoed by President Bush. That means that any real change would not be possible until some time in the middle of 2009.

The renminbi has already dropped almost 10% in the last two years since the Chinese started their policy of a crawling peg. For reasons I outlined at length a few weeks ago, it is likely that the Chinese are going to increase that pace over the next two years, for their own internal reasons. A higher renminbi valuation helps them slow their economy down from its way too fast pace of growth that is evident today. (If you would like to see that analysis, click here.)

By the time any real legislation could get passed, the renminbi will be very close to the level where the China bashers in Congress want to see it, if it is not already floating. Hardly enough to want to start a trade war at that time.

But let's look at what the bi-partisan economic illiterates in Congress are actually advocating. First, they whine about lost American jobs. But a 25% higher renminbi is not going to bring any manufacturing jobs back. China is no longer the low cost labor market. There are other Asian countries with lower labor costs. We just will not be able to competitively manufacture products that have high unskilled labor costs.

But we will continue to manufacture high value added items in a host of industries where skill and talent are required. Even though manufacturing as a percentage of US GDP is down, our actual level of exports and manufactured products is up by any measure. It is easy to write about the closing of a plant, and it makes the headlines, but the fact is that free trade has created more jobs by far than we have lost.

Secondly, if our cost of imports were to rise by 20-25%, that cannot be understood as anything but inflationary. And it would not just be Chinese products, but the products of all developing countries. Many Asian countries manage (manipulate) their currencies to keep them competitive against each other and the Chinese. You can bet that if the renminbi rises another 20%, there is the real prospect that they all will.

And much of what China and the rest of Asia produces is bought by those on the lower economic rungs of the US ladder. So, if Congress gets its way, they would be advocating putting pressure on those least capable of paying higher prices. But no one lobbies for the little guy. Congressional members can pander to their local unions and businesses without having to answer for what would be higher prices.

And higher prices means more inflation which means that interest rates have to be higher than they should, which means higher mortgage rates, etc. Protectionism has a very high cost. Free markets create more jobs everywhere.

Finally, we should hope the Chinese continue to allow their currency to rise slow and steady. Neither country needs the turmoil a rapid rise would induce. The world needs a stable China. We are watching world credits markets freeze up because things went very bad very quickly in the relatively small subprime world. A 20% drop in the dollar in a few months would be even more catastrophic. Senators Lindsey Graham and Chuck Schumer are competing to be this century's Smoot and Hawley that creates a depression from trade wars where none should be.

The danger in all this is that politicians who have little economic literacy create a hostile environment with their rhetorical poison, with both sides feeling the need to play to their "home crowd." That is a very dangerous environment.

It won't happen, but I would like to see the following question asked in the presidential debates to those (like Hillary Clinton, Obama and Dodd, etc.) who basically advocate a weaker dollar.

"Why are you advocating a weak dollar policy? Why do you want American wage earners to pay 25% more for the goods we buy from foreign countries? Do you really think there is no connection between the value of the Chinese currency and the rest of the currencies of the world? Do you think American consumers need to send even more money overseas and get less for our dollars? Do you think the American consumer is so well off they can afford to pay more and that it will have no affect on the US economy? Do you realize that a 25% lower dollar will mean a rise in world oil prices? Do you think there is no connection between the value of the dollar and US prosperity?"

I won't hold my breath.

Back to 1998

Let's get in the Wayback Machine and revisit 1998. (For reference for my foreign readers, the "Wayback Machine" originally referred to a fictional machine from a segment of the cartoon The Rocky and Bullwinkle Show used to transport Mr. Peabody and Sherman back in time.)

First, there was the Asian currency crisis and then Russia looked like it would default on its debt, causing a crisis in the credit markets. A hedge fund called Long Term Capital Management had leveraged their bond positions about 80 to 1 based upon the relationship between certain types of bonds always, emphasize always, converging upon a certain price. They diversified on bonds throughout the world as an "extra" protection.

Except that the markets in the fall of 1998 were not acting as they had in the past. The relationships changed just a very small amount, but if you are leveraged 80 to 1, then small is enough to wipe you out. The Nobel Prize winners who designed the system overlooked the possibility that the market could become irrational.

Fast forward to 2007. Again, the credit markets are in turmoil, and the subprime mortgage problems are spreading, as predicted here last January. Let's look at some things that are similar to 1998.

First, normal relationships between certain types of bonds have been turned on their head. For many companies who go into the credit markets, there are different types of debt they sell. Certain types of bonds or loans are considered "senior" because in the event of the company going bankrupt, they get paid first. Then debt that is subordinated to the senior debt gets paid, and lastly the shareholders get to split what is left over, if anything.

So, clearly, it stands to reason that senior debt is more valuable than subordinated debt. Why would you pay more for the riskier debt? So, if you want to put on a hedge, you can "go long" the senior debt and "go short" the subordinated debt. And in the past, that works.

Except not this time. There are a number of funds that are having real problems and are being met with high redemptions because they are exposed to the subprime markets. But no one is buying the subprime debt, so they have to sell what they can to meet redemptions. And what sells? The quality senior debt. At a discount, of course.

So, if you are another fund holding that debt instrument that just traded down, you just saw the value of your high quality loan or bond drop. But because the subordinated debt you sold as a hedge is not trading, there is not a price for it, so you can't show the profit there should be on the pair trade. Your fund is down for the month. Bummer.

Now, if you are not over-leveraged and forced to sell, you can wait a few weeks or a month and the normal relationship will come back. And you may even benefit as quality will rise even as the riskier instruments fall. But until there is a price made on your hedges, you cannot just make up a price based upon normal rational markets.

And if you are in the lucky position of having cash, you can go in and buy very good debt at a fire sale price today. There are a lot of debt instruments of very good and profitable companies that is on the market for much less than what it will be in a few months when things get back to normal. And if you are a company with cash, you may be able to go back in and buy your debt at a discount.

Energy and currencies can bring prosperity. We've combined both.

The End of the Quantitative World

I should first note that the average hedge fund made money in July, and some did quite well. There are a number of hedge fund strategies that have the potential to benefit in this type of environment. That being said, if a fund has invested in the subprime mortgage space (unless they are short), they are losing money. It is easy to see the relationship between the subprime mess and the funds that invested in it. But there are other funds which are losing money, and the connection to the subprime markets is less clear.

There are any number of statistical relationships which have simply not functioned as they have in the past. Large quantitative hedge funds that employ teams of mathematicians and physicists to develop complex "black box" trading programs to computer trade on these relationships are finding themselves losing money. As Spencer Jakab writes:

"Quantitative hedge funds running 'black box' models are primarily market neutral, seeking to exploit small inefficiencies in valuations and historical volatility between similar securities. A period like the last few weeks would have typically seen such funds outperform most of their peers in the hedge-fund community, but they have instead shocked investors with steep losses.

"Because risk managers were able to demonstrate that they were less risky, on paper at least, they were allowed to use far more borrowed money than other leading hedge fund strategies. Some are clearly overextended. 'The inherent leverage is killing them,' said a broker at a major investment bank who deals with hedge funds."

"Analyst Matthew Rothman of Lehman Brothers wrote that the models are working in exactly the opposite way they should to protect a black box fund in an up or down market. 'It is not just that most factors are not working but rather they are working in a perverse manner,' wrote Rothman. 'The names that are short are outperforming, often notably, while the names that are long are underperforming, although less severely.'"

Goldman's Global Alpha, which has been losing money for two years, is down 26% for the year and down almost 40% since the end of July. It is not surprising they are being hit with redemptions. And that forces them to sell. Many of the largest hedge funds are the very quantitative funds that are being forced to sell, putting pressure on the markets.

In 1998 problems in Asia and Russia spread to the rest of the markets, affecting Norwegian bonds and US stocks. It took a few months to sort out, and a lot of people lost money. Today, problems in the subprime mortgage markets spread to other credit markets and the affect is spilling over into stock markets.

But there is a difference. Today, instead of one fund that was at the epicenter of the problem, the problems are spread around the world among scores of funds and permeate the largest institutional and pension funds. While that means the losses are spread among thousands of investors, it also means that central banks can't bring everyone to the table to "fix" the problem.

The problem of the last two days was triggered by BNP Paribas telling investors in three of their funds that they would not be allowed to redeem. This simply froze the European markets. The European Central Bank has injected $211 billion into their system. Central banks have put $339 billion into the world system in the last 48 hours. And you should be very glad they did, by the way.

I heard on TV that some are saying the Fed is bailing out banks. Not they way I read it. They are simply taking short term "repo" paper for a few days to inject liquidity. If you are going to have a central bank, then this is a proper action. The fact that the excess liquidity which produced the bubbles can be laid at the Greenspan Federal Reserve's feet is a topic for another day.

And while we are on the topic, I think BNP Paribas probably did the right thing. They have funds which have invested in all sorts of credit vehicles. Nothing is trading, so if they tried to meet redemptions, they would have to sell assets at much distressed prices, and then guess at what prices the other assets should be valued at in the absence of a market price. If they guessed to little, then those exiting would lose too much, notice their losses were too high and sue. If they guessed too high, then those remaining would notice that they lost more than they should have and then sue. BNP was in a no win situation. To be fair to all investors, they have to wait until the market prices the assets in their portfolio.

They have not said what those assets are. If they are not US mortgage related it is likely they will turn out ok. If there is subprime in the mix, they will take significant losses.

Subprime for a Long Time

And one last difference between 1998 and today. Back then, the problems in the markets became known and were priced into the markets in relatively short order. It is going to be several years before we know the extent of the subprime losses. Remember the table that I used last week which showed the bulk of subprime mortgage interest rate resets was not until the first half of 2008. It is going to take years for the markets to know what the losses on the subprime will actually be.

And it is not as if it should be a total surprise. Any investor can go to their Bloomberg and pull up a listing of subprime Residential Mortgage Backed Securities. There are 2,512 of them. If you sort by the ones with the most loans over 60 days past due, you find that the average RMBS has 12.39% of their mortgages over 60 days, and 2.39% have already been repossessed (REO in the next table), with almost 5% in foreclosure.

The table below shows the RMBS with the highest level of 60 day past due (or worse) mortgages in them. Yes, the worst two offenders are the 2006 vintage of RMBS. But notice that a lot are from 2000, 2001, 2003 and earlier, well before the supposedly lax standards of the past few years. The third listed RMBS, the INHEL 2001-B is selling at 18 cents on the dollar (you can't see this from the table), and has been dropping since 2003. Over 25% of the mortgages in that portfolio have already been repossessed or are in foreclosure, with another 25% past due for over 60 days. Can you say ugly?

But you can also find paper from 2001 that is not doing badly. It should be clear to anybody who did a little due diligence a few years ago that there were problems in the subprime RMBS markets. There was a great deal of difference in the quality of various offerings. So it paid you to do some homework. If you could not get transparency, then you were taking a gamble.

That being said, many of the European and Asian institutions who bought this paper relied on the credit rating agencies. They relied on the models built by the investment banks that put this paper together. As I have written, they sold their AAA rating but put legal language buried in the documents that basically said, "OK, this is not what we mean by AAA in our other ratings." The document for the RMBS mentioned above was 300 pages of fine print. I will bet you that the vast majority of people buying this paper did not read it or understand what they were reading if they did.

You can bet lawyers all over the world will look at this same screen I show below. They are then going to ask the bankers and credit agencies how they could put such a high rating on the paper seeing the problems in these securities? "Really, you didn't look at the lending standards?" It's all hindsight, of course. But that's what lawyers do. And in front of a jury, it will be a tough day for the banks and credit agencies.

And let's close with a few paragraphs written by my friend and partner Jon Sundt of Altegris Investments. I think this is one of the better pieces I have seen looking at the complex environment we are in today. Most of the press tends to greatly oversimplify and lump all funds, banks and bonds into one category, when the truth is there is a lot of difference. Full disclosure, Jon and I and the rest of my international partners are in the business of finding hedge funds for clients, so we have both an inside view into what is going on, as well as a clear bias. I am proud of the job that Jon and his team have done and happy to be associated with them. That being said, let's read Jon's take on the situation.

The Fugu Ultimatum

"Indeed, if you look at the indices for different hedge fund strategies out there, you will find a large dispersion of results for July, with some strategies gaining money and some losing money. The differences between a long/short US manager, a multi-strategy Asia manager, and a leveraged CDO manager are too numerous to mention in this article, but the press would have you believe that these managers are all bound together.

"Let me reinforce my point with a basic but very appropriate analogy. In Japan, there is a distinctive puffer fish called the Fugu. It is served in special sushi restaurants by master chefs. Fugu tingles in your mouth when you eat it. It is supposed to be an exotic aphrodisiac in Japan, where diners spend hundreds of dollars a serving to eat it. The problem is that eating Fugu can kill you. There is an old saying in Japan, 'I want to eat Fugu, but I don't want to die.' People have been known to literally drop dead in sushi bars from cardiac arrest and pulmonary failure if the Fugu they ate wasn't prepared correctly. You have to be a specially trained and licensed Fugu chef to prepare and serve it. Personally, I would want to see the stats of the chef before eating Fugu...just a simple 'number of customers killed' would work for me.

"Now imagine a family in your town called the Griswolds. (You may remember them from the National Lampoon 'Vacation' films.) Suppose for their next trip, the Griswolds decide to travel to Japan and pursue some gastronomical thrills and eat the infamous Fugu. So they do some cursory research, march into a Tokyo Fugu restaurant, plunk down $1,000 and order a huge plate of Fugu. And die on the spot.

"The next morning as you sit at your breakfast table sipping coffee, you read the following headline:

"LOCAL FAMILY DIES EATING EXOTIC POISONOUS FISH IN TOKYO"

"You think to yourself, no problem... you continue sipping coffee... and maybe mutter... 'They should have known better.'

"Now imagine instead that you read the following headline:

"LOCAL FAMILY DIES IN FISH RESTAURANT"

"Your reaction may be very different. You are likely going to cancel your reservation at the local sushi bar until you hear more. What if all fish are tainted? Or is it just that restaurant? Or is it a specific type of fish? You'll have lots of questions, and you might assume, until you know more, that no fish are worth eating.

"My point is that events like these and potential losses should not come as a surprise to knowledgeable and well-educated investors, whether in Bear Stearns' funds (the current focal point of media attention) or other funds. The name of one of the Bear Stearns' funds was 'The High-Grade Structured Credit Strategies Enhanced Leverage Fund.' If this name alone didn't suggest possible concentrations in potentially high-risk investments, I don't know what would. According to one Citibank report, the fund at one point was 80:1 leveraged! In March of this year, the subprime story was all over the news. At a time when most news sources were already talking about interest rate increases hurting subprime borrowers, Bear Stearns appears to have been marketing a fund that invested in illiquid/exotic mortgage credit instruments with high levels of leverage.

"While I don't personally know the full details behind the reasons Bear sponsored this fund, it is clear in my mind that investors seem to have been taken by surprise as to what they had invested in. As I see it, and to return to my analogy, this fund may have been serving up large plates of Fugu to investors clamoring for a bite. The 'diners' appear to have either been unaware of the risks, or more likely, had not seriously considered what could, and in fact did, go wrong.

"Not all CDOs have danger written all over them, but those backed by subprimes would, with the benefit of hindsight, seem to have been quite clearly headed for trouble. It is a very narrow and specialized breed of hedge fund that trades in such a space. Like a sushi 'Fugu' bar, such investing is not typical of all hedge funds. That doesn't mean there aren't billions of dollars exposed to it... it just means it isn't your everyday long/short hedge fund."

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90 Years and Still Going Strong

It's time to hit the send button. Tomorrow is my mother's 90th birthday. She is still going strong, with two new knees and two new hips. She had an amazing and difficult life. Born on a Mississippi cotton farm, she joined the Women's Army Corp (yes, my mother wore combat boots) and met my Texan Dad in Europe. Dad became an alcoholic when I was young and mother had to assume the responsibility for many years to support three kids until Dad joined AA and was able to work steadily again.

She never complained. She just met her life with a simple faith and trust. I remember getting up every morning in Bridgeport, Texas. In the winter we would stand shivering in front of the Dearborn gas heater while she read the daily bible passage. I learned to work watching her, and learned to love to read when our TV died and we were too poor to have it fixed. Life was good.

I leave for Europe in ten days. After meetings in London and a speech in Copenhagen for Jyske Bank, I am going to visit Poland and the Czech Republic, two countries that I have wanted to visit for a long time. It will be fun to be tourist for ten days and lots of new friends to meet.

I usually like to read sci-fi when I am on vacation, but there is not a lot that interests me now that I have not already read. So, I will do some more serious reading. I will pack The Black Swan. I am going to look for a biography of George Washington. And I am looking for another biography or two to take as well. I am open to suggestions.

Have a good week. And remember that family and friends are the most valuable credit you can have.

Your planning on making it to 90 and beyond myself analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

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Association of Investor Awareness - Week of 11/06/2008

The Rally May Have Legs – Or Not!A Banquet For Value InvestorsDividends Shine In This MarketA Yield Bonus That Few Investors ConsiderThe Bluest Of The Blue ChipsLove Those Dividend AristocratsThe Bottom Line This Week

The Rally May Have Legs – Or Not!

A Banquet For Value Investors

Dividends Shine In This Market

A Yield Bonus That Few Investors Consider

The Bluest Of The Blue Chips

Love Those Dividend Aristocrats

The Bottom Line This Week

Fighting Deflation Instead of Inflation?

How do You Spell Stagflation?

How do You Spell Stagflation?

Cooking the Inflation Books

Gaming the Producer Price Index

Consumer Spending is Up, but then Again, It May Be Down

A Two Dimensional Problem

Saudi Justice

New York, Toronto, Europe and Thanksgiving

The Return of Muddle Through

Sea Change at the Fed

The Black Swan

Should the Fed Cut Interest Rates?

Hope Is Not a Strategy

The Panic of 2007

The Fugu Ultimatum

The Rally May Have Legs – Or Not!
A Banquet For Value Investors
Dividends Shine In This Market
A Yield Bonus That Few Investors Consider
The Bluest Of The Blue Chips
Love Those Dividend Aristocrats
The Bottom Line This Week