Survival

For the past 10 years, investors have lost money. The chart below indicates the net annual nominal yield (including dividends) with monthly compounding for 10 years. For the 10 years ended in December 2008 and 2009, the yield was a negative -1.58%, and -.89% respectively.

Factoring in the inflation rate (as measured by the Consumer Price Index) it was even worse, with a negative yield for the 10 years Ended December 2008 and 2009 of -4.09% and -3.45%. So much for the buy and hold theory.

The Table below shows various percent changes for the 10 years ended 12/31/08 and 12/31/09 and the related nominal annual yields compounded monthly. The Gross National Product grew at 4.64% and 4.29% respectively. The Inflation rate as measured by the Consumer Price Index was 2.53% and 2.57%. Commodity investments provided a 1.83% and 5.25% yield. Gold (the best of the best) yielded 10.48% and 13.85%. New homes (based on price only, assuming no carrying costs) yielded 4.10% and 2.97% while the US dollar collapsed, declining 16.76% and 27.50% for the 10 years.

Even high quality stocks such as Cisco Systems, Coca-Cola, Microsoft, General Electric and Bank of America provided negative yields for 10 years. It is highly unusual for any ten year period to provide negative yields in common stocks. What’s going on?

The Federal Reserve policy of low interest rates and easy money has fueled the “era of the bubbles.” The creation of retirement plans many years ago created a new demand for stocks. Mutual funds started popping up that were more than willing to handle Employee Retirement Plans. Then for an encore, Exchange Traded Funds (ETF’s) were created to give investors access to any type of investment desired. Today there are quotes from Mutual Funds, and ETF’s that fill 3 pages of the daily newpapers. Today the average investor can invest in Brazilian Reals, Platinum, Gold, Natural Gas and Oil – all through Mutual Funds or ETF’s. It’s no wonder that America does not produce anything any more. The United States has become a service economy.

There are too many Mutual Funds, and ETF’s, all competing for investor dollars. Their only business is to own stocks, bonds, and real estate, regardless of whether such investment medium is reasonably priced. In fact I submit the continuous buying has created bloated stock values.

The current high priced stock market is just another bubble. The bubble is fueled by low interest rates, complacency, and easy money. The stock market wins by default because there are no other alternatives. Where do you put your money? Real Estate, Commodities, Gold, Debt instruments? In my opinion the stock market is overvalued and will decline materially from current levels.





Dr. John Hussman (hussmanfunds.com) referring to the current stock market notes that “Most of what we are seeing now is a tendency to make marginal new highs, back off slightly, and then recover that ground enough to register another marginal new high. As I’ve noted frequently, when market conditions are characterized by unfavorable valuations, overbought conditions, over bullish sentiment, and upward yield pressures, the market’s tendency is exactly that – to make continued marginal new highs for some period of time, followed by abrupt and often steep losses virtually out of nowhere.”



Personal Consumption as a percent of GDP is about 68% to 70%. For the Economy to improve, you need the Consumer to spend money. If he’s unemployed and his asset base has been depleted, it’s impossible for that to happen. As a result GDP drops. As GDP drops, so does the stock market. Over the next few years, GDP will not grow at the levels of the past. Pimco (an investment manager) has termed this slower GDP growth as the “new norm”.

The consumer is in the process of de-leveraging and saving, not spending. This process of de-leveraging is deflationary. Our politicians and leaders have printed money and added substantially to Public Debt which is inflationary. For inflation to really get going, the consumer must spend money. While we wait for the consumer to get out of debt and save his money we get deflation.

So, in the short run, we get deflation (a correction of the price level which is not positive for most investments). As the Economy improves and the unemployment rate starts to drop, the money supply (which has been expanded exponentially) turns over faster (economists call this turnover of money “Velocity”.) As velocity goes up we get inflation.



US Public Debt is estimated to be over 100% of GDP by 2010/2011. This assumes that GDP will grow by 5% in 2011 and almost 6% in 2012. In my opinion, these assumptions are overly optimistic. The size of US Public Debt as a percent of GDP will probably be over 100% by 2011. The creditworthiness of the USA and its Reserve Currency status is at risk. The US Dollar is a currency that other countries can use as a reserve (saving). China, Brazil, Russia, India, and most other countries use the US Dollar as a reserve. This means, that US Dollars are hoarded, not sold. Should the US lose their Reserve status, dollars would be sold, US Dollar denominated Bonds would be sold, and interest rates would go through the roof, which would make it substantially harder for the US to finance their nonsense, and could well have the US Bonds rated “junk”. Needless, to say, the Stock Market would crash.

The US Economy is undergoing a major correction of excesses that have been building since the late 80’s. There are major cross-currents in today’s World Economy: Deflation/Inflation; credit standing of the USA and other developed countries; Public Debt etc. The US Dollar in a deflation, make sense, as long as it is still considered the “Reserve Currency”. Stocks will not do well in a deflation or inflation. Some Bonds will due well in a deflation (US Bonds) and Commodities and Real Estate should do well in an inflationary environment.

In the interim, stay liquid, get out of debt, and hold some Gold. The theme is survival!

STOCKS ARE NOT CHEAP!

“You have to choose (as a voter) between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect for these gentlemen, I advise you, as long as the Capitalist system lasts, to vote for gold.” George Bernard Shaw.

The great stock advisor, Richard Russell who writes the “Dow Theory Letters” (ww1.dowtheoryletters.com) received an e-mail September 2, 2009 from one of his subscribers that I think needs to be quoted. The e-mail reads, “Let me get this straight – Obama’s health care plan will be written by a committee whose head says he doesn’t understand it, passed by Congress that hasn’t read it, and whose members are exempt from it, signed by a president who smokes in secret, funded by a treasury chief who did not pay his taxes, overseen by a surgeon who is obese, and financed by a country that is broke.” Only in America.

So here we are, with the Stock Market raging, interest rates at depression lows, the Federal Reserve printing money, Economists suggesting the recession is over, and those that make a living selling stocks proudly announcing the Bear Market is over.

When I went into this business in 1968 I was taught that a stock price was equal to the present value of the dividends + the present value of the residual (sales price at a future date). That in my opinion was the basis for all asset valuations, from Income Producing Real Estate, to the value of a Patent. This valuation concept involved several assumptions, namely, (1) what are the dividends of the future? (2) what are the future earnings? (3) what discount (yield) interest rate do you use? (4) what will the future asset price be? (5) what time frame do we use? Since 1968 the 5 year average annual compound growth rate of the S&P 500 earnings is 6.23%. Below are some assumptions regarding the SP 500.




At a price of 998.47, the SP 500 is selling for 27.34 times 2010 estimated earning’s, and provides a dividend yield of 2.20%. This is not cheap!

Using the above assumptions, the SP 500 must sell for $1,805.40 at the end of 5 years (2014) to yield 15.00%. This price results in a future PE ratio of 36.94 times earnings, and a Peg ratio (PE divided by the Growth rate) of 6.16. Based on valuation concepts, the required future price (to yield 15%) seems almost impossible. Conclusion, the SP 500 is too high. Also note that the Payout Ratio is very high and probably is overstated. If the growth rate is changed to 12.00%, the required future price to yield 15% is $1,770.38, which is 27.51 times earnings, and results in a Peg Ratio of 2.29. In my opinion this future price is still too high, and a 5 year compound growth rate of 12.00% is not going to happen. Conclusion, the S&P 500 is too high.

Now let’s assume I lower the yield required from 15% to 10%. At 6% growth, the required S&P price in 5 years is $1,423.40 which is 29.13 times earnings, and results in a Peg ratio of 4.85 times. The stock is still too high. If I lower the required yield to 5.00%, the 5 year compound growth rate of earnings must be about 14.00%. It is likely, the inflation rate over the next 5 years will be a minimum of 5.00% and Income Taxes will be higher. Subtract income taxes and inflation from the 5.00% yield, and you end up with a loss.

CONCLUSION: STOCKS ARE OVERVALUED! THE CURRENT PRICE IS BASED ON UNATAINABLE ASSUMPTIONS OR INFERIOR YIELDS ON INVESTMENT.



The above chart is the Log of the SP 500 Earnings per Share from December 1900 to August 2009, with estimates through December 2010. The blue line is the trend line. Note the big leaps over the trend line from 1995 to 2007 driven by low interest rates. Also, note the estimated earnings to 12/2010 are almost back on the trend line. It is no coincidence that the stock analysts that predict future earnings stay close to the trend line.

Wait, don’t Economists believe that the fair market value of publically traded assets reflects the consensus of all the minds in the universe, and therefore at any given time, the asset value is correct. Does not each investor buy and sell assets based on rationale thought?

It has been a major assumption by economists that all economic decisions are based on rational thought. Economists describe a formal process for making rational decisions: People consider all the options available to them. They consider the outcomes of these options and how advantageous each outcome would be. They consider the probabilities of each of these options. And they make a decision. The reality is that the bulk of the population do not have the foggiest idea about probability, let alone the various options available to them. As many sociologists have pointed out, most economic decisions are made because “it feels good.”

There is an emerging new school of economics that is interested in the behavioral aspects of economic decision making. In this discipline, psychology and sociology play a part in explaining the so called “white noise” (rationally unexplained economic phenomena) that occurs in markets and society from time to time. Public manias and panics are well documented such as the Tulip Bulb fiasco, the South Sea Bubble, the dot.com boom, etc.

However many of us have known for a long time that: what makes markets go up and down, have nothing to with rational thought. How do you explain investors paying one month’s wages for 1 Tulip Bulb? How does an investor pay $75 for a stock that has not recorded a profit for 10 years? Answer: They expect the price to go higher (confidence). At any given time, collective emotions play a large part in determining market values. There are graveyards full of investors who got caught up with the popular sentiment of Bubbles and Panics. Why would any rational human being buy a stock which by its nature is merely a piece of paper?

As investors screen through investment alternatives, they can choose money market accounts paying less than 1% per annum, a 30 year US Treasury Bond yielding 4.15%, Real Estate that appears to be in a constant free fall, Commodities like Oil, Copper, etc that fluctuate as much as 5% to 7% daily, and don’t know how to buy them anyway, the stock market, that is famous for providing large returns (mainly from the hype of those that prey for a bull market, and profit accordingly). There is currently $9.544 trillion in “Money Zero Maturity” accounts (money market accounts) that are potentially available for investment. $114.9 billion has come out of these accounts since 6/15/09 which translates to some or the entire rise in stock prices. Why are people buying, and not selling?

Most individuals that still have stocks have major losses. Hope springs eternal. As stock prices rise, there sense is to hang in there, buy on the way up, and try to recover their large losses. In addition, all the media constantly reminds us that the bull market has started, the recession is over, and good times are ahead. No one hypes bonds, commodities or real estate anymore. Common stocks win by default.

As stocks started to advance, the Obama affect set in. Obama gives great speeches, and gives the impression that he knows what he’s doing. However, as time went on, every thinking man came to realize he has no idea how an economy works, and is quite frankly over his head. By that time, the market was already rolling, and most folks hung in there anyway.

Now we confront the reality. I think the market is going much lower for several reasons:

(1) The real estate troubles are temporarily deferred but not over (see prior months report);
(2) Banks have received a reprieve with mark to market accounting changes, by not being forced to write down their junk assets. However, a meaningful percent of their assets are still crap;
(3) Most stocks are overvalued;
(4) The printing presses of the Federal Reserve are running full time;
(5) The unemployment rate is rising, which translates to lower consumer spending;
(6) The creation of staggering debt by Congress facilitated by the Treasury Department and endorsed by our President continues ad-nauseam;
(7) The US dollar continues to fall, as our trading partners advocate abandoning the Dollar as a reserve currency.

For the same reasons, I think our economy continues to be in trouble, and expect a return to a recession by 2010. On a lighter note, Gold broke out over it’s resistance of $985 per ounce, and my new Granddaughter Nola, age two months, is looking good.

THE ROOTS OF RECOVERY APPEAR TO BE WEEDS

Many pundits have been talking about the “green roots” of recovery. They proudly proclaim, “The bear market and Recession is over.” Not so fast, Bozo. Take a peak at the eye popping chart below. The Mortgage Reset market takes a break through 2009 and starts up in earnest in 2010 and 2011. As long term interest rates rise (due to the expectation of inflation), the housing problem is not over. If anything, they are only deferred.

GNMA (the Government owned Mortgage Company) is now making loans to home owners equal to 110% of the appraised value of the home, with subsidized interest rates. This got us into trouble to begin with. Robert Campbell the respected housing analyst, in his “Campbell Real Estate Timing Letter” writes:

“…there are strong similarities between Japan and the US. In Japan, driven by years of easy credit the Japanese stock and housing markets became a bubble. The bubble burst in 1990. One of the first lessons learned—or relearned, actually—is that when asset bubbles burst, there is nothing you can do to re-inflate them. But that’s what every Government US plan is still trying to do—keep housing prices from falling. In doing so, all we are doing is wasting trillions and trillions of dollars and digging ourselves into a deeper financial hole. Another lesson learned from the Japanese experience is that plunging asset prices do not result in a typical recession. The recessions are worse—sometimes far worse.”

“There is no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic laws on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.” John Maynard Keynes, 1919.

The printing of money that has just taken place in the past 18 months is mind boggling. Below is a chart of the Monetary Base. This is the basis for all money and debt creation. The Monetary Base is composed of two factors, namely, Currency In Circulation and Bank Reserves. When the Monetary Base goes up, it triggers inflation. When it goes up 77% in one year, God help us.

The decline in the Monetary Base from February 1921 to September 1922 was facilitated by oversupply of goods and a decrease in demand, following World War I. The massive 1921 recession was followed by a rapid recovery. The Keynesian economic philosophy ignored this recession because it suggests that government intervention is not required in such cases. Free markets adjust prices and supplies much more efficiently than any government coordinated action. This should have been the model for the great depression and the current boondoggle. Instead we repeat the errors of the past—massive Government spending, trade protectionism, and intervention in the free markets.

The expansion of debt is the driver of inflation. If a residential unit could not be acquired without financing, the price of a new home would probably be less than $50,000. Bubbles in assets are a result of too much money and credit chasing a given supply of assets. The next bubble? Gold and Commodities.

The massive expansion of US Debt can only lead to a crowding out of private capital and - at the same time trigger declining bond prices and an increase in interest rates. The only way to reduce this expansion of debt is Government Surpluses in the future (not likely given Obama, Pelosi, and Frank at the helm), or increase US output significantly (not likely to happen in the short run).

The renowned Economist, John P Hussman (www.hussmanfunds.com) writes, “The price level is essentially the ratio of two marginal utilities – the marginal utility of goods and services divided by the marginal utility of government liabilities.” (“Marginal” in economic terms means the increase or decrease of utility, and “utility” means the satisfaction level of an economic decision.) Hussman continues, “We have seen no inflation in response to the huge issuance of Treasury securities because presently the marginal utility of goods and services is depressed (because people are still in the process of shifting away from credit financed consumption), while the marginal utility of government liabilities is still elevated (because people are still averse to holding savings in the form of more risky asset). Unless the current, unusual profile of marginal utilities persists indefinitely, we can expect that a normalization of the relative utilities of goods and services to government liabilities will result in a large upward ship in the US price level.”

John Taylor, and economics professor at Stanford University wrote in the Financial Times (May 2009), “To bring the debt-to GDP ratio down to the same level as at the end of 2008 would take a doubling in prices. That 100 percent increase would make nominal GDP twice as high, and thus cut the debt to GDP ratio in half, back to 41 from 82%. A 100 percent increase in the price level means about 10 percent inflation for 10 years, but that would not be smooth – probably more like the great inflation of the late 1960’s and 1970’s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”

Over the next ten years, inflation is a lock. In the short run (next 18 months) the deflationary trend will continue. The banking system is now experiencing problems in rising delinquency rates of credit card debt, commercial loans, and real-estate loans. The consumer will continue to payoff debt, cut spending, and attempt to save.

The best investment you can make today is: get out of debt, have some cash savings and take a position in Gold.

I hate to be the bearer of bad news. I would like to report that the Economy is about to rebound, and the Equity Market will experience the biggest bull market in history. Problem is, I don’t believe it.

On a lighter note, my Granddaughter hit in the winning run for the Aliso Viejo softball girl’s championship game.

THE THREE STOOGES

The three stooges: Barney Frank, Nancy Pelosi, and Harry Reid have done it again. Attempting to tax bonuses at 70% to 90%, spending money like it was theirs, slapping on earmarks, and denying any involvement in the chaos of the mortgage debacle. Nancy Pelosi proposed that Credit Card Companies should extend a larger credit line to the card holders in the hope they will spend more money. You can’t make this up. There are other stooges like Chris Dodd, Timothy Geithner, and Rahm Emanuel, to name a few. There all killing us. It never ends. And our current leader said, “When you’re headed for a cliff, you have to change direction”. How about putting on the breaks! The politicians feel like they have to do something, so they do. So they throw money around like it theirs.

Is it just me, or does our leader look like Alfred E. Newman of Mad Magazine (Mad Magazine-www.dccomics.com/mad/). Below, courtesy of Mad Magazine is Alfred E. Obama. Check it out.

The basic Obama solution to our economic crisis using FDR’s and Keynesian policies of the 30’s quite frankly don’t work. They did not work then, and they won’t work now. Attached is a chart of the unemployment rate during the depression. Sadly the War reduced unemployment, not Politicians spending plans. In 1938, unemployment started to rise again. By 1939, the inception of WW II, unemployment rates finally declined.

You don’t have to be an economist to realize that our problem today, is the unemployment level. Large unemployment rates create social and economic problems. You can’t fix the housing problem by screwing around with mortgage rates, principal reductions, and extending the mortgage life, if the mortgagee does not have a job. You can’t fix the problem of toxic assets by changing accounting principles (mark to market). If the assets stink, they stink.

The current unemployment problem is very much like the classic question, “what came first, the chicken or the egg? If you believe in evolutionary theory, the egg came first. What came first, employment or unemployment? If you believe in a free market economics, the employer came first. Give American Business and employees some incentives. Reduce payroll taxes, give tax credits for fixed asset purchases, allow a tax deduction for dividends, and lower income tax rates for the top individual tax brackets. Let’s face reality; for Economic growth, entrepreneurs make much better employers than the US Government.

Our leaders gave money to the Banks, and are now upset because the banks “won’t lend money”. How can they be upset? Banks don’t want to make risky loans and good companies don’t want to borrow. The “Geithner” joint venture between our Government and Hedge Funds will bid on toxic assets (now referred to as “Legacy Assets”) of banks and other financial companies. Obviously, in an un-leveraged world, the bids will be at less than book value. Ah, but our leaders have given the Hedge Funds 6 to 1 leverage. Now they can bid much more since the leverage is non-recourse. Bank of America as of 12/31/08 was leveraged 18.95 to 1 (if you believe their Financial Statements). The Balance Sheet indicates an asset “Investments” totaling $1.375 Trillion, and a Tangible Net Worth of $86.583 Billion. Assuming the investment is worth a generous 75% of carrying value, the loss would be $343.75 Billion or almost 4 times their net worth. I don’t think Bank of America will sell their assets at a deep discount, and I also don’t think the hedge funds would pay a premium for stinky assets. Good luck with your plan Geithner. In my opinion most of the large banks, AIG, Auto Makers, should be placed in receivership, letting the receivers restructure the failed companies.

The war continues between deflation and inflation. Below is a chart of inflation expectations. The chart measures the yield difference of the 10 year T-Bond and

the Treasury 10 year Inflation Indexed Bond (TIP). Currently, Inflation expectations are rising. Investors sense a rising price level in the immediate future. Do you think it’s because of all the money being printed by our beloved leaders in Washington? Below is a graph of the 10 year TIP and Gold. Both prices are rising.

One of the most powerful economic tools the United States has is our Dollars status as the main Reserve World Currency. If the US lost its reserve status, we would not be able to print the money our debt is denominated in. It would also mean that our creditors would no longer hoard dollars as a safe haven or as a store of value. Taking away the reserve status of the US Dollar would be one of the most significant ways to weaken the USA. China recently called for an extension of the use of SDR’s (special drawing rights) created by the International Monetary Fund (IMF), and the eventual replacement of the dollar as the World’s reserve currency. China, Russia and most of Europe bristles at the thought of the US as the perpetual world economic power. The Achilles heel of the USA is the dollar, and the powers that oppose the US know it. On March 27, at the United Nations, the UN Advisory Committee said: “World leaders should give urgent attention to reaching consensus on creating a global reserve system that would replace the US Dollar as the main international currency.


We as a County are in big trouble. If we lose our Reserve status, Richard Russell (http://www.dowtheroyletters.com/) writes, “…if it happens it will happen through the United Nations by “Order” of the World. God help us.

I still think stocks are still overvalued, and recommend staying liquid, with a little Gold as a hedge against inflation and panic. Get out of debt, and prepare for a continuing struggle between deflation (in the short run) and inflation in the long run.

NOTHING IS POSSIBLE

“WHO SAYS NOTHING IS IMPOSSIBLE?
SOME PEOPLE DO IT EVERY DAY!” MAD
MAGAZINE E.C, PUBLICATIONS INC.

The money flowing out of Washington is so large and has happened so fast, that only the tooth fairy understands what just happened. What we do know is that the mammoth infusions of fiat money is hyper-inflationary over the next five years, and probably does very little to “Put America Back on its Growth path”. The Euphoria over the election of the new President is about to come to an end. Our Congress and President have lost it.

The Stock Market which represents the best and brightest minds in America, and back their opinions with real cash, have voted on all the Politicians bail-out’s, and “Saving America Programs”, and have posted the following results from Election Day to 2/20/09: SP500 lost 26.70%, NASDAQ lost 21.12%, DOW 30 lost 26.76%, DOW Transportation Index lost -41.13% and the Wilshire 5000 lost 25.86%.

How do you like the vote by real people who invest real money? To add insult to injury, the loss in dollars, since election day (measured by the Wilshire Index, above), is $2.303 Trillion.

Since the peaks of the American stock market and housing, $8.05 Trillion has been lost in the stock market and $7.5 Trillion has been lost in housing. Investments in stocks and housing (since the peak in October 2007), have lost $15.5 Trillion. Globally, the estimated losses from the peak in stocks and housing are $30.0 Trillion for stocks and $ 30.0 in housing. A whopping $60.0 Trillion has been lost because of excessive liquidity and the expansion of irresponsible credit. You think that providing bee keepers with insurance will set the US Economy on fire?

We have a big problem. Yes, someday housing and stock prices will advance, but today, World investors are mad, and do not trust housing and stocks as an investment. It is my experience (since 1968) that investors are not quick to return to investment alternatives that buried them. Housing will again be a place to live and the Stock Market will be a trader’s arena, with the general public staying away.

The chart below indicates the ratio of Money to the market value of the Stock Market. The average ratio since December 1991 has been 54.07%. For the seven days ended 2/9/09, the ratio is 107.24%. Note that the Ratio rose over the average from 1/14/02 and peaked on 3/10/03 at 81.14. After the peak, money still exceeded the stock market and occasionally dipped under the market value of stocks but never got a major foothold. As a result the stock market has been rather boring on the upside and only recently got interesting with its crash. The possible good news is that there is a lot of liquidity standing around waiting for an opportunity in investing in something other than boring old cash.


Money in the chart above is MZM which is defined as: Currency in circulation plus demand deposits plus Large Time Deposits plus Term Repurchase Agreements minus small denomination time deposits plus Institutional Money Funds. The stock market value is defined as the Wilshire 5000 index.

Is the Stock Market today really cheap? In my opinion, no, and I’ll tell you why. Over the past 20 Years, the advent of individual retirement plans increased the demand for stocks exponentially. Add to it Hedge Funds, and other investors of OPM’s (other people’s money) and you had the perfect formula for a Bull Market. The supply did not keep up with the demand. New suppliers emerged (Mutual Funds, ETF’s etc) to accommodate the new demand, but the stock supply didn’t match up with the new demand. Since Mutual Funds and 401K Plans were “always” invested in the Stock Market, it was this set of players that created of one of the greatest bull markets in the History of America.

The Bull Market from November 1990 to August 2000 was the longest in history lasting 118 Months. The most current bull market was the third largest on record lasting 56 months from March 2003 to October 2007. The second longest Bull Market lasted 71 months from November 1923 to September 1929 (remember that one?). In the most current bull markets, most decisions were made by men that had never seen a market crash.
Due to the advancing prices, new theories of value emerged. The old school of value that said “buy good stocks that had a 5 to 12 PE multiple and a 4% to 6% dividend.” was dismissed as “out of touch”.

From the period December 1973 to October 1990, the average of the price earnings ratio and dividend yield for the SP 500 was 11.75 and 4.32% respectively. From November 1990 to December 2008 the PE and dividend yield on the SP 500 was 23.71 and 2.04%. The demand and supply increased to the point that everybody was invested one way or another in the stock market forcing up the PE and driving down the yields. Old school investors learned the hard way, that investing in stocks can be very risky. In the good old day’s stocks carried a risk premium.

At this writing the SP 500 closed at 770.05. Per share earnings estimates, for the years 2009 and 2010 are $41.88, and $51.48 and dividends per share estimates are $12.62 and $23.20. This results in a PE ratio for 2009 of 18.39 and 14.96 for 2010. The dividend yield for 2009 and 2010 would be 1.64% and 3.01%. This hardly represents a risk premium. To arrive at a historical “stocks are cheap” basis the S&P 500 would have to be at 617.76 to achieve a 12 times PE (2010 Earnings). On a yield basis, the SP based on 2010 dividend expectations would have to be at 464.00 to yield 5.00%. Using 2009 earnings and dividend estimates would make matters even worse.

I suspect that the earnings and dividend estimates for 2009 and 2010 are overstated, because historically analysis’s are slow to change their estimates (they work for the very people that are trying to have you buy stocks).

As a concept: buy stocks when they are cheap and sell when they are expensive is common sense. In his book “Irrational Exuberance” Robert J. Shiller (Professor of Economics at Yale University) did a study of returns on stock investments and showed that PE ratios and Dividends indicate to a great extent when stocks are cheap and when they are expensive. He says:

“…as a rule and on average, years with low price-earnings ratios have been followed by high returns and years with high price-earnings ratios have been followed by low or negative returns.” (Page 187 2nd Edition). And, “As a matter of historical fact, times when dividends have been low relative to stock prices have not tended to be followed by higher stock price increases in the subsequent five or ten years. Quite the contrary: times of low dividends relative to stock prices in the stock market as a whole tend to be followed by price decreases (or small-than-usual increases) over long horizons, and so returns have tended to take a double hit at such times, from both low dividend yields and price decreases. Thus the simple wisdom—that when one is not getting much in dividends relative to the prices one pays for stocks it is not a good time to buy stocks—turns out to have been right historically.” (Page 188 2nd Edition).


We need to watch two statistics that will determine the investment strategy for the next 2 to 5 years. The first relationship that bears watching is the ratio of Gold Prices divided by 10 Year Bond Prices. In determining the war of Inflation/Deflation, Gold and 10 Year Bond Prices should de-couple. Currently, both Gold and 10 Year T-Bonds Prices have been going up together. For Deflation to be the winner, the ratio above should start going down. If Inflation is the winner, the ratio should be going up. Note the chart above indicates, the Ratio is going up, which translates to a brief victory for Inflation.

The 2nd thing that you have to pay attention to is the yield to the Chinese in investing in US Bonds. The above chart reflects what the Chinese yields are in Yuan, in investing in 10 Year US T-Bonds for a holding period of 1 year (including interest).
Note the yield for the year ended 2/20/09 is 7.70%. However, the yield is declining. The significance of this chart is, that if the Chinese start losing money on owning US Treasuries, they will be inclined to sell these Bonds, which would drive T-Bond yields higher, and contribute to an Inflationary expectation.

I continue to advocate buying Gold on dips (10% to 20%), and short term Cash Instruments such as T-Bills, and Federally Insured CD’s. The stabilization of the World Economies will take a long time (2 years or more), and in the interim, stay liquid, out of debt, and own some Gold.

Game Theory 101

Many moon’s ago, the Mathematics Department of various Universities, came up with the notion of “Game Theory”. The theory dealt with games from Business to Monopoly. The results of those studies were profound. The basic principals of the theory centered on the concept of “fair games”. That is, a game is “fair” when the player has a 50% chance of winning, and a 50% chance of losing. Thus, “fair” produces no winners or losers.

In investing, the propositions of Game Theory are:

(1) Never play fair games (other than for amusement). Find games that have a higher probability of success than failure.

(2) Never play games unless you understand the rules. The rules must be articulated in an understandable way. The rules cannot change during the game. Do over’s etc cannot be allowed.

(3) Make sure you know the players in the game, and their skill level. Your skill set should be as good, or better, than the other players in the game.

(4) You must understand the game. Life is short – If you don’t understand the game, find another one. If there are no games you understand, become a spectator.

In the current crisis, most players in the game are under 50 years old, and have never seen a “game” this tough. Folks under 50 did not play the bear markets of 1969-1970, 1973-1974, and 1976-1978. In business school they probably did not even study the Depression of the 30’s. Currently, there is no game you can play (other than Gold), that gives you a fair chance of success. Stocks, Real Estate, Commodities, Foreign Currencies, Bonds – they all suck! Why?

(1) BECAUSE THERE ARE NO RULES, AND THE RULES CHANGE DAILY.

(2) Who are the players? You, me, the Federal, State, and Local Governments, Banks, Other World Sovereignties, Finance Companies, Special Interest Groups, the Unemployed, etc. In short - everyone on this planet.

(3) The Game today is totally incomprehensible. Do-overs are now allowed. Without understanding the game or rules, you must sit on the sidelines and allow the other players to fail.

There is a major war going on between Deflation, and Inflation. We all know that there is a credit collapse. The market value of assets is under siege. Liabilities against those assets in many cases exceed the asset value. The collapse of asset values and credit is clearly deflationary. Wait – here come our favorite rule changers, the US Federal Government. The Fed’s always gets us with taxation and inflation.

Our Governments boondoggle (TARP, Stimulus Plan, etc) is presumably going to “get our Economy back on its feet”. As of this writing I have seen nothing that will materially stimulate the Economy. In fact it appears that most of the money has been thrown at Banks and Auto Companies that are Bankrupt and social programs that provide no stimulus. Our beloved leaders, (President Obama, Nancy Pelosi, Barney Frank and Harry Reed) are running amok. The package totals $819 Billion, and may run up to $900 Billion.

There is: $345 Million for the Agriculture Department computers; $650 Million for TV converter boxes; $15 Billion for college scholarships; $1 Billion to deal with the Census problems; $88 Million to help move the public Health Service into a new building next year; $2.1 Billion to pay off a looming shortfall in public housing accounts; $870 Million to combat the flu; $400 Million to slow the spread of HIV and other sexually transmitted diseases such as chlamydia; $380 Million for a rainy day fund for the Women, Infants and Children (WIC) program that delivers healthful food to the poor (this group got $1 Billion last fall), $87 Billion to bail out the States providing Medicaid, Bee Keepers Insurance, and Medicare funds for Illegal Aliens.

Also everyone that has an Income Tax ID card (which includes those that do not have a Social Security Card) will receive a tax rebate of $500 if single, and $1,000 if married. People that do not pay taxes get the tax credit too. Remember the last Tax Rebate program didn’t work because people saved or paid bills with the windfall.

There is more nonsense in this package, but you get the idea. Upon being questioned on the bill, Rep David Obey, D-Wisconsin, one of the chief authors of the house package and chairman of its appropriations committee said, “If the house is burning, you’re not going to worry about which hose you grab, so long as you get water on the fire.” Is he crazy? The printing presses are going wild. As Richard Russell the guardian of the Dow Theory (www.dowtheoryletters.com) said (tongue firmly in cheek), “buy Paper Stocks.”

The forces of Deflation have been strong. Yet Gold and TIPS (Inflation indexed US Bonds) are rising, suggesting that: (1) There is an Inflation expectation over deflation, or (2) There is a major fear that the Worlds paper currency will become worthless or (3) both of the above. The Worlds currency today is referred to as fiat currency or fiat money. By definition fiat money is currency or money whose usefulness results not from any intrinsic value or guarantee that it can be converted into gold or another currency, but instead from a government’s order (fiat) that it must be accepted as a means of payment. For example the US $100 Bill is only worth $100 because our government says it is. Obviously there is no intrinsic value of the bill except maybe the value of the paper (5 cents?)

The game is now very complex. Stocks in my opinion are not cheap but overvalued considering where we are in the economy. A SP 500 Index to be cheap would be 600 or less (currently at 850). US Government Bonds are not cheap (a 10 year yield of 2.842%, is not my idea of a risk justified return). Income producing Real Estate is not cheap, due to vacancy rates rising and a substantial oversupply of rental space. Housing isn’t cheap, since you can’t buy a house today and rent it out at a profit. All other investment alternatives are in a state of uncertainty, because of the absence of rules.

In my opinion to make money over the next three years, the proper investment game to play will be decided on the direction of the price level, and the “real” value of the Dollar and other World paper (fiat money) currencies. If the “people” ever figure out that the current mass flooding of paper money causes inflation, and that our currency is really worthless, we will have the largest Economic and Political crisis ever faced in modern times. Below are some of the charts I use to follow the Deflation/Inflation, worthless US dollar sentiment. Below are three charts that indicate the ratio of Gold Prices divided by: the Ten Year US Treasury Bond Price; the Inflation Indexed US 10 Year T-Bond (TIP); and the US Dollar Index. Also there is one chart indicating the ratio of TIP to the 10 Year T-Bond Price.




Note that the TIP is also rising against the 10 Year T-Bond. Like all market data (that reflects investor sentiment), this could all change tomorrow morning. What’s interesting about the TIP to Bond chart is that it shows the initial Deflationary sentiment (dropping ratio). Currently however the TIP shows strength, and with it confirms the other Inflationary sentiments. My opinion is the stimulus package will stimulate very little except Inflation. It seems likely we will continue our credit and asset collapse followed by high rates of Inflation.







It is prudent to be very risk adverse today. Invest in Federally insured Cash Instruments, and some Gold. If you have a Mortgage that has an interest rate of more than 3.673%, make extra principal payments. Stay liquid, and out of debt. This economy and the Federal Solutions thereon will not have a happy ending.

OH NO, ANOTHER BUBBLE

See the tables below, for the Financial and Economic Results of the bubbles bursting in 2008. 2009’s Bubble will be the collapse in the US Treasury Bond market and Commercial Real Estate. The chart below indicates Commercial Real Estate Expenditures versus The American Institute of Architects Billings for Commercial Real Estate lagged by 10 Months. The AIA Index leads Commercial Real Estate Expenditures by about 10 Months. Note the total crash in 2009 of Commercial Real Estate.



There are several reasons this investment vehicle is the next casualty of the credit crunch.

Many buyers “borrowed money” on commercial real estate based on what “cash flow will be” based on unreasonable inflation and demand assumptions, not on what cash flow actually was. Exceptionally high prices were paid on current small yield assumptions. Liberal financing was provided by “cash rich” banks that bought into these bloated expectations. The result, too many office buildings were built that were overleveraged. As the recession sets in, lost jobs create higher vacancies. In many cases, the current cash flows do not service the Mortgage Debt.

As the bail-out money sloshes into the poor hopeless, hapless US Economy, the potential for the next Grand Bubble becomes probable. In a “free market” economic system those that screw up, are allowed to fail. Most children only learn the lessons of life when they are allowed to fail and pay the consequences. Yet here we are, $8.5 Trillion has been pumped (and printed) into the American Economy (God knows what additional money will be printed) and the borrowing rate for Banks (Fed Funds) is at or near zero. The Federal Reserve is out of bullets. Your and my Government has decided to fight the current mess caused by years of easy money, easy credit, and low interest rates with easy money, easy credit and low interest rates. The Government is now supporting risk taking, with our bailed-out banks having little to lose. The Stag-Deflation is on.

The US Economy is dedicated to consumption. Consumption was 70.52% of GDP, in the 3rd Quarter of 2008. If Consumption falls, GDP falls, and if it falls far enough, we get a recession, or even worse, a depression.



Note the parabolic growth in consumption starting in 1980. The US consumer went on a buying spree due to easy credit, low interest rates and the “Wealth Effect”. The Wealth Effect is that wonderful emotional feeling you get, when assets you own go up in value (like your home and stocks). This increase in paper wealth creates the illusion that you can spend more because your wealth is rising. The US consumer borrowed on his new found wealth, and spent it on consumable goods, not appreciating assets. The average individual does not realize that it’s only wealth creation if you sell it.

Besides blowing money and over levering, the consumer bought a home with no money down, and without anyone checking his credit or his ability to pay. And look what happened. The housing prices declined and the market collapsed. For an encore, he just lost 50% of his retirement plan and/or his personal investment account in the stock market. DO YOU SERIOUSLY BELIEVE THE US CONSUMER IS NOW GOING TO GO OUT AND BUY/LEASE NEW CARS, BIG SCREEN TV’s, AND A NEW HOME? DO YOU REALLY THINK HE’S GOING TO POUR MORE MONEY INTO THE STOCK MARKET? I’LL BET YA THE US CONSIMER IS WORRYING ABOUT HIS JOB. ANY MONEY HE GETS FROM A BAIL OUT WILL BE USED TO PAY DOWN DEBT. IF HE HAS ANYTHING LEFT (WHICH IS DOUBTFUL), HE WILL BUY A PRAYER RUG.





The socialization of America is under way. The Government owns the Auto Industry, the Mortgage conduits (Fannie May, and Freddie Mac), Bear Sterns, and controls numerous big City Banks. The Government is now encouraging us to: spend money by giving us Income Tax Credits; and borrow money because interest rates are at all time lows. ARE THEY NUTS? Isn’t this how we got our self into this mess!

Look at the poor commodity market below. It’s a blood bath. Commodities tell us that Deflation has started.



Now we hear that our Government is very upset with the banks that got the bail out funds. They aren’t lending the money. As of this date we (the people that actually paid for the Bail-Out) don’t know who got the money. The Government is now putting pressure on the Banks to make loans. This means that the poorest credit risks will receive bank funds (taxpayer money), and once again the taxpayer takes a big hit.

The Government also wants to bail-out the poor foreclosed home owner. By lowering his interest rates and adding years to the payout, the homeowner is now supposed to be able to afford the mortgage. Isn’t it highly probable, that the sub-prime borrower is the first to be unemployed? Whatever the Government does to save foreclosed homeowners, only defers the ultimate foreclosure and collapse of credit. Anyone want to own a Mortgage Company?

The other great idea our Government has is to resurrect a plan that did not work in the Great Depression and certainly won’t work this time. Namely, get money out to the “shovel ready” infrastructure projects. This concept will put some folks to work with pay, and may be a benefit to the US Economy in the long run. However, how many “shovel ready” projects do you think exist? Translation: throw the money around as quickly as possible at hastily “dreamed up” projects that have no chance of being efficient. I see projects like building bridges, tea gardens, etc. The Government will of course impose environmental constraints on all of their projects. Just imagine the lobbyists running amuck finding “shovel ready” projects for their Brother, Mother, Uncles and Aunts. The result: another boondoggle, with little improvement in our current situation, and we all go deeper in debt.

President elect Obama has a plan that creates 3.5 Million jobs at a cost of $775 Billion (trust me; Congress will spend a lot more on this monkey business). This translates to an expenditure of $221,400 per new job. What not just give everybody $2,500 Tax Free?

The zero maturity money (money market funds) is now on the rise again growing at more than 10% for the year (See chart below). The world is awash in money and no one is taking any risk. Investors, out of fear, have driven the 90 Day T-Bill to a yield of .11% on 12/31/08. This build up of liquidity coupled with an unbelievable increase in Bank Reserves (printing press money), and low interest rates, sets the stage for the next bubble.

Economists and Financial Analysts base there work normally on past history. The Economic and Financial Models are all very sophisticated and contain elaborate equations that purport to forecast the future. The models are always based on past history and assorted assumptions. From 1965 to 1972 I ran complex models to forecast future Economic and Investment levels. I always achieved the same forecast results: Some I got right, some I got wrong, and mostly I got really wrong. Economists call the difference between what actually occurs and mathematical Forecasts as “white Noise”. What the mathematical models fail to take into account is the “people factor”. Investor and Consumer Psychology play’s a major role in determining outcomes in Finance and the Economy.



The human element needed in all equations, is: what is the investors current experience with investments? What is the consumer’s outlook for the future? In my view the investor is tired of losing money, and the consumer wants to keep his job, get out of debt, and save some money. Soon or later they all change their mind and return to taking risk and spending, but for now I find it highly improbable.

In my view the Recession will last past 2009 and probably end some time in 2010. Falling prices, slow to negative growth, and declining asset prices is our immediate future. Hold on to your cash, get out of debt, and stay close to your family and friends. The only risk you should take is going to and coming home from work.