Wealth-Ed now has a new permanent home at http://www.Wealth-Ed.com You will automatically be redirected in 5 seconds. Please update your bookmarks. Thanks!

Fixing a Deflation: A Most Intelligent Analysis

I have reprinted in total an interview between fund manager Ray Dalio and Barrons. This is the most detailed and well-thought-out description of what is a deflation and how it is repaired that I have seen. It echoes my thoughts and commentary almost verbatim, but with a lot more detail and credibility. Read on to understand what is happening and how we get out. I will put my commentary in brackets[]:

http://online.barrons.com/article/SB123396545910358867.html?page=2&page=sp

SATURDAY, FEBRUARY 7, 2009 INTERVIEW

Recession? No, It's a D-process, and It Will Be Long

Ray Dalio, Chief Investment Officer,
Bridgewater Associates

By SANDRA WARD

AN INTERVIEW WITH RAY DALIO: This pro sees a long and painful depression.

NOBODY WAS BETTER PREPARED FOR THE GLOBAL market crash than clients of Ray Dalio's Bridgewater Associates and subscribers to its Daily Observations. Dalio, the chief investment officer and all-around guiding light of the global money-management company he founded more than 30 years ago, began sounding alarms in Barron's in the spring of 2007 about the dangers of excessive financial leverage. He counts among his clients world governments and central banks, as well as pension funds and endowments.

"The regulators have to decide how banks will operate. That means they are going to have to nationalize some in some form." No wonder. The Westport, Conn.-based firm, whose analyses of world markets focus on credit and currencies, has produced long-term annual returns, net of fees, averaging 15%.

In the turmoil of 2008, Bridgewater's Pure Alpha 1 fund gained 8.7% net of fees and Pure Alpha 2 delivered 9.4%. Here's what's on his mind now.

Barron's: I can't think of anyone who was earlier in describing the deleveraging and deflationary process that has been happening around the world.

Dalio: Let's call it a "D-process," which is different than a recession, and the only reason that people really don't understand this process is because it happens rarely. Everybody should, at this point, try to understand the depression process by reading about the Great Depression or the Latin American debt crisis or the Japanese experience so that it becomes part of their frame of reference. Most people didn't live through any of those experiences, and what they have gotten used to is the recession dynamic, and so they are quick to presume the recession dynamic. It is very clear to me that we are in a D-process.

Why are you hesitant to emphasize either the words depression or deflation? Why call it a D-process?

Both of those words have connotations associated with them that can confuse the fact that it is a process that people should try to understand.

You can describe a recession as an economic retraction which occurs when the Federal Reserve tightens monetary policy normally to fight inflation. The cycle continues until the economy weakens enough to bring down the inflation rate, at which time the Federal Reserve eases monetary policy and produces an expansion. We can make it more complicated, but that is a basic simple description of what recessions are and what we have experienced through the post-World War II period. What you also need is a comparable understanding of what a D-process is and why it is different.

You have made the point that only by understanding the process can you combat the problem. Are you confident that we are doing what's essential to combat deflation and a depression?

The D-process is a disease of sorts that is going to run its course. When I first started seeing the D-process and describing it, it was before it actually started to play out this way. But now you can ask yourself, OK, when was the last time bank stocks went down so much? When was the last time the balance sheet of the Federal Reserve, or any central bank, exploded like it has? When was the last time interest rates went to zero, essentially, making monetary policy as we know it ineffective? When was the last time we had deflation?

The answers to those questions all point to times other than the U.S. post-World War II experience. This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s. Basically what happens is that after a period of time, economies go through a long-term debt cycle -- a dynamic that is self-reinforcing, in which people finance their spending by borrowing and debts rise relative to incomes and, more accurately, debt-service payments rise relative to incomes. At cycle peaks, assets are bought on leverage at high-enough prices that the cash flows they produce aren't adequate to service the debt. The incomes aren't adequate to service the debt.

Then begins the reversal process, and that becomes self-reinforcing, too. In the simplest sense, the country reaches the point when it needs a debt restructuring. General Motors is a metaphor for the United States.

As goes GM, so goes the nation?

The process of bankruptcy or restructuring is necessary to its viability. One way or another, General Motors has to be restructured so that it is a self-sustaining, economically viable entity that people want to lend to again.

This has happened in Latin America regularly. Emerging countries default, and then restructure. It is an essential process to get them economically healthy.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money [Exactly, but keep reading, the story gets even better].

It isn't complicated. It is the same as all bankruptcies, but when it happens pervasively to a country, and the country has a lot of foreign debt denominated in its own currency, it is preferable to print money and devalue.

Isn't the process of restructuring under way in households
and at corporations?

They are cutting costs to service the debt. But they haven't yet done much restructuring. Last year, 2008, was the year of price declines; 2009 and 2010 will be the years of bankruptcies and restructurings. Loans will be written down and assets will be sold. It will be a very difficult time. It is going to surprise a lot of people because many people figure it is bad but still expect, as in all past post-World War II periods, we will come out of it OK. A lot of difficult questions will be asked of policy makers. The government decision-making mechanism is going to be tested, because different people will have different points of view about what should be done.

What are you suggesting?

An example is the Federal Reserve, which has always been an autonomous institution with the freedom to act as it sees fit. Rep. Barney Frank [a Massachusetts Democrat and chairman of the House Financial Services Committee] is talking about examining the authority of the Federal Reserve, and that raises the specter of the government and Congress trying to run the Federal Reserve. Everybody will be second-guessing everybody else.

So where do things stand in the process of restructuring?

What the Federal Reserve has done and what the Treasury has done, by and large, is to take an existing debt and say they will own it or lend against it. But they haven't said they are going to write down the debt and cut debt payments each month. There has been little in the way of debt relief yet. Very, very few actual mortgages have been restructured. Very little corporate debt has been restructured.

The Federal Reserve, in particular, has done a number of successful things. The Federal Reserve went out and bought or lent against a lot of the debt. That has had the effect of reducing the risk of that debt defaulting, so that is good in a sense. And because the risk of default has gone down, it has forced the interest rate on the debt to go down, and that is good, too.

However, the reason it hasn't actually produced increased credit activity is because the debtors are still too indebted and not able to properly service the debt. Only when those debts are actually written down will we get to the point where we will have credit growth.

There is a mortgage debt piece that will need to be restructured. There is a giant financial-sector piece -- banks and investment banks and whatever is left of the financial sector -- that will need to be restructured. There is a corporate piece that will need to be restructured, and then there is a commercial-real-estate piece that will need to be restructured.

Is a restructuring of the banks a starting point?

If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings.

On the issue of the banks, ultimately we need banks because to produce credit we have to have banks. A lot of the banks aren't going to have money, and yet we can't just let them go to nothing; we have got to do something. But the future of banking is going to be very, very different. The regulators have to decide how banks will operate.

That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?

Nationalization is the most likely outcome?

There will be substantial nationalization of banks. It is going on now and it will continue. But the same question will be asked even after nationalization: What will happen to the pile of bad stuff?

Let's say we are going to end up with the good-bank/bad-bank concept. The government is going to put a lot of money in -- say $100 billion -- and going to get all the garbage at a leverage of, let's say, 10 to 1. They will have a trillion dollars, but a trillion dollars' worth of garbage. They still aren't marking it down.

Does this give you comfort?

Then we have the remaining banks, many of which will be broke. The government will have to recapitalize them. The government will try to seek private money to go in with them, but I don't think they are going to come up with a lot of private money, not nearly the amount needed.

To the extent we are going to have nationalized banks [Citi, BAC for sure, as I have maintained; they are already Fed controlled, if not completely nationalized], we will still have the question of how those banks behave. Does Congress say what they should do? Does Congress demand they lend to bad borrowers? There is a reason they aren't lending.

So whose money is it, and who is protecting that money?

The biggest issue is that if you look at the borrowers, you don't want to lend to them. The basic problem is that the borrowers had too much debt when their incomes were higher and their asset values were higher. Now net worths have gone down.

Let me give you an example. Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower.

If you shouldn't have lent to them before, how can you possibly lend to them now?

I guess I'm thinking of the examples of people and businesses with solid credit records who can't get banks to lend to them. Those examples exist, but they aren't, by and large, the big picture. There are too many non-viable entities. Big pieces of the economy have to become somehow more viable. This isn't primarily about a lack of liquidity. There are certainly elements of that, but this is basically a structural issue. The '30s were very similar to this.

By the way, in the bear market from 1929 to the bottom, stocks declined 89%, [note: in 1929 the DJI stocks were very extended and had the same kind of PEs as 2000. When stocks tanked in 2008, the PEs were much lower because the air was already let out of the stock market, so we will not need to see a DJI of 1400 before this is over. We probably already has seen the DJI low] with six rallies of returns of more than 20% -- and most of them produced renewed optimism. But what happened was that the economy continued to weaken with the debt problem. The Hoover administration had the equivalent of today's TARP [Troubled Asset Relief Program] in the Reconstruction Finance Corp. The stimulus program and tax cuts created more spending, and the budget deficit increased.

At the same time, countries around the world encountered a similar kind of thing. England went through then exactly what it is going through now. Just as now, countries couldn't get dollars because of the slowdown in exports, and there was a dollar shortage, as there is now. Efforts were directed at rekindling lending. But they did not rekindle lending. Eventually there were a lot of bankruptcies, which extinguished debt.

In the U.S., a Democratic administration replaced a Republican one and there was a major devaluation and reflation that marked the bottom of the Depression in March 1933. [The timing of the change in Presidents is remarkable in its similarity. The market decline and recession started in 1930 and two years later, there was an election. This time, the housing market peaked in 2006 and two years later, there was an election. I think we are in early 1933 if we use the Great Depression as our reference. That was a great time to get long the stock market]

Where is the U.S. and the rest of the world going to keep getting money to pay for these stimulus packages?

The Federal Reserve is going to have to print money [my blog friends who fear the printing press need to pay attention here. This point is why I discount what I hear from Marc Faber, Jim Rogers and Peter Schiff. They don't know their history]. The deficits will be greater than the savings. So you will see the Federal Reserve buy long-term Treasury bonds, as it did in the Great Depression [this answers the question about who will lend us the money to back the printing press]. We are in a position where that will eventually create a problem for currencies and drive assets to gold [which, in this context, is okay. I am long gold, but I am also long our economy].

Are you a fan of gold?

Yes.

Have you always been?

No. Gold is horrible sometimes and great other times [because its only value is as an alternate currency or jewelry. Gold has NO inherent value. It is an unproductive asset]. But like any other asset class, everybody always should have a piece of it in their portfolio.

What about bonds? The conventional wisdom has it that bonds are the most overbought and most dangerous asset class right now.

Everything is timing. You print a lot of money, and then you have currency devaluation. The currency devaluation happens before bonds fall. Not much in the way of inflation is produced, because what you are doing actually is negating deflation. So, the first wave of currency depreciation will be very much like England in 1992, with its currency realignment, or the United States during the Great Depression, when they printed money and devalued the dollar a lot. Gold went up a whole lot and the bond market had a hiccup, and then long-term rates continued to decline because people still needed safety and liquidity [this is a point that changes my thinking a bit. I think in terms of either / or; but Dalio makes the case for an overlap of the appreciation of both asset classes].

While the dollar is bad, it doesn't mean necessarily that the bond market is bad. I can easily imagine at some point I'm going to hate bonds and want to be short bonds, but, for now, a portfolio that is a mixture of Treasury bonds and gold is going to be a very good portfolio, because I imagine gold could go up a whole lot and Treasury bonds won't go down a whole lot, at first.

Ideally, creditor countries that don't have dollar-debt problems are the place you want to be, like Japan. The Japanese economy will do horribly, too, but they don't have the problems that we have -- and they have surpluses. They can pull in their assets from abroad, which will support their currency, because they will want to become defensive.

Other currencies will decline in relationship to the yen and in relationship to gold [hmmmm, I don't know if "less bad" is good enough for me. I think Japan is in this with the rest of us; though recent currency action supports Dalio's case here].

And China?

Now we have the delicate China question. That is a complicated, touchy question. The reasons for China to hold dollar-denominated assets no longer exist, for the most part. However, the desire to have a weaker currency is everybody's desire in terms of stimulus.

China recognizes that the exchange-rate peg is not as important as it was before, because the idea was to make its goods competitive in the world. Ultimately, they are going to have to go to a domestic-based economy. But they own too much in the way of dollar-denominated assets to get out, and it isn't clear exactly where they would go if they did get out. But they don't have to buy more. They are not going to continue to want to double down.

From the U.S. point of view, we want a devaluation [YES!! this is the point I always make: we must create inflation to get out of this problem, thereby devaluing the dollar]. A devaluation gets your pricing in line. When there is a deflationary environment, you want your currency to go down. When you have a lot of foreign debt denominated in your currency, you want to create relief by having your currency go down. All major currency devaluations have triggered stock-market rallies throughout the world; one of the best ways to trigger a stock-market rally is to devalue your currency.

But there is a basic structural problem with China. Its per capita income is less than 10% of ours. We have to get our prices in line, and we are not going to do it by cutting our incomes to a level of Chinese incomes.

And they are not going to do it by having their per capita incomes coming in line with our per capita incomes. But they have to come closer together. The Chinese currency and assets are too cheap in dollar terms, so a devaluation of the dollar in relation to China's currency is likely, and will be an important step to our reflation and will make investments in China attractive. [this is a major thesis of mine, and I own FXI, the China equity index fund and will buy more. This is a long term phenomena that will last my lifetime. China will be the major source of commodity demand for decades, so commodities are a great investment here]

You mentioned, too, that inflation is not as big a worry for you as it is for some. Could you elaborate?

A wave of currency devaluations and strong gold will serve to negate deflationary pressures [YES!! another of my points: inflation cancels deflation], bringing inflation to a low, positive number rather than producing unacceptably high inflation [this is the point where Faber, Rogers and Schiff are most wrong because they do not acknowledge the role of cancellation of deflation] -- and that will last for as far as I can see out, roughly about two years.

Given this outlook, what is your view on stocks?

Buying equities and taking on those risks in late 2009, or more likely 2010, will be a great move because equities will be much cheaper than now. It is going to be a buying opportunity of the century.

Thanks, Ray

.

Refuting the Arguments of Gold Bugs

Today, I answer the blogposts of a couple of gold bugs who are a little overwrought with the idea of a new age where gold is king:

"Another Case for Gold": http://livingoffdividends.com/2009/01/31/another-case-for-gold/comment-page-1/#comment-32504


"Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.

You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).

But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:

1. “if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” - POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
2. “Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT - NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar through Treasuries and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
3. “They’re not going to fund an inflationary dollar at 2%. Ever.” POINT - DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supply (we can only wish for that right now), then interest rates will be bid higher.
4. The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quoted every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
5. “[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT - many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
6. The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before (and on average for Americans, it is), it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.

Looking Up for Energy and Resource Stocks

Swiss investor, Marc Faber, still hates America, but he has a good track record for market prediction. So, I paid attention when I read this in Barrons today, in the Investor Roundtable Part 3:

Faber: When volatility diminishes (in the next few months), you want to be in cyclical industries. Among the most cyclical stocks are resource producers. They were driven up by incremental demand from China, and then collapsed. In the next six months they could have significant upside. I like Rio Tinto, BHP Billiton and CVRD [Companhia Vale do Rio Doce].

The financial crisis and collapse in commodities will keep supplies out of the market. Nobody is exploring now. There is no money, and projects are being postponed. Whenever the recovery comes, in five or 10 years, resources stocks will go ballistic from today's low levels. If you're optimistic about the next six months, too, when the news may be slightly better than today, you should own them. Freeport McMoRan Copper & Gold fell from 127 to 15 and is now 26. Xstrata, in Switzerland, is another one. A lot of these stocks are more attractive than gold, because gold is at a 20-year high relative to industrial commodities.

Scott Black: Rio Tinto's balance sheet isn't in good shape. They have a refinancing issue.

Faber: Worst-case, the Chinese government could buy them out. China has taken a big stake in the company. Meryl recommended Kaiser Aluminum [KALU] earlier today. I would add Alcoa.

Felix Zulauf: You're not saying this is the beginning of a big bull market, but of a base-building process from low levels.

Faber: Correct, but when stocks decline by the magnitude seen in resources shares, or the Nasdaq after 2000, a base-building period follows that can extend for several years. When you print money, you can get an artificial bull market (in cyclical and resource stocks) that exceeds everyone's expectations.


And this is a quote from Scott Black, another on the Barrons Roundtable of great investors (and a disciple of Benjamin Graham and value investing). He makes the case for XTO. But the arguments and metrics can be applied just as well to the Canroys (though it appears XTO did a much better job of hedging than PWE or PGH):


BLACK : My next pick is an old favorite, XTO Energy, in Fort Worth. The stock is 37.58, there are 577 million fully diluted shares, and the market cap is $21.6 billion. The company did a smart thing by hedging approximately 77% of its natural-gas production in 2009. They have locked in 1.6 Bcf [billion cubic feet] of gas at $8.94 per Mcf [thousand cubic feet], and 62,500 barrels a day at $118.85 per barrel. Production has been growing dramatically, and should average about 2.67 Bcf per day in 2009, up 18% year over year. About half the increase is from drill-bit growth, the rest from acquisitions. XTO bought Hunt Petroleum last year for $4.2 billion, figuring it could triple reserves, which are now 80% gas, 20% oil. It has 12 Tcfe [trillion cubic feet-equivalent] of gas and 500 million barrels of oil.

BARRONS: What are you pricing reserves at?

Black: I value the gas reserves at $3 per Mcf and the oil at $8 per barrel. Breakup value is about $44 a share, so the stock is selling at 85% of breakup value. My 2009 revenue estimate is $9.86 billion -- slightly higher than the Street's -- which converts to $4.50 a share in earnings. Return on equity is 15.5%, return on total capital 10.3%. Free cash flow is $2.28 billion. XTO has cut its capital-spending budget this year, to $3.8 billion from more than $5.3 billion. They are wed to the notion of knocking $1 billion to $2 billion of debt off the balance sheet.

Their finding and development costs were $1.45 to $1.50 per Mcfe in 2007, and $1.65 in 2008. This year they could fall to $1.50. XTO is one of the few energy companies with rising earnings, because of hedging. They will earn about $3.75 to $3.80 a share for 2008, and $4.50 for '09. The stock sells for 8.3 times earnings and 3.6 times discretionary cash flow. It is extremely cheap. You've got asset and earnings protection. And they are in every major field in the U.S. -- the Barnett Shale, Fayetteville and so forth. Energy is a controversial investment today, but XTO is the cream of the crop.

Schafer: If they hedged this year, does that mean next year's earnings will be down?

Black: No, because they hedged 2010, too.

Goodbye, President Bush; We Will Miss You

I do not name this post sarcastically. I know I am in the minority, but I will miss President Bush. Yes, he was hard to watch and listen to at times, with his less than perfect execution of the English language (and won't the liberal comedians miss him for this?!). And yes, he was bullheaded and stubborn and overly loyal to his friends; and he could stick too long to his conservative principles when pragmatism suggested otherwise. But that is also why I liked President Bush. Like every human, he was fallible. But unlike most politicians, he was humble and able to laugh at himself. He knew he was not very polished and he reveled in his imperfections.

I just read a great piece on President Bush's retirement from the Presidency by Karl Rove. Yes, it is biased as Rove was Bush's right hand man for many years. But it is also honest and true. Read the article below. I think regardless of your political orientation, you will appreciate the great human being that is George W. Bush. And note his accomplishments. Did anyone besides me and Karl Rove get the irony of President Barak Obama warning terrorists that "you cannot outlast us"? This statement was only made possible by the unpopular policies of President George W. Bush. In the unvarnished re-examination of historians, he will be remembered for protecting us at one of our darkest times.


OPINION
JANUARY 21, 2009, 10:48 P.M. ET

Bush Was Right When It Mattered Most

http://online.wsj.com/article/SB123258532378704477.html

By KARL ROVE

Its call sign has always been Air Force One. But on Tuesday, it was Special Air Mission 28000, as former President George W. Bush and his wife Laura returned home to Texas on a plane full of family, friends, former staff and memories of eight years in the White House.

The former president and his wife thanked each passenger, showing the thoughtfulness and grace so characteristic of this wonderful American family.

A video tribute produced warm laughter and inevitable tears. There was no bitterness, but rather a sense of gratitude -- gratitude for the opportunity to serve, for able and loyal colleagues, and above all for our country and its people.

Yet, as Mr. Bush left Washington, in a last angry frenzy his critics again distorted his record, maligned his character and repeated untruths about his years in the Oval
Office. Nothing they wrote or said changes the essential facts.

To start with, Mr. Bush was right about Iraq. The world is safer without Saddam Hussein in power. And the former president was right to change strategy and surge more U.S. troops.

A legion of critics (including President Barack Obama) claimed it couldn't work. They were wrong. Iraq is now on the mend, the war is on the path to victory, al Qaeda has been dealt a humiliating defeat, and a democracy in the heart of the Arab world is emerging. The success of Mr. Bush's surge made it possible for President Obama to warn terrorists on Tuesday "you cannot outlast us."

Mr. Bush was right to establish a doctrine that holds those who harbor, train and support terrorists as responsible as the terrorists themselves. He was right to take the war on terror abroad instead of waiting until dangers fully materialize here at home. He was right to strengthen the military and intelligence and to create the new tools to monitor the communications of terrorists, freeze their assets, foil their plots, and kill and capture their operators.

These tough decisions -- which became unpopular in certain quarters only when memories of 9/11 began to fade -- kept America safe for seven years and made it possible for Mr. Obama to tell the terrorists on Tuesday "we will defeat you."

Mr. Bush was right to be a unilateralist when it came to combating AIDS in Africa. While world leaders dithered, his President's Emergency Plan for AIDS Relief initiative brought lifesaving antiretroviral drugs to millions of Africans.

At home, Mr. Bush cut income taxes for every American who pays taxes. He also cut taxes on capital, investment and savings. The result was 52 months of growth and the strongest economy of any developed country.

Mr. Bush was right to match tax cuts with spending restraint. This is a source of dispute, especially among conservatives, but the record is there to see. Bill Clinton's last budget increased domestic nonsecurity discretionary spending by 16%. Mr. Bush cut that to 6.2% growth in his first budget, 5.5% in his second, 4.3% in his third, 2.2% in his fourth, and then below inflation, on average, since. That isn't the sum total of the fiscal record, of course -- but it's a key part of it.

He was right to have modernized Medicare with prescription drug benefits provided through competition, not delivered by government. The program is costing 40% less than projected because market forces dominate and people -- not government -- are making the decisions.

Mr. Bush was right to pass No Child Left Behind (NCLB), requiring states to set up tough accountability systems that measure every child's progress at school. As a result, reading and math scores have risen more in the last five years since NCLB than in the prior 28 years.

He was right to stand for a culture of life. And he was right to appoint conservative judges who strictly interpret the Constitution.

Few presidents had as many challenges arise during their eight years, had as many tough calls to make in such a partisan-charged environment, or had to act in the face of such hostile media and elite opinion.

On board Special Air Mission 28000, I remembered the picture I carried in my pocket on my first Air Force One flight eight years ago. It was an old black-and-white snapshot with scalloped edges. It showed Lyndon Johnson in the Cabinet Room, head in hand, weeping over a Vietnam casualty report. George Christian, LBJ's press secretary, gave it to me as a reminder that the job could break anyone, no matter how big and tough.

But despite facing challenges and crises few others have, the job did not break George W. Bush. Though older and grayer, his brows more furrowed, he is the same man he was, a person of integrity who did what he believed was right. And he exits knowing he summoned all of his energy and talents to defend America and advance its ideals at home and abroad. He didn't get everything right -- no president does -- but he got the most important things right. And that is enough.

Mr. Rove is the former senior adviser and deputy chief of staff to President George W. Bush.

Reflation Economics (or "The Minsky Solution")

As your resident amateur economist, I would like to offer up an article coming from one leg of the PIMCO triumvirate (Paul McCulley, the others being Bill Gross and Mohamend El-Erian) who rule the private sector bond world.

McCulley is the Central Bank expert of the group and his expertise is near Nobel Laureate in its quality and insight. The PIMCO group anticipated the current banking crisis and declared the cause well in advance of the blowup. The PIMCO team labeled the cause as the "Shadow Banking System" and saw the leverage that was being created by hedge funds and others using the tools like "carry trade" to create money through leverage.

Like the rest of us, this group of economists thought the outcome of "shadow banking" would be inflation, as easy money created excess demand. None of them forecast the total collapse of the system and the resultant deflation. However, McCulley suggested the possibilty through his analysis of Hyman Minsky's work as an economist 30 years ago. McCulley uses Minsky to explain money growth and contraction, and does so at times with his stuffed bunny he keeps in his office (he calls "Bun-Bun").

I thought you might find this article insightful. Here is a sample with my paraphrasing in parantheses:

(It is the explicit responsibility of the Fed to provide a “more than proportionate” response to an economic contraction). That is indeed what is needed to save capitalism from its inherent debt-deflation pathologies. The paradox of deleveraging and the paradox of thrift are beasts of burden that capitalism simply can’t bear alone (that is to say, Capitalism is not a perfect economic system, but occassionally needs help when excess greed or fear get in the way). Only the Minsky Solution can lift that load.”

Here is the entire article:

http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2008/GCB+December+2008+McCulley+All+In.htm

PIMCO and specifically, Paul McCulley, is the originator of the idea of “Shadow Banking”, which has come to dwarf the Federal Reserve system in the last 10 years. The amount of assets controlled by the shadow bank makes central bank policy implementation difficult, if not impossible. Shadow banking is the creation of money from nothing by private institutions, like hedge funds. Such financial institutiosn were increasingly deregulated in the 1990s and 2000s. Because they could use instruments like the “carry trade” to create money with very little invested capital, by use of massive leverage, the system effectively grew the money supply outside the control of the Central Bank. This was thought to be inflationary by the PIMCO team as late as 2007, but proved to be deflationary instead.

Now, that the shadow banking system is collapsing, it is following exactly the Minsky model. The Minsky Moment, modeled as the “Ponzi Unit” (in the McCulley chart), was achieved almost exactly at the time the biggest real-life ponzi scheme was uncovered, the Madoff Fund. Talk about life imitating art!!

So, the real central bank must transfer the leverage that is disappearing in the private sector, to the public sector, in order that the economy does not collapse into oblivion. I would like to ask Mr. McCulley what is the step to follow in the Minsky Model: how does the leverage that the public sector absorbs from the private sector get resolved? By time alone?

http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm

My Projections for 2009

How bad was 2008 from an investment perspective? From Barrons issue on January 5: "The S&P 500's 37% loss of 2008 served to knock three-quarters of a percentage point off the annualized index total return since 1927, to 9.7% from 10.4%, according to Aronson+Partners. The 10-year trailing returns for large-cap stocks now appear to be at their worst level since 1827, says Morgan Keegan, and trailing returns of world equities versus bonds are at their weakest since the late 1970s, says BCA Research."

So, combined with the Tech Bust in 2001-03, we could say we are simply in the worst period for investors in 200 years. We should have "mean reversion" at some point. It has to get better!! The article goes on to say: "the lousy risk adjusted record for stocks that now dominate investors' memory is discrediting equities in the public mind as a wealth-building asset class." For those with a 20 year time horizon, this is what we want to hear. I was very worried a couple years ago when volatility had gone to less than 10 (as measured by VIX). Low market price volatility goes with a perception of low risk. When the market loses its risk, it also loses its prospects for return.

For the stock market to achieve its typical 4-6% real return (the return above inflation), there must be a perception of risk. If there is no risk, then returns will be only 1-2% over inflation (see TIPS returns as an example), and the ability to grow wealth by market investing will be lost.

Santoli goes on in his Barrons article: "This is helpful, and implies the direction of mean reversion for asset classes will favor stocks again before long, though who knows from what ultimate level? The five years following the 10 worst calendar years for stocks were always up in total -- sometimes not much, sometimes a lot, an average of about 10% annualized -- yet three times the year immediately afterward was down more than 20%."

All this is good and sounds very reasonable. But the title of this post is "Projections for 2009". I know you are looking forward to my annual amusing, but rarely insightful projections. I understand that by January 4, you have already seen more than enough forecasts. But I have been doing this since 2002 now (except last January when my crystal ball was all cloudy), so I don't want to break the string (though I just admitted I did last year). Here goes:

• Government backed interest rates (mortgages and Treasuries) will stay low throughout 2009 (less than 1% for 2 year bonds); but sometime thereafter, maybe early 2010, they will start rising and continue going up as inflation heats up along with an economic recovery.
• By the July 2009, the high yield and corporate bond interest rates will begin to decline, narrowing the historic spreads against risk free Treasuries
• Crude oil will continue weak throughout 2009 in a range of $25 -$60 per barrel; as a result production and exploration will be reduced and lower production with higher demand will set the stage for a rebound to over $100 sometime in 2010 or 2011; enjoy low gasoline prices while you can;
• Gold prices will stay under $1000 in 2009, but will not decline under $600; but gold could increase to over $1500 by 2012 because of a weaker dollar caused by inflation from excess money supply created in 2009;
• In early 2009, GM will be forced to declare bankruptcy (or an equivalent government reorganization); same for Chrysler; this will set the stage for a revamping of the American auto industry and will usher in a new era of manufacturing competitiveness; Ford will escape bankruptcy, but will benefit from the changed labor and franchise rules;
• At least five major mall retail brands will declare bankruptcy and will be closed; candidates: Abercrombie, Zumiez, GAP, Hot Topic, Lane Bryant, Foot Locker, Eddie Bauer, Ann Taylor; but look for the retail sector to outperform as soon as 2010;
• General Growth may become a victim both due to the above store closings / bankruptcies, but also due to the debt it took on to acquire Rouse Companies; its survival depends on selling several of the Rouse flagship properties: Fanueil Hall (Boston), Harborplace (Baltimore) South Street Seaport (NYC) and its Las Vegas malls (Forum Shoppes, Fashion Mall, Highland Mall);
• Official unemployment will top 8%, but will not top 10%;
• Mortgage rates for 30 year fixed rate Fannies will be less than 4.5% with no points; but these rates will rise in 2010;
• The stock markets will see a range and return by year end of DJI: 7000 - 10,500 (13%); S&P500: 725 - 1100 (15%); NASDAQ100: 1400 - 2200 (10%); with the lower end of the range reached in the first half of the year (there will be a retest of the November low, but that retest will be the bottom of a new 20 year secular Bull market, albeit the new Bull will be sleepy for several years while the economy and debt are repaired);
• The best asset class return in 2009 will be in high yield bonds (junk) with a 30% total return;
• The 2nd best asset class return in 2009 will be in energy stocks, both producers and equipement providers, though producers will have the best total return at 25%;
• The worst asset class in 2009 will be Treasuries with 30 year bonds returning a negative 20%;

Gheit - Oil Price Forecast for 2009

Fadel Gheit has a very good record of predicting the direction and level of oil prices, similar to Boone Pickens in accuracy. He is pointing to higher prices for oil in 2009 and thinks the sell-off is overdone. All this has good implications for the CanRoys. They are very much oversold right now. Pennwest, as an example, can be profitable and cash flow positive at $40 oil. Its costs will come down in 2009 as demand for oil services drops hard. Its fixed cost overhead is not very high (for administration only) and its debt load is reasonable with maturities out several years (much better than American companies like Chesapeake which is in real trouble after taking on too much debt).

The past couple years, it has become popular among the CanRoys to minimize the monthly distribution and instead direct a lot of cash flow to capital improvements and acquisitions. PWE and Daylight have been down around 50% of cash flow directed to distributions. The historical average is closer to 80%. PWE has announced it is drastically cutting back on capital projects in 2009 and selling some properties, so it can preserve cash flow to maintain distributions at the lower oil prices. This is more the historical model.

The lower oil prices should also discourage the Canadian national government from going through with taxing profits on royalty trusts. Oil is not the big treasure chest it was perceived to be by some in Parliament. We may see the Liberal party take control of Parliament soon and then change the terms of the taxation program, either lowering to 10% or maybe eliminating the Harper - Faherty program altogether.

It seems very possible by the end of 2009 the Canroys can recoup the cash flow they had in 2006 and rebound to the prices they were trading at when oil was at $60/barrel in late 2006 (after the Halloween Massacre), when stock price was around $30 for Pennwest (PWE), for example, and $17 for Pengrowth. Also, most of the Canroys are highly hedged for 2009, which will aid cash flow. Pengrowth (PGH) has an 50% of its oil sold forward at $80 for 2009 and 50% of its gas production at $10. The other Canroys have similar hedging programs in place which will stabilize dividends. The market has not factored this in by driving prices down 70% and yields up by 300%.

Here is what Fadel has to say:

MONDAY, DECEMBER 29, 2008
ELECTRONIC Q&A


How to Profit on Oil's Comeback
By NAUREEN S. MALIK

Oppenheimer's Fadel Gheit is big on independent energy producers.


OIL AND BASEBALL -- NAMELY the Yankees -- are two passions that are remarkably similar for Fadel Gheit.

While he makes his living off the first and is an avid fan of the second, the managing director of energy at Oppenheimer says both markets are subject to the "bubble." Crude-oil prices have collapsed and salaries by baseball's A-listers could be next?

"Unfortunately the sports bubble hasn't burst yet, and it will, mark my words it will," says Gheit, who thinks Alex Rodriguez should be making $3 million, not $50 million, for a job some people would take for free hot dogs.

Manager's Bio
Name: Fadel Gheit
Title: Managing director and senior analyst covering the oil and gas sector, Oppenheimer & Co.

Education: B.S. in chemical engineering, Cairo University; MBA in finance, New York University

Hobbies: Watching sports, mainly the Yankees, but also watches the Mets, Giants and Jets.As for oil, Gheit, who was a skeptic as oil breached $100 a barrel earlier this year, has turned positive while others are decidedly negative about energy at the moment. Oil prices rallied to $145.29 in early July before recently falling to the low $30-range.

Gheit, an Egyptian with chemical-engineering training, joined Mobil Oil in 1980 as oil prices touched record highs due to escalated tensions in the Middle East. He traipsed around the Arabian dessert examining oil production before jumping to Wall Street.

Gheit has seen crude oil go up because of war, revolution, and other major global events. Oil supplies in particular have been impacted, but this downturn "has to be one of the worst" because it is a global economic issue.

Oil "is not a free market," says Gheit pointing to Wall Street speculation. He has repeatedly testified in front of Congress, urging the government to create an energy plan and a better regulatory framework to oversee the market.

While that regulatory framework will take time, Gheit sees plenty of reasons to bulk up on energy stocks now.

Barron's Online: Do you think oil is sustainable at these levels?

Fadel Gheit: No, I never thought that oil prices are sustainable above $100. I never thought they were sustainable at $30 either. The global economy will recover, whether in a year or two or three. Two years of higher prices usually bring additional investment and will expand supply and curtail demand and consumption as companies and consumers try to become more energy efficient. The flip side of the coin is the exact opposite. When you have extremely low prices, that will dry up investment and it will take years for the industry to go back on track. That's why you create feast or famine because of the lack of coordination between producers and consumers, the lack of transparency in the financial market [and] basically the lack of government supervision either because of indifference or corruption.

Q: What could per-barrel oil prices go and what is a suitable level?

A: I think oil prices over $60; $65 would be pushing it. We don't need it.

Q: Do you think OPEC is going to cut production even more?

A: Absolutely, OPEC will cut production and we will feel the impact within six weeks of production cut. These people cannot balance their budget at $50 per barrel and so they are hurting pretty badly. One of the reasons I don't want to see $30 per barrel is because I really do not want to see major disruption, regimes could be thrown out.

Q: What does this mean for profits and the marginal cost of production?

A: To operate, the cost [for oil producers] has increased by almost 16%-20% annually over the last five years. It was one of the sharpest inflationary periods in recent history and the reason is that everybody, because of the increasing oil prices, was chasing limited capacity of services, so oil-service companies were basically gouging the industry. We are hoping that the costs are going to go down, but we are talking about 10%, 15%, 20%, not 40%, 50% or 60%. We are also going to see more technology advancement because people will pay more attention to efficiency and cost efficiency.

Unless oil prices recover sharply next year, or we believe that oil prices will average $40 next year, it means that there will be about a 40%-50% drop in earnings and cash flow. Most companies will limit their capital spending to availability of funds , which may be coming from cash flow, so that means that capital spending will be down by as much as 40% [in 2009]. Longer-term projects do not get derailed once they start because any delay becomes counter productive. But new projects will be delayed.

Q: You have been touting large integrated-oil companies such as Exxon Mobil (ticker: XOM) throughout the year. Are they still a good bet?

A: Integrated oil is very simple. We believe that the dividends are safe. Companies like Shell (RDS-b) and BP (BP) offer 6%-plus dividend yield. Both stocks are down significantly this year. Shell in its history only suspended its dividend once during the Second World War. Now if you don't trust the market, but believe oil prices will not go above $40-$45, then you should own Exxon.

A company like Exxon has been underinvested for five years, not because they are stupid because they were smart. They didn't chase barrels for exorbitant price and cost. They have $40 billion cash. They can buy any independent-oil company and pay them a 30% premium without going to the bank. They can buy Apache (APA), Chesapeake Energy (CHK), Devon Energy (DVN), EOG Resources (EOG), Noble (NE). The market value of Exxon treasury stock is $205 billion. That is higher than the market value of BP, Chevron (CVX), Royal Dutch Shell (RDSA) and Conoco Phillips (COP).

Q: What about natural gas?

A: The rule of thumb is natural-gas is traded at one-tenth-to-one-eighth the price of oil. Gas is stuck in a way, because what determines where gas prices go include winter demand. The other thing is most natural-gas producers in the U.S. cannot maintain production if gas prices go below $6 per cubic feet.

Q: What are your top oil and natural-gas stock picks?

A: Right now I think the upside potential will be the independent producers. They have much higher beta. They gain the most when oil prices rise and they lose the most when oil prices go down. I think we are at or close to the bottom of commodity prices. When prices move higher, Exxon doesn't gain as much as Anadarko Petroleum (APC) or Apache or EOG or Devon.

These stocks will do much better than the S&P 500, but more importantly, we think they [will meet] the threshold of 20% returns in 12 months for an Outperform [rating]. Most of them are onshore natural-gas plays in the U.S. The exception is that Apache has 45% of its operations outside the U.S. But believe it or not, these stocks respond to oil prices.

The best asset play is Devon. Occidental Petroleum (OXY) and Devon have the strongest balance sheets. The companies most undervalued in the group, I would say are Anadarko and Pioneer Natural Resources (PXD). Chesapeake's debt level is double the size of the company. Anadarko has $10 billion debt, which they are trying to bring down as fast as they can.

Q: Refiners have been beaten badly throughout the year. Why are you now positive on names like Sunoco (SUN) and Valero Energy (VLO)?

A: The biggest upside potential is going to be in the refiners over the next two years. These stocks are down so far this year about 65%. I put a Sell rating on the refining stocks in January and they went down 75%. A few weeks ago we raised our rating on them to Outperform. The stocks so far are up about 20%.

Q: Thank you.

The Past as a Portal to the Future - Part 2

In my continuing quest for "Truth" where the economy and markets are concerned, I have been reading up on some of the more pessemistic points of view. I have never been a very good pessemist, even though I can talk a good game. By definition, the pessemistic perspective is extreme, and therefore less likely than some middle-of-the-bell-curve scenario. I am inherently a pragmatist and live in the middle of that bell curve. But even if I have a hard time following with actions the completely negative point of view, knowing it helps harden me against the possibility of it coming true. So, it is worth knowing and understanding.

I have read books by super-Bears, Robert Prechter and articles by David Tice. I am even willing to listen to or read Marc Faber, Bill Fleckenstein, Doug Kass and Jeremy Grantham, all of whom have been right to this point in time about the depth and severity of the financial crisis. But most of these guys have been calling for the 2008 market since the mid-1990s or earlier. Had I gone to cash when they first recommended it back then, I would still be down today from where I am. I find timing the market to be very difficult because of my optimism about the future. The only time I can bring myself to sell is when stocks or funds are obviously overvalued as the Techs were in 2000 at 50 or 100 PEs, or when gold was at $1000 earlier this year.

But after weighting my portfolio to large cap, low P/E, high dividend payers, I have mostly held on through this firestorm knowing that even in the deepest depressions (1930s) a consistent program of reinvesting to average down cost will eventually get one back to even. But being out of the market and getting left behind leaves almost no chance of ever catching up. As they say, "there is no bell ringing at the bottom". If the market were to rebound 25% to 11,000 in February, how many people would then invest. How many more would consider that to be a "dead cat bounce" and continue staying on the side line, perhaps as the market went higher? This is the danger of getting in and out of the market. (for readers in retirement without the requisite 10-15 year time frame to absorb the worst possible scenarios and rebuild a portfolio, cash and Treasuries should already be the game plan and hopefully is).

Here is an article that makes the case for "the worst is yet to come". The comparison, which I respect very much and might end up being true, is that we are at 1937 but with the 1930-32 plunge of 90% from top to bottom to come. The author makes the case that since so far a complete crash has been forestalled by government intervention, it must still be in our future. Of course, in the 1930-32 period, Hoover did try hard to stop the market and economic plunge, but his advisors had little historical insight to work with and none of the Federal and State social safety nets we have today. History has shown us the Hoover administration did much too little, too late to stop the plunge. Because the market and economy fell so far and so hard, it took 10 years to rebuild.

I take on faith (we don't really know if it will work) that the Feds can backstop the economic decline. It is one grand experiment we are all living. But the naysayers don't know any better that the decline can't be stopped. They are no more believable in their claims. And haven't most of the people that should go to cash already done so? The rest of us should wait it out, if we can afford to do so. Pulling out enmasse will just make problems worse as it would further collapse the capital base in the economic system. This is one of the logical fallacies of the Bears. They make the case everyone should get out because the market is about to fall. But it is the panic selling that drives the markets lower. If everyone stays put, becomes more optimistic and holds on, the market CAN'T fall. We will see if Obama and his team can change mass psychology and eliminate the panic impulse that creates Depressions. My bet is they can. But if they can't, I will wait patiently for the fever to run its course.

Here is the article with its accompanying charts.

http://www.howestreet.com/articles/index.php?article_id=8243

To My Good Blog Buddy, Nirav

(Note: Nirav's post tried to make the case that Deflation is just a mirage made up by government flunkees to fool us into believing massive printing of dollars is needed. This would lead to Hyperinflation that would sink our economy. Instead, Nirav wants to see big tax cuts and dramatically lower government spending, along with increased consumer saving and decreased spending. He comes from the Jim Rogers school of economics). http://livingoffdividends.com/2008/12/18/the-deflation-scam/#comment-26971

Nirav, I had a hard time understanding the point of this post Nirav, I had a hard time understanding the point of this post.

The title declares that Deflation is a Scam. This implies it is something made up or false, maybe a government conspiracy. But nothing in the post makes the case for any of that. Your data from the Government show that we have experienced a -12.9% contraction on “All Items” through November. That is the definition of deflation. Are you saying those numbers are made up or falsified? The same data show that in some areas, like Education, there has been some small inflation. But overall, we are experiencing a currency deflation.

It would really be quite hard for you to convince me or probably most others, anything else. We can see it all around us, whether it is gas prices, home prices (and eventually rent as vacant homes create competition for apartments), utilities; even food will come down since raw ingredients like grain have dropped a lot in six months.

There is no question that we are experiencing deflation right now, today. The only question that can be debated is really more a speculation: will we experience deflation tomorrow? I commented in my last post that the government is TRYING to create inflation. It is working very hard to push people away from cash. By definition, that is the only way out of deflation. Any increase in price, even just to get us back to zero price change, would be defined as inflation (or maybe “dis-deflation”?)

Because inflation is the only way out of this mess, it is better to just plan for it (invest in the correct stocks and commodities, and probably not bonds), rather than make arguments that we shouldn’t have inflation. Almost all economists agree that some amount of inflation is required in a healthy economy. Inflation means growth. It means there is demand for the economy’s goods and services. It is excessive inflation that is a problem (over 5% maybe?) not inflation itself. Deflation ALWAYS means a sick economy. It is never desirable for declining aggregate prices since it means too little demand for the amount of goods and services the economy can produce at optimum production.

And what does any of this have to do with tax policy? A deflation is not a tax event nor is an inflation. “The head of the International Monetary Fund, Dominique Strauss-Kahn, warned that advanced nations will be hit by violent civil unrest if the elite continue to restructure the economy around their own interests while looting the taxpayer.” Huh??? That statement by someone name Strauss-Kahn(S-K for short? I don’t have much regard for economists with the IMF) makes little sense. Is S-K a Republican or conservative? What does he/she mean by “restructure the economy around their own interests while looting the taxpayer”? That is non-sensical.

The assertion by some that a Republican controlled government would “restructure the economy for their own interests”, though I would not agree with the notion, is at least logical. Republican’s generally favor “supply side” economics that reward the captains of industry (high tax bracket) with the hopes of “trickle down” benefits to the proletariat workers. I understand how this could be perceived as “looting the taxpayer” in the way of S-K’s thinking.
But the new Democratic Administration and Congress, which support and are driving our current economic strategy, are trying to reflate and support the massive financial restructuring TO BENEFIT the proletariate, NOT the elite. The Dems are for socialism, if anything. Obama himself said he wants to redistribute wealth from the rich to the poor. So, current policy favors the poor. Seems hard to get to Civil Unrest from here.

Now a good deflation, that is how we get civil unrest. High unemployment goes with deflation, almost by definition: as prices fall because of declining demand, business cuts back its production to decrease supply; to cut back production it lays off workers; fewer paid workers creates lower demand leading to even lower prices; and so on. Once there is 15% or more unemployment with many literally out in the streets with nothing to do: well you know the saying about idle hands. Check out the civil unrest in France the past few years for a reference.

So, stop worrying so much about inflation. It is the least of our worries right now. To get to hyperinflation requires the destruction of a country’s productive assets, ala Germany after WW1. Then, any printing of money is hollow, since it can’t be exchanged for anything tangible (like the dollar can be for desirable American assets like Pebble Beach). As long as money is exchanged for assets, even if impaired, it is not devalued by the action. This is why TARP is not really “printing money” as many proclaim. Something was received in kind for the capital infusions, namely assets, either ownership for taxpayers in the company (80% in a a couple cases) or in securities held, like RMBS’s or CDO’s (which contrary to popular opinion, do have some value).

It is much easier to pick good investments during inflation than right now during a deflation. Do you know even one good asset class right now? The answer is no, unless you cite the horrible US dollar (that no one wants, until right now, when it is all anyone wants). I welcome inflation. 5%, no problem, in fact GREAT; 10%, I can still find lots of ways to make money; 20%, okay, there is a limit, but we saw in 1980 how we get out of that one.

A Turning Point in the Bond Markets

"It is always darkest just before the dawn." This very old and somewhat trite saying, is nevertheless very true (unless the moon happens to be high in the sky at 4am). It goes for our financial markets and the economy as well. We are in the deepest economic decline since the Great Depression. And if not for quick action by our Federal government, we might even exceed the depths of "The Greatest". Whether you agree or disagree with the philosophy of a central bank that interposes itself into market workings, it is hard to deny it is having some effect.

Yesterday, Ben Bernanke shocked the world by dropping the overnight Fed Funds rate (rate at which banks can borrow very short term from the Fed) to 0-0.25%. Basically, free money. In one way, this is just recognition that is where the short term Treasury rates are anyway. No point in keeping the overnite rate at 1.0% when the 3 month and 6 month Treasury bonds are yielding 0.01% and 0.2% respectively as of today. For these rates to be good investments, the currency MUST deflate (each dollar be worth more at a later date). But more likely, the buyer of such Treasuries just is making sure he still has tomorrow what he has today.

The past few weeks have also put to bed any notion that Gold is the world's safe haven currency. There has never been a time, probably not even the 1930s, when such a currency has been more in demand than right now. Yet, what do the world's investors flee to in times of absolute financial terror? Gold?.... No way....US Treasuries, instead. The irony is that the more money the Feds print, the more expensive it gets as measured by higher priced / lower yield US Treasury bonds. What a deal the Feds have (and by extension, we taxpayers). This anomaly is allowing the Fed and Treasury to buy up all the toxic mortgage and corporate debt at almost no cost to the taxpayer, at least not yet!

What this all suggests is that we are at another bottom of sorts, a yield bottom. Or to take the inverse, we are at a Treasury bond market top. Tops and bottoms when they can be identified, always make for a good time to evaluate a position and make changes to it. There are two possible routes in the bond world that make excellent sense at this time. One, go short the Treasury bonds by selling short Treasury ETFs, like (IEF), or by buying Ultrashort Treasury ETFs like (PST).

Another really good strategy at a yield bottom like now, is to go to the other end of the credit quality spectrum and buy the hated high yield (junk) bonds that now at historic spreads (differentials) to Treasuries. Even James Grant, a super-contrarian who called the credit and market crash years before it happened, likes high yield corporates and senior bank notes at this stage (see below). Today's high yield bonds are at a 20% spread over Treasuries (which is to say they are yielding right about 20% with Treasuries near zero). The normal spread of high yield corporates over Treasuries is around 6-7%, and the spread was as low as 4% in 2006. There will eventually be a reversion to the mean. Moving from 20% spread to 7% spread should result in at least a double for the high yield market. In the meantime, reinvest the 20% annual dividends to buy more fund shares.

I am counting on the Fed fiscal and monetary actions to turn around the economy, forestalling any wide spread defaults on corporate debt. I personally have loaded up on junk funds. I am buying into the Fidelity Advisor High Income fund (SPHIX). Another good mutual fund I have owned in the past (in 2002-03 before the recovery in that cycle) is Vanguard's High Yield, (VWEHX). A new low cost IShares ETF is also available under the ticker (HYG). I have done a comparison and all three trade in lockstep and have a similar yield around 12% as of today (a little lower than the junk bond universe because the quality is somewhat better in these funds). So, pick your favorite fund company and go with it.

Here is what James Grant said yesterday about a similar class of investments, senior bank loans, which have been heavily sold as a result of the hedge fund unwind. Senior bank loans were part of the "carry trade" play, with hedge funds borrowing short term, low interest loans like Japanese bonds, and then buying higher yielding funds like the senior bank loans. As hedge funds were forced to meet redemptions the past six months, Seniors and High Yields, were sold off indiscriminately:

Grant Says Forced Sales Create Opportunities in Bonds

By Carol Massar and Gabrielle Coppola
Dec. 17 (Bloomberg) --

Investors seeking safety in Treasuries may be missing out on opportunities created by forced selling in credit markets, according to James Grant, editor of Grant’s Interest Rate Observer.
Investment-grade corporate bonds are paying record yields relative to benchmark rates, “in this time of zero yield elsewhere,” Grant said today in a Bloomberg Television interview. Residential mortgage-backed securities and bank loans secured by assets are also attractive now because money managers forced to dump the securities to meet investor redemptions have made them artificially cheap, he said.

Yields on investment-grade bonds relative to benchmark rates have hovered near record highs as investors shun all but the safest debt in the deepest economic crisis since the Great Depression. The Federal Reserve cut its benchmark interest rate to as little as zero yesterday, further reducing yields on Treasuries, to try to ease the yearlong recession.

“Of course there’s trouble, that’s why there’s a bear market,” Grant said. “But that’s when you’re supposed to be interested in value. It’s not when everyone’s happy.”

The average yield over benchmark rates on investment-grade corporate bonds was 651 basis points yesterday, 5 basis points shy of the record high set Dec. 5, according to Merrill Lynch & Co.’s U.S. Corporate Master index. A basis point is 0.01 percentage point.

Market ‘Anomalies’

Forced selling may be distorting prices for secured bank loans. Senior bank loans that are higher up in the capital structure of a bank, meaning owners of the bonds would be paid before other debtors in the event of a default, are trading at lower levels than junior portions of the structure, he said. That means safer loans are cheaper than their riskier counterparts.

“All these anomalies are part and parcel of the liquidation in the credit market,” Grant said.

“That’s why we’re bullish on credit, because so many things simply don’t add up.”

Grant is the founder of Grant’s Interest Rate Observer, a financial journal. He was a columnist for Barron’s before founding the Observer in 1983.

Comparisons between 1930 and 2008

It is very clear we are in an historic economic period. As I have said (maybe too many times?) before, "History Repeats (or at least it rhymes)". But which period are we comparable to? The 1930s or the 1970s? This is the big question because the proper investment (and survival) strategy are almost opposite.

The 1930s was a period of terrible deflation leading to economic Depression. There are a lot of parallels between then and now. Are we headed back to the 1930s, or worse? Some would have us think so, in which case sell everything and go 100% to cash and hide it under the mattress.

On the other hand, this period could be more like the 1970s. Again, there are many reasons to think so. And the strategy in this case would be to buy everything possible that is a real asset. Paper money (cash) just becomes more worthless every day with inflation and a stagnant economy. Real assets will grow in value at least as fast as inflation reduces the value of a dollar.

I won't try to answer the question because there is not enough information to know for sure (and if I really knew this answer, I could name my price). But I did find some interesting academic notes on the subject from an Eric Rauchway, an economics professor at UC Davis and author of a noted book on the Great Depression. You can read his notes or hear his podcast at this web link:

http://www.econtalk.org/archives/2008/12/rauchway_on_the.html

If you don't want to take the time to listen or read in entirety, here are a few bullets that compare the 1930s to now, paraphrasing the author / interviewee, Rauchway:

• Fed raised interest rates, first in 1928 to attract foreign investment; Followed by drop in consumer spending. Immediate transfer via the uncertainty mechanism to the real economy.
• Parallel, recent drop in automobile purchases after Fed raised rates in 2006 to cool economy;

• 1930: people afraid they will lose their jobs;
• 2008: Bankers afraid they will lose their jobs and be unable to pay their bank borrowings back. Strange that Treasury Secretary Henry Paulson is angry about that, given the history. Nice parallel with the 1930s.

• Hoover administration created the Reconstruction Finance Corporation in 1932,
• Similar to the Troubled Assets Relief Program (TARP) in 2008.

• RFC originally going to lend money to banks to prop them up. Realized that this is not going to work and they have to recapitalize the banks. Hoover doesn't like the idea of buying bank stocks (nationalizing) in return for the capital (big mistake, as it helps bring public support on board and eliminates moral hazard).
• We recently went through in a few weeks what we went through from January 1932 to March 1933 back then. We sped it up, and we accepted bank equity or warrants in exchange for capital. However, the speed discomfits consumers. Banks now are rather cautious in lending, as a result of speed and uncertainty. Consumers are not yet spending.

• In the 1930s, Fed administrators were frustrated that the banks weren't lending after being recapitalized; RFC said it would lend in their stead, only to find that there weren't enough qualified borrowers.
• Maybe we'll recover much quicker too (because the bank recap was sped up). Uncertainty about what may happen next is offsetting, (though and is holding back lending). Lending encouragement is working as shown by declining spreads between various lending classes like mortgage rates and Treasuries. We must avoid being too conservative in our qualification of borrowers and must make borrowing very attractive with excellent rates and terms;

But here are ways the two periods are quite different, to the benefit of the current period:

• Hoover signed the Smoot-Hawley Tariff Act, with some zeal. Contrary to the myth that he was a laissez faire ideologue. Not a stand-idly-by guy.
• So far we have avoided any protectionist legislation, like rescinding NAFTA. Protectionism shuts off a need source of capital flow.

• Hoover became increasingly desperate through 1932. At some point you have to say Hoover should have been doing more. Hoover tried to coordinate businessmen to prevent a drop in wages. Ineffective, can't get enough businessmen to agree.
• We now know that direct government control of the economy does not work. Nixon proved again in 1972 with wage-price freeze. Get around it by letting companies laying people off--pay higher wages but hire fewer people. This keeps consumers buying, if fewer consumers;

• In early 1930s, unemployment was about 25%, annual figures: just shy of that in 1932, about that in 1933.
• From that experience we know now that unemployment is necessary, so wages will fall to a point to entice firms to hire workers; but if people don't have jobs, economy won't recover, people don't have any money to buy things, so firms have no money to pay for more employees. Circular flow of macroeconomics understood and hard to navigate politically.

• Difference then vs. now: no unemployment insurance, no deposit insurance, no old age pensions--state level and some private stuff, but tapped out by 1931 or 1932. Agricultural difficulties of the 1920s also used up some of these social welfare resources (in farm states).
• Now there is an extensive social welfare safety net at the state and national level; Feds can create money if needed, to keep people fed and sheltered; can also provide funding to states if needed and can provide medical care and food stamps, programs not in place in early 30s.

• In 1930s as people lost jobs, they drew money out of their savings, putting pressure on the banks. Banks already suffering because foreign debt was going into default (post WW1); stock related debts (margin accounts) going into default; municipalities and states going into default. No brake, no way of softening the blow.
• Today we have FDIC deposit insurance, hence eliminates runs on banks. Banking system won't collapse.

• In 1930s, there is a stark contrast between Hoover in 1930 and Roosevelt in 1933 (with hindsight). Hoover doesn't do anything to stop the bank runs. People's savings just vanish, no recourse. Lack of confidence in the system with no deposit insurance, people wondering if their bank will be next.
• We have many protections in place today to avoid bank runs as witnessed recently, especially Indymac

An even earlier depression in 1894, was the worst depression before the Great Depression. It was 40 years before the 1930s Depression (notice the 40 year cycle?) and somewhat fresh in people's minds, pretty horrible, but we don't have good measures. What happened to banks in 1894? There were pressures on banks.

There is controversy over how bad the unemployment was and how contraction of the money supply contributed to the 1894 Depression. But in 1930s, the money supply contraction can't be laid at Hoover's feet--the Federal Reserve was at fault for that. They created money on one hand to recapitalize failing banks, but took it away with the other, believing if they didn't it would create uncontrolled inflation (which we now know is better than uncontrolled deflation and is the stated goal of Bernanke and probably L Summers to come).

Hoover did increase spending, limited by institutions of the day (or lack thereof) and circumstances. But the Federal government wasn't big enough in the early 1930s to have a big effect on the total economy. Hoover tried to create big increases of public works by working with the state governments. But too little, too late, not enough stimulus."

These are the conclusions, in short, of Eric Rauchway. They are even better understood by Ben Bernanke and also by new, incoming Chair of the Council of Economic Advisers, Christina Romer. She is said to be more an authority on the Great Depression than Bernanke.

Logically, the best way out of excess debt is inflation. Inflation allows the debt to be paid in ever cheaper dollars, at the expense of the lendor, of course. But that is a story for a later day. So, if Bernanke and Romer have learned from the 1930s and do everything that it is said Hoover, and then FDR did not do, namely not doing enough to stimulate the economy, I think it is a solid bet they will ere on the side of over-stimulation which will lead to inflation and a run in hard asset prices.

Tough Sledding in the Markets and Economy

The jobs report came out this AM and it is not good, even very bad news. Job cuts of 533K were announced for November and October was revised up (down) to 320K from 240K; September was revised up to 403K from 284K. That is a lot of job loss the past 3 months, the worst since Q2 of 1980 when Paul Volcker shocked the economy into submission with 20% interest rates.

But those of us who follow the market daily are not too surprised by this bad employment "print". The stock market has been crashing anticipating very bad economic news, serving its function as oracle of the economy. And some of us (me) have seen job cuts at our own place of employment based on painful forecasts for 2009. So there is a very good chance the lousy numbers are already "baked in the cake" of the stock market. Today's (Friday's) early stock market action certainly suggests that, as the DJI is only off by 90 as I write now, but still well above the lows from mid November.

All of the economic slowness, global recession and the resultant strength of the dollar is just hammering energy, much to the displeasure of my portfolio. But at the same time, the government policy makers around the world appear prepared to "throw the kitchen sink" at the economy to get it going again. This will mean a recovery in 2009, maybe beginning as early as Q2. As soon as the world economies recover, the demand for energy will return and drive oil prices back up, though maybe not to $150 since the hedge funds have been hit hard and leveraged speculation in the near future is unlikely. But I think we could all live with $75-80 oil which more accurately reflected the rising demand and tight supply of early 2007. Prices in that range are economically sustainable and would create a stable environment for the Canroys.

I am swallowing hard and holding on to my energy shares, knowing that there will someday be an economic recovery and when it comes, there will also be some inflation to pay for all the money pumped into the economy. Higher economic demand accompanied by mild inflation will be a good environment for commodities and energy.

Here is more on oil:


$25 Oil Could Happen Before a Return to $100
December 05, 2008
By Matthew Hougan

http://seekingalpha.com/article/109393-25-oil-could-happen-before-a-return-to-100?source=article_lb_articles


Jim Wiandt says that oil will go to $100/barrel before it hits $25/barrel. I'm not so sure.

The reason I'm confident that the Dow Jones industrial average will top 10,000 before it hits 6,000 is that stocks are a leading indicator. They anticipate recoveries, typically turning upward 6-9 months before the economy as a whole. We are already one year into the recession, so I'm guessing we are getting close to the point where stocks will turn the corner. When you add in the fact that valuations and yields are the most attractive I've seen in my adult investing life, the outlook for equities is quite good.

Oil, on the other hand, reflects mostly immediate, near-term supply and demand. If the economy gets worse before it gets better, stocks might see the light at the end of the tunnel, but oil won't. It can't. Prices will keep falling as demand deteriorates in real time and the current supply glut gets worse.
Remember, oil is expensive to store. For the most part, it won't just sit around waiting to be used if there is a lack of demand. (Some can be stored, but not that much). It must be sold and used at whatever the current clearing price is.
And we have yet to see the magnitude of supply cutbacks in the oil market that we've seen in aluminum, copper and other commodities. The world is continuing to pump out millions and millions of barrels of oil.

Here are a few facts to consider:

• Oil has averaged a nominal price above $50/barrel in just three years in the history of the world: 2005 ($50.04/barrel), 2006 ($58.30/barrel) and 2007 ($64.20/barrel).
• On an inflation-adjusted basis, oil has averaged an annual price above $50/barrel for just 12 of the 62 years of the post-war era.
• The average inflation-adjusted price of oil in the post-war era is $33.65/barrel.
• Oil traded below $25/barrel as recently as 2002.
  

As the saying goes, "This time it's different" are the four most-expensive words in investing. So why not $25/barrel oil?

I was amazed during the recent oil price retreat how quick people were to say that $100/barrel was the "right" price for oil. $100/barrel is off the charts historically, and completely neglects both the supply and demand impacts that high oil prices have.

To put it another way, stock prices are now trading where they were in 1997. What's to say oil shouldn't be trading where it was in 2002?
The truth is, I have no idea where oil prices are headed. But I don't think it's a gimme that they're going back to $100/barrel. In fact, if you gave me 2-1 odds, I'd bet they hit $25/barrel first.

P.S.: One more thought about oil. Even if you strongly disagree with me and think crude oil is a screaming buy, please be careful before you buy a crude oil futures ETF like the US Oil Fund (NYSEArca: USO). Oil is in a violent contango. A fund like USO faces a 3% monthly headwind from contango right now, meaning oil prices must rise about 3% each month just to offset the losses from rolling contracts forward. Until that situation is reversed, investing in crude oil futures could be challenging... even if I'm wrong about crude oil prices.

Will Liberals Finally Unseat Tories?

Those of us in America with investments in Canroys have been more than disinterested bystanders when it comes to the Canadian Parliament. PM Harper's Tory (Conservative) party decided in October 2006 to break promises to its constituents and begin taxing the profits of Canadian Royalty Trusts. This devestated the valuations of all Canroys. The oil and gas trusts, which are also treated as non-taxable trusts in America (under the concept of Master Limited Partnerships), were especially hard-hit as there was no precedent for taxing the income of asset trusts.

Those of us invested in Canroys were outraged, though the Americans among us could do nothing about it. But the Canadians can, and apparently will. In today's Globe and on the CBC website, I found an article that the Liberal and NDP (New Democratic Party) parties have agreed to form a coalition that will force out the ruling Tory party, Finance Minister Flaherty and PM Harper. While there is no guarantee that the Liberals will roll back the law change regarding taxation of Canroys, there have been indications that the taxes will at least be modified. At this time of decreasing oil prices, we need all the help we can get to support the price of Canroy shares.

Here is the article in total:

http://www.cbc.ca/canada/story/2008/11/30/canada-coalition.html?ref=rss

A Floor Under the Price of Oil (and Gas)

This article demonstrates what we have always discussed regarding the floor on the price of oil. As compared to the early 80s when relatively high prices encouraged exploration around the world for easy to develop oil glutting the market, new discoveries are in hard to reach places, like 10,000 to 20,000 feet under the ocean. Even though the discoveries in deep water the past few years add to the known world oil supply, they will not get developed at lower (current) prices. This means we are stuck with the lower cost reserves that are dwindling around the world.

The Alberta oil fields are relatively inexpensive to develop and produce. They are generally profitable at $30-40 / barrel, depending on the formation and the oil quality (the amount of stimulation required to get it out of the ground). The really cheap oil that is profitable at $10 / barrel is just about gone in North America (light sweet crude near the surface, like West Texas crude, or "Jed Clampett" crude as I call it). So, when you hear people talk about oil going back to under $20 / barrel, they really don't know what they are talking about.

Some of the more adventerous or less proven drillers are not a good idea right now. But PWE, PVX and PGH have very good operations that don't have many questions.

Also, see www.mcdep.com for his educated opinions on the status of the oil market.

I have attached an article from Barrons Online titled "The Downturn's Impact on One Oil Driller, Callon Petroleum gets a downgrade after it blames economy for decision to terminate project."

"The Downturn\'s Impact on One Oil Driller";

CALLON PETROLEUM (Ticker: CPE) announced that it has decided to indefinitely suspend development of the Entrada field, located in the deepwater Gulf of Mexico. Management cited the recent collapse in oil and gas prices and higher-than-expected development costs as the reasons for terminating the project.

To date, Callon has successfully drilled two exploration wells at this field. The third well recently reached a total depth of 21,100 feet but needs to be sidetracked.

In March 2007, after owning 20% of Entrada, Callon acquired the remaining 80% interest from BP PLC (BP) for $150 million. Subsequently, in the first quarter of 2008, Callon sold 50% of the field to Japan's ITOCHU Corp. for $155 million, with Callon remaining the operator. At the time of the divestiture, Callon estimated Entrada's development costs to be approximately $300 million.

At year-end 2007, Entrada had an estimated 192 billions of cubic feet equivalent (Bcfe) of proved reserves (a total of 339.6 Bcfe of proved plus probable reserves). After adjusting for the divestiture, Callon's pro forma year-end proved reserves were 168 Bcfe. Therefore, approximately 57% (96 Bcfe) of the company's total proved reserves are now uneconomic in the current commodity price environment.

The field was expected to begin initial production in the first half of 2009. With the project now halted, we are lowering our earnings estimates, and our proved net asset value also decreases accordingly. Entrada was expected to double the company's production rate, and without this new source of cash flow, Callon will likely be forced to make major cuts in its capital budget for 2009.

After two years of planning, the suspension of the development of this large asset is a very negative event for the company. Ultimately, Callon may have the opportunity to divest its remaining interest to a company that has the balance sheet to see the project through to its conclusion, but in the near term, Entrada's economic value has diminished considerably. Based on the potential for a large reserve write-down, the minimal visibility on production growth, and the uncertainty about the company's post-Entrada operating strategy, we are downgrading Callon Petroleum shares from Market Perform to Underperform.