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2008 Outlook: I Don't Know


If you are unsure about what is next play it safe, close to the vest and don't try to be a hero...


I have been giving serious thought to the US economic mess and have been wrestling with my 'Outlook for 2008 and beyond.' Fortunately, my firm has been early in recognizing the credit crisis, but now must look beyond just the sub-prime mess. One of the trading commandments I live by is 'what the market knows isn't worth knowing.'

This is just another way of saying that when 'news' makes it to the front page of my local newspaper it is time to focus your attention on the next potential issue. We need to focus on the unknown. The unknown is what can undermine portfolios and wreak the greatest amount of havoc in the future, which brings me to the title of this piece - 'I Don't Know.'

I feel fortunate to have a good handle on the macro-economic situation we are facing, as grim as it feels. But what bothers me, and what I don't know, is the following. We are now in uncharted waters for leverage, risk, derivatives, and moral hazard, more than has ever been seen before, and quite possibly, more than we ever may see again in our lifetime. The unwinding of these enormous risks may likely be corrected by some event(s) that we have never witnessed before. Deflation? Hyperinflation? Recession? Depression? Stagflation? Or some unkind combination?

In the movie Fast Times at Ridgemont High, Sean Penn plays a lovable stoner without a clue who is named Jeff Spicoli. One of his memorable moments in the movie was an exchange with his history teacher, Mr. Hand.

Jeff Spicoli: I don't know.
Mr. Hand: [goes to blackboard and writes the words 'I Don't Know', then underlines them, reciting it aloud] I like that. 'I Don't Know.' That's nice.
- Fast Times At Ridgemont High

I am not proud to say "I don't know," but it is honestly the way I feel about the markets. If you are unsure about what is next while managing money, play it safe, close to the vest and don't try to be a hero. I will prudently attempt to squeeze as much return as possible from the markets until the future seems less opaque. I will not hide from risk nor will I hide from the truth. For the one thing I do know is that on the other side of this uncertainty lies the land of opportunity. By not losing during times of uncertainty I am in a position to profit afterwards. The key to winning is not to lose.

Bulls, Bears, HOGs and Objectivity

I know many people that are permanently bullish and some that are permanently bearish. The perma-bulls tell you to remain 100% invested in the 'long run' as stocks are the highest returning asset class over very long periods, like 100 years. I have no argument with the long term rate of return, but I have yet to meet an investor that either has a 100 year time horizon or can actually sit through all of the bear markets that occur during 100 years. In fact, most that I know have difficulty sitting through any down move at all. It is very difficult to 'turn off your screens' or 'turn off your TV' for 100 years.

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The perma-bears, on the other hand, wake up 'praying for rain.' They will look at all of the market data and simply focus on the bad news. This process is fruitless as the perma-bear can be hibernating in his cave for decades at a time.

I have not been terribly constructive on stocks over the past ten years, and alas, stocks are at the same level (using the S&P 500 as a proxy) as they were nearly ten years ago. If I were a perma-bull, I would have sat through those ten years, absorbed tons of volatility and had not much to show for it except that I had burned through a ton of 'emotional capital' which comes with volatility, particularly downside volatility. On the other hand, if I was a perma-bear, I would have missed out on all of the wonderful intermediate term trading opportunities along the way, many of which I have been fortunate to catch for my investors.

We are in a secular bear market in stocks that began in either April 1998 (the NYSE net 'advance/decline line' topped then) or in March 2000 (the S&P 500 topped then), depending on your perspective. But within secular moves that last 20 years or so, there are usually five to ten 'cyclical' markets. With the advent of exchange traded funds (ETF's), the choices that we have as investment managers has increased, which has benefited my firm's investors. I took the opportunity with the latest 'Fed rally' to reduce my equity exposure to my lowest in a number of years.

In my opinion, we are either in a recession, or very close to being in a recession. Further, it appears that we may be in the early stages of a stagflationary period when the economy contracts as inflation increases. Just how much is inflation increasing? I use inflation numbers that include food and energy as it is a farce to exclude them. I also use the relationship between ten-year Treasury yields and annual CPI or PPI changes as a guide to see whether yields are too high or too low. A prudent investor should demand a higher ten-year Treasury yield than inflation, but recently announced CPI and PPI year-over-year statistics show that real yields (interest rate minus inflation) are in fact negative. In the two charts below, I have gone back 42 years and shown the relationship of yields versus inflation. Real yields in CPI are now slightly negative and real yields versus PPI are decidedly negative. There are two possible outcomes-either inflation needs to decline or yields need to increase. As such, I am cautious as it regards longer term Treasuries.

10 Year U.S. Treasury Yields minus Year-over-Year Overall CPI

Click here to enlarge.

10 Year U.S. Treasury Yields minus Year-over-Year Overall PPI

Click here to enlarge.

I want to remain objective, so while I saw the sub-prime mess coming, I don't focus on it as much anymore as the subject is now on the front page of every newspaper. So what do I focus on now? The unknown. The unknown is what scares market participants the most. In this case, I am focusing on prime loan, credit card, auto and interestingly, motorcycle loan delinquencies! You may have wondered why I typed 'HOGs' as opposed to 'hogs' in the top of this section. HOG is the ticker symbol for Harley Davidson, the foremost American manufacturer of motorcycles. And when I consider that the consumer is stretched to the limit in debt, I need to focus on what was truly a 'discretionary' purchase. What can be more of a consumer discretionary item than a Harley? Watching HOG loans will give me another anecdote to piece these stories of the credit unwind together.

Continued on Page 2

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