It is time for my annual financial self-examination.  I do this each year and make my findings public to create personal accountability.  2009 was much better than the 18 months before.  My aggressive total portfolio lost 50% in 2008.  In 2009, I reversed that horrible trend and gained back a good part of what I lost.  And for all of 2009, through Thursday, December 24, I ended the year at +40% (all numbers are Year Over Year), beating the SP500 and FFFDX (Fidelity Freedom 2020) indexes by a considerable margin (+20%, and +14%).  And from the March 7 bottom, I gained 126% (showing just how deep my portfolio had sunk in 2008 and early 2009, -65%).  The only way for those kind of gains is commitment and staying with your long term strategy.  At the panic bottom in early 2009, many were getting out of equities and going to bonds.  They still are there.  My performance was aided by a continuing commitment to commodities, tech and emerging markets.  I also tripled my commitment to high yield (junk) bonds and financials near the generational lows in March, which helped my overall return.   A couple of speculations, such as buying General Growth in April as it entered bankruptcy protection also paid off. 

As bad as 2008 was, it is really the past ten years that have been very poor for investments of almost all kinds.  Those who say we are at the beginning of a multi-year bear market really haven't done their homework.  The Bear began in early 2000 with the collapse of the Tech bubble.  The Nasdaq 100, which was as high as 5100 in March that year dropped below 1100 in October 2002, a collapse that rivals the Dow Industrials collapse from 1930 to 1932.  Yes, the markets recovered (as they did in 1933-36), and the Dow Industrials, really an old-world and narrow index today, did reach new all-time highs of 14,200 in October 2007.  But the Nasdaq stocks barely recovered to 50% of their all-time highs (a classic Fibonacci retracement).  The bubble transferred from equities to real estate in the mid 2000s.   Of course, it was here that historic damage was done over the past two years.  

Given all this, I take some very small satisfaction in being down only an average of (-1%) annually for the past ten years in my overall portfolio.  This is especially true because much of my capital contribution was at the end of the period (2006-07) making the subsequent drop that much more damaging to my portfolio.  During the same ten year period, the SPY (-0.63%) and the FFFDX, a life benchmark portfolio for people retiring in 2020 (+2.23%) have better performance.  I am biased to the optimistic side of investing and comfortable with risk and so have a "higher beta" portfolio than most my age.  But had I seen the 10 year bear to rival the 1930s coming, I might have just left my investments in a bank account.  Hindsight is 20/20 so I am not second-guessing myself, and am happy to have kept up with passive index funds. 

It is a perilous but fun exercise to predict events over the course of a year.  It is impossible to really know the future, but mentally stimulating to give it a try.  And the result helps shape decisions throughout the year.  Here are the Wealth-Ed.com predictions for 2010:

1. The American stock markets will rise by 10-15%, defying the consensus which considers the market to be either fully or over-valued as of December 31, 2009 (too far, too fast).  SP500 will reach 1,270 during 2010 and will end the year close to that level; range will be 9500 - 11,300 DOW; 1020 - 1270 SP500; 1980 - 2490 NDQ 100;
2. SP500 aggregate earnings will exceed consensus expectations of $65-75.  They will finish the year at $85 which will justify a 1,275 SP500 price based on a PE of 15
3. The stock markets will follow the classic pattern of strong in winter and fall and weak in the late spring and summer which is the source of the saying: "sell in May and go away"; it will be a good year to follow that advice
4. The US dollar will strengthen into the second week of the new year and will then fall through the winter months as Treasuries are sold to finance riskier equity investments;  there are a record $8.4 trillion dollars on the side lines in cash, money market and other near money funds (as measured by M2, according to Fed Reserve report H.6); the dollar will drop to $70 DXY by the end of March and then rebound in the late spring so DXY (dollar index)  will exceed $80 by September.  An improving economy and higher Treasury rates will be the impetus for dollar strengthening
5. The Fed will hold short term interest rates low until mid-summer; it will allow long term rates to drift higher and the 30 year Treasury will hit 5% by June;  by July, the Fed will begin to signal its intentions to let short term (Fed Funds) rates increase as the economy continues to strengthen and the unemployment rate finally starts to decrease (first in June); evidence of higher interest rates will push the stock market down and the dollar will strengthen;  the 10 year Treasury (the basis of many mortgages) will finish the year over 4% from a current 3.5%;
6. As the dollar weakens to 70 DXY in the first half of the year, the "carry trade" will re-appear from its Holiday hiatus and weak dollar investments will excel, including Energy, Materials and Emerging Markets; but sell those investments in April as the dollar shows signs of reversing; TBT will be a very good way to play the reversal in the dollar (ultra short the Treasury complex); by October, the shock of higher interest rates wears off and the stock market picks back up with domestic and cyclical stocks taking the lead from the weak dollar stocks of the year's first half; advice: rotate investments away from commodities and towards cyclicals and industrials as dollar strengthens at end of year;
7. Healthcare stocks continue their comeback as the Senate finally gets a greatly weakened bill passed in January.  It goes back to the House for conference and is finalized by the end of March.  The public option is gone but the expanded Medicaid program remains bringing another 30M people onto the public funded program.  Healthcare stocks continue their recovery with more people to receive care in 2010 and beyond; buy UNH, WLP, BDX, MDT, MRK, JNJ and PFE early in the year
8. Gold reaches its peak early in the year at 1400.  Gold bugs are crushed when the dollar strengthens later in the year.   The Fed proves to be much more adept at taking liquidity back out of the market than was anticipated by doomsayers and gold falls back below $1000.  Severe inflation (over 5%) never materializes due to the global production and labor overcapacity
9. Oil prices range between $60 for a low and $100 for a high in 2010; the low will occur in the late spring or early summer as winter demand dissipates and the dollar begins to strengthen with the beginning of tighter money supply, but though "weak dollar" speculation dissipates, the price peaks at $100 as the economy picks up pace at year end;
10. Natural gas outperforms oil as record supplies are reduced and demand begins to exceed supply by year end; gas ends 2010 at nearly $8 per mmcf  propelling the natural gas oriented production companies back to 2005 levels; PWE reaches $30 in late 2010 (was as low as $6.50 in March; I have stayed with this for the round trip);
11. The Republicans gain seats in both the House and the Senate as Independents that voted for change in 2008 are sorely disappointed in what is delivered and vote for economic stability and a balanced budget which the Republican party promises.  Enough seats are gained so that the Democrats lose their supermajority in both houses.  Awareness of this political shift is what fuels the market to new highs from the summer doldrums, starting in October.

Regarding 2009: I was in such shell-shock from the beating I took in Q4 2008 that it was January 3 before I got to my annual crystal-ball adventure.  But predict I did and those predictions are below or by clicking here: 2009 Wealth-ed Predictions.  This will be the ninth year I have made my annual predictions;  the first time in December 2001.   In December 2002 I made a call for the 2003 market to begin a great run starting in March.  I hit that one out of the park and expect to do the same this year.  Looking back at my early 2009 post on the direction of the market, I did prognosticate quite a bit of the year's direction and events correctly with only a few minor errors in timing or magnitude, not direction.

• 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. Right - the commitment to easy money by the Fed pushes the normalization of interest rates out to mid to late 2010 now; I never imagined Bernanke would stay this aggressive this long, but am glad he has; 
• By July 2009, the high yield and corporate bond interest rates will begin to decline, narrowing the historic spread against risk free Treasuries; Right - this was my best call in early 2009; the Junk-to-Treasury spread peaked at over 2000 basis points (20%), historic highs; I loaded up on high yield debt (via FAHDX) in March and it returned 70% from there before I began getting out of the fund in October.
• 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; Right - on the downside but not on the upside; and right on the general weakness in demand and its impact on supply, which has really dropped (as indicated by active drilling rig count); the peak price  ($83) exceeded my expectations because of excess monetary liquidity created by the Fed that sought out risky assets; still I benefited from this rebound as oil/gas producers via the Canroys, remain one of my largest positions;
• 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; Wrong - but for reason of timing as the Fed has been much more successful in creating monetary stimulus than I thought they would; but it is a good thing that there is excess stimulus, some of which ends up in risk assets like gold,; the spike in gold prices also mistakenly anticipates hyperinflation; If the Fed can withdraw stimulus in a timely way in late 2010, they can avoid high inflation, which will stop the gold spike below $1500. (and if they are unsuccessful, the spike can proceed to $3000 the next few years)
• 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; Right - but I didn't think Obama would be as brash as he was in protecting the unions at the expense of bondholders, including individuals and retirees; but given his constituency, I was not too surprised at who he chose to favor;
• 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; Wrong and Right - wrong for good reason that the Fed was more successful stimulating the economy than I thought possible; but the names above are all in deep trouble and would have gone down if not for the Fed actions; support to consumer spending has unexpectedly helped GGP (see next); Right: Eddie Bauer went bankrupt in June, Ann Taylor closed half its stores, Lane Bryant and Foot Locker closed many of their stores, just avoiding bankruptcy;  but the retail sector did better than expected at year end as stimulus got consumers spending again (RTH +17.8% for 2009)
• 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); Wrong - but I figured out I was wrong in April and bought GGP at that time instead at $0.65 / share; the key to investing is to stay nimble;  now it looks as though GGP won't have to sell any properties as it exits bankruptcy; I closed my GGP out at $6.60 in early December;
• Official unemployment will top 8%, but will not top 10%; Wrong - even the "official" number could not be kept under 10%, though it probably will not go any higher than 10.5%
• Mortgage rates for 30 year fixed rate Fannies will be less than 4.5% with no points; but these rates will rise in 2010; Right - though credit is so tight that few people can qualify for the record low interest rates; look for mortgage rates to rise once unemployment declines for 3 straight months and as the govt pushes banks to start lending again;
• 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);  Right - in fact, one of my best calls as I was two months earlier than Doug Kass on my market recovery prediction; I did not forecast the "panic bottom" in early March, but that lasted for only three weeks; I nailed the DOW as it ended up 13.5% for the year; SP500 was up 19% and NDQ100 was up 42.6% (my prediction was 2200 and it is 2210 today)
• The best asset class return in 2009 will be in high yield bonds (junk) with a 30% total return; Right by a landslide; and the returns were quite a bit better if catching the bottom in March as I did (+70% from January, but +90% from March);
• The 2nd best asset class return in 2009 will be in energy stocks, both producers and equipment providers, though producers will have the best total return at 25%; Right - sort of; a close call between Technology (+60%) and Materials (+48%) / Energy (+30%); I lump energy and materials together because they trade in a similar way; they all did well for the same reason, the weak dollar and easy money chasing risk assets (and foreign markets);  my idea of energy for investment are Canroys which did much better than the big integrateds like Exxon that make up the indexes; PWE which I own in a big way, is up 76.8% for the year, dividends reinvested; PVX is up 71.2% and PGH is up 41.1%
• The worst asset class in 2009 will be Treasuries with 30 year bonds returning a negative 20%;  Right - the TLT, which is a basket of Treasuries with an average maturity of 20 years, is down (-24.79%) as of today (December 25) and 30 year is worse;  this trend should continue in 2010 and longer term Treasuries should again be a poorinvestment with net losses over the year; long TBT in 2010 is a good way to take advantage of this future trend;

Doug Kass recently predicted the S&P500 stock index will finish the year at 920.  It is currently right at 1000 (on September 2, 2009).  I agree with the prediction of 920 sometime in the next couple of months.  I think 900 may be possible and even lower to 875 based on the bottom set in July.  But unlike Kass, I think the market will rebound by year end.  I will wait for signs of a possible rebound once this current drop (begun last week) is further along.  The signs of the bottom to this dip will be a stall in the decline just as the recent market top was shown by a stall or resistance around 1040.  The rebound will happen when the market goes up on bad news.  I think that may happen during the Q3 earnings season the middle of October into early November.  I am still thinking that 1200 is a possibility by year end.  This would completely retrace the panic selloff starting from the Lehman collapse on September 15, 2008.  So, if we wait until 900 to redeploy our cash raised the past few weeks, that could provide a nice 33% finish to the year.

Where Kass is probably wrong, along with many others on Wall Street, is that there are just too many people with a bearish market view.  There is virtually  no one on the financial networks (CNBC, Fox Biz, etc) today saying that the selling should be ignored and the market will go much higher.   There are just no Bulls as far as I can tell.  The market always confounds the consensus position.  It has to in order to work.  If there are a majority of bears, then by definition, there is hardly anyone left to sell.  Once all of us who had our finger on the trigger, pull the trigger, there isn't anyone left to sell.  So, I think the decline will be shallow and the market will rebound in 6-8 weeks.  This can't be like the panic last year because all the retail investors that bailed out in the fall and winter are still on the sidelines.  People who sold everything in January and February never got back in. 

There are a lot of factors to a panic that are missing right now (as they usually are, fortunately).  To get a true financial panic, first everyone must be euphoric and unaware of or discounting trouble.  Then when the decline starts because the market just can't go any higher (everyone who is going to buy has bought), investment holders must be forced to sell at any price by margin calls or other financial misfortune.  Last year, there was a cascading of events that are no longer in play.  Most importantly, the leveraged, collateralized securitization market, the core of the trouble, is almost completely unwound (except CMBS, which is where there is still concern).  The leverage in 2007-08 was in the carry trade, which is what caused the dollar to soar and interest rates to drop when foreign currencies were sold and dollars bought to cover margin calls.  The securitized loans are mostly back inside the big banks now with backing by government guarantees or in private hands where they have been de-levered which allows them to be held to maturity, if needed.  So, there are no large institutions needing to dump stock or other financial instruments into an illiquid market to raise money to stay afloat.  That is a big and significant change.

On the way down, I am using portfolio hedges to protect my positions.  I like the SP500 Double Inverse fund by Proshares, with ticker SDS. 

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I like this ETF because it is a double short of the SP500, which is a pretty basic / broad index of the market and includes all the big financials, techs and energy companies.  I also hold another hedge, hte Proshares product called DUG.  DUG is basically the double inverse of the energy market, something like IYE but with a little Materials exposure too. 

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I use it to hedge all my Materials and Energy exposure, although I also use covered calls for this on stocks like Suncor that have good premiums.  I also have used covered call options on the Canroys, but the premiums are not very good because of the large dividends.  It is just an alternative to outright selling them. 

Even though it has become popular, I don't do those Direxion 3X ETFs.  They are just too wild for my taste.  Even the doubles are a little scary and I am careful to keep my exposure balanced with opposite long positions.  I don't bet naked short, even now when I am pretty convinced the market is going lower.  The market always goes up in the long run, so being short should be very tactical and short term.  I don't want to get caught on the wrong side of that trade.

Reflation. It is a very provocative concept. We all know what is meant by the term Inflation. It is almost intuitive because we have lived with it all of our lives. Those of us over 40 have a special affection with that word as we experienced the 1970s and some of the worst that inflation can bring.

But few of us have a good idea what is meant by the term reflation. Whether we should embrace or fear it. My way of looking at reflation is to "fill the hole" left by the deflation caused by housing, stock market and other financial asset price contraction. All that asset value had to go somewhere. The assets underlying value didn't just disappear, though much of the derivative paper might have.  Assets were revalued by a mass panic of the entire American and global population. But this was a psychological phenomonon, and so it can be reversed.  It is quite possible for assets to regain their previous value with some encouragement.  That encouragement comes in the form of reflation and what it encourages: the "animal spirits" of the market place.  Until we find asset price recovery through the process of reflation, diminished values will wreak havoc on the economy through slashed consumption, falling corporate and tax revenues, declining profits and higher unemployment.

Reflation is made possible by the expansion of the monetary supply, offsetting money supply reduction that occurs from asset price contraction. But it is an indirect offset. If my house was worth $600,000 in 2007 and is now worth $400,000 in July 2009, to reflate the economy the government doesn't just send me a check for $200,000 (though a case can be made for doing just this ala "Helicopter Ben"). Rather, monetary expansion trickles through the economy: first to bolster the banking system where it originates from programs like TARP and TALF, then through Federal "stimulus programs" that eventually (belatedly?) result in a "Cash for Clunkers" program, and finally to home owners through firming home prices and higher wages with economic expansion and increasing demand; all from the proverbial "thawing" of a frozen credit system enabled by backstopping the banking system.

But reflation comes with a price, and it is political, not numerical. Because reflation originates within the Federal government (the Federal Reserve Banking system and the Treasury), the only entity which can legally create money from nothing, it comes with plenty of strings attached. Those strings will be pulled by the majority political power, Democrats at this point in time. The party in power will seek to use economic reflation policy to achieve social policy and, in the case of liberals, a redistribution of wealth. Whether one agrees or disagrees with a specific policy or program,  it is beside the point. The point: because there are strings attached, reflation through fiscal policy or monetary means there are conditions that are inefficient and carry plenty of future baggage (entitlements).

Bill Gross wrote about our economic reflation policies and what it means for our economic future. In his eyes, the future is none too optimistic. Bill Gross suggests we are doomed to many years, perhaps decades, of below trend economic growth, his "new normal". Those of us less than 70 years old, who did not experience life during the 1930s and 40s, will probably need to recalibrate our expectations.

I personally take exception to the characterization of 3% Nominal GDP growth, as Bill Gross forecasts, as being a "New Normal".  Such a growth rate is an aberration and would mean perpetual recession. It is actually an old normal at a time of zero or negative inflation, like right now when Nominal GDP equals Real GDP.  Rather, 3% "real" growth in a mature economy like the American, is an "old normal"; more like the economy of the 1950s, 60s, 70s and 80s, on average. In fact, the Real GDP expanded by an average of 3.45% between 1951 and 2004. It is important to look at "REAL" data as it strips out the effect of inflation, which was pronounced during the latter half of that range.

In Bill Gross' words:

Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

Gross goes on to make the point that we can't expect to see 5% Nominal GDP growth as we did in old normal times.  But his point doesn't make much sense as it was actually much higher on average in the past 50 years.  Even at face value, his statement begs the question "what part of that nominal GDP  will be inflation?"

I expect we will actually see moderate inflation once reflation has been achieved.  It is the natural result of successfully reflating the economy and having it run at productive capacity and full employment all while running a Federal fiscal deficit to fnance reflation policy. Because full employment (around 95% of the workage population) is a Federal policy goal, and because the Feds have the means to control reflation (monetary expansion), I expect this goal to be successfully met.  So, we can therefore expect moderate inflation once stability is achieved.

Bill Gross concludes his August 2009 newsletter by making the case for 3% Nominal GDP for the forseeable future:

A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

Yes, I suppose a 3% Nominal GDP would have the effects described if it were possible.  But the PIMCO scenario is highly unlikely and Gross' reasoning is flawed in many ways.  If we are  indeed in a period of lower interest rates, then P/Es will not contract but will likely expand.  P/Es run inverse to the Treasury Yield Curve, the infamous Greenspan "Treasury discount model".    So, low interest rates should result in higher stock prices once stability returns to the economy.  However, I believe we will see higher interest rates once the economy is reflated and the economy stabilized.  This will result in attenuated economic growth of around 2-3% Real GDP, plus an inflation rate of 5% which will cause Nominal GDP to run above 7% as opposed to the 3% forecast by Bill Gross.  American Nominal GDP ran between 7 to 13% during the late 1970s, a period of anemic economic growth (real), large fiscal deficits and moderate to high inflation.  Even in 1981, during a severe recession, nominal GDP grew by 4.4% due to the high embedded inflation.

Like Gross, I do worry that the "strings attached" to reflation policy will "substantially change the character of the American capitalistic model".  But political pressure from the right should counter the most extreme of what the left has to offer.  We already see evidence of this in respect to nationalized medicine and "cap and trade".  So, even this concern of Gross' is overblown.  Another threat comes from foreign interests who might not want to help America reflate by continuing to buy Treasury bond issues that support monetary expansion / quantitative easing.  But I think these foreign entities (China, India, Oil Nations, etc) see that it is their own self-interest to reflate the American economy and rekindle its consumer sentiments.

I think Mr. Gross has fallen prey to his shifted paradigm of a "New Normal". His position does not take into account the resultant moderate inflation that must naturally  follows a reflationary policy.  We can expect inflation in 2012 and after of perhaps 5 to 7%. This will result in a Real GDP that is negative if we sutract inflation from the Nominal GDP forecast of 3% suggested by Mr. Gross. Zero or negative Real GDP is not consistent with full employment and will not be tolerated by our political process.  So it cannot happen for an extended period of time invalidating the PIMCO argument. I suggest the PIMCO triumverate re-examine their assumptions.

Bill Gross August 2009 Investment Newsletter

Being a Contrarian can be very lonely.  Therefore, all Great Investors find themselves very lonely as only contrarians become Great Investors.  Jeremy Grantham has been lonely a very long time, but he is what I consider a Great Investor, along side Warren Buffet, Bill Gross and Julian Robertson.  He first began calling for a market top in 1998 and acted accordingly by going primarily to cash by 1999.  He saw the overvaluation of the internet bubble and the beginnings of a historic loosening of regulations while at the same time greed took over the American and then world culture. 

So here we are in 2009, fully 11 years after Grantham and GMO first called for a top in the American stock market.  They did get long Emerging Markets in 2000 and beat the market averages by doing so.  Still, this long period of bearishness has made Grantham a bit of a pariah among the investment community.  But Grantham has a lot to teach us about removing emotion from investing and staying hard against the tides of  popular opinion: that is being a Contrarian. 

The January / February 2009 letter reviews the past 11 years and the ideology shift that led to the market crash.  It also discusses how the economy will come back from its depression and the likely direction of global markets over the next seven years.   He handicaps the current "reflation" strategy and the likely resultant inflation and what that means for investors.  It is a very long and somewhat arduous read as Grantham is a statistician and quant.   But like with Dr. Robert Shiller who Grantham references and I think respects, the reader is rewarded with a 200 year history of investing and countless interesting and relevant antecdotes to our current situation.  This is a newsletter to file away and review at least once a year for reminders of how Grantham arrived at his conclusions and whether they are proving true.

I will reference and link his 2009 Market Analysis published in two parts in January and February.  More recently, on March 10, Grantham published a piece titled "Reinvesting When Terrified".  I will also reference that letter and provide a link to a video interview with Jeremy Grantham by Steve Forbes.

GMO 2009 1st Quarter Investor Letter

Steve Forbes Interview with Jeremy Grantham - Video

http://www.forbes.com/2009/01/23/intelligentinvestinggrantham.html

Reinvesting When Terrified

Jeremy Grantham

It was psychologically painful in 1999 to give up making money on the way up and to expose yourself to the career risk that comes with looking like an old fuddy duddy. Similarly today, it is both painful and career risky to part with your increasingly beloved cash, particularly since cash has been so hard to raise in this market of unprecedented illiquidity. As this crisis climaxes, formerly reasonable people will start to predict the end of the world, armed with plenty of terrifying and accurate data that will serve to reinforce the wisdom of your caution. Every decline will enhance the beauty of cash until, as some of us experienced in 1974, ‘terminal paralysis’ sets in. Those who were over invested will be catatonic and just sit and pray. Those few who look brilliant, oozing cash, will not want to easily give up their brilliance. So almost everyone is watching and waiting with their inertia beginning to set like concrete. Typically, those with a lot of cash will miss a very large chunk of the market recovery.

There is only one cure for terminal paralysis: you absolutely must have a battle plan for reinvestment and stick to it. Since every action must overcome paralysis, what I recommend is a few large steps, not many small ones. A single giant step at the low would be nice, but without holding a signed contract with the devil, several big moves would be safer. This is what we have been doing at GMO. We made one very large reinvestment move in October, taking us to about half way between neutral and minimum equities, and we have a schedule for further moves contingent on future market declines. It is particularly important to have a clear denition of what it will take for you to be fully invested. Without a similar program, be prepared for your committee’s enthusiasm to invest (and your own for that matter) to fall with the market. You must get them to agree now – quickly before rigor mortis sets in – for we are entering that zone as I write.

GMO JG Reinvesting When Terrified March 2009

Doug Kass has a terrific track record of predicting the tops and bottoms of recent markets.  He has been known as a short seller the past several years as he thought the market over-valued.  Now, however, he has picked March 5, 2009 as the bottom and has gone long.  He was nearly alone in his convictions on that date, but has recently been joined by more and more investors, including yours truly.  Why does Kass think we have reached the bottom of this Bear?  Read on for more:

http://www.seabreezepartners.net/newsArticle.asp?id=449

March 24, 2009

Why the Bears Are Wrong
By Doug Kass, The Edge

I continue to believe that the early March low represented a yearly and, quite possibly, a generational market bottom.

The mustard seeds for the economy and the U.S. stock market have begun to take root.  The rate of change in 10 of 12 factors in my watch list are improving.

On Feb. 17, I presented a watch list of conditions that, if in an improving trend, would likely indicate that a sustainable up move is possible for equities.

It is time to review this checklist (and add one more factor) to determine the market's standing. Our new grades and those of two weeks ago are in parentheses and will be updated in the weeks and months ahead.

1. 1. Bank balance sheets must be recapitalized. Yesterday a comprehensive bank rescue package was introduced. It is obviously too early to consider its full impact, but the details of the program suggest to this observer that it will likely be effective in clearing toxic bank assets. (We grade the package a B+, up from a D+ only two weeks ago.)
   2. Bank lending must be restored. While bank lending standards remain tight, my view is that yesterday's announcement of ring-fencing toxic bank assets will almost unquestionably succeed in unclogging the transmission of credit. (Grade B, up from a C previously.)
   3. Financial stocks' performance must improve. Financial stocks have finally awakened from the dead, and the recent outsized move to the upside could foreshadow continued market strength. Historically strong relative performance in the shares of asset managers -- such as Franklin Resources (BEN), T. Rowe Price (TROW) and AllianceBernstein (AB) -- presage a better equity market, and Monday's strong group action was conspicuous in its outperformance. (Grade B+, up from a D.)
   4. Commodity prices must rise as a confirmation of worldwide economic growth. Beginning two weeks ago, commodities' prices began to strengthen, and the Fed's message last week accelerated that trend. Gold, copper (at the highest level since November) and crude oil (over $54 a barrel) continued to rise yesterday, reflecting a combination of continuing inflationary and currency debasement fears coupled with the possibility that worldwide economic growth might stabilize sooner than later. Finally, the TIPS market is forecasting some higher inflation, and a little inflation is better than a lot of deflation. (Grade B, up from a C+.)
   5. Credit spreads and credit availability must improve. Spreads remain worrisome and the transmission of credit remains poor, but the economy should gain traction as public policy is implemented, money is made more available and lending terms are liberalized. (Grade D, flat from two weeks ago).
   6. We need evidence of a bottom in the economy, housing markets and housing prices. As I have written, the retail industry has exhibited evidence of sequential improvement in the January through March period. Other economic signs are somewhat more ambiguous but, nevertheless, are showing some life. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in the affordability indices and a better relationship between home ownership and rental costs. Nevertheless, yesterday's strong existing homes sales release raises the specter of a better spring selling season than most anticipate. I contend that housing could surprise to the upside and might lead most other economic indicators higher. (Grade C+, up from a C-.)
   7. We need evidence of more favorable reactions to disappointing earnings and weak guidance. I am encouraged by the better price action in the face of poor earnings results and guidance in a wide range of companies, including Freeport-McMoRan Copper & Gold (FCX), FedEx (FDX), Airgas (ARG) and General Electric (GE). (Grade B+, up from a C+.)
   8. Emerging markets must improve. China's economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive, but other emerging markets remain moribund. (Grade B up from a C.)
   9. Market volatility must decline. The world's stock markets remain more volatile than a Mexican jumping bean. (Grade C+, flat with two weeks ago.)
   10. Hedge fund and mutual fund redemptions must ease. I am comfortable writing that the worst of the redemptions are behind the asset management industry. Nevertheless, the disintermediation and disarray in the hedge fund and fund of fund industries still have a ways to go. And while brokerage account liquidations appeared to have decelerated last week (coincident with rising share prices), my high net worth brokerage contacts (such as Baron Von Broker) continue to experience account closures and a panicked constituency. (Grade C, up from a D).
   11. Marginal buyers must emerge. Low invested positions at hedge funds and by individual investors no doubt fueled March's market rise as the fear of being out has begun to replace the fear of being in. These two classes could continue to be the near-term marginal buyers fueling stocks. Corporate acquirers could also emerge as important marginal buyers, and the recent step up in merger and acquisition activity -- for example, Genentech (DNA), Petro-Canada (PCZ), Schering-Plough (SGP) and Daimler (DAI) -- is a concrete indicator that another important marginal buyer has surfaced. As the year progresses, a meaningful upside move awaits a broad asset allocation move of pension funds out of fixed income and into equities. (Grade B, up from a C.) To the above factors, I am adding a 12 factor in my watch list:
   12. The market's internals must improve. I am comforted by a number of improving technical conditions that have emerged since the March low and that have continued in force over the past two weeks since the market has made program off that nadir. Indeed, the conditions of the recent low were different than others -- in sentiment, volume, number of new lows and in intensity. The move from the October lows to the March lows indicated growing fear and gave way to rising cash positions and the loss of hope, but the market's internals were improving. November's DJIA low of 7,552 was nearly 11% below the October low of 8,451, and the March low of 6,547 was 22.5% under October's low. While each new low was more frightening than the prior one, however, there were improving technical and sentiment signals. For example, NYSE volume at the October low expanded to 2.85 billion shares; at the November low, volume dropped to 2.23 billion shares; and at the March low, volume was only 1.56 billion shares. As well, new lows traced decreasing levels: At the October low, there were 2,900 new lows; at the November low, there were 1,515 lows; and at the March low, there were only 855 new lows on the NYSE. Moreover, the combination of last Tuesday's 12:1 ratio of advancing stocks over declining stocks coupled with that day's 27:1 up-to-down volume ratio has not occurred in almost 65 years. Remarkably, yesterday was the fifth 90% upside day in March, which is evidence of a broadening market.

In summary, 10 out of 12 factors (including our newest, market internals) on my watch list are in an improving mode. Though many variables are currently accorded relatively low grades and the outlook remains debatable, the delta (rate of change) in almost my entire watch list is improving and flashing a green light for the U.S. stock market.

A classical wall of worry is being reinforced by an overwhelming consensus that the recent advance was a bear market rally. Moreover, the negative "chatter," as Jim "El Capitan" Cramer describes it, appears loosely constructed and fails to credibly argue against the salutary effect that $4 trillion of stimulus will have on the domestic economy.

Based on the 12 considerations comprising my watch list, I respectfully disagree with the prevailing negative consensus, most of whose members failed to properly analyze the cracks in the foundation of credit, in the economy and in equities two years ago. Indeed, it remains my view that the fear of further investment losses and possible investor redemptions are clouding many managers' objectivity in assessing the markets.

In the fullness of time, public policy aimed at stimulating the economy (in general) and in housing (in particular) should bear fruit, as will the ring-fencing of toxic bank assets serve to unclog the transmission of credit.

While it is unrealistic to expect a straight up move, I am growing increasingly confident in my variant and optimistic view that the early March low was not only a yearly low but, quite possibly, a generational low.

Coming Monday, March 30:  Jeremy Grantham 1st Quarter Commentary