Extracted from Jan 03, 2006 market update.

"One ought never to turn one's back on a threatened danger and try to run away from it. If you do that, you will double the danger. But if you meet it promptly and without flinching, you will reduce the danger by half. Never run away from anything. Never!" - Ralph Waldo Emerson 1803-1882, American Poet, Essayist

We are almost sure everyone has a ton of questions regarding our projection that the markets are going to top towards the end of the first quarter or the middle of the 2nd quarter. Before we get into the heart of the matter just remember that a lot can happen in 3 months in terms of gains. We have not turned bearish yet but are simply warning that it looks like things could change in the not too distant future. Many forces are aligning up and if things continue to unfold as they are doing so right now the markets could be in for a rather hard landing.

Property prices are falling across the nations (we have a few anomalies here and there), mortgage rates are rising, Gold is trading significantly past 500 (usually a sign of hard times to come), the situation is getting very hot on several geopolitical frontiers, Americans milking the equity out of their homes like there is no tomorrow, and finally we have an inverted yield curve. All that is left to put the final nail on the coffin is for the US dollar to resume its downward trend.

Rising mortgage rates

There are two problems here first normal rates have been rising for sometime which means that a 300k house is more expensive to buy today then it was about a year ago, even if the price did not budge. This alone has been putting some downward pressure on the prices of houses. The other factor is that most people do not qualify for conventional mortgages and hence they pay much higher rates because they go for those exotic ones where incomes don't have to be verified and teaser introductory rates are offered to lure them in. For the last 3 years or so the bulk of new mortgages are being issued to the sub prime market. This is a time bomb because many of these ARMS (adjustable rate mortgages) will reset in the next 6-12 months, many people will see their payments go up as much as 100%. The reason being that for the most part many of these mortgages did not even include the full interest payment let alone any payment towards the principle. Many individuals have purchased 2 or even 3 homes using these highly risky mortgages; in fact this even more dangerous then playing with options because you are taking on so much debt and leveraging yourself to the hilt. To make matters worse most of these people don't even know what their monthly payments will be once their mortgages reset; they are in for a huge shock. The resetting of these mortgages plus falling house prices is a ticking time bomb.

Falling housing prices.

Many people feel rich because of the rising values of their homes and most have actually spent this money by taking out home equity loans. Now forget rising rates and the mortgage time bomb and lets just assume we have to deal only with falling prices because there are too many houses on the market. Think about how these people who have already spent money they do not have are going to feel when they see the prices of their homes falling. If you think this is not possible once again all we have to do is mention Japan. Once prices start to fall consumers will start to cut back on spending because there will be no more avenues from which they can borrow money. In a rising rate environment credit is usually tightened as default rates start to go up. This entire housing boom has come about because of extremely easy credit a slight tightening and all hell could break loose. Off course then there is a trickle down effect and people start pulling money out of the markets or less money goes in etc. This means that serious correction in housing could pull the equity markets down significantly also. Take it one step further what happens when ones house falls below what one paid for it then paying the mortgage no longer makes sense and walking away from the home becomes the obvious choice. Once again we draw your attention to Japan.

Using the Home as an ATM

Increasingly Americans have been turning to their homes to supplement their incomes or to live the lifestyles of the rich and the famous; they buy things they don't really need with money they don't really have. This is a perfect plan to ensure that one has nothing but pain and hardship to look forward to when one retires; oops forget about retiring they will probably have to work themselves into the grave.

1) Home equity withdrawals, which include refinancing, or increasing mortgage amounts upon renegotiation, and new home equity loans. One in four homeowners who renegotiated their mortgage in 2004 also increased their mortgage amount by an average of $30,000, or almost half of the average annual household income. The report estimates that home equity withdrawals in Canada amounted to $21 billion last year. Cumulatively, over the past three years, home equity withdrawals sum to $55 billion, which is equivalent to more than 11 per cent of the growth in total Canadian GDP during this period.

2) The home renovations boom, through which much of the cash borrowed against home equity is finding its way back home. One-third of all the funds available to homeowners in 2004 through the combination of cash out mortgage refinancing and home equity loans was used to finance home renovations. Spending on home renovations totalled a record high of $28 billion in 2004 and is projected to rise to $30 billion in 2005. Full Story

Gold trading past 500

Usually when Gold trades past this level for a prolonged period of time it indicates that the economy is going to slow down and there is a very good chance that we will have a recession. So this is yet another problem.

Inverted Yield curve

If the spread widens significantly on a percentage basis and stays like that for several months then the chances of a recession go up significantly.

The US dollar

This is the nail on the coffin. It is both our belief (Tyler and I) that the US consumer for the most part is tapped out and that an infusion of foreign money is one of the main reasons the markets rallied. Why did foreigners decide to pump money into this country? The primary reason being that they wanted to take advantage of the dollar rally, but then why settle for just one thing if you can win in the markets also. We are talking about the big chaps right now not the small fish. Once the dollar starts to correct these chaps will start to take their money out and this could really be one of the main reasons the markets enter into a prolonged correction.

In several earlier essays (in 2004) we mentioned that the Dow was doing nothing when priced in other currencies. We actually plotted the Dow against several other currencies to show that even though Dow was moving up in dollars it was doing nothing in other currencies. Then when the dollar started to rise lots of pundits came out and stated that the markets would start to correct and we completely disagreed with this observation. In fact we stated that this would most likely attract the interest of foreign investors as it rightly did. In the same way once the dollar resumes it's downward trend this chaps will flee for the exits.

If we combine all these events together the situation really starts to look ugly and indicates that at the very least the housing markets and Equity markets could enter a corrective phase that will last at least 30 months. However we do not think they will correct in unison nor does it mean they will start to correct immediately. Unfortunately the market does not always react to new stimuli immediately there is usually a lag time and sometimes this effect can be a prolonged one. Timing is therefore of the essence as it could make the difference between winning or being completely blown out of the water.

As always we do not believe in panicking and this information is only being provided so that you have an idea of what could potentially happen. If any of you have Adjustable rate mortgages get rid of them ASAP. We hope that none of you bought houses in the booming hot areas of the US. We will be keeping an even closer on the markets for the next 3 months and will report any changes we see here first. So there is no need to panic as panic produces stress and stress kills. We believe in the principle that an informed investor is a relaxed investor.

If you have to remember just one thing out of everything we have stated above make sure you do not forget this. When the markets start to correct towards the end of the 1st quarter or middle of the second quarter and the following conditions are present

• Inverted Yield Curve
• Housing prices still declining
• Mortgage rates are still high
• Gold is trading past 500
• And most importantly the Dollar resumes its downward trend

Then there is a high probability that the markets are going to correct very very hard. Many so called top analysts will come out and state that the correction is nothing but a buying opportunity (it would be if the above conditions were not present); ignore them and risk takers can start buying puts. Commodities will continue to do well as will certain stocks and certain sectors but the overall market will be in trouble.

There are other troubling issues such as China holding the world largest US Dollar reserves by the end of this year, Russia flexing its muscles (because it is the worlds largest swing producer of oil and holds the worlds largest natural gas supplies) etc. We will talk about these issues under a new category titled "key Developments". The first of these essays will appear sometime next week. One must remember that a disaster is nothing but opportunity knocking in disguise, the trick being to locate the gems in the heap of rubble.

"No one that encounters prosperity does not also encounter danger." - Heraclitus BC 535-475, Greek Philosopher