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January 07, 2008

2008: Is Bernanke The One?
by Brady Willett

With most investors it is usually sub-conscious convictions that ultimately determine the investment path chosen. Formed partly from experience but largely by their character, there is no escaping the veracity of this. To paraphrase Morpheus, "Investor's are slaves. Like everyone, they are born into bondage, born inside a prison that they cannot smell, taste, or touch. A prison for their minds."

These are the investors that chased internet IPOs during the late 1990s, adopted the position of professional house flipper in 2006, and are likely to think gold is a sure bet after, and if, it skyrockets tomorrow. Put simply, these investors are forever bound to follow 'the herd' and/or and abide by the gambler's fallacy.

We do not intend to start 2008 off by offering a preachy commentary about how best to invest - in any event an investment pre-disposition will not be materially altered by a simple 2000 word essay. However, we will offer some contrarian viewpoints that may help illuminate different and potentially opportunistic possibilities. So without further adieu, take the red pill and we will show you just how deep our investment convictions go.

The Matrix is Everywhere

Failing to enact a single regulatory effort during his tenure as Federal Reserve Chairman, Alan Greenspan helped engineer a financial system anchored by unfettered innovation, unprecedented growth, and unending bailouts. Under Greenspan's tutelage market participants came to accept that although unexpected '100-year floods' would arrive much more frequently, this was of little concern because the Fed was on the job. Today every blip in the financial markets evokes an outcry for Fed assistance, the threat of recession unleashes a 'behind the curve!' attack against the Fed, and practically all of the major U.S. banks, reinsurers, and GSEs are thought of as 'too big to fail'. In short, by neglecting to fulfill his duty as financial market regulator and overly aggressively easing monetary policy time and time again, Greenspan unwittingly created two types of financial markets in the U.S.: one that has just been bailed out and is recovering and one that is about to be bailed out.

It is this 'matrix', if you will, that came under attack in 2007, and is likely to come under a continued barrage in the year ahead. This is not to say that the U.S. financial system will fail - we are bears not monsters - but merely to note that Greenspan's design is flawed because 'bailouts' do have longer-term consequences. As 70s style stagflation threatens to return (something Greenspan never even remotely faced during his tenure), there is the danger that monetary intervention will simply fan the inflationary flames. As unprecedented home foreclosures and falling housing prices exact a toll on the U.S. economy, Greenspan's successor, Bernanke, may be unable to productively flog the market into submission with cheaper credit. Yes, 2008 is all about a day of reckoning and an impotent rather than omnipotent Fed. Definitely not a year of 'recovery'...

With these negatives noted, there is still not enough evidence to suggest that the investing world is ready to be unplugged from U.S. dollar hegemony. Accordingly, we are of the opinion that no matter how ugly the U.S. downturn gets investors will remain comfortable conducting their investment activities in freely floating paper currencies.

2008 Prophecies

It would, of course, be disingenuous to proclaim any forecast with a high degree of confidence. 1-year is both a very long and a very short-term horizon. Instead we will take a moment to offer what are at best a series of speculations.

1) As the U.S. economy enters recession the rest of the world will feel the consequences. With much of the financial world ignoring ominous signals from the U.S. financial markets, the theory of 'decoupling' gained prominence in 2007. We flatly reject this theory (or that the global economy can perform well regardless of how the U.S. economy performs), and instead see a 'recoupling' of global growth tendencies in 2008.

2) As 'decoupling' proves itself fiction and U.S. investors check their confidence in foreign stocks, U.S. equities will outperform many world markets in 2008. It is worth noting that in 2007 U.S. investor's poured money with greater confidence into emerging markets and actually reduced their domestic mutual fund holdings for the first time since 2002. This trend has further reduced the premiums investors pay on U.S. equities compared to say Chinese equities, and is probably very close to running its course. The 'premium' concept is responsible for Buffett ridding his portfolio of PetroChina last year (Mr. Buffett says the sale was based solely 'on price'). For the record, PetroChina - the largest company in the world on the basis of market price - and some other Chinese companies are actually trading at a premium to their global counterparts.

3) The U.S. dollar will tread water for much of 2008 rather than drown. Central banks showed unity in 2007, if only in the form of rhetoric, as the U.S. dollar weakened. It is this unity that suggests further dollar weakness, or even a dollar crisis, will spark a more concerted central bank effort to support the dollar. Longer-term we remain dollar bears, as we believe it is not a question of if U.S. dollar hegemony will end, but when. However, with so many people bearish on the dollar and no viable alternative unearthing itself, don't be surprised by a stable greenback in 2008. Despite models and rap-stars flashing their admiration for Euros in 2007, it is still in the best interest of most of the financial world to support rather than run away from the dollar.

4) Gold is headed for a historic bust akin to that of 1980. This bust will arrive once the U.S. economic slow down starts to deeply erode strength in emerging markets and/or once investors recognize that central banks are unable to quickly reflate the financial markets. With nearly everyone growing deeply enamored with the idea of 'stagflation', our gold bust theory is based upon the yet unseen threat of deflation.

Super caveat: although we think gold is very close to a major bust we still own precious metals and recognize that such a bust may only arrive after the herd starts piling into gold.

5) China will burn out but will not fade away. A more sophisticated and thriving financial marketplace has not engendered a more sophisticated investor class in China. On the contrary, early in 2007 reports of taxi cab drivers investing their life savings in stocks with cocksure attitude were making the rounds, and by mid-2007 the same taxi cab drivers were happily borrowing more money to invest. Some very basic statistics suggest the mania has peaked, as new stock accounts being opened above 300,000 per day in mid-2007 were being opened at only a 100,000 clip towards the end of 2007.

Like the U.S. based internet mania, no one can be exactly sure when, but a great Chinese stock market bust is coming. When it starts everyone will claim it was obvious, although only a handful of analysts are bearish on Chinese stocks today. Our crystal ball is blurry when it comes to whether or not a market bust derails the Chinese growth miracle for an extended period of time.

6) Commodity prices will decline in 2008. Going against the grain with this call (not to mention the surging price of 'grains'), 2008 will weed out some of the speculative excesses in commodity markets. The story we envision here is not unlike recent trends in the price of copper, which has yet to surpass the level seen during its strong rally in early 2006. As the global economy 'recouples' demand for many commodities will flatten and commodity super-cyclists will spin their wheels as no new driver powers the commodities train forward. We see base metals as leading this softening (or pause) commodities price trend by mid-late 2008.

Caveat: If peak oil is really here certain commodities will remain more buoyant for much longer than anyone thinks possible...

7) Crystal ball grabag: The Federal Funds rate will end the year at or below 2%. Long-term U.S. interest rates will end 2008 flat or lower. U.S. equities will end 2008 lower, although they will not be down as much as many world markets. The contrarian dream of Japanese equities will remain exactly that.

8) Greenspan is already receiving is share of bad press, but by the end of 2008 his image will be fully transformed from that of miracle worker to wacko alchemist. No one will remember the 'good times' Greenspan supposedly helped create as times turn increasingly bad.

With these speculations in mind, we believe investor caution is key, and cash is king. Currently our asset allocation is as follows: approximately 15% precious metals (physical), 45% equities, and 40% cash and equivalents (20% USD - 20% CND). Our intentions are simple: lower our precious metals position as the gold price rises and slowly add to equities position as stock prices decline.

Conclusion - Like A Splinter In Your Mind

Be it the constant debasement of the U.S. dollar or the constant/relatively outsized increase in the size of the entire U.S. credit market, dollars and debt can only be originated at a cost. Former Fed Chairman Paul Volcker understood this certainty, and attacked runaway inflation with tight monetary policies at a time when financial markets were seething for support. As 2008 begins the threat of inflation is on the rise and homeowners are defaulting at an alarming rate. This strongly suggests that monetary assistance has the potential to make each of these problems worse, perhaps requiring a Volcker-type solution in the future.

"Cash is available. We should use that in larger amounts, as necessary, to solve the problems of the stress [of repossession]". Alan Greenspan. ABC News.

While Greenspan is correct in that 'cash' is available, what he neglects to mention is that availability is not the same thing as reliability. To be sure, Greenspan sees cash as being available to help stop a contractual U.S. home foreclosure because it was Greenspan that turned a blind eye as these toxic contracts were being created. What Mr. Greenspan doesn't disclose as he cheers for a bailout with one breath and warns of stagflation in the next, is that Fed policy plays a key role in determining whether or not stagflationary forces take root.

"It is the world that has been pulled over your eyes to blind you from the truth."

If you can free your mind from the idea that recessions and bear markets must always be short-lived because policy makers are on the job, you will come to realize that the very instruments used to conduct 'bailouts' are what help ensure the blowups tomorrow. The U.S. Federal Reserve was not thinking of the larger picture when they helped bailout LTCM, they were wrong to stand idly by while reckless speculation took over the stock markets in the late 1990s, and they were severely misguided to accept a housing/credit bubble as an effective means to support growth. It is these errors of judgment that lead us into 2008.

As alluring as it is to join the stagflation camp (our portfolio is currently positioned for as much), we are bound to the conclusion that Volckerism will eventually return to the U.S. Fed and defeat Greenspanism. We can not buy into the argument that Bernanke ignores the price of gold and/or puts his trust into the heavily manipulated inflation statistics. Rather, even as the Fed continues to 'print', if their success/failure ratio starts declining as the inflation readings keep climbing, we think Bernanke will awaken to the real challenges at hand.

In short, the U.S. will not do its best impression of Weimer Germany in 2008, but instead embrace a much needed economic breather as the Fed adopts a perpetual plan of easing (a la 1990s Japan and 2001-2003 Greenspan).

Needless to say, it is the inevitable demise of the U.S. dollar as the world's reserve currency that throws any outlook into hysterics. When residing as Fed boss Greenspan had a sign on his desk saying 'The Buck Starts Here'. Apropo, Bernanke would do well to adorn his office with the opposite: 'The Buck Doesn't End Here'.

Brady Willett
FallStreet.com

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