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VOLUME  1.14 
DECEMBER 21, 2009 


Hopefully Some Return Too
There have been five overriding themes for by 2008 than they were in 1929. A good part

our investment letters during the past year. of the reflation effort is to transform private

Below we list and review them. debt into public debt, and this will surely

1) Expanding liquidity drives financial create another, different debt monster. As

markets, particularly when it occurs in the the year draws to a close, credit rating

face of a sub-par but recovering economy agencies are starting to downgrade

and weak price inflation. This is the sweet sovereign debt and credit default swaps

spot in the cycle we so often talk about, and (CDSs) and are showing increased concern

it is the best of all times for stock and that some major developed countries are

corporate bond prices when perception of going to have problems servicing their debt

risk abates. (e.g. Japan, U.S., etc.).

2) The Great Reflation underway since The markets are starting to tell us that

late 2008 has done its first job - aborted Governments with brittle, over-extended

what surely would have been a full scale fiscal positions will soon have to put in

depression at least on the scale of the 1930s. place credible fiscal consolidation -- tax

That was Act I. increases, expenditure cuts, decline in

3) No one should believe that the huge services, etc. This means more deflation,

reflation underway will make the economy more uncertainty.

and financial system whole again. The

private sector debt excesses were far greater


4) Zero interest rates in the U.S. together destruction of savings and investment in the

with Federal Reserve asset purchases, much of U.S., and has created massive disequilibria in

it low quality, has done its job of inflating asset the global economy and financial system.

prices which improves balance sheets. Better Economics 101 tells us clearly that all

financial markets greatly help capital raising disequilibria eventually get corrected. The

ability, further strengthening balance sheets. interesting questions are how and when? That

As a result, they are much improved. The will be the story for Act II of the drama and it

question is over sustainability. Fears of hasn’t been written yet.

renewed asset bubbles have surfaced, As the year 2009 draws to a close, there

complicating Fed and other central bank is clearly an aura of unreality. We barely

decision making. Do they risk tightening too survived a near-death experience nine months

soon or too late? Does a middle ground exist? ago. However, the pain and the fear for most

Zero interest rates are an extreme anomaly and people were brief. It was not like the 10-year

cannot last unless the U.S. economy remains depression in the 1930s that changed attitudes

permanently depressed and in deflation like for two generations. The recent experience

Japan has been for 20 years. This seems probably won't change many peoples' attitudes

unlikely but cannot be ruled out. at all, and may even have a perverse, moral

5) The great flaw in the international hazard effect. If the U.S. and other

monetary system has allowed the U.S. - the governments are always going to bail out the

key reserve currency country in the world - to banks and other over-indebted, overleveraged,

run up a $4 trillion tab with foreign central reckless players, and stick the costs onto the

banks and has created excess liquidity and sober and prudent, why not join the former? As

asset bubbles in countries buying those dollars. Mark Whitehouse put it in a recent article,

It has also contributed mightily to the

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"Let's default and go to Disneyland - the intervention, bailouts, and stimulus etc. to do

American dream - default and then rent." “whatever it takes” to put air back in the burst

The music is playing again, people are balloon. Simply put, the government took the

up on the dance floor and the bankers downside out of the economy and risk assets.

(somewhat diminished in numbers) are getting The odds were very high that the

rich once more and raising tens of billions of market environment would be good for some

dollars in equity on the much-improved stock time and it has stayed that way. However, the

market to pay off their TARP loans so they can so-called fundamentals are very artificial - the

pay out mega bonuses. Meanwhile, the banks stimulus, the subsidies (first-time home buyers,

are sitting on hundreds of billions of dollars of cash for clunkers, moratorium on foreclosures,

bad loans with more to come (default lags can etc.), the zero interest rates - none of that can

be long). last.

The question for investors is - do you A second key point we have been

get up on the dance floor like everyone else emphasizing is that no one knows what the

and pretend that the crash was a bad dream? underlying economic conditions are really like,

Or, do you pay attention to the unresolved and more important, what they will look like in

problems, do a little dancing, but be ready to 6-12 months. No one knows how sensitive the

grab a chair when the music stops? still over leveraged economy is to a rise in

A key point we have been making all interest rates. No one knows how long nervous

year and will continue to do, is that the stock foreign central banks will keep buying dollars.

market in March 2009 met most of the criteria No one knows whether the recovery in asset

for a durable bottom. These were: good prices might morph into a full-blown asset

valuations, massive fear, very expansionary bubble. Or the reverse. No one knows when

monetary policy and government through

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sharply rising government debt: GDP ratios estimates -- how high the stock market might

will hit the wall, as in the case of Greece. go and how long it will keep rising. Estimates

No one knows how much debt is too of numbers and time are useless and, in this

much. The private sector debt super cycle went highly uncertain world, no one should believe

through a process of steadily rising over 25 such forecasts.

years to reach 170% of GDP. All along the The issue is risk and uncertainty. The

way, the same questions were being asked - dilemma for investors as they face near-zero

how much is too much? The answer was: a lot returns on safe, liquid, short-term assets is that

more than most people thought. But when you if they want some return, they are necessarily

get to the end, they don’t ring a bell to give driven to accept a level of risk that is

you a warning. Think of the elastic band uncomfortable and unknown. While this is

analogy. You keep stretching it; it weakens always true, the difference going into 2010 is

gradually until a “certain” point. Along comes that a lot of things could go very wrong on

a shock and it snaps. That happened in 2008 very short notice. For most of the post-war

with the private debt structure. It will happen period, that was not the case.

with the government debt if a credible plan is

Investment Conclusions
not put in place to bring it under control, but no
Our take on the investment environment as the
one has any idea of when. It probably won't be
year draws to a close is as follows:
for quite a while, but no one will give you a
1) We are not yet in a full-fledged asset
written guarantee.
bubble, although as we pointed out last month,
A third key point we strongly believe is
gold and other commodities may be a lot closer
that there is no long term any more for
to one. The recent correction in those markets
investors. It is totally inappropriate in this
is helpful and the injection of a little risk may
environment to think in terms of point

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curb speculative juices for a while. Risk assets 4) The world will remain very

in most developed markets are still well below deflationary for some years and Government

old highs. The exception is real estate outside bond yields are very low as a result. The risk is

the U.S. Quite a few markets are getting too on the side of an increase, but it will likely be a

hot for comfort. gradual trend.

2) The Fed and other central banks will 5) There will be enough economic

continue to talk of exit plans, but they are as strength for awhile to support corporate credit.

concerned as we are that underlying economic Spreads against Treasuries should be flat to

conditions have been driven by artificial down. That will continue to provide

factors and are not nearly as strong as recent opportunities to enhance returns.

data suggests. Remember, the two most 6) The stock market environment will

powerful influences driving Fed policy are remain good for the time being. Profits have

first, unemployment, and second, elections. recovered substantially, liquidity is plentiful,

There is 10% unemployment and a much and interest rates are so low that investors will

worse picture counting discouraged workers continue to be driven to riskier assets - stocks,

and structural unemployment. With a key corporate bonds, commodities, emerging

election next year, the Fed will not be markets and probably gold, although that looks

tightening any time soon. like a very speculative market.

3) Foreign central banks will continue to 7) Markets of countries, ex. the U.S., with

hold their nose and buy enough dollars to strong currencies, sound finances, stable

prevent a collapse. Dollar erosion over time, politics and with commodities making up a

with periodic rallies is a better bet. Moreover, large percentage of the GDP, should continue

dollar short positions are huge, so don’t count to do very well. Examples are Canada,

out sharp counter-trend moves. Australia, Brazil, Columbia and Norway.

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There are more. High-growth developing Great Reflation lies ahead. Therefore,

countries like China and India will also do investors, as we have emphasized before, must

well, but as valuations get stretched, volatility look for milestones to assess whether

will increase a lot. Good entry points are underlying conditions are changing. The most

essential. important to watch are:

A final note - remember the U.S.

reflation is an experiment never before 1. The dollar

performed in peacetime except in post-1989 2. Treasury bond yields

Japan. The lesson there is not very consoling. 3. Corporate credit spreads

Japan never got past Act I - the avoidance of a 4. Credit defaults swaps on sovereign debt

depression. Act II, as we pointed out, is all

about restoring equilibrium and returning to We have added the last one to our

sustainable, non-inflationary growth. Japan has previous list because credit rating agencies are

had less than 1% real growth for 20 years even getting nervous and are still licking their

with zero interest rates. Lack of growth has wounds after their catastrophic performance

pushed the debt to GDP ratio close to 200%. prior to the crash of 2008. There are, of course,

Forget an easy solution; there does not seem to a variety of other milestones to watch which

be any solution and ultimately there will be a we will be monitoring. For the time being, we

yen collapse and a sharp rise in interest rates don't see any significant signs that the

that will cause havoc with government debt. liquidity-driven improvement in asset markets

However, the U.S. is not Japan; there won't continue into 2010. But remember, this is

are many differences which we will explore in a risky, uncertain world; you should carry

another letter. The point is that the U.S. is more liquidity than normal, be more risk

experimenting with the unknown. Act II of the averse if you are not in a position to recoup

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losses easily and if you have taken a big hit to

your net worth as a result of the crash.

Tony & Rob Boeckh

December 21, 2009

*All chart data from IHS/Global Insights, and

may not be reproduced without written

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Interest Rates

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