Forecasts, TV and Little Red Riding Hood

Good afternoon,
I hope everyone’s Thanksgiving lived up to their expectations. If I seem weary, I’m still suffering from an over-indulgence of Tryptophan and training for a half marathon.

All forecasts are wrong, some are useful. What makes a forecast useful ? Does it forecast the right direction? Is it accurate in magnitude? It it’s timeframe relevant? What is its probability of success? And the icing on the cake is its accuracy from a trend record. I’ll take the first four always.

“Over the next ten to twelve years, we will see three recessions that will slowly move the average price-to-earnings ratio of stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades.

Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.” The Third Wave, Toffler

I bring this up because I believe investor success in the next 20-30 years will depend not only on how well information is processed but also how well an accelerated rate of change is managed. Think back the changes our grandparents have seen they went from the combustion engine and putting a man on the moon to talking to their grandkids via the voodoo magic of wireless. Are you ready for the change to come in the next 30-45 days? The “fear bubble” is close to being oversold. All of the variables to date — fiscal and monetary policy initiatives, the price of oil, lower government bond yields, political change in Washington and now quantitative easing by the Federal Reserve — seem to be working together to arrest the credit crisis, bolster economic activity and put a floor under deeply distressed stock prices. Confidence is the key. If confidence can be rebuilt, stock markets will perhaps anticipate a recovery. Although we are not making a case for it yet, a lot of the ingredients seem to be falling into place.

Our TV Nostalgia seems to be for the 60’s and 70’s yet our markets are harkening back to the extreme volatility levels of the 30’s. Andrew Mellon, appointed Treasury Secretary in 1921, gave us our current legacy of Treasury Secretaries. Our current history of frequent financial crises has put the spotlight on the Treasury Secretary as well. Today we have Mr. Paulson who seems to be always just behind the curve. I believe his talents lay in what was initially important to the current administration –tax policy, skeptical of government influence and China. He is less of a strategic thinker than a grand negotiator. The newest prospect the Obama Administration is dating seems to have broad appeal to Wall Street. Timothy Geithner is someone, who I believe won’t need on the job training. He spent a decade learning through the Asian financial meltdown and had the foresight to see some of the systemic risks in our current financial system. This bodes well for our future as a national economy.

Little Red Riding Hood and the Wolf have yet to meet. John Maudlin says it best “Sure, we had a credit crisis in August, but the Fed came to the rescue. Yes, the subprime market is nonexistent. And the housing market is in free-fall. But the economy is weathering the various crises quite well. Wasn't GDP at an almost inexplicably high 4.9% last quarter, when we were in the middle of the credit crisis? And Abu Dhabi injects $7.5 billion in capital into Citigroup, setting the market's mind at ease. All is well. So party on like it's 1999.

"However, I think when we look out the window from the lofty market heights, we see a few fire trucks starting to gather, and those sirens are telling us that more are on the way. There is smoke coming from the building. Attention must be paid."

I had been pounding the table for over a year to get out of the stock market. All of the signs of upheaval were there. And now many portfolios are down by 50%. And the fire of a credit crisis is blazing all around us. The firemen in the form of the Fed, the US Treasury, and central banks all over the world are trying to put it out.

And while the stock market may enjoy a serious rally over the next few months, we are not out of the woods. The fire is still raging and we are witnessing ever-more aggressive attempts to get the fire of the credit and housing crisis under control.

Yesterday the Treasury announced yet another huge $800 billion bailout, but this one has a different flavor. Much of the previous bailout money has come from the Treasury either borrowing money and buying assets (which does not create new dollars) or simply taking assets onto the national balance sheet, guaranteeing the debt. With this latest move, the Fed is going to buy $600 billion in mortgage bonds by monetizing, or creating, new dollars.

Normally this would set off more alarm bells, over worries about inflation. But these are not normal times. With the twin bubbles of the credit and housing crises still imploding, we are seeing a massive deleveraging and the disappearance of multiple trillions of dollars from consumers and businesses. And the bond market clearly expects more softening and maybe even deflation. The 10-year bond is below 3%. I wrote 10 years ago that we could see the 30-year US bond below 3% by the end of this decades-long cycle, which we began in the early '80s with Paul Volker.

As I wrote last April, the velocity of money (how fast a dollar moves through the economy) is slowing rather dramatically. It could fall another 10% and just get back to the average for the last 107 years. Given the growth in population, inflation, productivity, and other factors, the money supply will need to grow by 7% annually for the next several years to keep the economy at equilibrium. Remember, GDP (gross domestic product) is essentially the velocity of money times the supply of money. If the velocity slows down, the money supply needs to rise just to stay even.

The Fed is going to have some room to pump up the money supply without seeing inflation rise precipitously. I think this is the first of what will be several large injections, as they will keep it up until the economy begins to recover. They will especially do more if it looks like we could roll over into a deflationary environment next year.”

Conclusion – Little Red Riding Hood made it to Grandma’s not without some peril but nimble thinking and steadfast persistence.



Sources: The Third Wave, Toffler, Enter, Pursued by a Bear- James Suowiecki, John Maudlin, ML-PIA Proprietary Research. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 1, 2008, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Merrill Lynch to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. A portion of the income may be taxable. Some investors may be subject to the Alternative Minimum Tax (AMT). You cannot invest directly in an index. Discuss your investment needs with your financial professional before investing.