JASMTS

 

Sample Hard Copy Update

Best Performance in a Leading Role:

January 12, 2001

And the Nominees are: Joseph B.,
Mary M., Abby J-C, et al

With this being the season in the entertainment industry when everyone is vying for nominations for various awards including the Academy Awards, I thought I would nominate a few individuals in the investment field that have clearly given excellent performances. Of course, in order to protect the guilty, I have not listed their full names. However, I am sure you know the ones I mean. You know, they are the same analysts that were calling for massive gains in stocks as we began the year 2000. Now, amazingly, with seemingly no pangs of conscience, they are saying the same thing about 2001. The only problem is, their followers have lost 50, 60 70% or more of their money. Yet, these analysts can look right into the camera and declare that Ďthis is now the time to buy.í They look so convincing; I truly think their acting ability is unparalleled. Oh well, at least they might have something to fall back on!

As you know, we did call for a rally beginning sometime prior to year-end 2000 that I said could be quite powerful. This was based on those components in the model that are more short-term oriented, as well as other technical analysis that I use. However, I did not nor do I recommend playing the upside of this rally. As we have seen, the volatility makes this move, even though it has seen some stocks rise a fair amount, too dangerous. We should rather wait until we either get to critical mass readings in the model or to a new buy signal before we make any ventures into the stock market. Remember, even though the NASDAQ is some 15% off its lows, it now has to gain 100% to get back to where it previously was. That is the downside of investment mathematics: an initial 50% loss requires a subsequent 100% gain to offset. So donít get too anxious just yet. Wait until we get the signal we need so that we can go forward confidently.

So with everything that is going on, what is the outlook for the real first year of the new millennium? To say the least, it looks very interesting. Let me explain.

First of all, as we forecast nearly a year ago, we are clearly seeing a dramatic slowing of the economy. In fact, the economy appears to be slowing so quickly that it scared the Federal Reserve so much that they acted inter-meeting to reduce interest rates in an attempt to revive the economy. The question is, will this work? As far as the market is concerned, it did have an initial positive reaction but then retreated. But the essential question is, can the Fed perfectly manage the economy and eliminate all risk over the long term in the financial markets? I seriously doubt it. You see, there are a lot of things that are different now than in past times. Furthermore, we have not had a serious recession since the early 1980ís, and the cumulative effects of delayed consequences are starting to be felt. That is, we have used every financial trick in the book over the last twenty years and have had a great deal of luck as well to avoid all but only the mildest of slowdowns. But, has the business cycle been eliminated? I donít think so! Just as an individual might improperly treat a symptom for years without consulting a physician and then finds out the underlying disease is much worse than it otherwise would have been if treated properly earlier, so too is it with the economy. We have done everything possible, usually due to political expediency, to avoid even the prospect of a slowing economy, thereby delaying the inevitable and almost guaranteeing an intensification of the severity of the recession.

If you look back over the last 18 years that the bull market in stocks has been in place, you would see that one of the chief reasons for this secular bull market was a long-term trend of falling interest rates. Now, to be sure, we have had brief periods when interest rates ticked higher, but the trend has generally been in place all that time. If you look at the following chart, you can clearly see what I mean. Beginning with the peak in interest rates in 1981 (which were raised to staggering levels to fight the inflation of the 1970ís) you can see the downward trend.


Source: Federal Reserve Bank of St. Louis

This environment of generally falling interest rates was achieved primarily because inflation was relatively subdued during most of that period. Why was that? Well, initially, of course, it was due to the wringing out of inflationary expectations by those very high interest rates in the early 1980ís. After that, particularly during the last few years, it has had to do with a lot of events that worked to our advantage.

For example, many of the economies in the world have been in recessions or worse for several years. This allowed us to purchase their goods at very low prices and kept a lid on inflation. Even though we didnít have the money to pay for all these goods, we kept importing them anyway and this is why we have record trade deficits every month. However, with our dollar strong and our investment markets booming, foreigners felt comfortable financing these imbalances and so we were able to keep on buying. Naturally, in order to finance these deficits (just like the individual that enhances their lifestyle by using credit cards) we took on record levels of external debt. We borrowed so much from foreigners (by selling our bonds and other treasury securities) that the level of U.S. Federal debt held by Foreign and International Investors climbed from around 400 billion dollars in 1990 to over 1200 billion dollars by the third quarter of last year. That is ONE TRILLION TWO HUNDRED AND TWENTY FIVE BILLION DOLLARS! Thatís a lot of borrowing! But what makes this so ominous is that it puts us at the mercy of foreigners. Why? Because if we lower interest rates too much, or if the value of our dollar is undermined too much by inflation, or if our financial markets continue to collapse, or for many other reasons, they may begin to bail out of their holdings. If that were to happen, it would be disastrous, and yet I believe it is not only possible but also in fact likely.

That is one of the chief problems with this attempt by the Federal Reserve to revive the economy: there may just be too many external factors over which they have no control. For example, unlike their easing in 1998, they now must factor in the effects of high oil prices. In fact, oil prices have tripled since then. Furthermore, that event was a financial crisis. Now, it appears that we are entering into an economic crisis. The differences are very real and the latitude that the Fed has to act is much changed from the previous circumstances to the present. So, will the Fed be able to bail us out again? Well, although anything is possible, we will not know for sure unless we were to get a new buy signal in the model. Meanwhile, it looks much more to me that we will soon slip into a deflationary style recession /depression. That is why I do not want to exit our bond positions just yet, even though they have declined slightly lately from their highs. If we get the signal in the model that we are going into a deflationary black hole, bond prices will soar and almost all other assets will collapse. With the stakes so high, and with our potential so great, we must be patient a little longer until we see clearly which way we should go.

Right now, the readings in the model are holding steady, and this is one of the reasons the market has not been under too much pressure lately. Furthermore, the interest rate components of the model have been declining, adding additional buoyancy to stocks temporarily. But to declare that the bottom is in would be premature and very unwise. Again, we must wait for further evidence in the model. The good news is that I expect to have a much clearer picture about whether or not we are slipping into a deflation by early next month. That will go a long way to telling us how the rest of this already turbulent year will unfold.

Position. At this time you should be out of the equity market. Your funds should be in  (the positions are know to our paid subscribers). Realize that if you have joined us recently and are interested in purchasing the (XXXXXXXX) you may be purchasing near an interim top in price. It may back up some more before it gives a lower risk entry point. However, this has to be weighed against owning them at all if you have not yet purchased, since at that time when the market begins to melt down they will appreciate further and very sharply.

Meanwhile, take care and have a great weekend.

COPYRIGHT, 2001, JAMES A SHEPHERD, INC. ALL RIGHTS RESERVED. SHORT EXCERPTS, WHICH DO NOT EXPOSE OUR PRESENT POSITION, MAY BE USED WITH FULL CREDIT GIVEN. ANY USE OTHER THAN AS INTENDED, OR INDICATED HEREIN, IS STRICTLY PROHIBITED. RECOMMENDATIONS AND ADVICE GIVEN HEREIN ARE MADE WITH THE EXPRESS UNDERSTANDING THAT SUBSCRIBER ASSUMES ALL RISK OF LOSS. THE COMPANY OR ITS AGENTS GIVES NO GUARANTEE, EXPRESS OR IMPLIED. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. ALL INVESTMENTS CARRY RISK.

Past Performance Does Not Guarantee Future Results

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