Financial Advise Stock Market Crash Great Depression Inflation Deflation Bear Market Jim Shepherd's financial advisor service uses a financial investment model that 
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		far in advance of anything available in the U.S. financial markets.
Monday March 23, 2009  
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In this Report Jim Shepherd discusses the following subjects around the 'Goofy Rules of Investing':

Christmas Rally (Santa Clause Rally)

January Effect

Buy and Hold rule

3 Horsemen - Interest Rates, Oil and Real Estate

Wholesale Inflation (PPI)

Fed Funds Rate, FOMC, Ben Bernanke

If you have been around the investment arena for any length of time, you undoubtedly have been exposed to many supposedly infallible 'rules' that are continuously touted by analysts and commentators. They have various rules for almost every situation, but the main purpose of these so-called axioms is to make sure that you follow their directives and invest in the instruments they are promoting. I am sure you have heard about the 'summer rally rule,' 'The Christmas or Santa Claus rally rule,' the 'January effect,' the 'three steps and a stumble rule,' the 'buy and hold rule,' and so on. Most of these 'rules' are nothing more than inventions of investment professionals created to make sure they have a steady stream of commission income throughout the year. Now, to be sure, there are many very good and competent investment professionals and I know more than a few of them. I am just saying that the vast majority of people in the investment business know very little about the reality of the markets and rely on these easy to sell stories in order to maintain their sales quotas.

Right now, there is a very important 'rule' that is being heavily discussed and dissected that you need to pay careful attention to. It relates to the activities of the Federal Reserve and it is crucial that you understand that, far from being a reliable guide, it is merely a mythical notion that many are relying upon for direction. I am, of course, referring to the Federal Reserve's two-year long campaign of increasing the level of the Federal Funds Rate. Since June of 2004, as of the last meeting, the Fed has raised the official rate of interest 17 times in succession. For at least the last three or four meetings, and particularly since the new Chairman Bernanke took over from the retiring Alan Greenspan, the debate has focused on when the Fed would be done raising rates.

One FOMC member stated a number of months ago that they were "in the ninth inning" of rate increases, implying that the Fed would soon be finished with their rate rises. Then, in a famous misstep a few months ago, the new Chairman Bernanke made a statement to a reporter that implied that the Fed could soon pause in their campaign of rate hikes. This sparked a sizeable rally in the stock market but was subsequently reversed as additional commentary emerged from the Chairman and various other Governors that implied that the Fed was not likely to pause. Indeed, in the latest meeting, contrary to what some thought a few months ago, they did raise rates again and gave the impression that they would still likely do so at the August meeting.

You may ask: Why is this all so important to us? Well, from the standpoint of the investment community, it is believed that once the Fed stops raising rates the stock market will move dramatically higher. Their 'rule' is that once the Fed stops, stocks rally. Yet, like most of these aforementioned 'rules' this one too is not very reliable. In fact, as I will demonstrate, the important thing about Fed action is not so much when they finally quit raising rates, but rather how far they go and when they change the trend from increase to decrease.

Obviously, with the sharp declines the stock market has experienced recently, many of the brokerage communities' commentators have been desperately trying to reignite a rally by urging investors to jump back in just before the Fed stops raising rates. This will be the perfect time, they say, since that will spark a long rise in stock prices. They seem to imply that this is a rule that has always worked and is almost certain to work again. Some of their arguments sound very convincing, and when they are given free reign to espouse their views on the various business programs (whose income is derived by selling advertising to these very same companies that are supplying the supposedly impartial and unbiased analysts and commentators) they can certainly create a sense of urgency amongst the uninformed viewers and listeners. Like always, they will pocket their commissions whether or not their directives are profitable. If things do not work out as they forecast, they will simply say that it was an 'aberration' and fall back on one of the other 'rules' they will dust off for the next situation. And so on and on it goes. Please observe the following chart of the S&P; 500 index.

Contrary to what most of the commentators and analysts are telling you, the last increase in a rate cycle is not the time to buy stocks, at least in three of the most dramatic examples in the last twenty-plus years. If you had followed their advice at those times, you would have lost substantial sums of money and would have missed some outstanding opportunities in other areas, such as those the model indicated. Let's look at the first one of these referenced incidents and analyze what happened.

In the first box, as you can see, the last rate increase in the long and painful cycle that took the Discount Rate to a punishing level of 14% occurred on May 5, 1981. At that time, Fed Chairman Paul Volcker (interestingly the newly appointed Fed Chief) had been waging an all-out war against the double digit inflation that had sprouted in the 1970's. If you would have followed the adage to buy as the Fed reached the end of the increase cycle, you would have experienced significant pain in your stock portfolio. Until finally bottoming in August of 1982 (when the model issued a strong 'buy' signal, ushering in the longest stock bull market in history) the S&P; declined some 23%! It certainly was not the time to buy stocks in May of 1981, as the Fed ended their rate-hike campaign!

I also wanted to point out the effect, as the rate trend changes, of decreases in official interest rates. Although I cannot fully explain the details of my proprietary measurement of when a trend change in official rates becomes predictive of stock direction, I can show you in the above example how dramatically that event affected the stock market in 1986. As you can see in the second box above, the Discount Rate was decreased on August 21, 1986 from 6% down to 5 1/2 %. This did spark a sizeable rally (which the model already had us positioned for) in stocks, as the market soared to all time highs by August 1987. In fact, the S&P; increased during that time a remarkable 38%! Indeed, that is the way to make money in stocks.

However, again contrary to the current mantra that is out there regarding the Fed, you can see what happened in the next case of the Fed coming to the end of a tightening cycle. In the third box, I have pointed out that the Fed (under its newly appointed Chairman Alan Greenspan) finished its rate increases as of September 4, 1987 as it raised the Discount Rate to the level of 6%. Was that a good time to buy stocks? I hardly think so, as the model issued an initial sell signal that month and then a critical mass signal in October of that year, just before the largest crash in U.S. stock market history! If you would have followed the rate rule as set out by the financial media, you would have seen your holdings in stocks decline by 35% in just a matter of a few weeks, before finally stabilizing. I doubt that most investors would want to experience such gut-wrenching declines, especially since at the time they did not know, as we do now, (and as the model forecast by virtue of its buy signal in 1988) that the stock market would eventually move to new highs many times before the end of the bull market in 2000.

Speaking of the year 2000, let's look at the last example I have included of when the Fed ended a rate increase cycle. As you can see, the Fed finished its rate hike cycle as of May 19, 2000 when it increased the Discount rate from 5 1/2% to 6%. As I am sure you are aware, that was not a good time to buy stocks! In fact, it was just before the Tech meltdown began. The model, of course, had issued a sell signal relative to stocks as of late 1999. Although the NASDAQ did move up temporarily after that signal thanks to Y2K liquidity injections, the Dow Jones Industrial Index peaked in January 2000. The S&P;, for similar reasons to the NASDAQ, moved a little higher until it peaked in March of 2000. The model did its job, though, and got us completely out of stocks (after racking up huge profits in the preceding years in stocks) and had us position ourselves in Long Term Treasury Bonds, which have to date produced a positive return of over 70%. That was not the case for those that followed the rate hike rule as of May 2000. Had you invested in stocks pursuant to that rule at that time, you would have seen a decline in your S&P; equivalent portfolio of nearly 50% before finding a bottom (although I believe a temporary one). If you had bought into the heavily touted technology sector, you would have experienced a catastrophic decline of nearly 80%! There is little chance that anyone following the normal rules of investing, as set forth by the investment community, could ever recoup those kinds of losses.

We've Looked At Some 'Rules'---Now Let's Look At A Law

It has been widely stated by the Investment community that "this time an inverted yield curve is not predicting an economic downturn, certainly not a recession." They claim that the inverted yield curve is overrated as a predictor as it has incorrectly predicted several recessions that never occurred. Is this true? Is this really what happened and, if so, can we ignore the current inversion? Let's examine the facts.

As you may know, I predicted (after the model had already issued its sell signal in stocks in late 1999) a recession following the yield curve inversion that took place in 2000. Indeed, we certainly did see a dramatic slowdown in the economy, particularly related to employment and corporate earnings but the recession itself was statistically mild. Why was that? Well, the chief reason was that interest rates fell so far so fast that people were able to borrow themselves out of trouble for a period of time. This ability to borrow cheaply gave the illusion that the economy was stronger than it actually was because as the consumer continued to borrow to spend, GDP data remained fairly robust. This is not surprising since Personal Consumption Expenditures (Consumer Spending) now represent around 80% of GDP (Gross Domestic Product). Yet, the yield curve inversion indeed did correctly forecast a big slowdown in what was, at the time of its origin, a booming economy.

However, since interest rates are now essentially in an inverted yield curve situation (short-term interest rates higher than long-term interest rates) and most likely will be in a more pronounced state soon, we must examine past history to see just how important this comparison may be. Again, if you listen to the pundits, you will clearly hear them say there is nothing to worry about.

Since I began developing the model in the late 1970's, I often look at the period beginning in 1980 as a sort of real time analysis of my research. It also happens to be the period of time (from 1980 onward) which has produced some of the most phenomenal opportunities in the investment world, as well as some of the most painful economic periods for those that were not prepared for what was about to transpire. The late 1970's marked the end of a period of double digit inflation and the beginning of the end of hard asset appreciation for that cycle. The model would have had us (historically) invested in hard assets until January 1980, just before Gold, Silver and Real Estate began a long decline. I had done very well during this period investing in those very assets, albeit without the guidance of the model at that time. However, once the commodity bubble burst as a result of incredibly high interest rates (thanks to Fed actions), the economy entered into a pronounced tailspin. Anyone who can remember what the economy was like in the early 1980's will know it was not a good time for those that had borrowed too much against assets such as real estate; neither was it a good time for those that had loaned too much against those same assets (such as the Savings & Loan Industry).

History proves that the U.S. economy experienced a severe recession in the early 1980's. History also shows very clearly that this event was predicted in advance by the yield curve inversion that preceded it. Please refer to the following chart, which compares very short-term interest rates (Effective Federal Funds---the rate that the Federal Reserve directly controls) to longer term rates (10-year Constant Maturity Rate). As you probably know, long-term interest rates are usually higher than short-term rates because they carry longer term risks, associated with future inflation and diminished real purchasing power of the underlying asset, than shorter-term instruments do. When the yield curve inverts, short-term rates move higher than longer-term rates and this causes many problems for both lenders and borrowers.

As you can see, the yield curve inverted in early 1980, a clear warning that trouble was just ahead. This certainly proved to be the case, as the economy soon went into a tailspin. Real estate prices collapsed, which soon led to the bankruptcy of many Savings and Loan institutions. Eventually, the fallout became so severe that the agency that insured the Savings and Loan Institutions, namely the Federal Savings and Loan Insurance Corporation (FSLIC), itself became insolvent and was eventually merged into the Federal Deposit Insurance Corporation (FDIC). Some 200 Billion Dollars in insured loans were written off during this period! The economy staggered along and the stock market collapsed. The stock market finally bottomed in August of 1982 (just as the model issued a powerful 'buy' signal), and soon the economy began to regain its footing. Yet, to say that the inverted yield curve signal was incorrect is foolish.

Let's look at another example of this early warning. As you can see, the next time the yield curve inverted (except for a brief blip in 1987) was in late 1989/early 1990. What occurred after that event? Well, again, we certainly saw a pronounced slowdown beginning in late 1990 and continuing into 1991, as oil skyrocketed in part as a result of the Iraq invasion of Kuwait. The stock market also suffered, as the major indices lost some 20% of their values in the fall of 1990 (as predicted by the model). Then, in early 1991, the model issued a powerful 'buy' signal which indicated that stock prices would soon recognize the stronger economy and better earnings that would occur later in the year.This proved to be very profitable for us, but the important point I wish to make is that once again the inverted yield curve predicted in advance the slowdown in the economy and the related decline in stock and real estate values.

The next example of this phenomenon occurred in early 2000. At that time, I warned that a recession was imminent (as we have previously discussed). Although, as we said, it did not appear statistically to be too severe, I believe that the change in the fundamental structure of the U.S. economy that resulted from this slowdown will affect us for years to come. After all, it was the bursting technology and Internet bubbles that led to such a dramatic loss of high-paying jobs that the employment landscape changed in a massive way. Furthermore, the manufacturing jobs that were lost in other industries as a result of this slowdown were shifted offshore, as consumers demanded ever lower priced items. These high paying jobs that were lost in the U.S. were replaced by much lower paying service sector jobs and so real income, relatively speaking, has declined precipitously since this trend began. However, as I said earlier, the fact that consumers could continue to borrow indiscriminately due to ever falling interest rates (until the Fed began raising rates again in 2004), the economy never appeared to slow down too much. Yet, if you are one of the millions who lost their high paying jobs over the last five or six years, you know things are not as rosy as they may appear. Also, with the yield curve now inverted again, and with it likely to get much more inverted as yet another rookie Fed Chief (Ben Bernanke) continues to wage waragainst an imaginary enemy, there is little doubt that at least a recession is just ahead. With so much debt in every area of society, it is likely to turn into something much worse than just a recession!

The Three 'Horsemen' : Interest Rates, Oil & Real Estate

Although the above triumvirate are not of the apocalyptic variety, nevertheless, history warns us that they are about to inflict significant pain. Unlike what many are saying about which past environment most closely resembles our current environment, it looks to me that things are eerily similar to what happened in the early 1980's as the economy and the stock market were about to fall into an abyss. Let me point out some of the similarities.

In both cases, we had a relatively new Federal Reserve Chairman bent on fulfilling a mission. In the earlier case, as we previously noted, Paul Volcker justifiably battled against double digit inflation but in the view of many went too far in his campaign. His efforts literally brought the economy to its knees. In this current case, we have a newly appointed Fed Chief who seems determined to fight a foe that really does not pose as much of a problem as many claim. In the 1970's, wholesale inflation peaked at nearly 20% per year. (Please refer to the chart below comparing the peaks in wholesale inflation during the 1970's and during this era). In this cycle, we have not even seen anything more than 5%, and that was only on a one month basis. (Remember, the way I calculate inflation is at the wholesale level on a month over previous year's month basis, so that seasonal adjustment is not necessary and over time you get a true picture of the rate of inflation; also, by looking at the wholesale level, we get a view of what is likely to appear at the consumer level six to nine months in the future and we can prepare accordingly by taking on investments that will benefit from the expected emerging environment). So, to me, Chairman Bernanke has already gone way too far in his rate hike continuation and has set the stage for a dramatic slowdown in the economy and a collapse in stock prices.

You may ask, why would interest rates at these current levels have such a profound effect on the economy considering how much higher they were at past times, such as the aforementioned early 1980's? The chief difference is the underlying rate of inflation. If interest rates are relatively as high now compared to the underlying rate of inflation as they were in the 1980's, then the pressure on the economy is virtually identical. Unfortunately, that is exactly the scenario we are now in.

The second of these similarities relates to the most important of all commodities in the modern world, oil. Just as was the case in the early 1980's, oil is soaring in price, just this week hitting another all time high in price. Of course, this price is in nominal dollar terms; adjusted for inflation, the price of oil in the early 1980's would have been around $90 per barrel in today's dollars. So we likely will see even higher prices ahead for oil for a short term until the economy really begins to slow and demand falls. The demand from those countries that have been competing with us for oil, primarily China, will also obviously decline sharply since most of their demand relates to production needs to supply all the widgets we buy from them, ballooning the trade deficit.

Oil is a major problem for the American consumer right now and has two interesting aspects in its impact on the economy. On the one hand, just as was the case in the early 1980's, it is a major drain on the average American's budget. It is like a tax on the consumer, slowing the economy, because unlike many items, we need gasoline to get to work, etc. It is not easy to dramatically cut back on our use of energy---that is until the price becomes so prohibitively high that there is no choice. That is right around the corner.

The second, and rather ironic, aspect of oil is the influence it has on the perception of inflation. As you know, I have argued many times that there is little real monetary inflation now, such as was the case in the 1970's. Rather, especially the consumer price index, due to the heavily weighted gasoline component, appears to show much more inflation than there really is. Obviously, oil at the level it is has a profound effect on those prices directly related to energy. Yet, so far, this has not spilled over into true monetary inflation (too much money chasing too few goods). Please look at the following chart of M2 to get a graphical view of this fact. Contrary to popular myth, money supply has been declining sharply.

Real Estate

The third and perhaps most important of these similarities we are discussing is real estate. I recall very clearly how real estate exploded in value in the late 1970's to the early 1980's. In fact, at the time, I was in the real estate development business myself. Fortunately, my partners and I sold off all of our holdings by late1981, avoiding the debacle that occurred after the real estate bubble burst. The pain for those that held properties was immense once the downward trend began in earnest.

In today's world, a declining real estate market will actually have an even more profound effect than it did in the 1980's. As I have pointed out, so many have borrowed so much against the value of their homes, that any prolonged downturn in price could trigger a wave of forced selling. Add to this the pressure of increasing mortgage payments caused by rising short term interest rates affecting variable rate mortgages, and you have the recipe for a national disaster.

Remember, with the economy so dependent on consumer spending, and with the consumer essentially tapped out with respect to borrowing potential, and with short-term interest rates on the rise affecting all consumer credit, there is no question the economy is on the edge of a precipice. As the economy falls into recession, or worse, our Long Term Treasury investments should soar in price as the risk of inflation vanishes. As for the stock market, I expect we will have received a critical mass signal and will have experienced phenomenal profits. Speaking of profits, however, don't let the current chatter confuse you.

Many analysts are saying that due to strong earnings growth the stock market will do fine. They say that earnings are continuing to grow at a double digit clip, insuring future stock market gains. Is this realistic? Well, even if the economy does not slow as we expect (which is highly unlikely) just ask yourself one question: if a company such as General Electric has seen its earnings grow significantly each year since 2000, why is its stock price half what it was then? The answer is that investors will not pay the multiples they did then, but the reality is that you have lost half your money if you invested in the stock back in 2000. The same applies to many other companies. You cannot rely on earnings growth alone, even if it occurs. No, once again, a so-called 'rule' is not too reliable.

Jim Shepherd
Jim Shepherd,
Founder and President

Economic crisis threatens everyone

As late as the first week of March, lenders refused to lend, clients refused to trade, and suddenly Bears Stearns was out of money. It was a bank run, more or less.

A collapsing Wall Street bank has to be sold off by the Fed. We are facing the biggest money crisis since the Depression.

Time Magazine
March 31, 2008