Lafayette Lotto

Since 2007 I have compared the Lafayette housing market with the state lottery. Both have big winners and both are run by the government.

Once in a while a high end home in Lafayette will sell at 2007 peak bubble price. This event can create up to a million dollar gift to the seller above the "present value" or utility value of the home. The short term dysfunction in pricing props up the comparables and allows other sellers to continue the lottery. Historically, after a bubble, "high end" home prices trend downward much more slowly than their "lower end" brethren. Interestingly, most of the "high end" areas of the Bay Area are not trending down to fair value, they are staying close to 2007 bubble prices.

I made up the term "lottery" because I needed a new word to describe this unprecedented economic behavior. Our nation's leaders are desperately borrowing trillions of dollars from our children as they frantically attempt to keep home prices in a bubble. The end goal is for real estate values to stay unaffordable for the future generations that will have to pay off this boondoggle(scheme that wastes time and money).

I am not a psychologist so I don't quite understand why we hate our children as we are attempting to mortgage their future with stifling debt and unaffordable homes. But I am an accountant with a degree in economics so I do understand that this market manipulation is unsustainable in the long run.

I don't disagree with a flood of money to help the unemployed. I take pause when our government unconstitutionally borrows trillions of dollars with the malicious intent to artificially distort capital markets so they can reward bankers and speculators. The amount of money being spend on bailing out banks dwarfs the money going to the unemployed 100 to 1.

The worst part of it is that this malicious money only creates short term distortion and will have no long term effect on the housing market. No amount of hope, money and debt that our politicians and their lobbyists throw at our housing market will keep real estate prices from going back to valuations that are in line with historic value trends.

Lower priced housing markets like Antioch are almost through the bubble. Some "low end" areas are selling below 1998 prices. In Antioch it is easy to see how prices come back to fair value. Presently Antioch prices are below fair value compared to rents and household income. Speculators are being kicked out of the market as young families and prudent investors are able to feel the joy of owning a home that is "affordable". This is the same feeling that my generation was able to enjoy for 25 years up until 2001 when the government and the banks colluded to make real estate unaffordable.

The wave of foreclosures in Antioch is allowing families to trade hundreds of thousands of dollars of debt for rents that are half of their former mortgage payments. The only cost is a 2-5 year ding in their credit. Each foreclosure eliminates personal debt and in the end makes our country stronger. Why is the government involved in this at all? Well, it appears that they feel that all bankers need large bonuses to keep the country strong.

There is a rebirth happening in Antioch and other "lower end" housing areas. This has nothing to do with the government. Houses are coming back into line with fair value. This is a wonderful event. Fairly priced assets are the foundation of a sound economy. The fact that our government is attempting to fix prices with Ponzi schemes and market manipulation makes me question the soundness of our government.

It will be a long slog for "high end" real estate. The government would say that Lafayette is benefiting from the stimulus. I myself do not see any benefit to manipulating the housing market to delude young families into bad investments. House prices must come in line with intrinsic value in the future. I believe it is unethical for our government to spend trillions of dollars of our children's money to slow the process.

Let's look at the significant variables that will drive future high end home values:

• Prices on homes in Lafayette are selling at a 30% premium in relation to intrinsic value. Prices are also out of line with historic value trends. This makes sense because most of the time house prices find equilibrium at prices that buyers can afford. Eventually Lafayette prices must fall in line with rents and household income.
• If interest rates rise from 5.5% to 8.5% then homes must be discounted by 25% to have the same mortgage payment. As interest rates rise real estate prices fall - always.
• People are presently not saving. Historically we have saved 10% of our income. Future discretionary spending on housing will be reduced in the future due to higher savings rates that are in line with historical norms.
• Taxes for the upper middle class will increase at least 10% in the future. The upper middle class will pay for just about all of the debt that is presently being created by our government. This will also have a large effect on discretionary spending on housing.
• Rents in "high end" areas are trending downward so renting is becoming even a better value.

I can think of no scenario in which these 5 drivers will not push high end prices down at least 30%.

There are many other factors that will effect real estate in the future. Almost all of them will have a negative effect on "high end" real estate.

The recession of 2011 will have a significant effect on our nation's psyche. Hopefully this watershed event will send our nation on the road to saving instead of speculating. We must understand that the easy money of the last 25 years is over. Our government is spending trillions to keep the party going but this government largess must end soon. The longer it lasts the bigger the bill for the upper middle class taxpayer of Lafayette and for our country.

New buyers in "high end" Lafayette will slowly sink underwater over the next 5 years. During this time they will be responsible for the lion's share of the debt that is being created by our government. $1.3 trillion divided by 290 million is $4,500 a person. So this year an upper middle class family of four is responsible for about $45,000 of deficit for 2009. It works out to $4,500 for each family member and $4,500 each for another family of four that does not pay income tax. Also they will pay for half of an Antioch middle class family. Remember, the top 50% of taxpayers pay 96% of income tax with the highest proportion going to the upper middle class.

The $45,000 debt is just for 2009. The government is planning to run these deficits for at least 10 years. So multiply the $45,000 by 10 to get a realistic idea of an upper middle class family's portion of the government deficit.

The stimulus ends up being a circular function as it flushes through the upper middle class. The government debt is creating market dysfunction that is allowing high end home buyers to overpay for real estate. These new buyers will be underwater in their homes in 5 years and also be responsible for the $450,000 worth of debt that distorted the market to make the house seem like a good deal in the first place.

Let's look at the numbers comparing buying a mispriced home or renting the same exact $1.2 million home:

Realistic estimated loss in property value over 5 years = $300,000

Difference in cost of rent to house payments after tax = $120,000

Difference in cost to move = $48,000

So as a home buyer you are locked into a possible $420,000 loss until you decide to pay $48,000 to exit the investment.

As a renter I can move as many times as I want. I can buy a house next year or in ten years as my down payment grows with interest.

Also my landlord is responsible for cleaning my pool, maintaining my yard and cleaning my gutters.

It doesn't quite seem fair.

It's almost like there's a renter's bubble in Lafayette.

As a renter the only thing that I miss out on is the chance to hit the Lotto.

Almost a Homeowner:

I monitor the Lafayette housing market very closely. A couple of weeks ago a Real Estate Owned(REO) property came on the market that was very intriguing. It was a great lot with an older home on it that was priced at 2001 value. I inspected the structure and determined that I could rehab the house for $70,000 thus making the total cost of the property around $650,000.

I am presently not anxious to own a home in the Bay Area because home values are due to fall another 30% in the high end areas like Lafayette. But this house was pretty special.

On the property's third day on the market I made a low offer that was accepted by the bank. I had a termite inspection and found some wet wood termites. Not a big problem. Dry wood termites are the killer. So far so good.

I received the preliminary title report and decided to perform my due diligence on the "chain of title". I went to the county and found that the bank had botched the foreclosure of the property. There were 2 investors named on the Grant Deed and one of them was not included in the Notice of Default or named in the Foreclosure.

I informed the title company that I needed this included in the title insurance. They mentioned this to the bank and of course the bank backed out of the deal. They are going to start the foreclosure process again and hopefully do it right this time.

The funny thing about this deal is that I mentioned the tarnished "chain of title" to a couple of real estate agents and they said that I shouldn't worry about it. Of course now they admit that I was right. Real estate agents are a little to easy going sometimes.

I would like to express that if you are buying real estate in today's dysfunctional market you must to be very careful:

1) House Value: House prices are still 25% overpriced in Lafayette. If anyone tells you differently they are basing their assessment on emotion and not on the numbers. House prices in Lafayette are on average hovering at 2004 values($440 sq. ft.). Every so often a home comes on the market at a good value. It is normally snapped up immediately. Most of the home inventory in Lafayette is still priced at bubble values. If you buy a house in Lafayette at 2007 prices($545 sq. ft.) you could lose at least 30% of your investment over the next 5 to 7 years depending on the area. Some areas need to trend to under $250 sq. ft. to fall in line with historic value trends. One can argue against this fact but you will be using emotion, nostalgia and hope to defend your convictions. All numbers, trends and economic indicators point in the other direction.

I myself would not consider buying a home priced over 2001 value. In Antioch homes are being sold below 1998 value($110 a sq. ft.). Lafayette was selling at $213 a sq. ft. in 1998. About twice as much as Antioch. Presently the price per square foot difference between Antioch and Lafayette is 4 to 1. This change in buyers attitudes is not the magic of Lafayette but the stubbornness of high end markets to reprice. The same trend happened during the 1990 housing bubble. The same trend has been happening in Japan for the last 20 years.

The price of any home over the long run will trend with household income and rental prices. Antioch is driven more by rental prices. Lafayette is a little more affected by household income. Antioch housing prices are a good value compared to rents in the area. Lafayette homes are a terrible value in relation to household income, rents or any other variable you might care to use to compare.

The last problem with the Lafayette housing market is that there is far to much debt. Also, unfortunately, most of the houses that were bought after 2002 were financed with adjustable rate mortgages that will recast before 2013. A contracting economy, increasing interest rates and exploding "option ARM" loans will have a very negative effect on all high end markets for the next 5 to 7 years.

One could argue that the Antioch real estate market is forming a price bottom. No one can intelligently argue that any high end area of the Bay Area is close to a bottom.

2) Get good advice: Be careful, there are a lot of salespeople that will push you to buy a house. I love the quote by Upton Sinclair: "It is difficult to get a man to understand something when his salary depends upon his not understanding it."

Even neighbors, friends and family can be salespeople. Anyone that presently owns a home has a vested interest in puffing up prices. Most of these people have unrealistic expectations created by the previous 25 years of easy money:

• The government is the key to solving our economic problems
• You don't need to save because you can retire with the equity in your home
• Real estate prices always go up
• Cash flow is not important when buying a rental property
• Debt is important to economic prosperity
• It is not important for our country to save because we will always be able to borrow from foreign nations
• Buy a home while interest rates are low

The easy money period is officially over. Anyone that does not realize this fact is probably not going to give you the best advice.

3) The Economy: This area was my biggest concern when I made the offer on the house. Our economy is in a deflationary environment. Interest rates are set to increase. Unemployment will be high for an extended period of time. Almost none of the present economic malaise is priced into public opinion.

We have just ended the biggest private sector debt binge any country has ever experienced and now our strategy is to use taxpayer debt to grow the economy. What most people don't understand is that the "private sector" and "the taxpayer" are the same thing. Our citizens are being sold on a policy of borrowing money to pay off their own debt. This machination would be funny except that about a trillion dollars a year is being skimmed off the top by the government. The interest on the trillion dollars a year of graft will be paid by our children to foreign nations.

In 1985 foreign nations owned less than a $1 trillion in US investments. Today, 25 years later, foreign nations own over $15 trillion in US investments. Of course this is not the problem. The problem is the growth trend and our nation's willingness to "give away our country" instead of balancing our budget. If the present trend continues, in the future our largest government expense will be interest payments to foreign nations. Also, we will have a more difficult time paying this debt if a significant amount of our country's productive assets are owned by China, Japan and The Middle East.

Savings and increased productivity are the only ways to increase a nation's standard of living. The debt we are creating will actually reduce our standard of living as our children make onerous interest payments to foreign nations.

I am a little disappointed in not getting the house in Lafayette but there will be many more opportunities in the future as "high end" real estate prices trend downward.

The Sleep at Night Portfolio

During my years of investing I have found that I am very risk adverse. I hate taking risks in my investments although I also find it distasteful to miss out on big gains in the stock market. My portfolio needs to trend with the S and P but at times trend away from The Herd. The Herd is the group of momentum speculators that distort valuations in dysfunctional markets. The Herd does not look at historical valuation trends. The Herd drove the market to unsustainable highs in October of 2007 and also to extreme value in March of 2009.

I was out of the market in October of 2007 and dove into the market in March of 2009. Presently the stock market is 20% overvalued by historical standards. I have adjusted my portfolio to take only 15% of the gains on upswings in the market. I will move in and out of the market for the next year or so trending away from the movements of The Herd. I would like to lean toward market neutral until The Herd realizes that the taxpayer ATM can't create future wealth. It took The Herd 5 years to realize that the homeowner ATM was not the road to riches.

My concern back in 2007 was capital preservation. My sleep at night portfolio managed well during the recession. It is up about 14% since October 2007. The S and P index is down 25% over the same period.





My portfolio will always under perform during periods of market overvaluation. Presently the S and P is about 20% overvalued. I have only taken 60% of the profits in the S and P since May. But when the market was undervalued in March and April I was able to take 120% of the profits of my benchmark. My investments ended the year only taking 95% of the S and P gains. Very boring but of course I didn't lose an hour of sleep worrying about my investments.




My 95% take rate for 2009 does not include the small 1.2% distribution that I pay myself for managing the account. This distribution is annuitized so that I don't have to pay the early distribution penalty to the IRS. The management payment that I pay myself is similar to what most people pay their financial advisors or mutual fund managers. Most people don't realize how much money is siphoned out of market gains from investment management. I keep this money separate just as a reminder.

If you have a financial planner that invests in mutual funds there would be a 1% charge for the planner on top of an average 1.25% charge for the mutual fund manager. In my situation I am my own money manager and the bulk of my investments are invested directly in stocks. Therefore I pay no fees or charges. This is a very large savings in the long run. Let me explain why.

Presently the stock market is overvalued by 20% so I feel that it is prudent to only expect to make gains on the 6% corporate profits over the next 20 years, not including inflation. Let us assume that your financial planner takes 1% of your investment and your mutual fund company takes 1.25%. If there are 6% stock gains over the next 20 years then your portfolio will end up with an overall 3.75% year over year return. That works out to a little over 131% return before inflation for twenty years. Without the money management fees you would make 221%. Quite a difference.

If you feel that the 6% return is low please Google "Japanese lost decade". You will see that thanks to the advice of top Wall Street economists Japan has been able to have almost zero equity growth for twenty years. So I don't think 6% growth is unrealistic.

Our Financial Elite have a very impressive track record in Japan and they are presently providing the same unsound advice to our government.

So in theory, assuming 6% stock market returns, you can almost double your investment return by managing your own account and investing directly in stocks. It's not for everyone but it is sure something to think about. There is also a side benefit to managing your own investments. Less of our nation's resources are funneled to the Financial Elite of Wall Street.

One other area that will be a disappointment in the future are bonds. As interest rates rise long term bonds decrease in value. We have spent the last twenty years on the windward side of the interest rate mega bubble. These gail force tailwinds have made massive gains for stocks, real estate and especially bonds. We are starting a new mega bubble which means severe headwinds for bonds and real estate. This is the end of easy money and no one is talking about it or seems to care. It is a little disconcerting.

This is my advice. Don't plan on using speculation as an investment vehicle. Learn to save. I sold my house in 2007. Presently I am saving 50% of my "take home" household income while renting a home. It sounds crazy but to me it just seems like the prudent thing to do in this dysfunctional economic environment. This is an extreme contrast to 15 years ago. From 1995 until 2005 I didn't save a dime. It was almost foolish to save. There were huge stock gains and even bigger housing gains. During that period saving was unnecessary.

This easy money period is over. We have ended the interest rate mega bubble and we are creating another. There will be no gains in housing or bonds for the next 10 years. Stocks will gain 6% a year. If you are worried about inflation please Google "Japanese lost decade" to quell your fears. It is very unlikely that The Federal Reserve can create significant inflation before interest rates rise above historical trend. Once we see real interest rates above 10% then we can talk about inflation. Presently we have no idea what the real interest rate is. The government is spending trillions to distort the market. This market manipulation could go on for a generation just like Japan of the last twenty years.

As a country we need to save, pay down our debt and stop speculating. During the 1990's and 2000's the easy money made anyone who borrowed money and speculated with it a financial genius. Stocks, bonds, real estate, collectables, commodities, it really didn't matter where the money was invested. It was a boomtime and everyone made money.

The investment winds have shifted. For the next 10 years we will have a lot less financial geniuses. The smart money will be saved.

GDP growth vs Debt growth:

I listened to an economic debate last night on NPR between Jeremy Siegel and John Mauldin. Jeremy Siegel is a professor of economics at the Wharton school of business at UPenn and has in the past been a perma bull. John Mauldin writes one of the most widely read economic newsletters on the internet and is more of a perma bear. Here is the link if you want to listen: http://www.onpointradio.org/2009/12/an-economic-warning

Each economist gave his prediction of the strength in the economy over the next few years.

Jeremy Siegel predicted that the economy will rebound at a 6% to 7% pace over the next few years. His only premise is that the the current recovery will mirror recoveries of the past after similar deep recessions.

John Mauldin predicted that the economy will rebound at a 2% to 3% pace over the next year with a chance at a double dip recession in 2011. John's premise is that this situation is not like other recessions. In the next few years we as a country will deleverage and will have to start paying off our debt. We will even have to start saving. He also stated that there will be tax increases in 2011 as the Bush tax cuts phase out. His last observation is that it could take a decade or more for unemployment to trend below the 8% range. We are in a new "muddle through" economy.

Who do I think is correct?

It will be directly related to how much we borrow as a nation.

For Jeremy Siegel to be correct the government will have to borrow $2 trillion a year.

For John Mauldin to be correct we will only have to borrow $1 trillion a year.

Either scenario can be correct depending on how much debt our government creates. We could even create other scenarios by borrowing more money. $3 trillion, $4 trillion ... how much GDP growth do you want?

Both scenarios of Jeremy and John use debt, inflation, smoke and mirrors to solve our financial problems. Both of the scenarios will create bloated government and each will create huge distortions in the capital markets.

Why are both outcomes equally distasteful? Because our country's financial problems are already systemic and as a nation we just don't care. We have more debt financed at lower interest rates than anytime in our nation's history. The Federal Reserve has made a huge bet that it can create inflation to get our country out of this monstrous debt. The bet is premised on creating enough additional debt to force inflation so we will be able to pay off the monstrous debt that we already hold.

How monstrous is this debt?

The most recent Flow of Funds information from the Federal Reserve shows that the net holding value of homes with a mortgage is zero. Yes zero. $10 trillion of mortgages netted against a housing value of $10 trillion is zero for homes with a mortgage.

It is very odd to think that if you take out the subset of people that own their home outright then our housing stock is worthless. Of course as an accountant I might tend to value it at less than zero due to the $600 billion in sales commissions to exit this worthless $10 trillion investment.

Strike One.

Presently our banks are allowing hundreds of thousands of speculators to live in houses without paying mortgage payments. These squatters have been living in the homes for as long as two years before the bank will start to foreclose. The banks are doing this because if they foreclosed on everyone right now then their balance sheets would be insolvent. Presently The Federal Reserve is funneling trillions of dollars of taxpayer money(future debt) to the insolvent banks so the banks can allow the speculators to occupy the bank owned homes. This government debt also allows the banks to give out record bonuses this year.

Strike Two.

Presently the banks are not lending enough money to keep real estate prices in a bubble. Wall Street and housing speculators don't want to give back the false profits of the real estate bubble. Therefore the government is creating more debt through Fannie Mae and Freddie Mac to keep the bubble prices propped up. This will cost hundreds of billions in the next few years as Fannie and Freddie make bad loans to the next wave of speculators in this insolvent market.

Strike Three.

So the group of people that have mortgages on their homes are insolvent. The banks are insolvent and our government is insolvent. The only thing that is keeping this game going is debt.

Wall Street economists have already made the policy decisions for our nation. Negative GDP is not an option. Affordable homes are not an option. Lower prices are not an option. Losses for speculators are not an option. Sound government is not an option.

Whatever GDP number we get for the forth quarter will be smoke and mirrors. A large amount of debt by the government to create a small amount of growth for our economy. It really does not make sense. Unless or course you are a Wall Street economist.

Epitaph On A Tyrant by W. H. Auden

Perfection, of a kind, was what he was after,

And the poetry he invented was easy to understand;

He knew human folly like the back of his hand,

And was greatly interested in armies and fleets;

When he laughed, respectable senators burst with laughter,

And when he cried the little children died in the streets.

_____________________________________________

I would like to dedicate the following thoughts

to my father and his father on this special day.

Thank you both for being part of this country's greatest generation.

I am in Love with The Great Depression

I started gaining my affection for The Great Depression as The Tech Bubble was ending. My stock account was going to astronomical amounts. I bought my dream house. My financial life was fantastic in every way but in the back of my mind I knew something was very wrong. I soothed myself at night with investment books like The Intelligent Investor by Benjamin Graham and books of the Great Depression such as The Great Crash by John Kenneth Galbraith. I didn't read these books for knowledge or insight because I was very clear on the inevitable path of our country. I read them for purification and to calm my worried soul. Thoughts of The Great Depression have become my economic "Waldon's Pond" during this period of government mandated excess and speculation in our nation's financial markets.

As the 1990's were winding down I would compare the 90's to the 1920's. They are very favorably compared. The roaring 20's saw the advent of the radio, the auto and the airplane. The roaring 90's brought about home computers and the Internet. Both period's had massive speculation stoked with easy money by The Federal Reserve. The 20's of course ended in The Great Depression.

I had hope that the 1990's would end in the same way and that our nation would come to it's senses and stop living so far beyond it's means. I realized that our government and The Financial Elite would make the same mistakes as The Great Depression and turn a deep recession into a depression. But I also knew that the people of this country were resourceful and could come out of the ten year depression in 2009 with the same independent, hard working attitude that created my grandparents' generation.

My grandparents' and their contemporaries are considered our nation's greatest generation. I had equally high hopes for my own generation. I wanted to feel the same pride that my grandfather felt as he passed the economic torch to my dad.

But something odd happened after The Tech Bubble. There was just a very, very mild recession. There was practically no real unemployment. A pipeline was created between the government and the moneylenders. A pipeline full of gold that from the outside smelled of filth. No one noticed. No one cared. I can't compare it to anything that has occurred in our country before. One would have to go back to the times of Rome under Nero to find a similar totally self serving act. Our Empire is ablaze and our leaders are responsible!

A recession is a natural event. An economic Winter that follows an overabundant Summer. A cleansing that removes speculation and greed from the system and passes along fairly priced assets and a sound government to the next generation.

Business cycles have been recorded since the beginning of the industrial revolution and probably occurred even in primitive societies. Economies move from overproduction, excess and speculation to underproduction, prudence and saving. This cycle can't be regulated because it is tied to the avarice of being human. Recessions will occur even in a tightly controlled society, as we are seeing today. The only difference is that in a free society everyone is aware of what is happening and can react accordingly. In the tightly controlled society The Financial Elite are able to mask the business cycle. This allows the Financial Elite more power and with this power the ability to choose the winners and losers in our economy.

Our Financial Elite have pilloried The Great Depression and made it a priority to protect us from recessions at all costs. The costs that we are presently incurring are massive debt to future generations and the destruction of sound government. This is the antithesis of the business cycle. It is not sustainable in the long run.

The reason that I love The Great Depression is that in spite of massive government intervention the people of this nation were able to survive and then prosper. The Great Depression forged a generation of fiercely independent, highly productive, family and community oriented households. This was the most productive body of citizens any nation has ever known. This was the Middle Class. My grandparents' generation.

The antithesis of my grandfather's generation is my generation. We robbed trillions of dollars of our children's inheritance to prop up stock values after the Tech Bubble which sent our housing market into a bubble. We are presently borrowing tens of trillions of dollars from foreign nations to prop up inflated housing prices that occurred during the housing bubble. We have created the biggest government in our country's history with borrowed money.

So we have spent the savings of our grandparents' generation and borrowed more. We have used this money to inflate asset values and create bigger government. We are passing the debt, the inflated asset values and the government boondoggle to our children. My generation will go down in history as this nation's most selfish generation. It is a very helpless feeling being carried by this ravel of avarice.

I don't blame our people, I blame the tyrants, The Financial Elite. They are far to cunning for our pampered populous. My lament is that we are appeased by bread and circuses as our country is being looted and then burdened with stifling debt.

I am very sure that my grandfather's generation would never have allowed this to happen. A generation that formed massive strikes against unfair employment, rallied against unjust government and to a man gladly sacrificed their lives to keep this country free.

My hope looks to the future as my mind dwells in the past. I await the glory that my children and grandchildren will feel as they slay this dragon of debt. Like my grandparents did before me. I bide time in between two great generations. "They also serve who only stand and wait".

A recession is a natural event. An economic Winter that follows an overabundant Summer. A cleansing that removes speculation and greed from the system and passes along fairly priced assets and a sound government to the next generation.

I am in Love with The Great Depression

Herd Theory - What If?

One of my investment barometers is The Herd. The Herd is the group of momentum investors that speculate in the financial markets during times of economic volatility. The Herd does not use valuation or economic variables to make investment decisions. Fear and greed push The Herd in and out of financial investments.

In 2007 The Herd was my biggest consideration when I sold my home and decided to rent for a while. This started when I asked a question to which I already knew the answer:

What if housing is overpriced compared to rents and household income?

The response seemed delusional. Everyone said it was impossible for homes to be overpriced. At the time I thought it seemed mathematically impossible for homes not to be vastly overpriced.

I have noticed a few periods of mass delusion in the past 20 years but 2007 seemed like the worst... well the worst until now.

I pose 4 questions that the stock market, the bond market and The Herd have already responded with: "That's impossible".

What if interest rates move sharply upward in the future?

Presently the bond market is betting that interest rates will remain low for an extended period of time.

In reality the Federal Reserve is spending trillions of dollars to keep interest rates at historic lows creating a bubble in long term treasuries. This is devaluing the dollar and creating a super-bubble in carry-trade as risky assets are purchased in dollar denominated debt by other countries. Also the federal reserve is financing new debt in short term vehicles. Eventually all of this debt will have to be re-financed into longer term treasury bonds. So there is a bubble on top of a bubble while the federal reserve is asleep at the wheel holding short term debt vehicles for our country's long term debt. I can't see a scenario where this is not a problem. The worst case would be a snap back of carry-trade investments cascading into a bursting of the treasury bubble with worldwide debt markets rushing to refinance short term debt into long term debt as interest rates spike. It would make the skyrocketing interest rates of the 1980's look like a cakewalk.

If interest rates rise in this manner it will be due to risk aversion of the bond market and not from inflation. There are many people that are predicting inflation in our future. I am not investing with an eye toward inflation because we are presently in a deflationary environment. Increased interest rates plus deflation will equal stagflation. Very similar to the 1980's.

The Federal Reserve is presently "betting the farm" with the hope that they can create inflation in the future. Since the bet is already on the table, for our country's sake let's hope that they are right and I am wrong. But either the fire of inflation or the ice of risk aversion will have the same shocking effect on the bond market. Neither scenario is priced into present long term yields.

What if the unemployment rate rose to 13%?

Presently the stock market has priced in a recovery in the economy early next year. The Herd expects the unemployment rate to quickly trend downward back to normal in 2011 or 2012. Nine months after the "end of the world" selling of March, 2009 the stock market and The Herd have priced in a 100% recovery in the economy.

In reality the unemployment rate is still trending upward and could easily hit 13% in 2011. It is a distinct possibility that it will take decades to come back down to the 5% to 6% range of 2007 and that is only with the most optimistic economic assumptions. If we remain in the same trend as the past 10 years we will never get back to 5%. Since 1999 there has been a net loss of 300,000 jobs in the private sector. We have drunkenly gone through the biggest private debt binge in our country's history, created the most fiscal stimulus that any country has ever attempted, with the loosest monetary policy in history and still we have negative private sector job growth. We have also stimulated the economy by starting two wars in the past 10 years. Even after all this stimulation, we still have fewer private sector jobs today than a decade ago.

Although there has been no increase in private sector jobs there has been a huge increase in government jobs, government pay and government benefits over the past ten years. Taxes to pay for this government largess will be a massive drag on the private sector for generations to come.

What if the present monetary and fiscal policy does not help the economy?:

Presently the Financial Elite of our country are using massive spending programs to jump start the economy. They are 100% focused on increasing debt as opposed to the historical norm of using debt destruction to heal the economy.

In reality there is no point in history that one can pinpoint to prove that the Keynesian "prime the pump" theory has ever worked. Our Financial Elite use The Great Depression as their only example. But they can't explain why The Great Depression lasted over ten years as Hoover and then Roosevelt poured government money into the economy and devalued the dollar by 50%. This policy is exactly what our government is doing today except Roosevelt's stimulus was directed at jobs and markets. Today money is directed toward gimmicks or given directly to Wall Street.

Roosevelt never insulted the public with gimmicks such as "cash for clunkers" or moral hazards like bailouts for bankers. Roosevelt directly gave people jobs. He also took the high road and enlisted the Pechora Commission to dig to the root of the banking problems. The Glass-Steagall Act that came out of the Pechora Commission helped the economy for 50 years until lobbyists were able to coerce enough people in Congress to repeal it. Now Goldman Sacks is able to game the system by using depositor and taxpayer money to gamble in the financial markets. Most of Goldman's revenue from the last quarter is from these "trading profits".

Debt destruction would solve our economic problems a lot more quickly than what we are doing now. Definitely there would be a lot of pain for speculators and rightfully so. A quick deep recession would cleanse the system of the greed and speculation that has developed over the last 25 years of easy money from the Fed. It would reprice assets to fair value and could probably be over in a year or two. It might even get rid of our delusion that allows the Federal Reserve to exist at all.

But since we have decided to use debt to prolong the downturn I agree with Roosevelt and would like to help the down and out instead of the rich. Our present government's "rob from the poor and give to the rich" mentality seems like the antithesis of Roosevelt to me. I will be very surprised if there is any banking regulation that comes out of all of this economic pain. I have a feeling that our country's delusion will just turn to apathy. We are going down the wrong road and it is definitely not the high road.

What if the debt created by the government becomes a drag on the economy?

Presently our government says that easing the pain of this downturn in the economy is more important than the consequences of the debt in the future.

In reality our country as a whole is much more in debt than anytime in our history. We are piling on more debt to this record number every day. A small part of the debt is being used to fight a war, one could argue that it is necessary. A small part of the debt is being used to help the unemployed, which seems like a prudent thing to do. But the lion's share of the debt is being used to reward speculators, to bail out Wall Street and to make government bigger.

How can anyone think that loading our children with massive debt to fund bigger government and to bail out Wall Street is appropriate? Roosevelt's debt was funded by liberty bonds. The interest on these bonds were paid to Americans. A large part of our present debt is funded by China, Japan and The Middle East. If the trends that I have talked about continue, then in 30 years our biggest government expense will be interest payments to foreign nations. Our country's out of control dependence on debt is one of the biggest economic threats that our nation has ever faced. Looking back in history, most countries are not toppled by war but by debt. I hope we come to our senses soon. Our children's future is at stake.

Our present economic paradigm is built on assumptions that don't seem to be founded on reality:

• We learned during the housing bubble that we could not use the home ATM to create lasting wealth. But now we feel that the taxpayer ATM can create future prosperity.
• We are assuming that interest rates will stay low for a long time even though they are being kept artificially low through trillions of dollars of borrowing from foreign nations.
• We assume that the unemployment rate will go down to 5% even though it is almost mathematically impossible for that to happen and there is no period in history where our country has created enough jobs to fill this large of void.
• We are sure that Keynesian fiscal stimulus will "prime the pump" even though our water table of savings is historically low and Keynesian stimulus has never been proven to work in the past.

The financial markets could have a temporary "V" shaped recovery but long term recovery for our nation back to the prosperity of the last decade is mass delusion on a grander scale than the housing bubble. It is mathematically impossible to accomplish a repeat of this false prosperity without very high inflation. Presently we are experiencing deflation.

Investing

I purchased some SPY(Exchange Traded Fund that tracks the S & P index) during the recent stock market dip so my retirement account has increased 1% with the last 7% increase in the S and P. I am slowly selling SPY as the market rises. I have an overall gain of about 11% compared to the 2007 high point for the S and P. Now I feel it is prudent to protect my capital in a market neutral position. I will try to eke out some profits using tactical and generic hedges against the large stock portfolio that I presently hold.

The stock market is priced about 13% above fair value so it is not richly valued. My hesitation about being market positive now is due to The Herd. As I said above, The Herd seems to have some unrealistic expectations about the economy and could bolt from the stock market at any time. The only substantive change in our economy between the "end of the world" market low in March of 2009 and today is that the government is wildly running around throwing away large chunks of borrowed money. Most of this money is being funneled into our insolvent banking system. The same insolvent banking system that will shell out the largest amount of bonuses in the history of Wall Street this year. The same insolvent banking system that should have been liquidated in 2008.

The frenetic and manic policy by our government does not seem like the catalyst to a "V" shaped recovery in the economy. I am betting it will cause market volatility of historic proportions in the next few years. A once in a lifetime opportunity for traders. Hedge funds and Goldman Sacks could make monster returns. I would suggest to invest in them but unfortunately the executives always take most of the gains.

The two previous dips in the stock market in March and in November of last year came sharp and quick. It seems like the market has already forgotten these earth shaking downturns. The S & P index could rise to 1500 and it would not surprise me. But if it did I would be tempted to buy a large short on the market like I did in 2007. For now, I am content with just protecting my capital, making a little gain on the market volatility and sitting back to enjoy the show.

My investment advice:

My advice to the reader:

• Spend less than you make (save),
• Invest what you save in investments that are priced at below average historical value(avoid The Herd)
• Slowly move into and out of investment positions (dollar cost average)
• Diversify into a varied group of investments (diversify)
• Use debt and leverage sparingly and only if the investment and the market warrant the speculation (don't speculate with more than you can afford to lose)
  

I have not lost an hour of sleep in my investments since Enron collapsed in 2001. At $5 a share they had a fantastic looking balance sheet. I lost 4% of my retirement account and learned a lot. The Financial Accounting Standards Board came out with rule FAS-157(mark to market) after the Enron collapse. This rule states that companies must report their assets at market value. It was a great rule. Of course that great accounting rule has just been repealed and now our banks have become little Enrons. It's odd that the CEO of Enron went to jail but the banks that collapsed our financial system are being bailed out with trillions of dollars and will receive record bonuses this year. This is all a part of our country's present economic delusion.

I would like to suggest that one should never invest in anything that causes a lost hour of sleep. We are entering a period that could have more market volatility than anytime in our nation's history. Don't depend on the government or speculation to fund your retirement. Your savings will serve you in retirement and it could also help save our nation.

May you sleep soundly in a diversified mix of very safe investments with absolutely no debt.

That's what I do.

Wave Theory and Tactical Volatility Investing:

The graph above is a history of the 10 year treasury yield compared to federal funds rate. When the economy goes into a downturn especially during an election year the Federal Reserve always gooses the liquidity in the financial system by lowering the Federal Funds rate. There have been a few times in the past where Federal Reserve Governors have "spiked the punch" way beyond what is prudent and necessary. Alan Greenspan was the poster child for this action. He is almost single handedly responsible for the Tech Bubble and the Housing Bubble with his 250% and then 360% spikes in liquidity to prop up Wall Street. The wave of liquidity in 2003 that created the housing bubble was the biggest in history, at that time. It might be hard to see given that 6 years later the Federal Reserve is creating a wave of liquidity that is 10 times bigger than Greenspan's record setting wave.

The graph shows events very clearly. Every period of rampant speculation is preceded by monetary easing from the Federal Reserve. This creates excess liquidity in the system, followed by speculation and is then followed by an economic downturn. This cause and effect didn't start with the Federal Reserve, they have just perfected it. Tulip mania in Holland is one of the first recorded liquidity induced manias. The speculation in Tulips was caused by all of the gold that entered Holland via the new world trade. This increased the money supply and created perceived inflation and speculation in Tulips. The Great Depression on the other hand was not caused by excess gold coming into the country. It was fermented with speculation by the easy money minted from the newly created Federal Reserve.

I have always thought it would make much more sense to have the federal funds rate pegged to the 10 year treasury yield. In this way there would never be a temptation for our government to manipulate the nation's money supply for political and financial gain, as is happening now.

Throughout history there have always been business cycles. Periods of overproduction, speculation and debt followed by periods of underproduction, prudence and saving. The Federal Reserve was created to help keep liquidity in the financial system during periods of underproduction and remove liquidity during over productive periods. Seems pretty simple for anyone that has a little bit of common sense but here is my concern.

Our present Federal Reserve Chairman does not seem to understand basic concepts about business cycles:

1. 
   
   From 2004 through 2006 Bernanke spoke widely about our country's "great moderation" and how the Federal Reserve has eliminated the business cycle. (At the time my charts were showing the biggest bubble I had ever seen happening in our housing market.)


2. 
   
   In 2006 Bernanke denied the existence of the housing bubble. (At the time I was working desperately to fix my house so I could get it on the market. I was really worried about the bubble.)


3. 
   
   In 2007 he finally admitted that the bubble existed but said it would not have a significant impact on the economy. (At the time I took out a very large short position in the stock market to protect my retirement account.)


4. 
   
   In 2008 he started by far and away the biggest flood of liquidity into the financial system in the history of our country. Presently our Federal Funds Rate is 2,725% below the yield on the 10 year treasury yield and destined to go much lower as long term yields rise. This is only part of the story. There are also trillions upon trillions of dollars that are physically being thrown at the financial system willy-nilley as if thrown from a helicopter. (This is a Jekyll and Hyde manic moment, a complete 180 degree turnaround from ignorance, to apathy, to thinking that it is the end of the world. The "end of the world" policy response brings him all the way back to ignorance in my opinion.)


5. 
   
   Back in 2002 he gave a speech saying it would be good policy to drop money from helicopters to solve deflation problems in the economy. (I remember when Bernanke gave the helicopter speech. That was when Bush and Greenspan started creating the housing bubble with easy money, massive tax breaks and a war. I talked to my kids at the time and they understood my concerns. They were only 10 and 12 years old.)

Today my quandary as an investor is that I know that I can get a 12 year old child to understand the business cycle but Chairman Bernanke's actions make it seem that he is clueless and at least one step behind the curve. Therefore, in my mind, I have a Federal Reserve Chairman that I feel understands the business cycle on a lower level than a 12 year old child. Bernanke's research on the Great Depression is worthless in my opinion. His elegant 20 variable econometric models of a million variable world are not indicative of the real economy. He has consistently ignored behavioral economics even though this school of economics is the most useful in measuring economies in crisis and is the most accurate in predicting economic downturns. But his most damaging oversight in this current crisis is focusing on our nation's income statement when the balance sheet is the problem with our present economy. How does borrowing more money solve the problem of rampant speculation and a record setting debt burden?

Maybe Bernanke is eloquent, brilliant and focused but he lacks common sense. We need people with common sense guiding us through these turbulent times. Paul Volker, Elizabeth Warren and Shiela Bair have the brains and the common sense but are being underutilized in this crisis. Paul Volker is not a genius but he is loaded with common sense. Our nation owes him a debt of gratitude for his handling of our inflationary economy of the 1980's. Alas, but he is not Federal Reserve Chairman now. We have the brilliantly manic math whiz. What is an investor to do?

How do I invest in this market?:

I can not find a period in history that matches what we are going through now. Never before has the government spent so much of our future resources(debt) to try to keep the economy functioning normally. Never before has the economy been in such disarray. Our government is expending a vast amount of our future's national wealth to prevent current business cycles. This is the same mania as during the housing bubble when speculators were using their homes as ATM's. What our government is doing is not sustainable just like the homeowner ATM's. Bernanke and other policy makers do not understand that this short term manic behaviour is distorting the capital markets and is in no way sustainable in the long run. As a prudent investor I am resigned to an extended period of dysfunctional markets with government officials that have no common sense choosing the winners and the losers in our economy. Cash for Clunkers, Wall Street Bailouts, Tidal Waves of Cash to the banking system, Bailouts of home speculators, Health Care Reform, Higher Taxes fueled by massive government debt. None of it makes sense other than that the government feels that it must choose winners and losers. Presently, savers, prudent investors, seniors and future generations are being penalized. Speculators and Wall Street are the chosen winners. The message is very clear.

For prudent investors this is a brand new game. Not only do we have to worry about the basic investment variables of risk and reward. There are two new variables that for an extended period of time will usurp prudent investing. These new variables are the government and The Herd. The government is choosing the winners and the losers. The Herd is the group of speculators that is constantly trying to figure out where the rewards of the government are being placed. The capital market has been put on hold for a while. Buy and hold will not work anymore because of the massive volatility and dysfunction of the next few years.

I shorted the market in 2007 when it was overvalued and the recession was pending. I dived in at extreme value in March. The market is above fair value now so I am market neutral. My retirement account is presently 10% above the value of the 2007 stock market high which means I averted the recession. Now is the time to avert the government distortion in the capital markets. I am setting up trading bands and will move my positions incrementally toward market positive or negative as The Herd charges in and out of the market. My goal is to loosely trend with and against the S & P Index based on market valuation and volatility until just before the recession of 2011. Timing the recession of 2008 was easy to avoid because all of the indicators were pointing to a downturn. There will be no indicators pointing to the sharp downturn in 2011. It will be the "Minsky Moment" when The Herd realizes that Keynesianism can prime the pump but can't replace the water table, that our population can't use speculation as a retirement vehicle and that the period of easy money is over. This will be the Waterloo for speculators and the defining moment for the prudent investor.