Sunday, December 20, 2009

Intellectual Bubbles

You Say Tomato...
Ever since I can remember, I've been a contrarian. Don't know why, exactly, it's just in my DNA. I became a Yankees fan because every other kid in my class was a Mets fan. This was in the 60s, mind you, when the Yanks stunk and the Amazin' Mets sent 9-year old hearts aflutter. I liked Nixon when I was 12 because everyone else was for McGovern, at least where I went to school. (I have since given Nixon - a crypto-socialist - a major downgrade, but that's beside the point.) In high school, I didn't drink or do anything pharmaceutically adventuresome, putting me in a distinct minority. My abstemiousness was not driven by a desire for monkhood - heck, the other kids did look like they were having fun - I just didn't like others defining for me what was cool. Going along seemed like a cop out. I was pretty stubborn about it.

Perhaps this is why I gravitated toward the investment business, where it is widely accepted that being contrarian is useful, although this is interesting because so few investment professionals actually are. This is because it is truly difficult to go against what lots of other people are saying. It's uncomfortable, and sometimes worse.

This has led me over the years to be highly suspicious of what I call the "lazy consensus." It comes in many forms, and not always financial. I have found that behind every lazy consensus is a core of true believers who rigidly manage their orthodoxy and punish dissenters. When you see this, you should smell a rat. Good ideas should stand on their own merits.

All this got me thinking that while we have seen great financial bubbles in recent history, we have recently also witnessed the greatest "intellectual" bubble of our lifetimes...

What is an Intellectual Bubble?
Is it just me, or do others also want to deliver a 2 x 4 to the head of the next person who uses the word "sustainable?" Has a word ever been more over-used, or become more loaded with alternative meaning? Google the word and you get 67 million hits. But wait, here's something interesting:

Google Search Volume for the Word "Sustainable"

Source: Google Trends

Even as web searches for the word "sustainable" have been declining over the last few years (top graph), media references have exploded (bottom graph). My take on this is that while the media remains fully committed to the global environmental agenda, the rest of us are experiencing eco-fatigue. We are tired of being hectored for just living our lives. Polls support this. No more self-righteous twaddle, please.

The results are even more pronounced for the word "environment":

Google Search Volume for the Word "Environment"

Source: Google Trends
So, I know I don't have to tell anyone about "Climategate" (13 million Google hits, up from zero two months ago), which has dealt a devastating, deserved, blow to the global warming - er, climate change - industry.

The man-made global warming furor has had me pondering a notion, which is that bubbles exist outside of finance. Call them "intellectual bubbles," and they tend to dominate the societal or academic conversation for periods of time, and only one point of view is officially tolerated.
I have written extensively over the years about one intellectual bubble, that of Efficient Market Theory (and all its corollaries). EMT won for its champions a passel of Nobels and became accepted as fact in faculty lounges everywhere. And yes, its dissenters were dealt with harshly, usually in the form of academic rustication or denied tenure. Accordingly, many skeptics quietly towed the line in the name of self-preservation. Interestingly, this persisted for years - perhaps decades - after EMT was dismissed as poppycock everywhere else, i.e. in the real world where the rest of us are trying to make a living.

This seems to be a defining characteristic of intellectual bubbles: the elites hold on to their beliefs long after the rest of the world has moved on. In this respect, intellectual bubbles differ from financial bubbles which tend to end more suddenly when asset prices tank.

The graphs on the previous page are splendid evidence of this reality gap; if we accept the media as the "elites," you can see they are getting more worked up about the sustainability/environmental "movement" even as the general public grows weary.

How does this happen? It's not hard to see, really. The elites get highly vested, either financially or reputationally or both, in a certain outcome. With global warming, you have a large number of people who actually want global warming to happen, even though they are the same voices warning of its dire consequences. I offer as exhibit one the following email from the Climate Research Unit:

“As you know, I’m not political. If anything, I would like to see the climate change happen, so the science could be proved right, regardless of the consequences. This isn’t being political; it is being selfish.”

 - Phil Jones, CRU Director

Yikes. The CRU had staked its entire reputation on global warming, not to mention the fact that more grant money seemed to flow every time they sounded the alarm more urgently. If global warming panned out, the world might lose, but they would be big winners.

Or how about Al Gore? No one has staked his reputation on global warming more publicly than Gore. More than this, he has made major investments in companies that will prosper if he succeeds in scaring the world sufficiently enough to spend enormous amounts of money on the green technologies he says we need. So of course he will continue to parrot the party line long after facts and logic have left the room.

The U.N.? They will be huge beneficiaries in any new global climate scheme as they will administer the trillion dollar transfer of wealth from the first world to the third (precisely the agenda in Copenhagen as I write). Think Oil-for-Food on steroids. Don't expect them to change their tune.
Scientists? They want to keep the gravy train of grants going. The CRU's grant money had tripled since the 90s.

Governments? Fuhgedaboutit. They love the carte blanche to involve themselves in the private economy. For instance, no person on the planet thinks we can achieve 80% carbon reductions by 2050 (a la cap and trade), but the mere fact of it becoming law would give government the legal right to intrude everywhere in the name of reaching the target. It is this "right" that they are really after.
Understand people's incentives, and you understand how illogical, even harmful, agendas can persist for so long.

Financial bubbles also persist for longer than seems possible for much the same reasons. Think of the mortgage bubble. Way too many people were making money originating mortgages for anyone to question what was going on. Same thing in the internet bubble. Remember all research analysts who kept making ever more bullish calls? Reputation and money are powerful motivators.

What are some other intellectual bubbles of the past? How about overpopulation and food shortages? The Club of Rome issued its famous report called the Limits to Growth in 1968. Piling on to this were other Malthusians like Earth Day founder Paul Ehrlich, who wrote books with cheerful titles like The Population Bomb, The End of Affluence, and Extinction. The bubble's general theme predicted an overcrowded planet with widespread food shortages/riots by the mid 1980s. A good chunk of the world's population bought into it, including an enthusiastic U.N. (sound familiar?). Much to their disappointment, food became cheaper and more abundant than ever, and if anything, low births rates (at least in industrialized countries) became more of a problem than overpopulation.
Then there was DDT, yet another environmental bubble. A book called Silent Spring in 1962 practically created the modern environmental movement and led to DDT being banned globally under the Stockholm Convention. To this day, most think of DDT as a poison, and yet its absence in Africa is causing something like one million deaths a year in Africa from malaria, mostly in young children. DDT is effective at mosquito control, and yet the international community - those pesky elites, again - threaten to withhold aid from Africa if they ever use DDT.

The "No Nukes" movement was another bubble in the 70s and 80s. Public opinion has long since moved on as years of data and safe operating histories have undermined the movement's premise, and yet movement elites - e.g. Greenpeace - stubbornly resist giving up the ghost.

Fear seems to be a common theme with intellectual bubbles. A few elites - say, scientists - write a paper or testify before politicians eager to script new law and journalists who are equally excited about selling papers by promoting some new, lurking danger, and that's often all it takes.
The public takes these elites at their word because, really, how are they going to independently verify anything? With global warming, there only three original data sets in the world, and one was just declared lost by the CRU. (They "accidentally" threw it out with the trash when they moved. And the dog ate it.) The other two won't let anyone else look. Layered on top of this are wildly complex models that are impenetrable to all other than the authors.

So, we rely on the self-appointed experts for how to think. Here's Laurie David, who produced An Inconvenient Truth, that masterful bit of agitprop:

"The predictions of the world's best scientist are coming to terrifying life. Scientists are certain that these deadly events will only become more common -- and more extreme -- as the earth continues to heat up. More intense rainfall, more extreme flooding, more crippled infrastructure and unsanitary conditions, more homes and businesses lost. More, more, more..."
-August, 2007
No fear mongering there. No, sir.

(Note: the one exception to the "fear" precondition is EMT, so I admit I haven't come up with a perfect explanatory model, but I'm working on it.)

So, how do we spot bubbles, financially or otherwise? Well, it's not supposed to be easy, otherwise the bubbles wouldn't happen in the first place. The best advice is, I suppose:
  • Look at how proponents behave. Do they have quiet confidence in their convictions, or do they tend to shout down at those with differing opinions? Do they willingly share their data and analytical processes with others, or do they shun transparency? 
  • Consider the incentives of those with the most strident opinions. No one is above responding to personal incentives, and that includes scientists and journalists who are supposedly above such things. All journalists have a philosophical view of the world they are invested in, whether left or right, and their work is infused with it. Sometimes it's subtle, sometimes it's not. With scientists, the left has long accused those being paid by corporations to study, say, cigarette smoke, of being bought and paid for. Now they have discovered their own scientists have a "for sale" sign hung around their objectivity.
  • Use common sense. Again, this is hard when everyone at cocktail parties says you're being stupid. But along the way, it's good to listen to your inner voice that asks things like:
If markets are really efficient, how can stocks be revalued by 25% in one day in the absence of any news? (1987)
Does it make sense for a company with no operating history and no real business plan to be worth a billion dollars? (1999)
Is something amiss when banks don't ask mortgage applicants for any down payment or even a personal financial statement? (2006)
Can we really project climate trends 40 or 50 years into the future when the weatherman can't even tell me whether I'll get rained out of golf this weekend? (2009)
Sadly, we humans go collectively insane more often than we should. None of us are completely immune, but if you go against the grain even once or twice and get it right it can have a profound positive impact on your life. Just ask John Paulson.

Thursday, November 26, 2009

One More Thought on Inflation and Commodities

Speaking of inflation, some alarmists are concerned about a “bubble” in oil prices, citing the recent run-up. Well, it all depends on your point of view.

If you look at it from a U.S. dollar perspective, it does look like oil has been rallying strongly:

Source:Bloomberg WTI price

Look at the same data from a currency perspective of a commodity producing nation and you get quite a different picture in, say, Australia:

In Aussie dollars, oil prices are flat and can be justified because a large part of their costs are denominated in its own (strong) currency.

What we have is not a bull market in commodities so much as a bear market in the dollar.

We also see why hard assets are a good hedge not just against inflation but against currency weakness as well.

Wednesday, November 25, 2009

The Great Debate: Inflation vs. Deflation

The Great Debate

I would like to return to a subject we have touched on in the past: the inflation vs. deflation debate. Few things matter more in the world of investing than getting this call right, and the fact is some very smart people have come to very different conclusions while looking at the same data. So what's really behind this debate?

What spooks everyone, of course, is the tremendous increase in money supply, which you can see below:

Source: IMF, Bloomberg

In and of itself, though, more money does not cause more inflation. The monetarists - who, again, I love and respect - got this part wrong. More money in circulation only tends to result in inflation when people are actually doing something with it, which is otherwise known as the velocity of money.

To understand why, consider first how money is created. Popular imagination has it that the Treasury prints money, but that's not how it happens. The Treasury has little to do with it. What actually happens is that the Federal Reserve "monetizes" debt, which is to say they go out and buy government debt from banks at market prices. The debt goes back on the Fed balance sheet and the cash goes to the banks.

The key piece then becomes, what do the banks do with the cash? Normally, they lend it out and the money then has a "multiplier effect" through the economy since banks can loan $10 for every dollar in reserves. But that's not happening now. Banks are licking their wounds and hoarding cash to rebuild their balance sheets. As a result, the money is not yet "out there" chasing goods and services. Furthermore, the money is already out in the real economy is being hoarded to repair business and personal balance sheets. Are you spending as much money as two years ago? Didn't think so.

So, the deflation vs. inflation debate is really just an argument over when (and how much) the velocity of money recovers. In the graph below, you can see how much it has declined lately. This is why there's no inflation right now.

Source: OECD, Bloomberg

But we need to pull the onion back one layer further. What will cause velocity to come back? It turns out that velocity is highly correlated with employment, which is quite logical. People don't spend when they're out of work. Here's the history:

The correlation here is 0.75, which is really high for anything in economics land.

So, inflation won't kick in until employment starts to recover. When will this be? Don't know, although much of the policy coming out of Washington is totally anti job creation. It's a fair bet that employment doesn't come roaring back, which means inflation is not an immediate threat.

But, Scott, you have been ranting about the inflationary threat for months now. What gives?

Inflation is a huge threat, it just won't happen in the next few months, and maybe not for a year or two. Employment (and therefore velocity) tends to be mean reverting. It will return, and when it does, the Fed will almost certainly find it has overshot the mark. It has to overshoot the mark because the alternative - deflation, depression - is far worse. And then there's the fact that the government owes $12 trillion that it would very much like to inflate its way out of.

My friend Mike Kelly said it best: it's like you get to a party late and everyone else is already a couple of drinks deep, so you decide to play catch-up. Pretty soon everyone else is looking at you like you have three heads and your wife is giving you the hook. You overshot the mark. (I'm told this happens to, you know, other people.)

Anyway, it's last call and the Fed has its face in the punchbowl.

The Fed, Later That Same Evening

(Wonkish aside: I am not a proponent of the so-called Phillips Curve, which states that there is a long-run relationship between employment and inflation. The relationship simply doesn't exist over time. Having said that, because of the extraordinary amount of money being pumped into the system, employment in this particular cycle will be the trigger that causes velocity, which will be a key trigger that causes inflation. The other triggers, as I've covered in previous letters, are emerging market demand for raw materials and a socialist-driven supply drought.)

Friday, October 30, 2009

Prediction Markets Revisited

Those of you who have been receiving this letter for years know that prediction markets are one of my pet subjects. The recipient list has grown a great deal of late, though, so I thought it might be a good time to revisit the whole concept. (Apologies to those of you for whom this is familiar turf.) Prediction markets are a wonderful source of non-biased information, which is something that's increasingly difficult to find.

A prediction market is a real money market where you can bet on just about anything that has a binary outcome, i.e. it will happen or it won't happen. For instance, "A magnitude 9.0 earthquake will occur anywhere on earth before December 31," or "Where the Wild Things Are will win the Oscar for Best Picture." Contracts trade between $0 and $10. At expiration, winning bettors collect $10, while losers forfeit their entire bet. So let's say a contract trades at $4, a bettor who believes the event will occur puts up $4 to make a profit of $6, while an investor who thinks the opposite can short the contract, putting up $6 to make $4. We can directly infer that the "market" believes there to be a 40% probability of the event occurring.

Let use a real example. Currently, "Democrats to win White House in 2012" is trading at 65%, meaning things look pretty good for the Dems, at least right now. If you think the odds are higher than 65%, you simply put up $6.50, and after the election you get your $6.50 back, as well as another $3.50, assuming you were correct. It might seem like this is a long time to wait for a payoff, but these contracts trade continuously, so one can play shorter term trends. Here you can see the "Dems to win White House" contract over time:

(Interestingly, another contract allows one to bet on who the Democrat nominee will be, and Obama's odds are only 82% (is Hillary in the wings?). We can then infer that Obama's odds of being the next president are 53% [0.65 * 0.82].)

Now, what is so cool about all this, exactly? It isn't, at least for me, the appeal of having yet another way to gamble money. Rather, it is because these markets represent great information flow about future events, some of which we care a great deal about. Yes, some are (entertainingly) frivolous, but many are quite important. For instance, what could be more relevant right now than getting a handle on whether health care reform will pass? Yes, there are polls, but prediction markets have proved far more accurate, because they are anonymous and use real money.

Prediction markets are rooted in the "wisdom of crowds" concept (see James Surowiecki's excellent book by the same name), which holds that the aggregated wisdom of a group of random people is frequently more accurate than the smartest single member of the group. Surowiecki's opening example comes from an early 20th country fair in England where fairgoers, for a sixpence, participated in a contest to guess the weight of an ox. The guesses had a high degree of variance, but the average guess was, ultimately, only one pound away from the actual weight. This was considerably more accurate than the guesses of some butchers who were present.

When I was teaching my Yale class, each year I would perform much the same experiment. I would pass around a glass jar filled with change and ask the students to guess the total dollar amount. As with the ox, many individual guesses were comically off, but once again the average was amazingly accurate.

The best site for prediction markets is I just checked, and here is where just a few of the markets are trading:

Event Probability

Healthcare passes (before year end) 10% (wow)

Healthcare passes (before July) 12%

“Cap and Trade” passes (before Dec. ’10) 41%

Romney wins Republican nomination 25%

Pawlenty wins nomination 22%

Palin wins nomination 22%

Palin announces her own TV show (before Dec. ’09) 13%

Republicans recapture the House 30%

Highest marginal tax rate will be > 38% (2010) 21%

The Dow will close above 10,000 this year 54%

The Dow will trade below 6500 this year 16%

U.S. debt subjected to credit warning (before Dec. ’10) 25%

Iran conducts a nuclear test (before Dec. ’10) 16%

Obama sends > 10,000 to Afghanistan 85%

Higgs Boson particle to be observed (Dec. ’10) 11%

Verizon to sell iphone (Dec. ’09) 10%

Freedom Tower to open (Dec. 2013) 45%

BofA repays TARP money (Dec. ’10) 35%

Roman Polanski extradited (Dec. ’10) 70%

There are many, many more. Intrade even lets you suggest contracts. The Roman Polanski one was mine.

Another robust prediction market involves movie grosses, which can be found at This one is slightly different in that no real money is involved (it’s an onshore concern), but nonetheless, it has a record of remarkable accuracy in an area that is notoriously unpredictable. You can see how this would be of great interest to Hollywood insiders. Essentially, bets are made using play money on how much a movie will gross. If a movie "stock” trades at $90, it means that the market believes the movie will gross $90 million.

Here, for instance, we see the movie stock for Avatar, James Cameron’s first film since Titanic. It trades at about $180, and it is interesting to observe its history. There was a long period of hype for this movie that built up expectations to a very high level, and this was reflected in the stock. But then the trailer apparently didn’t live up to the hype, so the stock traded down. $20 says James Cameron checks the price at least once a week.

Another interesting site is, which is an “arena for long term competitive predictions.” Basically, people make very long term bets, with the proceeds going to charity. Bets are hotly debated by posters. Here’s the marquee bet:

Featured Bet - Long Bets

Duration 10 years (02008-02017)

“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.”

Warren Buffett

Protégé Partners, LLC

Stakes: $1,000,000
(Will go to Girls Incorporated of Omaha if Buffett wins,
or Friends of Absolute Return for Kids, Inc if Protégé Partners, LLC wins.

Bring it on! Warren Buffet and a fund-of-funds firm in a $1 million smackdown. So far Buffet is getting his clock cleaned with the S&P down 24% while hedge funds are down 5%.

Entrepreneurs will find many more uses for prediction markets in the future, particularly for use in large corporations as a way to collect uncolored information from employees, suppliers, and customers, who would otherwise have an incentive to shade their projections on such things as sales. This is already happening to a small degree, but I believe it will grow.

The guessing game with the ox was chronicled by a famous British scientist/statistician named Francis Galton, who had wandered into the fair that day in 1905. Galton was a knighted polymath best known for his work in genetics (he was Charles Darwin’s cousin, as it happened) and statistics. Born prominently, Galton was also a noted elitist who coined the term “eugenics.” He believed that certain people were just meant to run things. He asked for the betting slips on the ox because he thought an analysis of the data would illustrate his point, which was that the masses are basically stupid and should stay out of the way. He viewed the results with some dismay. A collection of country rubes smarter than the experts? It wasn’t what he wanted to find, but to his credit he didn't bury his findings.

Which leads me to my last point, and the other reason why I love prediction markets: they are inherently anti-elitist. They are populist by definition. Who doesn’t tire of the pontificators and the pundits, of the nattering nabobs (to borrow from Safire, by way of Agnew)? We are carpet bombed 24/7 by know-it-all philodoxes, and more than telling us what to think, more and more they are telling us what to do. That’s where I get off the bus.

Prediction markets cut through all the b.s.

Thursday, October 29, 2009

Gotta Love Trees

No matter what’s happening in the world, trees grow. We love that 60% of the return on timber comes from biological growth, making it both uncorrelated to most other investments as well as unique in the commodity world. We also love that timber is an excellent inflation hedge:

Note the huge returns for timber in the 70s, when the U.S. government printed money with abandon. Hey wait, that sounds exactly like…now. Trees, which are limited by existing acreage and take many years to grow, are by nature limited in supply. When the supply of money increases, trees become scarce relative to dollars, and therefore must rise in price. It’s not very complicated. (One other interesting thing in the graph above is that timber prices seem to anticipate inflation by a year or two.)

I have discussed parts of our inflation thesis in previous letters. We covered how I like the monetarists but that they only worry about the supply of money while they should additionally worry about the supply of goods, and that socialist economies are very much detrimental to the supply of goods. I also discussed how I’m not buying what the Keynesians are selling, which is that too much economic growth is the root of inflation. This month, I’d like to add one more thought, which is that most economists’ views of inflation are too parochial. To predict inflationary trends, a global perspective is now necessary. For instance, over the last 15 years or so, most overestimated inflation because they didn’t properly understand how deflationary the globalization of the labor market would be. China, in particular, has suppressed global inflation through a combination of abundant, inexpensive labor and ample manufacturing capacity. Now, however, I fear what the underestimating is happening in the other direction.

To understand why, consider that much of the current debate about inflation vs. deflation in the U.S.A. has been about domestic indicators such as unemployment and capacity utilization. Conventional economics says that if lots of factories (or people) are sitting idle, then new production should be easy to bring online, and inflation will be negligible. This thinking overlooks a key difference in this economic cycle vs. prior ones: the U.S.A. and the developed world matter much less than they did in the past.

As an illustration of this trend, the graph below shows how the demand for finished steel - one of the key inputs into most infrastructure projects and industrial and consumer goods – has flat lined in the developed world over the past decade. All of the growth has come from developing markets, especially China. The same holds for just about any other commodity you’d care to pick.

In a nutshell, you can’t analyze squat these days (little academic lingo there) without considering what China and India are doing. China, most of all, is becoming a massive net consumer of commodities. And the thing about commodities – as I suggested about trees – is that you can’t gin up the supply quickly. Oil, metals, timber…the supply is highly inflexible. Thus, as China continues to grow, it will put enormous pressure on commodity prices, which flow through to the price of absolutely everything right here at home. We got a sneak preview of this from 2005-2008.

So you see, the fact that a bunch of factories in the U.S. are underutilized is of little consequence. More parochial concerns such as a wanton monetary policy and socialist/bureaucratic bottlenecks will simply add fuel to this simmering fire.

One other thought. Here is the past volume of searches on Google for the words “inflation protection:”

The top graph represents the prevalence of the search term relative to all other search terms. Before the Lehman meltdown, there weren’t enough searches to even register, but things changed in a hurry.

The words “deflation protection” don’t register at all.

(Google Trends, by the way, is a very interesting tool, and I almost feel like one could build a quant model off it, something I plan to give more thought to in the future.)

Thursday, September 24, 2009

The Rising R-Squared of Politics and Markets

I always preface this endeavor by saying that predicting the stock market is a fool's errand, but who can resist sometimes? So, at the risk of looking stupid, my view is that we are witnessing one of the great bear market rallies of all time.

A year ago, when we were all collectively peering into the abyss, I predicted a 20-25% rally starting in late January or February. Seemed like a bold call at the time. I got the rally right but wildly underestimated the magnitude, which is now over 50%. My prediction was predicated on the sheer amount of cash that was being accumulated, with one the largest chunks coming in January in the form of hedge fund redemptions. I figured some of it was bound to start trickling back into an oversold market, and it did. But there were other factors that really juiced this rally.

First, of course, the government has turned on the monetary spigot like no time in history. No one wants to risk deflation, so there's nothing subtle about this. Official rates have been lowered to near zero. The government is also artificially lowering rates in private credit markets through its TALF program (in which Belstar participates). And of course, those printing presses are humming.

Second, the government has passed the largest fiscal stimulus bill in our history. The effect of this is debatable because very little of the money has actually been spent, but it's possible it was a short-term psychological prop to the market. (Note: the use of proceeds in these measures is highly dubious. More on this below.)

And then there's politics. It may seem like I've been dwelling on this a lot lately, and it may also seem like I have "taken sides." But markets are affected by politics, so you can't very well have an opinion on one without having an opinion on the other. Market commentators who studiously try to avoid saying anything political ignore the elephant in the room. Or the donkey.

The new laws being contemplated in Washington today such as cap and trade and healthcare will have a profound influence on the American economy, and more specifically on corporate profits. They are game changers. If you try to analyze what's going on in markets without considering the political landscape, your views are meaningless. Ah, for the days when all we had to worry about were P/E ratios. So, agree with me or not, you will get my honest opinion.

So, let's take a look at the market this year, viewed through a political lens:

Here's my take. When Obama was elected, there also came large gains for Democrats in Congress. This was something the implications of which many didn't fully ponder, at least not until November 5th, 2008. The market traded off initially, rallied somewhat in December, but then tanked hard through early March. It was during this period that the full scope and ambition of the Obama agenda crystallized for many. With a strong Democrat majority and a completely cowed Republican minority, it appeared there were no limits on Mr. Obama's power. This very clearly had negative implications for industries such energy, insurance, utilities, drugs, healthcare, agriculture, and others. Is it any surprise the market tanked? The S&P was down 29% by March 9th.

Then something interesting happened. In early March it became apparent that "cap and trade," which amounted to an enormous tax on energy (cum a serious dose of social engineering), was not a slam dunk. Democrat House members from energy and agriculture states got an earful from their constituents and balked, and while the measure passed, it was by a mere 7 votes, and passage in the Senate suddenly appeared unlikely. This was a surprise to many, and the first falter of the legislative juggernaut. The rally's inception coincides almost perfectly with the appearance of the first meaningful opposition to the president's agenda.
Next, in middle/late March, another key initiative faltered, the so-called "card check" bill, which was a sop to big labor, and decidedly anti-business. The market gathered momentum.

Then, just as the rally appeared to be waning in mid-summer, the town hall meetings started, the ones where droves materialized to vent their opposition to Obamacare. Again, no one saw this coming. Republican lawmakers - too busy rummaging around for their spines - had been ready to roll over, and passage seemed likely. But as the reality changed, the market once again picked up steam.

Below you can see the odds of healthcare legislation passing this year. Note that the odds peaked in mid July, just about when the town hall protests started, and just about when the market began its latest surge. Coincidence? Hmm.

Which brings us to today. The political aspect of the rally is somewhat perverse: the market rallies because something bad is less likely to happen rather than something good will happen. Corporate profits won't stink as bad as we thought, huzzah!

Moving beyond politics, the liquidity argument has been stretched a bit thin. Obviously a lot of that cash has been spent. Although cash levels are still reasonably high, I would argue that they will stay high relative to pre-meltdown history.

Monetary stimulus has definitely helped, but it runs the risk of going too far and causing hyper-inflation, as I've discussed in previous letters. Also, the TALF program will expire next year. Will credit spreads blow out when not artificially constrained by the Fed? Very possible.

As for fiscal stimulus, all this does is borrow from the future to ease our pain today. It is the policy equivalent of being a 12-year old. The amount of debt we are accumulating is unconscionable. The one area where I might have been sympathetic to fiscal stimulus is with national infrastructure, roads, bridges, electrical grids, etc. The fact is, much of this needs repair or modernization, so what better time than now when people need work? Also, this money shouldn't be considered spending, per se, but rather investment. Economies need infrastructure, so there's a return on that investment. Sadly, the stimulus bills we have passed have little to do with this. Mostly, they give money away to pet projects and special interests. My personal fave is $150 million for "volcano research." That'll get the wheels of commerce rolling!

We are left with a rally that seems mostly artificial. The fact is that we are still deleveraging, so consumer and corporate spending will remain low. Tax rates are rising fast, particularly at state and local levels (although the Feds will catch up soon). Housing and autos have been briefly propped up by still more government programs, but "cash for clunkers" is over and housing tax credits will have to end as well. The sheer growth of government guarantees the future misallocation of resources coupled with a higher level of economic uncertainty hence higher risk and higher volatility We have taken about five shots of whiskey for a quick buzz, but the hangover awaits. It's difficult to imagine any other scenario.

Many, including I, have noted that the stock market rallied 48% in 1930, post crash, and went on to new lows. I wonder if this is an analog for today. Personally, I don't think new lows are in store, but we could be at the high end of a trading range that lasts years.

I should say, by the way, that I am by nature an optimist, so all this negativity doesn't come naturally. (It makes me feel sophisticated, though - have you ever noticed how pessimists are held in higher intellectual esteem, even though they are wrong most of the time?) I should, however, throw out two or three bright spots. First, emerging markets are quite healthy, and consumer-led demand from the newly minted global bourgeoisie will help our own economy, particularly the export sector. Second, the next great game-changing technology is just around the corner. Don't know what it is, but since technological progress is speeding up, it will be here soon. Will it be enough? Don't know that either. Third, the fact that I, a preternatural bull, am bearish is a very bullish sign!