December 2006 Newsletter
Issue Ten, Volume Seven

The End Of Another Long Year

By Mike Gasior

Given the title I have chosen for this year-end edition of my newsletter, one might suspect I'm setting the stage for a somewhat negatively toned tome. That would be an incorrect assumption, because the year was indeed a long one for myself and many of you, but it was an outstanding year for me personally and a reasonably decent one economically.

I do need to immediately fall on my sword and take whatever grief I have coming due to my extremely poor consistency with regard to getting this newsletter out on a monthly basis. It was quite simply the busiest year I have ever had in terms of business, and while fantastic for the old bank account, it resulted in me finishing 2006 a few editions short of a dozen. Obviously I won't pray for business to slow down but I will pledge to you that I will become more prioritized in 2007 and get back to being a more dependable newsletter-issuer.

This is my year-end edition where we get to review how I performed on my predictions of last year and I remain fool enough to issue predictions for 2007. Frankly, while I feel I did reasonably well on most things, the stock market was kind enough to screw me over yet one more time, proving that the equity markets need no firm economic reason to do anything. I've admitted in this newsletter on many occasions that I came into the financial markets as a bond guy and I proudly remain firmly committed to being a bond guy. I never much cared for the stock market and the stock market has always returned that sentiment to me.

One thing I am going to do differently this year is to use the 2007 predictions as launching pads to discuss some economic matters in more detailed terms. It is my hope to give you the chance to gain a better insight into why any given prediction of mine was made. Also, it will hopefully disprove that I just pluck these things out of thin air or something.

Even though a couple of months have elapsed since the last edition of this newsletter, this doesn't mean I've been at a loss for things I've wanted to share with you. I've always tried very hard to find and discuss topics I think you might not have heard about, or perhaps not given much thought to and I've got a few items like that to pepper in this month as well. Now on with the show.

THE 2007 SCHEDULE IS SET

I'm excited to announce a terrific schedule of programs for this year that include two brand new sessions that we will hold in New York, Bermuda and Grand Cayman. In total, there will be 12 of our most popular seminars held in New York, and 11 sessions offshore in Bermuda and Grand Cayman.

Rather than list all of them here, please visit the following link to see the entire schedule on one page:

http://afs-seminars.com/schedule.html

You can also link to all the pages that list the details of each program from there.

One thing I will quickly mention is that because we were unable to accommodate everyone who wanted to attend our Advanced Securities & Markets session in New York last month, we have scheduled another one to be held on January 22, 23 & 24, 2007 in New York and you can view that seminar and register for it at the following web page:

http://afs-seminars.com/advsec.html

The two new programs are titled "Mutual Funds & Variable Products" and "Fixed Income Calculations & Principles". Both are listed on the schedule and the website is currently being updated to include full class descriptions and content. Both topics have been very heavily requested and I think both are critical for anyone who needs a serious, more in depth understanding of these subjects. The links for those sessions are:

http://www.afs-seminars.com/mutual-funds.html

http://www.afs-seminars.com/fixed-income.html

Finally, if your organization would like to hold an in-house training session for your staff, my office will be happy to work with you to schedule any of our standard programs, or help you assemble a custom one that perfectly suits your audience (at no additional cost). Please call my offices at (860)347-6568 and they will answer any questions you may have about holding a session.

Finally, although my dance card is already somewhat full, if your group or organization would like me to speak at a function on the issues of the economy or financial markets, my office can also address those inquiries.

THE FIRST VIDEO COMMENTARY OF 2007 IS ON THE WEBSITE

Keeping in the theme of making these video clips educational, mini-seminars, this month I address the basics of hedge funds for anyone who would like more understanding of this increasingly huge and complex marketplace.

You can view the high-speed and dial-up versions of this month's video at the following links:

http://www.afs-seminars.com/video/2006-December-768K.wmv

http://www.afs-seminars.com/video/2006-December-56K.wmv

All prior videos can continue to be seen at this page:

http://afs-seminars.com/v-commentary.html

A COUPLE OF ECONOMICALLY IMPORTANT FACTS TO KEEP IN MIND

Did you know that since George W. Bush entered office in 2000 that the United States government has issued about $1.3 TRILLION of new debt?

Did you know that since 2000 U.S. investors (individuals, pension funds, insurance companies, mutual funds, et al) have reduced their net holdings of U.S. Treasury securities by $300 billion?

I gave a speech last year to a group of bankers and stated these very simple facts to them. Please remember that the group I am referencing is not just a gaggle of people whom I gathered on a random street corner. This was a group that one would suspect is more sensitive to financial and economic facts and figures than most people. Yet they were unaware of these simple and unvarnished statistics.

What I want you to consider now that I've shared these facts with you is what this very straightforward information means.

One thing that is painfully obvious and requires no interpretation is that foreign (non-U.S.) investors have not only bought ALL the debt that the United States government has issued during the previous six years. It also means they bought all of it AND took another $300 billion of existing debt off the hands of U.S. based investors. I'll also make mention that there has been a similar trend taking place in the corporate debt markets, as well as mortgage and asset backed securities sectors.

As an American, I now ask myself what I think of this situation. On the one hand it is somewhat flattering and a wonderful show of confidence by these foreign investors who have cast a very solid vote of confidence in the strength and integrity of the United States to pay back all of their debts. On the other hand, why are U.S. based investors suddenly lightening their load with regard to their holdings of U.S. Treasury bonds, notes and bills? Do they know something the foreign investors don't know?

What if something should ever happen that might cause these foreign investors to become unhappy with the United States and cause them to start dumping our debt? Particularly uncomfortable would be if the U.S. ever aggravated Japan since the Japanese own almost exactly one third of all of America's debt. In a supply and demand marketplace, if this demand for U.S. debt was reduced, then the price of U.S. debt must go down. When the price of bonds goes down, the interest rate on the debt must go up.

Let us not forget either, that if these foreign investors were to start selling off these securities, they are defacto selling off the U.S. dollar as well since that is the currency which the bonds are denominated in. Suddenly the value of the dollar starts to weaken, making any U.S. asset worth less from a global standpoint.

I needn't tell this to my American readers because I'd be preaching to the choir, but it is no secret that both the U.S. Government and the U.S. consumer have been on a drunken spending spree for many years now. Both have been spending more than they take in and incurring massive piles of debt. I personally don't think the vast majority of Americans have the foggiest idea that it has been a massive influx of foreign money that has been financing all this debt.

What is the point I am trying to make, you ask? Truthfully, none in particular, except to share with you the simple situation that the United States is in. The fact is that Brian Williams, Katie Couric and Charlie Gibson are never going to tell the American people this story so I feel I ought to. Just for fun, walk over to somebody's desk near you and ask them:

"Did you know that foreign investors have bought every single dollars' worth of debt the U.S. government has issued over the past six years AND another $300 billion on top of that?"

See for yourself how many people actually know that. Also gauge for yourself whether or not it seems anybody even cares.

WHAT YOU DON'T KNOW CAN DEFINITELY HURT YOU

Did you know that almost all cars made since 2004, and most cars built since 1999 have an electronic device installed in the vehicle that is constantly recording everything about your driving; such as your speed, if you were pressing the accelerator or braking, whether or not you are wearing your seatbelt and so on? They are called event data recorders (EDR) and they are usually installed under your seat. EDR's constantly record everything about what is going on with the car. The moment the airbags are deployed all the statistics relating to your driving habits are electronically frozen for the time that transpired immediately prior to the crash. I'm willing to bet that the salesperson at the dealer never told you about this nifty little feature of your new automobile. Most likely because it has very little chance of doing you a damn bit of good.

The auto manufacturers claim that the EDR is an essential tool in helping them understand what happens during a crash, and that the data will ultimately help them manufacture safer automobiles and all of humanity will be better off thanks to the reduced loss of life. This is why these devices are already riding along on about 75 million vehicles.

I personally think this entire thing is bull**** and I'll tell you why.

This EDR does me no personal good whatsoever, yet I am supposedly the owner of it. We can also be sure that it was part of the cost of my vehicle too. I cannot access any of the data that it captures. I do not have the option to turn it off, nor can I have it removed.

The police and my insurance company, however, can gain access to this data without problem. The information contained within the EDR is subject to subpoena, so if I am ever at risk to either a criminal or civil case against me, this wonderful piece of electronic genius that I never asked for can testify against me in a court of law. How wonderful.

This scenario is not some sort of Orwellian fiction I'm spinning here for your amusement. It's already happening all over the place and Big Brother is most definitely watching.

There was a street racing crash in Lafayette, Louisiana back in 2006 in which 22 year old Brian Verret was racing his Ford Mustang, lost control of his vehicle and crossed the median, crashing head on into a Honda Accord killing all four passengers in the Honda. The Lafayette police immediately served a search warrant upon Mr. Verret and seized the EDR from under the front seat of his car.

Some might want to argue that this is simply the police using yet another tool to prosecute and punish a criminal, but I can wager that attitude might be different if you were Mr. Verret in this situation. What if your auto insurance company was suddenly trying to deny a claim you feel you deserve because of information they were able to retrieve from YOUR vehicle? And there are far more examples I could cite for you other that the crash in Louisiana covering both the U.S. and Canada. If you don't believe me, do a cursory check yourself on the Internet.

I have scoured the Internet trying to learn if somebody has figured out a way to remove these things from their own car, but have had no luck yet. I'll keep looking though, and will share with you anything I find. You guys do the same.

THE 800-POUND GORILLA IN THE ROOM

Were you aware that on a daily basis hedge funds account for between 30% to 35% of ALL trading on the New York Stock Exchange, and often up to 40% of trading on the London Stock Exchange?

Did you know that one single hedge fund operator in Greenwich, Connecticut, SAC Capital, accounts for 2% of all trading on the NYSE and the NASDAQ nearly every single day?

And finally, securities lending, which had typically been a somewhat obscure backwater of the financial markets has suddenly grown to what is estimated to be currently $3.6 trillion U.S. of securities currently out on "loan". This business is now growing at about 5% per year and there is somewhere around $16 trillion U.S. of securities that are available to be loaned. Pretty much all of this explosive growth can be attributed to the massive increase of money being managed by hedge funds today.

So there is an 800-pound gorilla in the room that you may not see, or know much about, but it's my job to tell you that it is most certainly in here with us.

REVIEWING MY PREDICTIONS FOR 2006

Some years this can be a somewhat unpleasant exercise, but I honestly am only mildly disappointed with my results for last year. There were a few predictions that seemed fairly wacky when I made them that actually worked out for me. As always, I will have the typical assortment of mixed nuts who will feel the compulsion to write me and grade my exam, yet be unable to point me to their fabulous predictions that were published somewhere or sent to the email boxes of hundreds of thousands of people worldwide. To those types, I urge you do keep yourself under control unless you are able to pee in the tall grass with the big dogs by actually hanging yourself out for your own public flagellation and ridicule by publishing your own prognostications each year-end on a global basis.

Now on with the results.

PREDICTION: Dow Jones - Below 10,000. There's a 25% chance of it being below 9,000.
RESULT: Dow Jones - 12,463.15.
Well this one was clearly a bloodbath and neither James Carville nor Mary Matalin could possibly spin this one my way. I even had the nerve to predict a 25% chance of it being lower than 9,000, and I'll even be honest with you that I would not have given even 10% odds of it going above 12,000. I was just wrong.

PREDICTION: NASDAQ - Below 2,000. There's a 25% chance of it being below 1,700.
RESULT: NASDAQ - 2,415.29.
Ditto my feelings with the Dow. The stock market and I often seem to be contrary indicators. It never goes up when I feel that the facts and economics most certainly show it should, and then it goes up like crazy whenever I don't think there's even a single good reason for it to. Sadly, this relationship is not consistent either, which makes using it as a market indicator useless.

PREDICTION: Ten-Year Treasury Note - Rising to 5.10%.
RESULT: Ten-Year Treasury Note - 4.71%
While I have to admit that I was 39 basis points off on this one, I don't feel all that badly about it. Most analysts and economists who I share a multitude of viewpoints with are also puzzled by this conundrum (as Alan Greenspan likes to refer to it) and also believed that long term rates should have moved higher.

PREDICTION: Fed Funds Rate - 5.00% with the Fed tightening three more times in 2006. Ultimately, this will be two times too many and the U.S. slips into recession in 2007.
RESULT: Fed Funds Rate - 5.25%
Also not too bad being off 25 basis points, or one tightening by the Fed. Clearly if I thought that 5.00% was two times too many and would nudge the economy into recession in 2007, you can probably already anticipate my upcoming prediction if they actually raised rates three times too many.

PREDICTION: Yield Curve - Inverting for the first and second quarter before a recession seems obvious.
RESULT: Yield Curve - Inverted.
I was in the minority with this viewpoint 12 months ago, but it was in place in the first and second quarter, and continues to this very moment.

PREDICTION: 30-Year Mortgage Rates - Above 6.50%
RESULT: 30-Year Mortgage Rates - Right around 6.00%
I missed this one due to my miss on the Ten-Year Treasury Note call. Had I hit the Note at 5.10%, I would have most certainly claimed a total victory here also. Mortgage rates are higher, but not quite as high as I expected.

PREDICTION: The Economy - First and second quarter remain strong with signs of slowing by the fourth quarter. Overall growth for the year of 3.6%.
RESULT: The Economy - Overall growth for the year of 3.3%
Rather than grade myself here, I'd prefer you make a mental connection between my observation of the Fed raising interest rates too far and my expectation of a recession. My prediction of 3.6% GDP growth for 2006 was in the bottom quintile of analysts making GDP predictions, and growth ended up even slower than I had expected. Do you see anything happening here?

PREDICTION: Real Estate - Residential market weakening considerably and the commercial segment becoming softer.
RESULT: Real Estate - Residential market weakening considerably and the commercial segment becoming softer.
Bingo. But I predicted this well prior to last December, when I titled my March 2005 newsletter "Real Estate is Over". It has been fascinating for me to observe how weak real estate has actually gotten without interest rates increasing very much at all. As I've already stated, there are plenty of "outs" that could substantially raise interest rates, so let's stay tuned to this one.

PREDICTION: Oil Prices -Oil will stay in a $50 to $70 range and finish nearly unchanged at $60.
RESULT: Oil Prices - $61.05 on the NYMEX
I just have to confess that landing this one as tightly as I did was almost purely luck since there were an endless myriad of events that could have occurred that would have made me (or any other forecaster) appear to be a fool. My prediction was based on no dramatic events (hurricanes, Iran, Venezuela, etc.) occurring in the world, and nothing did. Pure, unadulterated chance for me here.

PREDICTION: U.S. Unemployment - Rising slightly by year-end to 5.2%.
RESULT: U.S. Unemployment - 4.5%
This one looks like a fairly bad miss for me, but there is more here than meets the eye too. Yes, I'll be the first to admit that I am surprised at this quite low number for unemployment, but on another hand I find it fascinating that wage growth is pathetically low for such historically low unemployment. I also find it interesting to see such a low number in the middle of an economy that is already showing signs of decelerating. So mark me as "wrong" on this one, but remember that my grade is being based on a snapshot being taken on December 31st. I wonder, though, if we were rolling video, how the video might look in three or six months. I guess we'll find out.

PREDICTION: U.S. Inflation - CPI for the year at 3.2%.
RESULT: U.S. Inflation - 2.9%.
This was another example of my prediction of inflation for 2006 being among the lowest forecasts, and the number came in even lower than I expected. Without me taking you by the hand and leading you to a particular conclusion, you can likely sense a thread that sews many of these predictions together and arrive at your own tapestry of a viewpoint.

PREDICTIONS FOR 2006

My normal pattern would be to just launch right into these predictions as I have done in years past, but I opened up this edition by warning that I wanted to add more substance and background to each forecast. These are by no means qualifications I can use later to explain why I was wrong, but simply more food for thought for you readers who wonder why I might be seeing the future the way I am and perhaps help you solidify your own position and decision-making.

Another robust thing to consider in both my thinking and your own is how many variables there are in the economy and markets, which are totally arbitrary and random. In poker terminology these are referred to as "outs"; and these are the possible cards still in the deck, that if dealt, would either complete your hand or your opponents. I wager to argue that there might be more economic "outs" in the deck right now than I can remember in the past 50 years. Some of those "outs" are:

--An exodus of those foreign investors out of their U.S. Treasury holdings driving longer term interest rates up dramatically and the dollar down.
--A major terrorist strike in the U.S. or elsewhere in the world.
--An oil spike due to weather, Iran, Venezuela or God knows where else.
--A substantial and completely unexpected natural disaster in a major metropolitan area.
--An extremely serious and major military strike by Israel against Iran, Syria or both. I personally believe we've already begun counting down to this inevitability thanks to the world's major powers doing nothing at all to curb Iran's pursuit of nuclear weapons.
--Some sort of stupid, but not out of the question move by North Korea like launching a missile into Japan.
--The war in Iraq becoming much worse or much better unexpectedly.

With that, here goes.

Dow Jones - Below 11,250.
I will assume that no one is surprised at my negative viewpoint here, but at least you have to give me credit for being consistent. The prediction itself is effectively a 10% decline/correction from current levels and is based on technical rationale, although I will confess I am making a very early call here. We are indeed at new record levels in the Dow; however, we are at a level where there has been some resistance to the market going much higher than this. If the market does indeed stall at this level, there are no real levels of support until we get to the 11,000/11,210 range in the Dow. If support isn't found at that level, the next more major level of support is just above 10,000. The truth is that the current rally dates back almost 18 months now, with only one earnest pullback in April/May of 2006. If the Dow blasts comfortably through this supposed resistance level, who knows where the next stop is, and I'm eating more crow next December and looking like an idiot. God, I hate markets that do not require any logic or sense.

NASDAQ - Right near 2,000.
For the sake of keeping this short, my reasoning for this NASDAQ forecast is identical to the Dow, but is more negative because the NASDAQ shows no major support levels until it gets into the neighborhood of 2,000. If she starts to slide, the next stop is two grand or so.

Ten-Year Treasury Note - Staying relatively unchanged at 4.75%
Unless something dramatically changes in the attitude of the foreign investors who have been buying so much of this maturity, I don't see much happening here. The economy and inflation should not cause the bond market to demand much more than 4.75% in the way of yield.

Fed Funds Rate - 4.75%.
This prediction indicates two rate cuts by the Fed, and they will not be enough to stop a slip into at least a mild recession because the Fed won't even start the loosening until too far into 2007 and the momentum will be too much at that point. They could end up with three reductions, but four cuts would be extremely surprising to me.

Yield Curve - Upwardly sloped by year-end, but barely.
All the rationale for this prediction is contained in the other predictions.

30-Year Mortgage Rates - Unchanged at 6.00%
This is completely based upon my forecast for the Ten-Year Treasury Note.

The Economy - Beginning to slow badly by the third quarter, and overall growth for the year of 2.1%.
The economy has been sending an awful lot of mixed signals and it still has the Federal Reserve convinced that inflation is an earnest threat and I don't think they will begin reducing interest rates until June at the earliest. Perhaps even a couple of months later than that. Another factor that keeps them hamstrung is my earlier dissertation regarding the amount of foreign capital that permeates the U.S. economy. Reducing short-term interest rates might only give these investors an increased reason to take their money and move it elsewhere. My belief is that the Fed is walking an extraordinarily thin line and might ultimately find that they were in a lose/lose situation. And as much as a "soft landing" would have been wonderful, history might prove that a recession was the only inevitable outcome. With all candor, Ben Bernanke and the other members of the Open Market Committee might have already had this revelation and know the economy needs this recession before real healing can begin. So fasten your seat belts, it's going to be a bumpy ride.

Real Estate - Residential market weakening considerably and the commercial segment becoming softer more toward year-end.
This is exactly the same prediction from December 2005 and I left it verbatim. I do not foresee ANY rebound in residential real estate in the coming year, and if any of my "outs" should be dealt, this could turn quite ugly indeed. You have to consider that the current and somewhat uncomfortable, mood in the real estate market has come about with almost no substantial rise in mortgage rates whatsoever. So if I end up being wrong on the economy/inflation/interest rates, and you see the Ten-Year Treasury pop to 6.00%, and the 30-Year mortgage rate at 7.25%, there will be lines forming of people looking for windows to jump out of. I've been telling people this for two years now and you should keep it in the back of your mind.

Oil Prices -Oil will stay in a $50 to $70 range and finish nearly unchanged at $60.
This is another prediction that identically mirrors my one from 2005 year-end, and is the biggest sucker bet on the entire board given the amount of "outs" that could crush this one. Don't put an ounce of faith at all in my prediction, and if you hear others telling you that THEY know where oil will be on 12/31/2007, they are either an egomaniac, fool, or eager to hear themselves talk. Actually it's probably all three. So if NOTHING at all happens in 2007, then I'll likely be right on this one, but we all know there is very little chance of that.

U.S. Unemployment - Rising slightly by year-end to 4.7%.
This prognostication represents a 2/10's of a percent rise from this year-end, and is honestly lower than I really believe, but does dovetail into my vision of an economy slipping toward recession by mid to late year.

U.S. Inflation - CPI for the year at 2.2%.
The only real "out" I can see on this one is if oil prices spike a ton and the energy component of CPI makes this one blow up in my face. That said, inflation has already begun to visibly slow and there is nothing I can see on the horizon that will currently reverse that.

YOUR YEAR-END BRAINTEASER

I like this month's brainteaser a lot because it has a historical component as well as a business component. It's one of those trivia questions that not many people usually know the answer, but find it an interesting mental tidbit to put somewhere in the back of their head. Next month I plan to get back to the real brutal ones that I know many of you really enjoy.

Here it is:

"After World War II, what asset did Germany offer England as partial payment toward war reparations that Britain would turn down?

Good luck, and when you can't take it anymore you will find the answer at the following link:

http://www.afs-seminars.com/brainteaser_Dec2006.html

Copyright 2006, Michael Gasior. All Rights Reserved

AFS Seminars LLC
500 Chamberlain Hill Road
Middletown, CT 06457-5564

http://www.afs-seminars.com

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