May 2003 Newsletter
Issue Five, Volume Four

DEFLATE THIS

By Mike Gasior

I happen to know that I have a fairly large contingent of "mainstream" media types who subscribe to my newsletter. I will also occasionally find comments and facts from my newsletter showing up in mainstream newspaper, magazine and television outlets in the days after I send the monthly edition out. What is unfortunate is that no one paid much attention to the comments I have been making continuously about deflation. Let me remind you of them and then I'll continue:

--Prediction from December 2001 Newsletter

"U.S. Inflation - A negative number."

--Comment from Mid-Year Newsletter - June 2002

"It appears that long-term investors still expect some moderate inflation during their holding period and it is difficult to forecast very far into the future. I see basically no inflation whatsoever during the next two to three years and I fear some possible deflation. Until other investors begin to feel the same way, the yield curve will pretty much retain its current shape."

Well bond market investors have most certainly come around to my way of thinking since the 10 year Treasury Note yield has fallen from 4.82% in June of 2002 to a current yield of 3.33% as of this writing not even a year later. This shows that investors in these Notes expect effectively NO inflation whatsoever during the next 10 years and I still feel yields can head lower, but I'll get into that shortly.

This is an incredibly historic time for the financial markets we are living in and since it is easy to lose any sense of perspective when actually living through what might prove to be difficult times, I want to try to help my readers "see the forest for the trees". I can honestly say that the most interesting times of all are still to come and although I can occasionally be a little ahead of the curve, I have a fairly good track record for being correct in the end. I would hope that those of you who have been reading this newsletter for years or have attended my seminars going back nearly 14 years would vouch for that fact.

So let me, with words, slap you in the forehead with some bald-faced predictions and then back them up with my reasoning. You can feel free to begin your "you suck" email response at any time.

--There is no way the U.S. and Europe are going to escape a SERIOUS deflationary cycle in the coming several years.

--The economic situation in Japan will continue to worsen, as the West is unable to provide the financial horsepower to pull them out of the ditch they've driven themselves into.

--The U.S. stock market (and to a large extent, the major European stock markets) will decline significantly from current levels. I predicted in the December 2002 edition that I expected the Dow Jones to be below 8,000 by year-end 2003. I now feel we may have a serious chance at 7,000. PLEASE understand that this is NOT investment advice (and lose my email address if you make any investment decisions based on my comments) but I am actually considering getting on the short side of this market soon. I have not touched the stock market on the long or short side in a few years, but it is much too tempting to avoid now and even I succumb sometimes to lure of easy money.

--I had also predicted in December 2002 that the U.S. housing market would decline significantly as the bubble in that market burst, and daily I feel more confident about that forecast. I continue to expect approximately a 20% decline in residential real estate values nationally with the regional declines somewhat bigger or smaller depending upon local overvaluations.

So while you might look at this list of forecasts and think they seem somewhat grim, I come from a school of thought that there is opportunity in every market. Please remember your history and think of the quote "cash is king". Everyone loves to use the remark, but very few people recall that the saying was coined during the Great Depression, which just so happens to be the last major deflationary period in the U.S.

As a kid, Grandpa Gasior used to tell me millions of stories from the Depression (like how you couldn't walk through some bank lobbies because they were filled with appliances repossessed from borrowers who couldn't pay) and I would hang my head in the boredom typical of most 12 year olds. Now I'm reminded of one of the most important lessons of life, which is that "those who don't know history are doomed to repeat it". Obviously the people of my Grandfather and Ronald Reagan's generation are out of power and the current generations have no real sense for what the Depression was like. This may be exasperating the current trend toward deflation. All I have been trying to tell my readers and the people in my sessions is that the Japanese have many lessons they can teach us and we'd better start paying attention forthwith.

Now let me get to defending my forecasts.

THE DEFLATIONARY CYCLE AND JAPAN

Japan has been locked in a deflationary "death spiral" for nearly a decade and I keep reminding people that the situation there is only getting worse by the day. The economic minister has even been rumored that he will soon jump ship (a sinking ship?) and take a job with a U.S. Ivy League school; this will clearly make the Japanese consumer even more nervous (if this is possible) and cause even more damage to the economy there.

If you need a sense for how badly the situation is in Japan, let me quote you the following statistics:

10 Year Japanese Government Notes - .55% yield (55 basis points) 20 Year Japanese Government Bonds - .86% yield (86 basis points) 30 Year Japanese Government Bonds - .98% yield (98 basis points)

Please remember also that Moody's downgraded Japan's sovereign debt to a "junk" rating about 18 months ago, so the yields I just quoted have taken this credit risk into consideration. It is the first time in history that the yields on all long-term Japanese securities were UNDER one percent. This displays that investors hold literally no expectation that their economy will recover in the foreseeable future.

Germany just announced their most recent inflation statistics and many economists were startled to hear them announce negative numbers (deflation). With evidence of deflation clearly present in Europe's largest economy, forecasters are now seeing possible deflationary cycles present in many other EU countries.

China continues to gain ground in many manufacturing sectors and the cheapness of their labor has put tremendous strain on wages worldwide. You will see the rest of the world's standard of living stall as China tries to raise it's own. There is also wage pressure being caused by India and several other large Pacific Rim countries like Korea and Vietnam.

Within 10 days it is expected that Iraq will begin to pump oil again producing several million barrels a day and should reach 12 million barrels of production within 12-18 months. I don't feel I am very out on limb predicting that you may see crude oil prices nearing $12 per barrel in the next two years. While some economists would point to this as a stimulus, I take the contrary viewpoint that it will serve as a catalyst for further downward price pressures.

With the dollar now at historic lows versus the Euro and low against many other currencies, exporters of U.S. products will benefit, but the decline in the dollar will hurt the economy overall. There will be more pressure for U.S. companies trying to compete domestically against an increasing number of foreign companies who will have superior pricing due to the strength of their home currency; this will cause further deflationary pressure.

Nearly every single piece of economic data that I read of late convinces me that we are guaranteed at least some deflation in the next several years. Quite frankly I will be shocked if I'm wrong about these movements in the economy.

A DECLINING STOCK MARKET

There is no way for this current stock market rally to continue and the decline will be ugly and substantial.

As much as I've tried to share the Japanese experience with people there seems a tremendous need for American's to put their hand on the hot stove themselves and find out if it will burn them rather than learn from the experiences of others. I made mention last month that if you want an amazingly scary sight, take a graph of the U.S. stock market from 1999 until 2003 and lay it on top of a graph of the Japanese stock market from 1989 until 1993. If they appear nearly identical, try not to wet your pants.

All I need to remind people of is that the Nikkei 225 Index peaked just short of 40,000 nearly 15 years ago and now hovers at right around 8,000. I still don't think we share all the characteristics of Japan, nor do I think our economy or stock market will follow the precise pattern either. All I am simply saying is that there are lessons that can be learned from what has happened in Japan and we had better start paying attention.

To be as precise with you as I dare, my thoughts are that the Dow Jones Industrials will rattle in between 5,000 and 9,000 for the next seven to ten years. This is as bold as I'm willing to be with regard to such long-term predictions.

HOUSING PRICES

In many parts of the country properties are taking longer to sell and there have even been small declines in price in certain markets. I think the top in prices has already been reached and the decline will be slow and incremental over the next three years.

Another frightening visual experience is to take a graph illustrating housing prices from 1999 until 2003 and put that next to a graph showing the 30-year mortgage rate for the same period. What you will see will look like mirror images of one another and that housing prices have risen in PERFECT proportion to the decline in interest rates. The house you could have bought five years ago for $200,000 with an 8.25% mortgage is now costing $300,000 with a 5.75% mortgage. Interestingly enough, the monthly payment is basically the same so the decline in interest rates has allowed people to afford more expensive housing.

As I explained to my brother-in-law on why he shouldn't be chasing the current housing bubble was simply that if you take out a mortgage with a crappy interest rate, you can always renegotiate the rate again sometime in the future. However, if you pay a crappy price for something you have no ability to renegotiate that.

So if I can play father figure here once again, remember that just because you can afford something doesn't mean that it's worth the price you pay for it. And right now housing has NEVER cost Americans so much of their disposable income. This is why current housing prices are unsustainable. Period. Paragraph.

JUST A QUICK WORD ON THE TAX CUT

I know I have already expressed my opinion about the tax cut when it was just a proposal, but since it was just signed into law I feel compelled to mention something about it again.

As briefly as I can make my opinion clear, I just don't like the cut. It even stands to save me significant money personally (which I like VERY much by the way) but I'm not saying that I don't like it for the same limousine liberal reasons that Warren Buffet or George Soros are saying it.

Tax cuts usually do help the economy and the economy can clearly use all the help it can get. The problem is the fact that the government is not going to reduce spending even a dime and the entire tax cut, and subsequent increases in Federal spending are going to go right onto the national debt. There was little fanfare a couple days before the president signed the tax bill for the less publicized passing of an increase of the debt ceiling by nearly $1.5 TRILLION dollars.

Although I admitted the economy could use all the help it can get, I suspect this tax cut is going to amount to peeing on a forest fire. Sure, it might help a little bit but I'd prefer to keep my pants up thank you.

Not to mention, how would you personally like to be in a situation where your own debt was increasing at the same time the economy was in a deflationary cycle like the one I'm so worried about? See what I mean? All I'm saying is that this just doesn't seem like the most wise of choices to me.

GRAND CAYMAN AND BERMUDA SEMINARS

I am very excited by the response we are receiving for our two completely new programs to be held in Grand Cayman and Bermuda this year.

The Managing Portfolio Managers Seminar was specifically designed for anyone who must hire, audit, manage or in any way interact intelligently with the professionals who manage money. It will give the attendee a chance to understand the concepts of portfolio management, fiduciary responsibility, asset classes, world securities markets, performance measurement and perhaps most important, risk management. This seminar is a three-day program.

The other program is also brand new and is titled Securities Operations, Processing & Accounting. For anyone who handles securities transactions after the trade occurs, this seminar was designed for you. It will literally cover how the financial industry handles the initial settlement of securities trades, the security master set up as well as the many accounting and administrative issues that affect institutional investors of both "buy side" and "sell side" firms. This seminar is a two-day program.

Grand Cayman Programs will be held - July 14th through 18th, 2003

The link for Grand Cayman is http://www.afs-seminars.com/cayman.html

Bermuda Programs will be held - November 10th through 14th, 2003

The link for Bermuda is http://www.afs-seminars.com/bermuda.html

THE APRIL BRAINTEASER

I surprised at the amount of grief I took about the brainteaser last month and how lots of people thought it was too easy. This one I admit is pretty straightforward logically but it will at least make you think a little.

You wake up one morning and there's been a power outage so your lights are out making it impossible to see. You know you have 12 black socks and 8 blue ones in your dresser drawer. How many socks do you need to pull out before you've got a match?

If you want to check how you did with your answer, just go to the following URL:

http://www.afs-seminars.com/brainteaser_May2003.html

http://www.afs-seminars.com

Copyright 2003, Michael Gasior. All Rights Reserved.

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