As I mentioned a couple of weeks ago, the market’s recent new high was not reflecting the internals, as except for the Generals (high cap stocks), the majority of stocks were breaking down. This topping action, as noted back then (head and shoulders pattern), has now been completed and it is only a question as to whether we are seeing a correction in an ongoing, but aging, bull market or if we are witnessing the early stages of the next bear market which could last several weeks or even months. If we are embarking on a new bear market, it will be the third in a normal cycle of four bear markets in the confines of a major secular bear market that began in 2000. The good news is that the valuations remain reasonably attractive so any contraction should not come close to the downdrafts of 2000-2002 and 2007-2008. Further, some positive news can be extracted from the Fed minutes of April 25-26, with several members signaling “additional monetary accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough.” This has positive and negative implications for the market as it implies further action by the Fed, but also anxiety about a weakening economy. It is surely a big positive ( it would weaken the dollar) for commodities, emerging markets and of course, gold.

     Finally, like Jimmy Dimon, our recent performance has been nothing to write home about, but also like Jimmy Dimon our long term record, I believe, -especially in times of crisis- has been more than admirable. Thanks for you continued patience and remember: “successful investing is a marathon, not a sprint.”

The two charts below (courtesy of The Bank Credit Analyst) show an interesting parallel between 2002 and 2012 and what effect an increase in money supply has on the price of Chinese equities.. The bank believes that it is too early for a breakout at this stage of monetary easing, but after this chart was published, a substantial increase in money supply has been reported. Maybe, just maybe, it’s not too early, and if so, they do agree that a breakout of Chinese equities would have very bullish implications for all Emerging markets. 

Despite the tumultuous nature of yesterday’s sell off, our portfolios suffered minimal damage, and maybe the reflationary theme is starting to work again after a one year breather. Uncertainty in the economy, low interest rates and a gradual increase in inflation is a good recipe for a weak dollar, strength in gold, foreign currency, and commodities in general. In addition, it appears that China (it was up yesterday) is on the verge of loosening their money supply. It’s too early to tell whether the correction is over, but I’m very comfortable with our current allocation.

Recent problems in Europe, worries about a hard landing (don’t bet on it) in China, and misinterpreted comments by the Fed to not count on a Q3 were all negatives for my reflationary (dollar debasement) thesis and bearish for hard assets and emerging markets. On Monday, however, Bernanke suggested that the economy is not out of the woods and that more stimulus (money printing) would be forthcoming. This negative statement caused a positive for the market (don’t fight the Fed), but an even greater surge in hard assets (gold, energy). Gold is up again in early trading today.

Zephyr StyleADVISOR has completed its analysis for the ten years, January 2002 – December 2011, and Oristano Capital has been ranked #4 for best performance and #6 for lowest risk out of 228 large cap core advisors. I’ve always said that the key to above average returns is to get the long term macro right and I think I’ve done a pretty good job of accomplishing this. Although 2011 was a tough year for us and other real return investors (European deflation scare dominating the reflation theme), I’m comfortable that we are well positioned for the next several years of monetary debasement and the inflation that will inevitably follow.

As always, I appreciate your continued support and welcome your calls with questions, concerns, or just a lively discussion of what may lie ahead.

• Schafer-The US economy will bumble along and the market will do ok as long as we avoid the fat tails of either hyperinflation or deflation.
• Zulauf-All of Europe will be in recession in 2012 and probably in 2013. If he’s right, this could be the trigger for Germany and the ECB to get serious about quantitative easing and a big plus for inflationary assets.
• Hickey-We haven’t seen technology P/Es this low in over twenty years and as a result, he thinks the secular bear market in Tech may be coming to and end…possibly in October.
• Faber-BCA points out that from 1970 through 2009, developed markets have had real returns (after inflation) of 3.8% vs. 9.9% for emerging markets. Because of their lack of liquidity, emerging markets perform poorly when markets implode (2008, 2011), but outperform in the long run.
• Hickey-Comments on how bad gold stocks performed (down ~ twenty percent) in 2011 vs. the metal itself. He believes their will be a mean reversion this year and has weighted his portfolio toward the producers (NEM) and the miners (GDXJ). 

Two observations about the market: The first is that in the early going of 2012, cyclical stocks, emerging markets, and commodities have been outperforming. I believe this trend may well continue so long as the problems in Europe remain contained. The second is that the rally in the market since the October low has largely been the result of a lack of supply (sellers) and not the result of demand (buyers). This is not a healthy situation, as any negative development could bring in lots of supply. Hopefully, if the the market can continue to climb the wall of worry or if we get some good news, the large amounts of sideline money will reverse itself and create the demand necessary for a sustained upside market. Until such time, I think the prudent course is to remain well diversified and hedged.

As quoted by Reuters today, “Stocks rose on Tuesday after a bullish Alcoa forecast and encouraging Chinese trade data boosted the outlook for the commodities sector, signaling a stronger global economy”. Finally, at last, this is what I’ve been waiting for as gold, copper, energy and emerging markets are all trading strongly on the upside. Maybe this will put to rest the hard landing theory that many pundits have been predicting for China.

Just as the 2008 banking crisis in the U.S. caused deflationary fears to trump the reflation trade that has worked so well for most of the past decade, this years debacle in Europe has caused similar problems for real return investors (returns above inflation and currency debasement). However, with the European Central Bank reversing its earlier tight money policies and beginning to inject liquidity into the banking system, I hope and suspect that a mean reversion to the reflationary trade will reestablish itself in 2012.  

I thank you for your continued support and wish all of you a most healthy, happy, and prosperous New Year.

With central banks fighting a deflationary environment through inflationary policies, one would think that we are in an ideal environment for gold and gold mining stocks to flourish. Then why has the metal slumped over fifteen percent from its August highs? As stated before, I believe that in this deleveraging world, banks, institutions and individuals are selling gold to cover their debt obligations. The paradox is that the risk off trade is now running to US treasuries and cash instead of gold, when in fact these assets are becoming more and more diluted as the Government continues to print money. Here are some tidbits garnered from Barron’s this weekend:

• ETF focus: most advisors looking towards emerging markets, U.S. blue-chip stocks, and gold.
• David Kostin, chief U.S. equity strategist at Goldman Sachs- if multiple Euro nations default on their debt, he sees the potential for a drop in the S&P 500 to ~900, but a successful move to end the crisis could propel the market to 1400. I suspect that gold would do well in either scenario, as any successful conclusion is bound to involve some type of quantitative easing.
• Commodities corner states that the bull case for commodities has been overshadowed by the European crisis, but the fundamentals point to higher prices in select areas; most notably in gold and oil.
• With Asian inflation expected to cool from 5.9% this year to 4.6% next year and with European countries accounting for less than 20 % of Asian exports, Morgan Stanley is calling for the MSCI Asian Pacific ex Japan Index to end 2012 around 530 or up 38% from its recent level of 384.
• My friends Lee Quaintance and Paul Bodsky are at it again in the Streetwise Column. They argue that the U.S. base currency represents only about twenty percent of what’s locked up in checking, savings and time deposits. While the banks can only hope that demand for these obligations will remain subdued, Lee and Paul believe that we are closer to a tipping point than many believe (it’s happening in Europe). If this were to happen here, guess what. The banks would have to print money to pay off these debts. To use their expression, “voila, you have skin peeling inflation” as the new dollars would dilute the currency already in circulation by about seventy to eighty percent. Their solution? Gold and gold mining stocks. The losers? Cash and U.S. securities that ironically are in favor right now. 

 Merry Christmas, Seasons Greetings, and all the best for the coming year.

For the past several months, a tug of war has been waging between the forces of deflation and inflation. With the announcement today of a major easing by the world’s central banks, it would at least appear that the forces of inflation are about to win out. Defensive stocks (food, beverages utilities, and defense) do relatively well when deflation fears trump the fears of inflation, but cyclical stocks (basic materials, industrials, energy, gold and commodities) normally do better when the reverse is true. Today’s rally may not turn the market around, but from an allocation standpoint, a weighting shift from defensive to cyclical would seem on the surface to make sense.