Inexplicably, investors are more afraid of runaway inflation than depressions or panics, although both have occurred more frequently in our nation’s economic history. Even during this last face-off with possible depression, most investors were more concerned about inflation than deflation, perhaps the main symptom of an economic depression.

Investors often misunderstand inflation, or worse, take steps to "protect" themselves, which causes even more problems. In recent years, investors have grown more fearful of inflation. Since we believe no lasting investing fortunes have been made doing what everybody else thinks is a good idea, it’s high time to review the logic behind irrational inflation fears.

Our dollar gets a little less valuable each year (except for a brief period during the recent recession in which it became a bit more valuable and a period in the Great Depression where it became much more valuable). Ignore the wilder fluctuations between the dollar and other currencies, which tend to swing up and down, but over time go sideways, and think about the actual purchasing power of the U.S. dollar each year. It goes down slowly but steadily, like most currencies.

This feature of our currency is often held up as proof of the dangers of inflation, and in some cases, the overall decline of America. One wonders how our economy grew so much over the last century in face of such an embarrassing slide of our greenback?

Currencies grow less valuable by design. The government makes more of them every year for a variety of reasons, most of which make good economic sense. Rather than delve into the complexities of the expanding money supply, let’s just consider the opposite scenario — in which the dollar grows more valuable year after year, and is worth more in five years than it is today.

In such a scenario, which some pundits would herald as proof of the soundness of our economy, it would make sense for investors to hoard dollars. Why invest and take risks when you're guaranteed to enjoy a positive return by merely stuffing cash in a safe at home? If everyone did this, the economy would grind to a halt, since there would be no money left in the banks to lend out (no jokes about lending to No-Doc homebuyers, please!).

Suffice it to say the opposite is better. A slow decline in currency is good for the economy, if for no other reason (and there are other reasons) than it encourages people to either keep their money in the banking system or invest it. In fact, one of the dangers of the current government policy of low rates is just that — the population hoarding currency because yields on money markets, short-term CDs, and the like are essentially zilch. The other risk is taking too much risk in an effort to boost yield.

The first takeaway when investing in a world of steady low inflation is that you can’t invest in currencies themselves. Since short-term CDs and money market funds have done a fine job of beating inflation over time, staying ahead of this slow erosion in purchasing power is safe and easy. You don’t need an inflation-beating strategy in the long-term for your short-term safe money. Even the anemic yields on shorter-term investments in the last few years have kept pace with inflation, largely because inflation has been almost non-existent. Commodities have had far more trouble keeping pace with inflation since our last major bout with inflation.

Inflation will kill the stock market. That’s another zinger we always hear, largely based on the 1970s when stocks went nowhere for a decade and inflation zoomed ahead. Of course, we just had a decade of no gains in stocks, and inflation was about as low as it’s ever been. The Great Depression and ensuing 90% peak-to-trough hit to stocks was marked by years of ensuing deflation, not inflation. The inflation-mongers tend to use selective proofs of the dangers of inflation.

Inflation is a general increase in the price level of just about everything, including wages. In such an environment, stock prices should inflate along with everything else. If we had 100% inflation over a few years, Apple would be able to charge 100% more for an iWhatever, and earn 100% more as well.

Although there are some dangers from wild swings in inflation and resulting borrowing cost increases for some companies, the risk of inflation singlehandedly destroying stock prices is overrated. What receives less attention is the real reason stocks went nowhere in the 1970s – that they actually did go somewhere. They went from being very overvalued after the go-go 1960s markets to being very undervalued. That's what happened in the 2000s as well.

Longer-term stock returns usually stink when investors bid the prices up too high during periods of stock infatuation. Inflation, if it has any impact, is one reason investors fear stocks. But then, there's always some reason stock (or any asset) prices decline from overvaluation. The problem isn't the straw that broke the camel’s back. The problem is the big pile of straw.

When home prices began to collapse, the fall was blamed on the mysterious subprime problems, as though homes being as much as 100% overpriced from historical valuations had nothing to do with the crash. It was all blamed on someone with bad credit buying a $150,000 condo.

Homeowners do fine with inflation as well. For those that have a fixed-rate mortgage on a home (or homes,) there is NO BETTER scenario than inflation picking up. Your home, the asset, will inflate, while the debt, the liability, will become a smaller and smaller percentage of the home’s value. Moreover, the earnings from real estate (the rent) will climb as well.

Imagine buying a $300,000 home with no money down and a fixed-rate interest-only mortgage and then experiencing 100% inflation over the next five years. You’d be sitting pretty at year five, with a $600k home and a $300k loan. Our real estate market would be in far better shape if we'd had a good dose of inflation in recent years.

The funny thing is, experts never recommended buying a home as a hedge against inflation. For some reason, commodities are considered the inflation hedge we all need. If you have a $500,000 portfolio of stocks and bonds, how much would have to be allocated to commodities to protect you, anyway? Fifty thousand?

Let’s say we have 100% inflation. You might earn $50,000 if commodities prices double. Would that even cover your losses on the bond side? Compare that to putting 20% down, or $20,000, on a $100,000 condo. If we had 100% inflation, you'd have $100,000 in profits on your $20,000 investment, AND the rent you could charge on your condo would have doubled. Can commodities ever touch that? Of course, a leveraged real estate investment can become worthless with serious deflation, while commodities would merely fall hard.

Some probably think if we have inflation, commodities would go up far more than the rate of inflation, but such an explosive gain would be short-lived, as commodities are part of inflation, and can’t outpace the inflation rate for long.

Inflation benefits those who own assets, including stocks and real estate. However, it's not great for everyone. Inflation hurts lenders. If you buy a bond, you're a lender. The risk is you'll be paid back with inflated dollars. Fortunately, since interest rates tend to be higher than inflation, it would take a pretty big move up in inflation before bond investors got clobbered, but this is the area of your portfolio to watch if inflation ever takes off.

One solution is shorter-term bonds, CDs, etc., because you could simply buy new higher-yielding investments as inflation takes off. The risk here (one most investors are familiar with, including us) is you'll sit around earning very little waiting for inflation and interest rates to take off, meanwhile missing the higher yields on longer-term bonds and CDs. More has probably been sacrificed owning short-term debt as a hedge against inflation and rising rates than has actually been lost due to inflation over the years.

For those still anxious, there are TIPS, or Treasury Inflation-Protected Securities, which offer a guaranteed return over inflation. The trouble here – and we own some in our Powerfund Portfolios – is a little overvaluation. Honestly, if inflation stays under about 2%, you'd fare better in ordinary government bonds. Still, for those who remain concerned about inflation and are too risk-averse to take larger stakes in stocks or real estate, TIPS offer a way to definitively beat inflation. TIPS aren't like commodities, which could just as easily match inflation (or even worse, tank).

Remember, the government invented TIPS to LOWER their borrowing costs, not raise them. It realized it was paying an artificially high rate on Treasury bonds because investors irrationally fear inflation and demand higher rates in order to buy the bonds. Since the government controls inflation, it realized it could save money by taking this often ungrounded fear out of the picture.

If inflation is bad for long-term bond investors, deflation must be good, and it is (provided the person you lend to can pay you back, which many won’t be able to do if we experience major deflation like that seen in the Great Depression).

That's one reason why government bonds fared well during the panic of 2008 . The government will pay you a paltry 3% yield back along with your principal, unlike some leveraged company which pays a higher rate but may have trouble making the payment should the economy seriously tumble..

The future we fear in our portfolios is deflation, not inflation. Deflation can be a tough villain to slay, as Japan demonstrated in their roughly two decade-long battle with deflation. Deflation appears to be easy to beat. Just print more money. However, a sliding economy generates its own deflationary forces that are hard to counterbalance.

Inexplicably, investors are not as afraid of deflation, despite the fact the Japanese stock market is still down about 75% from its peak two decades ago. Half the reason we’ve owned Japanese funds in our portfolios is based on our expectation inflation will resume – a good thing.

Meanwhile, we’ll keep worrying about the things that are off other investors' radar.

Despite this relatively minor pullback, Vanguard 500 is still up more than 60% from the March 9th low. This spectacular run from the brink of disaster still leaves investors down around 30% below the fund's all-time high in 2007. That means those with a 100% allocation to the S&P 500 need the index to rise over 40% to get back to their peak value.

As we noted in our last performance summary, most of our model portfolios ended 2009 at all-time high values – no need to wait for another 40% miracle.

Much of our returns came from buying good funds in out-of-favor fund categories. The rest came from increasing our allocation to stocks when the market was weak and cutting back when it was strong.

There have been ample opportunities over the last decade to buy fund categories that were cheap (relative to the broad U.S. stock market) and earn outsized returns during a period in which stocks essentially went nowhere. Since we launched the model portfolios during the last bear market eight years ago, we’ve owned REITs, utilities, emerging market stocks and bonds, micro caps, small caps, foreign stocks, junk bonds, and energy and natural resource stocks, among others.

We may not see as many fund categories priced to beat the broad U.S. stock market by a wide margin over the next eight years, but we are buying the ones we think can do it. That's because U.S. stocks didn’t really "go nowhere" over the "lost decade"…they just went from really, really expensive to somewhat fairly valued.

The only way the next decade will stink is if the economy goes nowhere or stocks go from fairly valued to really, really cheap, like they were in, say, 1982. Stranger things have happened.

Since more of our gains may come from shifting our overall stock allocation at appropriate times, we want to point to a big danger in investing…bad timing.

Bad timing is a recipe for underperformance. That's why many experts recommend sticking with a permanent allocation to stocks and bonds in an index. Although we're not against this strategy (especially compared to the alternative: chasing hot funds and then selling them after they crash,) we try to get a leg up on the "Buy and Holders" by avoiding the crowd of investors that increase their stakes on the way up and sell on the way down.

For years, we’ve poked fun at the unwashed fund investing masses who buy high, sell low, and underperform benchmarks. But that doesn't mean "professionals" are much better at market timing. As a matter of fact, we just noticed a slipup by one of the biggest and best timers around — Mellon Financial.

Founded in 1983, Mellon Capital Management Corporation merged with Bank of America in 2007, and is now part of BNY Mellon. The firm describes itself as "a leader in asset allocation and quantitative investment strategies, with a history of innovation in portfolio management.” As a measure of its global success, the Bank of New York Mellon claims $22.3 trillion in assets under custody or administration and $1.1 trillion under management. Mellon Capital themselves manages $178 billion directly.

About $8 billion of that $178 billion is in the Vanguard Asset Allocation Fund (VAAPX). Mellon has managed the fund since its inception in 1988.

Vanguard Asset Allocation is a cheap way to get a good basic asset allocation between U.S. stocks, bonds, and cash (Treasury bills). The managers don’t pick stocks so much as they switch the mix between the three broad asset classes. At 0.39%, the fees for this service are cheap compared to most actively managed funds. Yet these fees are more than double what you could achieve switching up your own mix between Vanguard 500 (VFINX), Vanguard Long-Term US Treasury (VUSTX), and a Vanguard money market fund.

Unlike most balanced funds and target retirement funds, the mix is not fixed at, say, 60% stocks, 30% bonds, and 10% cash. The managers can increase the stock allocation if they think stocks are cheap, or pull back if they think stocks are expensive (sort of like what we do here, only we also choose fund categories we expect to outperform).

Unlike most market timers (although Mellon reps might call themselves asset allocators, they are essentially timing the market by choosing when to be heavy or light in stocks or bonds,) Mellon has done a very good job. Until recently.

Mellon decided stocks were cheap in the late stages of the bull market in 2008; so cheap, in fact, they went all in with VAAPX. They shifted their allocation to 100% stocks. No cash, no bonds. Although the fund used bonds in 2005-2007 to beat the S&P 500 by a small margin each year, the shift to 100% stocks led their 2008 return to essentially mimic the S&P 500 in 2008, down 36.39% compared to Vanguard 500’s 37.02% drop. Sadly for investors, 2008 was a great year to be in Treasury bonds. Vanguard Long Term U.S. Treasury was up 22.51% in 2008. A fund equally weighted in each would have suffered only a mild drop.

If the story ended there, it wouldn’t be that noteworthy. Good market timer gets sucked into buying the stock market dip that began in 2007, relying on the quantitative models that stocks were way cheaper than the "bubble" in Treasury bonds, only to learn stocks would fall far lower than most professionals ever imagined – over 50% from peak to trough – and that interest rates on government bonds would go ever lower, pushing prices much higher. It was a mistake many experts made.

But somewhere along the way, Mellon decided to increase their allocation to Treasury bonds and cut back on stocks. Apparently stocks, which were "cheaper" than bonds in 2007, were worth cutting back on after a huge drop. So Mellon turned to even more expensive bonds.

We understand. It was scary in 2008. The natural tendency is to buy what looks good and sell what looks bad. After a 50% drop, you stop thinking what a bargain stocks are, and start thinking maybe this is halfway to the 90% drop we had in the Great Depression. Near the bottom of the crash, Mellon increased its bond allocation and cut back on stocks. At the very bottom, Mellon was down to a 90% allocation in stocks, a figure it continued to cut until reaching the current 70% in stocks – cuts made while stocks were cheaper than the 100% stock allocation.

According to Mellon's own literature, the fund held 100% stocks through September 2008, then went down to 90% on November 5th, back to 100% on November 12th, and back down to 90% at the end of January 2009. It appears Mellon then went down to 80% stocks in May 2009, and 70% stocks in October 2009.

Trying to explain those moves in late 2008 and early 2009, the advisor pointed to increased volatility and Mellon's quantitative model to explain the changes in the allocation.

Such bad timing meant Mellon was no longer 100% in stocks during the market comeback; they had a small allocation to Treasury bonds, which tanked as investors shifted back to risky stocks. Vanguard Asset Allocation ended 2009 with a 17.92% increase, a big miss to the 26.4% gain in the Vanguard 500 Index, which they would have enjoyed if they had just stuck with the 100% stock allocation. Another way of looking at it? Mellon had 100% of the market downside, but only 70% of the upside.

Often it takes two mistakes to lose investing — buying high AND selling low.

Vanguard Asset Allocation has a slightly negative five-year return, while the 500 Fund is up a smidgen (as of 12/31/09). Any small fixed allocation to Treasury bonds should have meant beating the 500 over the last five years, but mistiming wiped out the previous year’s gains against the S&P 500. It's worth noting Mellon handled the 2000-2002 crash much better than this last one.

It is very difficult to merely stay invested during a crash. To actually head into the fire after a huge drop is more daunting still. We’ll continue to try to avoid the mistakes Mellon made in this last crash by trying not to do what seems to be the right thing to do.

Rarely will you see such gut-wrenching losses and widespread doom and gloom followed by an outcry of rapidly rising optimism. The stock market recovery of 2003 was not nearly as robust, despite a much stronger underlying economy and a growing housing bubble.

The actual changes in the economy (slow, steady increases in unemployment and housing troubles followed by slight improvements) appear glacial in comparison. But then, stocks have a tendency to bring out investors' manic-depressive side, which often results in overreaction both to down and upswings.

Perhaps that’s because so many investment funds use leverage, which magnifies losses and gains. Perhaps it’s because some investors watch that manic TV market prognosticator, the one who famously went on a network morning TV show just over a year ago to scare the bejesus out of everyone with his "sell everything!" rant. Although this message arrived just a few months after his incorrect "the bottom is in" message, it appears many still panicked, at least if you consider CD sales and stock fund redemptions during that time.

The market has recouped a sizable chunk of its losses from the crash with a 26.5% total return in the S&P 500 in 2009 – and that includes January and February’s perilous slide. However, the market would still have to climb about 40% to hit its highs of 2007 (heck, it would need to climb about 40% to hit its highs from March 2000,) which is why the 2000's were the worst decade to hold U.S. stocks. Too bad most thought stocks would always win over a period of ten years would be back in 2000 (in fact where told so by many experts). By comparison, the Powerfund Portfolios are all at or very near their all-time highs.

Although we don’t have the final numbers yet, it appears to have been a pretty good year for our model portfolios as well, partially due to a well-timed risk increase at the end of February. The graph below, borrowed from the Wall Street Journal, indicates the point at which we increased our allocation to higher-risk funds, along with the juncture at which we grew weak in the knees and cut the risk back a bit. In hindsight, we missed a good chunk of 2009's later returns by scaling back following the initial rebound. Let’s just say we made the easy money, although it felt scary at the time. We may miss a bit more as we prepare to take another "risk axe" to the portfolios and scale back the allocation to higher-risk bond funds and stocks.

Such trading – although far from frequent – is still critical to positive returns, since we primarily subscribe to "buy and hold" investing when stocks are cheap, as they have been throughout most of post-1933 financial history. If stocks are expensive, as they were in 1999 (and to a lesser extent, 2007,) investors will generally fare better with a larger allocation to CDs and bonds.

Back to Where We Started

We launched the model portfolios on April 1, 2002. That year went on to become the worst of a three-year bear market that continued until early 2003. Since then, the S&P 500 has returned approximately 10%, including dividends, which is to say investors' only return has been dividends. The index today is still down a whisper below where it was when the model portfolios were born.

During this same period, our model portfolios are up roughly 50-120%. We achieved these results three ways: (1) by owning bonds as well as stocks, (2) focusing on out-of-favor fund categories, and (3) buying on the way down and selling on the way back up.

If you review our trading commentary, you’ll note we were buying more stocks on the way down in 2002, and owned real estate, utilities, and emerging market stocks and bonds, which were out-of-favor during that time.

Last year’s crash in commodities and foreign markets did not scare investors away for long. The moment those markets improved, the bargains dried up, and the money began piling in anew. Although we witnessed a sharp tech rebound in 2003, it petered out, and the market remained flat for much of the decade as investors appeared to be done gambling on tech stocks.

As an example, look no further than the tech boom’s hot ETF, QQQQ. Now named PowerShares QQQ Trust, this Nasdaq 100 tracking fund now has less than half the dough found in either iShares Emerging Markets (EEM), iShares MSCI EAFE (EFA), or SPDR Gold Shares (GLD).

In 2009, fund investors poured back in, mostly into bond and foreign funds. U.S. stocks were not on most investors' radar. Fund investors apparently got the memo that the entire last decade was a loser, and seem to expect the next decade to be like the last one, one in which the U.S. dollar will continue to slide, foreign markets will rise, and commodities will be the only bankable investment. Fat chance.

We've previously noted how ordinary investment data tells us when expectations are too high. During bubbles, prices relative to earnings and expected growth rates are usually elevated. Even with hard-to-value items like gold, quirks in the data raise questions: Why is the price of gold today more than twice the cost of getting gold out of the ground? Why are gold stocks trading at higher valuations than Intel (INTC)? Intel is a near monopoly provider of a key computer component. Intel's products are loaded with intellectual property that's difficult to replicate – the polar opposite of the companies selling commodities.

We primarily focus on mutual fund investors' collective behavior, based on the recurring pattern of too much money going into areas shortly before they fall.

Sometimes, the data in the bubble can be skewed by the statistics of the time. Bubbles appear rational in the beginning. Usually, there is some legitimate history of wealth creation and a pattern of growth, whether in railroads, radio, the Internet, real estate, etc.

Bank stocks never really got that expensive in the last boom based on earnings, but the earnings themselves were inflated based on massive profits derived from record mortgage numbers – volume we may never again see adjusted for inflation.

Fund investor behavior is not the only place in which we see "irrational exuberance" near market tops.

Recently I was reviewing skyscraper history, and I noticed something interesting about the dates of some of the world's tallest skyscrapers. General building booms occur at the top of economic booms, and "tallest building" records correlate quite well with stock market peaks.

Record-high buildings are planned during economic expansions, which makes sense, since someone must need that new office space. But giant buildings are not just about economics. Ego also plays a significant role. Since construction costs can increase exponentially beyond a certain height, a luxuriously tall building doesn’t make much sense when compared to a few smaller buildings. The theory is that the mere greatness and attention of such a massively tall building will make up for any shortcomings in the actual economics. Build it and they will come.

These big buildings tend to break ground a few years before the end of the country's stock market run, and often near completion just as the rug is pulled out from under stock investors entirely – often, rather dramatically.

This pattern occurs not only in the U.S., but in other countries as well. In fact, we’re bringing this historical pattern to your attention because one such crash just occurred: the recent Dubai debt crisis.

Dubai is a bubble city. Seemingly overnight, the city transformed from a near vacant stretch of desert into a shiny global city, replete with the following "Oohs" and "Aahhhs": a tennis court hanging over the edge of a luxury hotel, indoor skiing, even manmade islands shaped like palm fronds and littered with fancy homes. Much of this development was paid for with debt, debt that is now in a perilous state.

This is not necessarily all bad, which is why investors loaned the creators of Dubai so many billions. After all, Las Vegas was once a strip of undeveloped desert, too. Dubai is a case of too much of a good thing, too soon.

But there is something else built in Dubai that's relevant to our story – the world’s largest building.

Burj Dubai is scheduled to be 2,064 feet of over 160 habitable floors and up to 2,684 feet including the massive spire on top. This mega-building is scheduled to open in January 2010 – just a few short weeks away from the Dubai debt problem. Dubai’s principal stock market crashed 7% in one day last week as economic fears rose over the country's debt burden.

During most of modern stock market history occurring within the last hundred years or so (The Dow was created in 1896, although stocks began trading in 1792,) the market experienced some of its roughest periods during the construction phases of the world's tallest buildings.

Certainly a tallest building must be going up somewhere at any point in time, and there have always been occasional market panics, but the pattern emerging is a bit strong for it to be chalked up to mere coincidence or data mining. Stocks top out around peaks of optimism, and companies hatch big building ideas during optimistic times. Just as startling is the near lack of panic during the periods in between big building construction projects.

Most big buildings take years to get off the ground, and economic optimism usually collapses before the building is complete. Often, tallest buildings go up in clusters right around the boom tops, with little building records for years following the crash. If mere technological advancements were behind big buildings, the distribution would be more spread out, or perhaps tied more closely to engineering innovations.

Here is a chronological list of the tallest buildings in the world, the related stock market, and the economic events that took place around opening day for the super structure:

• The Panic of 1873 occurred just as the Equitable Life Building became the tallest building in the world.
• In 1889, the Auditorium Building was top dog, followed closely by the New York World Building in 1890. In 1890, falling commodity prices led to tariffs on imported goods and federal government intervention to bolster the silver market. The economy was setting up for even bigger trouble soon.
• The Panic of 1893, kicked off by a large railroad’s financial collapse, was the worst since 1873. It was also one year before the tallest building of its time opened, New York City's Manhattan Life Insurance Building.
• In 1901, the panic coincided with the Park Row Building (1899) and Philadelphia City Hall in 1901, which reigned as the tallest until 1908. The Dow eventually fell about 50% before turning back up in 1903.
• The Panic of 1907 took place right before two more giant buildings hit the scene, the Singer Building (1908) and the Metropolitan Life Tower (1909). The market peaked in 1906 and eventually fell about 50% during the panic.
• The Woolworth Building was completed in 1913, and remained the tallest until 1930. In 1914, world stock exchanges closed for months due to World War I and reopened about 35% lower and a full 50% lower than the previous peak.
• The 1929 crash and ensuing Great Depression hit right around the time three big buildings were completed, each of which held the tallest title for a time. 1930 saw 40 Wall Street and the Chrysler Building. The Empire State Building arrived in 1931. All three buildings were cooked up during the roaring 1920's.
• So big a bust was the Great Depression that it took four decades for another building to break the record. The World Trade Center opened in 1972, and was followed closely by the Sears Tower in 1974. Of course, stocks peaked in 1973, and it took nearly a decade for the market to move onto new highs.
• In 1998, a new record holder opened. Of course, Malaysia's Petronas Twin Towers was completed a year after the Asian Financial Crisis and during a deep recession.
• The recent real estate and credit bubble "cluster" started with Taipei 101 in Taiwan in 2005. While the crash in emerging market stocks occurred quite a few years later, it’s worth noting that the building was increased to record-breaking proportions before construction commenced in 1999, right around the peak in Taiwan stocks, a level we are still under today.
• In 2008, the world's tallest building (by roof height), Shanghai World Financial Center in China, opened just in time for the emerging markets crash.
• And of course, the January 2010 opening of Burj Dubai is looming mere weeks after the Dubai debt panic.

Of course, other indications of opportunity, like valuations, are also taken into account. In fact, many of our favorite fund managers consider valuations relative to growth potential when choosing their holdings. But we still use general investor enthusiasm to select the areas in which we'll buy and sell.

Fund managers are arguably quite skilled at determining relative valuations. For example, an emerging markets manager can tell whether a Brazilian telecom company is a better deal than a Mexican cement company, but he'll never sell his emerging markets stocks after realizing emerging markets may be in a bubble. That's our job. We pull away the punch bowl before the market gets too drunk.

Research, as well as our own experience working with funds for nearly two decades, tells us that fund investors tend to be the most optimistic when they should be wary. Which is why fund investors as a group tend to underperform the market.

Market volatility generally highlights investment mistakes. The recent market crash and partial comeback offer plenty of examples of how buying high can destroy returns.

One way to gauge how poorly investors fared in a particular fund is to take a peek at the gains and losses on the fund's "books."

Example: If investors put $1 million into a new small fund, and it climbs 50%, the fund likely has about $500,000 in stock gains on the books. Much of that gain is probably unrealized, unless the manager sold the stocks that went up, in which case, much of the gains would have to be paid out that year as dividends.

Here's what typically happens: after a fund goes up 50%, more performance-chasing investors are bound to pile in. Let’s say $100 million goes into the fund, thanks to those nice returns. But then the fund falls 25%. The fund now has about $25 million in unrealized losses on the books (or realized losses, if investors decide to sell and force the manager to liquidate stocks to raise cash,) although the fund itself is still up in actual performance. That's how funds can show positive total returns when they've actually lost money for the typical investor.

Take the T. Rowe Price Emerging Markets Stock Fund (PRMSX). Thanks to the big recovery and strong returns before the crash, this fund is still up over the last one, three, and five years. In fact, the fund has averaged about 15% growth each year for the past five years. There were some volatile years, of course, accounting for a 60% decline in 2008, and roughly an 80% rise in 2009.

But the fund only had about $600 million in assets five years ago. Investor money has rolled in since then, and assets under management tipped the scales at about $5 billion before the crash in emerging markets (which fell more than the crash in US stocks).

The fund's lousy 2008 meant that investors lost more money than they made in the years leading up to the drop, although if you'd invested five years ago, you would never have actually been underwater during the crash. Even today with the comeback, the fund appears to have net losses on the books.

The more targeted a fund, the greater the timing mistakes tend to be. Not to pick on T.Rowe, which is by and large a good family with quality, relatively inexpensive funds, but the T. Rowe Price Emerging Europe and Mediterranean Fund (TREMX) has been trouble for investors.

The fund, which invests heavily in Russia, enjoyed spectacular returns prior to the 75% plunge in 2008 (a good chunk of it has now come back, with a return just over 100% so far in 2009). Five years ago, the fund had a mere $115 million in investor assets, but it ran up to around $2 billion right before the plunge. That poor timing left the fund with hundreds of millions of dollars in losses on the books. (One upside: anyone getting in now probably won't see a big year-end taxable distribution for quite some time, since they're literally buying someone else's losses.) The losses were so bad that the more targeted fund lost even more investors than the broader emerging market stock fund did. And fewer bought in on the way down.

Ideally, investors should be buying stock funds after others suffer big losses. Lately, the rebound has been so strong that investors are jumping back in a bit faster than usual, given the size of the drop last year, which makes the time frame of many of these deals short-lived.

Since April 2002, we've held an emerging market stock fund in our higher-risk model portfolios. First it was Dreyfus Emerging Markets (DRFMX), which we switched to SSgA Emerging Markets (SSEMX) when Dreyfus converted to a load fund structure in February 2003. It was tough selling a no-load fund back then. Few wanted to buy emerging markets — a sign of opportunity.

We cut this stake back in May 2005 following strong returns relative to the US markets, and cut it completely at the end of February 2006. Emerging markets didn’t make a return to our model portfolios (except for a brief period of shorting in our highest-risk accounts) until February 2009, near the bottom of the emerging markets crash (we used Market Vectors Russia ETF (RSX) for four months).

Emerging markets peaked in October 2007, but we missed it by a country mile. We'd sold out of emerging markets 20 months earlier. Yet emerging markets crashed well below the level at which we'd sold. Bottom line: we made money in emerging markets in the 2000's, while many investors lost (hopefully the recent recovery will save them). The extra returns we earned in our short-lived buy off the bottom was simply icing on the cake. In our Daredevil portfolio, two of our best three individual fund returns (206% and 80%) came from emerging markets – despite a major crash in emerging markets.

This time, we don't want to leave the party too soon, as we clearly did with our 2006 and 2009 sales in emerging markets. But the investors who pile in during the last hurrahs of strong returns often lose money. The best way to make money is to leave the party when the late crowd shows up.

We hate low returns as much as the next guy, but we like following the fund investing herd even less. We're also not keen on doing what the government tells us to do without at least first considering the alternatives.

After all, the government created low interest rates on short-term investments. It even lowered long-term rates by buying up mortgage and treasury debt with Federal Reserve play money. Ideally, lower rates should result in lower debt payments and increased borrowing, which is good for the economy (although the flipside is the economic drag that lower rates have on those surviving on fixed income portfolios filled with safe investments).

But lower interest rates also create an incentive to speculate. In a turbulent market, investors crave safety. Investors are also cyclical. They invest more when the market is in a boom period, and less during a bust. We believe the government lowers rates in order to counter this cyclical trend and punish the safety seekers. It's the government's way of trying to stop the snowball in its tracks. Far fewer investors would venture back into stocks and higher-risk bonds if they could earn 3-5% risk-free on short-term investments.

During the week of January 7th and March 11th of this year, individual investors held a record $1.37 trillion in retail class money market funds. The week of March 11th saw this year's market low — so far. The graph below demonstrates the inverse relationship between stock prices and money market fund popularity since January 2008. The cheaper stocks get, the more investors hoard their cash.

This inverse relationship kicked into overdrive around May 2009, when economic recovery first appeared attainable. Fund investors have pulled out nearly 20% of the money they held in money markets, and piled it into stocks and higher-risk debt. Some funds probably went into CDs, but the bulk went to higher-risk assets.

Total money market fund assets, including institutional class money market funds (high minimum and limited access), followed a similar pattern, and peaked at about $3.9 trillion around the same time. Today, that figure is down to approximately $3.4 trillion. That’s half a trillion dollars going back into higher-risk assets in just a few months. No wonder stocks and junk bonds are up.

We don’t know how long this trend will continue – probably just until the next scare in the market. Money market assets can only go so low, because as much as $2 trillion of the total will never find its way into stocks, regardless of market environment.

We generally like to add to lower-risk investments when others are cutting back, and vice versa. You may remember that we made our last major buy into higher-risk assets when money market assets were at their peak. Needless to say, if this money market total asset line continues downward, we'll begin buying where others are selling.

But how could we even consider a near-zero-return investment?

First of all, cash doesn’t really yield zero today. Image a fund yielding 0.50%. Inflation has been slightly negative over the last year- negative 1.5% a year at last count. That means your actual "real" or inflation-adjusted return is 2%. Even after you factor in taxes, which you only pay on the nominal 0.50% yield, the real after-tax return is still nearly 2%.

Compare this with a higher money market yield of 3% during periods of 1.5% inflation. After taxes, the nominal yield is about 2%. Adjusting for inflation, the return is about 0.5% real. Bottom line — a 0% yield coupled with deflation is better than a 5% yield with high inflation for investors seeking safety.

Deflation is also bad for stocks, but good for cash investors. If we can’t stop deflation, the stock market will eventually slide. And deflation scares us more than inflation, which tends to hurt creditors (bondholders) of relatively long-term bonds.

Stocks usually inflate with everything else, which makes sense, since stock earnings will inflate just as salaries do. But investors don’t believe this, despite a strong correlation between stocks and nominal (non inflation-adjusted) US GDP over the last century.

The reason for this irrational fear of inflation is the memory of the 1970s era, when inflation soared and stocks performed poorly. But inflation during that period was not the only factor driving stocks down. Stocks began the period at high valuations, and ended at ridiculously low valuations. This P/E compression explains much of the market. Even if inflation had remained elevated, eventually stocks would have taken off again. Another example of deflation threatening stocks more than inflation? The last two decades or so in Japan — although again, much of this can also be attributed to P/E ratio compression.

We’re not sure why the 1970s – a relatively brief era of high inflation in the grand scheme of things – scares people so. Investors tend to have selective memories; the Florida real estate crash of the mid 1920s didn’t keep people from speculating in Miami condos in the recent boom…

1) Stocks
2) Bonds
3) Cash (Money market funds, T-bills, Shorter-term CDs, etc.)
4) Real Estate
5) Hard Assets (Commodities, Antiques, collectibles, Art, etc.)

Stocks should be the best performers over the next decade. This prediction has less to do with our overall outlook on the economy, market, and valuations, and more to do with where investors are putting their money. Investors often shift money to broad categories and specific areas after a hot streak and shortly before a period of underperformance starts.

Frankly, hard assets shouldn’t even be on this list, since we define long-term investments as those capable of producing a stream of cash flows, either in the present (bonds and profitable stocks), or future (growth stocks with no current profits).

Investors still like commodities in spite of the drubbing they took last year, and have been more than happy to jump back in as prices rebounded this year, apparently hoping to position themselves for the next big move into triple-digit oil.

Real estate is superior to hard assets, but will continue to have limited appeal until more money comes out of the asset class.

Even in the face of massive price drops not seen in the US since the 1920's and 30's, and with deflation and a Florida real estate bubble pop destroying home values, real estate still appeals to most investors. The main obstacle preventing a resurgence of excessive real estate investing is a lack of financing. Apparently, banks have realized the downside to real estate, even if borrowers still want in on the action.

Real estate, unlike hard assets, offers income potential, and provides a far better hedge against inflation, especially since it is often purchased with fixed rate loan dollars. There will come a time when real estate may outperform stocks, but real estate prices will have to sink a bit more (or stocks grow more expensive) before that happens.

Cash is still a very popular asset class, but it’s growing less popular by the day. Money has been flowing out of money market funds for the past six months, capped off by a roughly $50 billion dollar outflow in July. Looking at past fund flows, it appears money markets reached peak attractiveness to investors at precisely the worst time to shift assets to cash from just about anything else: March 2009.

You can’t blame investors for bailing on cash lately. In addition to the exciting upward move in stocks, the Fed has effectively set interest rates at zero, which is now reflected in low money market yields. This move was part of the effort to stimulate the economy and encourage investors to move back into riskier assets desperately in need of their emotional and financial support. Fortunately for safety seekers, prices in general are falling, so a dollar in 2010 may buy more than a dollar in 2009 does. The real inflation-adjusted return of money market funds is perhaps 2-3% - tax-free. That's better than earning 5% on a money market fund when inflation is 3%, since your after-tax return is zero, adjusting for inflation and taxes.

Bonds are fast becoming the place to be, due mainly to a move back into riskier corporate bonds (kicked off because now that it appears soup lines are not in our immediate future — hopefully this time, everybody won’t be wrong, as is unfortunately often the case). This trend is a bit dangerous, since today's bonds have limited upside, yet in a doomsday economic scenario could still fall victim to a big hit – as much as 50% of stock market downside (for non-government debt), with only a fraction of the upside.

Since early 2007, investors have added nearly a third of a trillion dollars to bond funds. That pace picked up this year, despite low interest rates on bonds. Lately, we’ve seen about $30 billion flooding into bond funds each month.

The only way a bond investment is going to beat stocks and even real estate over the next decades is with low inflation rates, low interest rates, and slow economic growth. Although this is possible, it is the best-case scenario – enough strength in the economy to keep default at bay and the bond payments coming, yet not enough for stock earnings growth to outpace bond yields, nor enough to lead to higher interest rates, which could hurt those in current lower-yield, longer-term bonds. Japan in the 1990's comes to mind.

Stocks have been bringing in respectable money now that "the bottom is in" theory has gained widespread acceptance. Broadly speaking, investors began avoiding US stocks in March of 2007, and by the summer of 2008, eventually gave up on even formerly popular foreign stock funds.

Although the money has been coming back, domestic stock funds have seen withdrawals of nearly $200 billion since early 2007. During the same time period, about $50 billion went into foreign stock funds. Since the March low (when fund investors were bailing on all stock funds, big-time,) domestic stock funds have brought in more money, but after hot recent rebounds abroad, fund investors are now leaning toward foreign funds once again.

With this backdrop of investor behavior - which tends to be wrong - we expect US stocks to be the top banana over the next decade. How good this return is in absolute terms depends upon impossible-to-predict long-term economic and earnings growth rates. Stock performance could be as bleak as 3% a year, which would still be better than losing 2% a year in real estate or even more in commodities. At this point, the value of cash and bonds in portfolios is safety – so you don’t lose 50% of your money at a time you may need it – and to give you something to shift into stocks on future weakness that would increase expected stock returns.

The move into bonds by investors may not wind down anytime soon, and we could see even stranger valuation comparisons — for example, a 3% average fixed yield on the total bond market, while the S&P 500 yields 3%, a yield that generally grows over time as dividends increase.

Today, the total bond market yields just under 4%. Normally, that figure alone would make for a bad comparison to stocks. But now that corporate America has taken the axe to dividends, yields are down to about 2.3% on the S&P 500, even after the big drop in stock prices.

From the March low (hit just a few days after our last buy in our model portfolios), the market is up around 50% - among the greatest returns in a few months ever. Makes one wonder how much faster stocks could possibly go up in a short time period. What if the government did what everybody wanted it to do? Perhaps good and bad government policy is overrated as it pertains to stock prices.

In fact, all seems equally unimportant to the stock market, which appears to be trading largely on the growing sensation that the worst is behind us and while scary stories still exist, better to ignore negativity because deals on assets only exist when panic is still in the air. And the air is fast clearing.

With assets over the last 15 or so years in almost a state of perpetual overvaluation, the new normal because of the massive wealth globally chasing finite opportunities, there is truth to this theory: You can only safely buy during the brief periods when others do not.

It’s not just stocks. Home prices, which in many markets are still overpriced compared to historical comparisons to income and rents, are finding buyers and price stabilization. There have been stories of wealthy individuals buying up entire troubled Miami condo projects and (hopefully for their sake) pennies on the dollar.

We’re a little suspicious these properties will ever be worth more than some amount of pennies on the dollar if you define the dollar as the peak price. South Florida condos may be fifty cents on the dollar, or $500,000 instead of $1,000,000 a couple of years ago. But by this logic the Nasdaq is trading at forty cents on the dollar, the dollar being the 5,000 level it hit in 2000. Don’t read this to mean we think tech stocks are a bad investment, we just would be happy to sell out at some point in the future at many sixty cents on the dollar.

Tech stocks have been particularly strong, with the Nasdaq just breaking through 2,000. Of course, this is a level first breached in 1998. As for the S&P 500, 1,000 has just been crossed, a big move from the high 600s hit during the depths of the panic earlier this year. Of course 1,000 was first hit in 1998 as well. The Dow is not far off from 10,000, a level first hit in 1999. (Dull Dow stocks lagged in the late 1990s)

Most remarkable is how quickly the market made its run to its current levels. We all remember the late 1990s being an era of great stock returns. The S&P 500 was in the 600s back in early 1996. What took over two years in the boom years just happened in a few months.

This action has drawn more investors into the party, which unfortunately will end the party at some point. Some investors are likely wise to this and don’t expect to own the stocks they are lapping up today forever. There is probably some level they all have in their heads where they will scale back, something they should have done with more gusto the last time stocks were elevated.

Our biggest concern now is when “at some point” arrives. The problem with tops is similar to bottoms: They don’t seem obvious until much later. Making matters worse is the possibility that the government and investors are inflating assets once again.

The recent rise in stocks- although still down significantly from the market's peak - seems a bit strange, as the economy has, at best, merely stopped falling. Although “not getting worse” may sound like a good reason to pay more for stocks now than during the panic pricing of a few months ago, that's not a solid foundation for a long-term run in stocks. That is, unless something unusual is brewing in asset markets once again…

Everywhere you look, you see approximately 10-30% less business taking place then last year. Although it's possible this contraction is largely over, the economy won’t start growing at a fast pace for years to come. A cycle of layoffs can create a snowball effect, since reduced spending will result in more companies firing extra staff, and so on, and so on. So far, we seem to be avoiding such a death spiral.

The consensus is that if you artificially stimulate the economy, you'll get inflation and a falling currency. Many who think way, way out would also add that we're likely to see higher taxes (and reduced economic growth) in the future as the bills come due. Such are the things investors worry about when they are not worrying about a complete collapse of the financial services industry anymore.

But many investors don’t care about taxes and growth 5-10 years out. They're more worried about missing today's rally in case it cranks up another 25-50%. They believe inflation risk can be handled with investments in commodities, real estate, and higher risk assets, even stocks, and that currency risk can be managed with foreign investments.

The problem with this analysis is this: Prices on consumer goods aren't going up, but asset prices are. The price of music players doesn’t go up, but the price of music player stocks does. Rents don’t go up, but property prices do. The 1970's are over.

The "real" economy is smaller than it once was. The government is bending over backwards to stimulate it, but it's impacting asset prices more than the actual building and buying of stuff.

In other words, low rates won’t convince you to buy an extra TV or a car, but they may make you shift from safe, low-yielding assets to riskier assets so you can earn more money. This is similar to the impact of ultra-low interest rates following the last recession. During the last recession, governments (globally) helped generate a massive asset bubble centered around real estate by using ultra low-interest rates to get people to buy stuff and grow their businesses.

Instead, most of the borrowing was used to buy investments, and much of the business growth was based on providing homes to invest in or renovation items to increase the investment value of those homes. Although we saw major spending in the economy, it was more from borrowing against rising asset prices than from actual borrowing for the sake of borrowing. Most consumers may be too smart to borrow $3,000 to take a vacation, but they'll spend it if they can “earn” $100,000 on rising home values.

Governments may have no other choice. Although the world can handle a 5% or even 10% smaller economy, it can’t handle 50-75% smaller asset prices, not with trillions of dollars of debt backed by those assets. It’s possible the government is selling stimulus and bailouts to benefit the economy and individuals when in fact these measures are targeted squarely at re-inflating the asset bubble in the hope that participants will have learned their lesson this time around and therefore won’t take things too far the next time. A bigger question is this: can the government create economic growth and buy us out of a recession without most of the action hitting asset markets instead of real markets?

Can we get another speculative asset boom, only this time without the economy going along for the ride? Or can the economy boom again from the knock-on effect of rising asset prices? If asset prices rise, and the economy doesn’t join in the party, we’re just setting ourselves up for a boom built on even thinner fundamentals. We'd be like Wile E. Coyote when he runs off the cliff and realizes there's nothing but air underneath.

It’s a little early to be strategizing our gradual exit plan from overheated markets, since we only recently began planning our entry into stone-cold markets. But the way things have been going lately, we may be changing our plans sooner rather than later.

One reason for fear in the not-so-distant future is the government is surely aware that asset price “stabilization” is fast becoming asset price inflation. The Fed would probably love to start increasing interest rates from essentially zero to more realistic levels to nip the next bubble from forming, especially because commodities prices are taking off again. However, the central bank is probably scared such a move is going to mow down the so-called ‘green shoots’.

If this upward trajectory keeps up, there will be no choice. Stock investors may not mind the higher rates initially because they will assume it means the economy is recovering. The problem is the economy probably won’t be able to handle higher rates. It could cause a second wave of problems.

If this market continues to rise at this pace, we'll keep cutting back and eventually return to the stock allocations we had when the Dow was at 14,000.

The trades we just made were specifically to get out of our recent move into financials, near the market bottom in March 2009.

Our roughly 60% return in four months (double the overall market) in the Financials Select Sector SPDR ETF (XLF) marks a good exit point from financial services stocks. While financial stocks may have more upside, the bargains are gone and we don’t expect the sector to outperform the market going forward - the main reason to own a sector fund in the first place. For the time being we are increasing our bond allocation even though bonds are not screaming buys at current yields. We think we may see some more interesting stock fund opportunities in coming months. (For our Daredevil portfolio, we are cutting back on an even hotter fund we bought in March, our Russian ETF (RSX), which is up roughly 80% even despite a recent pullback. We also made some more significant changes to the Daredevil portfolio. (Please read Daredevil trade commentary for more detail.)

As we've been noting during this comeback, it does look like the government, in its infinite costly bumbling, did stop a train wreck in the financial sector, perhaps literally by making a pile of money for the train to ride into softly and safely.

Things were getting ugly, fast and government support helped stop the panic - hopefully for good or at least until the next bubble/crash cycle. This costly adventure for government will keep the lid on future economic growth (and earnings and therefore stock prices) for at least the next few years. We sincerely hope the executives at Goldman Sachs and other banks appreciate the fact that they would have lost their banks a few months ago, like Bear Stearns and Lehman Brothers, if not for the government. Too bad the government didn't get more upside for its efforts. Maybe taxpayers wouldn't be quite so on the hook for our generosity.

But just a few days ago, the market took off following a five-day slide, inspired by nothing more than news that the "sentiment index," one of the data points published by the Conference Board Consumer Research Center measuring the psyche of the consumer, "surged by the most in six years" in May.

On the same day, home prices were reported to have fallen nearly 20%, year over year, by March, but investors were apparently more excited that confidence was up, despite the fact that the same confidence index measured far higher back when the market began its epic tumble. Perhaps many need to be reminded that consumer confidence wasn't the problem that drove us into this economic tailspin. Falling home prices were.

However, it's understandable that investors were relieved that increasingly dire consumer forecasts might not in fact be written in stone. After all, the going consensus these days has been that consumers have permanently altered their spending behavior – they’ll be saving more and spending less from here on out, and this collective frugality will keep the economy in the doldrums for many, many years – if not forever.

These dire predictions warned that the consumer balance sheet could no longer run in the red because those providing us capital, including not only the banks, but ultimately China and other nations as well, are now cutting us off like a bartender at closing time. We were also told that the dollar would, of course, collapse, leaving Americans with little ability to buy stuff from abroad.

Here at Maxfunds, we never believed that consumers would all of a sudden lock their credit cards in a drawer. Our nation was built on consumers using borrowed money. We’re not even sure such borrowing is that bad. After all, some people get lazy when they don’t have car payments to make.

One of the wonderful things about America is how cheap we've made our core living costs – food, housing, transportation, and clothing. Nowhere else in the world can you earn so much relative to the cost of bare necessities.

The problem is that debt-fueled bingeing got way out of hand in recent years – and not so much loans to consumers buying TVs and jet skis as loans used to buy homes, which has never been considered reckless spending. Unfortunately, over the last few years, you’d have been much better off going on vacation with $10,000 in borrowed money than "investing" in a property with a $500,000 mortgage, a property that may now be worth only $250,000 in some parts of the country.

So while we’re confident that at some point in the future people will toss their syrupy "McCafe" and "upgrade" back into a Starbucks/Williams-Sonoma lifestyle (because frankly, hanging out in a McDonalds with your laptop just doesn’t feel like an adequate reward for a hard day’s work,) we're growing more concerned about the specific consumer we at Maxfunds spend our time tracking — the fund consumer.

It wasn’t long ago fund investors sought to emulate the lifestyles of rich and famous investors who routinely invest in alternative energy and private equity , the same investors who send their money around the world to exotic hotspots like "BRIC" countries (Brazil, Russia, India, and China) and "frontier" emerging markets in the Middle East, eastern Europe, and Africa. But now mutual fund investors have cut back on exciting mutual funds and downgraded to plain-vanilla bank CDs.

For the majority of the past three decades, mutual fund investors have piled billions of dollars each month into mutual funds, virtually unabated, other than a few brief panics usually coinciding with a sharply down market.

Previously, the worst stretch for fund flows was near the bottom of the 2000-2002 bear market. Over nine months during that period, fund investors yanked about $100 billion out of stock funds – half of it in July 2002 alone. As we want our Powerfund Portfolios to do the opposite of what most fund investors do, we added to our stock positions during this recent panic just as we did back then .

After the 2000-2002 bear market, investors quickly returned to mutual funds, adding about $250 billion over the next year. As the subsequent bull market ran on, investors became particularly fascinated with foreign stocks and commodities.

By 2007, fund investors had more or less given up on domestic stocks. They then began shoveling money into foreign markets since they were performing the best.

By the summer of 2008 – well into the crash in real estate and the drop in stocks – the money started to pour out of mutual funds. We’ve seen about $250 billion sold in both US and foreign stock funds – a record – since the withdrawals began.

We did witness a few brief moments of optimism, like when investors added a few billion in January, unfortunately just in time for the next plunge down. More recently, we’ve seen a few billion – perhaps $25 billion total - come back into stock funds now that the market is hot again.

There was a ton of money put into ETFs in 2008, but a good chunk of it was spent by institutional investors using ETFs in place of stocks or traders – and that group doesn't represent actual longer-term individual fund investors.

Fund investors may continue to wade back in. They tend to run out fast but slowly return as the waters look safe. But they may also throw in the towel and give up on an investing lifestyle of adding more and more money to stock funds.

The stock market has been punishing individual investors for well over a decade, especially those that invest like many fund buyers – piling in at the top, selling near the bottom. Fund investors have sunk nearly a trillion dollars into stock funds this decade, and have seen a good chunk of that wealth disappear. If such an environment keeps up, we could see a return to the sentiment shared during the fifty years beginning in the early 1930s and lasting until the 1980s, in which individual investors just didn’t want much to do with stocks.

On the one hand, we like to see investors bail out of the market, since that means higher long-term returns for those who stick around. An overinvested market is a low-returning one. On the other hand, if investors really depart funds for good, we’re going to have to get used to the other feature that goes along with 50-year periods of under-enthusiasm by investors: low valuations.

To put it another way, if fund investors check out and don’t check back in, the market isn’t going to move past its old highs any time soon, even if consumers return to Starbucks and other S&P 500 companies that are currently suffering reduced earnings.

At least a Grande Choc-o-holic Frappuccino tastes good. Most mutual fund investors still have a bad taste in their mouth.

So far, fund investors are just investing a few billion a week, nothing like the tens of billions they were unloading while the market was plunging in February and early March.

On this contrarian note, some popular themes, including some oldies but baddies, are now enjoying quite a resurgence in the investment world . Here are some recent market wisdoms, accompanied by a brief MAXadvisor (unpopular) opinion:

Popular Theme #1: Gold is your best bet against current economic and political problems.

At its best, gold is only a decent gamble when inflation and global economic and political fears are mounting. Today, these fears are either flat or falling, which is bad news for gold – a commodity with no real long-term investment merits other than its ability to “keep up” with inflation – a trait easily found in any number of hard assets (and surpassed by investing in TIPS).

Once you remove the mysterious and magical properties gold purportedly holds, it’s no better than most other commodities that have plunged over the past year. You’d be better served by hoarding aluminum in your basement .

Popular Theme #2: Inflation is going to take off any day now.

This idea sounds reasonable, especially given the government’s recent pattern of wild spending, bailouts, and Fed money creation. But we've seen this play before, and we know that ultimately, the falling economy trumps all government games. Besides, ballooning inflation is only one of four potential outcomes we might expect following the sudden collapse of a massive asset bubble:

1) If the government does nothing to help banks recover, it risks entering another Great Depression.

2) If the government takes steps to save the world, the end result is a slow economy and rising government debt that lasts for years. Japan experienced the same phenomenon following its bubble peak nearly two decades ago.

3) In the best case scenario, we won’t get another bubble to save us from the last, and the economy will grow like gangbusters.

4) There's a slim chance that reckless government policies will result in massive inflation, but this is the least likely outcome. Frankly, we'll be lucky to get a bit of inflation to support home prices and make debt easier to pay off. But wild double digit inflation? Fat chance.

Popular Theme #3: Interest rates are going to skyrocket any day now.

Right. Just as soon as the economy picks up and people stop buying Treasuries, start piling back into higher risk assets, demand even more money to borrow, and find little of it to go around. The call for dramatically higher rates has been going on for most of this decade. You can expect higher interest rates, alright — on credit card debt.

Just because safer bonds are a mediocre investment at current interest rates doesn’t mean that rates are going to double anytime soon, either. If rates climb much from these levels we will increase our stake in bonds.

Popular Theme #4: We’re entering another Great Depression.

A low probability event. It's much more likely we'll witness a massive wave of bank failures without experiencing an actual Great Depression. We may not even see double digit unemployment, and even that would be a far cry from the last depression, when unemployment rose to the 25% range.

Following decades of prosperity in America, there's also more wealth built up in the system than there was in 1929. Social Security payments, pensions, unemployment, and massive government spending may be an economic drag in the long run, but they’ll keep us out of deep trouble this time.

Popular Theme #5: Oil is going back over $100 soon.

If by "soon," you mean 2020, why, then yes, it is. That's because we're eventually going to run out of oil. So its price will significantly increase over time. But the slow economy is only part of the reason why that won't happen right now. Commodity gambling was a big part of the recent commodity bubble, as was an unsustainable, debt-fueled global economic boom. It’s not going to just come back overnight. The only positive thing we can say about oil is that it will perform better than gold.

Popular Theme #6: The housing market has hit bottom.

Not in places where prices are down less than 25% from their peak and still up over 100% from the last decade.

Popular Theme #7: This is the start of a big new bull market.

The bear market may have ended in early March, but most of the recent euphoria is based on short-covering and relief that most of the panic has left the market and financial system. Waves of minor panic and overall sluggish economic and profit growth should keep the lid on any major multi-year upswings.

Popular Theme #8: The U.S. Dollar will collapse soon.

The U.S dollar is done collapsing. We’re not perfect, but we’re still better than just about everybody else, and that’s all it takes to keep our currency propped up.

Popular Theme #9: The consumer economy is gone forever.

We overdid the credit thing. We noted here years ago that financial services have had too great a role in the stock market and the economy. Home lending was completely out of control. But if you think Americans are going to pay down all of their debt and live by cash alone for the next generation, you don’t know much about diets, financial or otherwise.

This country was built on debt, and will continue to use debt to achieve its goals, even if those goals include buying a TV you can’t afford. A little debt keeps people working hard, and on a philosophical level, it doesn't really matter whether someone buys a couple of TVs for $1,000 cash, or one TV for $500 in principal and $500 in interest over a few years.

In fact, if they buy two TVs, much of the money goes abroad, and the results will end up in a landfill someday, but if they buy one TV, much of the financing profits stay in America. This practice is only bad when you buy two TVs with borrowed money from your phantom home appreciation and can’t afford the payments…

Let's consider a few basic financial factoids currently circulating: (1) stock markets typically recover before the economy does; (2) recessions rarely last more than a couple of years; and (3) compared to recent history, stocks are now cheap.

Combine all of these factors, and what do you get? Some pretty bold and beautiful advances in the market, despite a lack of visible improvement in the economy. Factor in massive stock shorting by momentum investors and hedge funds – risky stakes this deep into a bear market that will have to be covered if the market takes off – and you have a recipe for a month like March – one of the best on record. Of course, “best month evers” often follow “worst month evers”. Even with March’s 8.5% jump in the S&P 500, the market is still down 11.5% in 2009.

At this point, we're as guilty as the other bottom-fishers, although we'd argue that we had far more cash, bonds, and shorts at the top then most (at least, compared to the average 2008 performance of most mutual fund and advisory firms.)

In fact, our latest trade made at the end of February was a mere five (largely bad) trading days from what some believe is the elusive "bottom" – around Dow 6,500 and 666 (gulp) on the S&P 500. Of course, last fall, Dow 7,500 was supposed to be the bottom…

So far, the market has rebounded approximately 20% since the low in early March. Some more beaten-down areas, notably the Russian ETF and Financials ETF we added in the last trade, are up even more than the market. Better still, we got out of our commodities short just in time to witness a commodities comeback (which we expect to be short-lived).

We don't assume that the market will continue to rise without dropping again or that the economy is mounting a recovery, but we are confident these prices will work out in the longer term regardless. Besides, we have a master plan if things grow appreciably worse: buy more and wait patiently. For now, we're comfortably continuing to zig whilst other fund investors zag.

There were monster outflows from stock funds right before the latest bottom, and there appear to have slowed now that things are "improving." Specifically investors took out around $60 billion from stock funds in the three weeks through March 11th (just in time to miss the big move back up). But as contrarians, we prefer to do our investing when the market appears to be eroding, when other investors panic. Which means we're likely done with major trades for the time-being. Although you never know. The waves are crashing in awfully fast these days.

Brother, can you spare a billion?

The latest iteration of government aid to the not-so-needy-but-important-nevertheless sparked the most recent rise in down-in-the-dumps banks and other financials. We're talking 20% hikes in one day for some in this area, notably the government’s new investment partners, highfalutin Wall Street money managers, many of whom didn't do such a great job avoiding investments in troubled debt in the first place.

Specifically, the government laid out details on how it plans to use previously set-aside rescue funds to buy troubled "assets" (and we use this term loosely…) from banks in order to free them up to make more, hopefully slightly less crappy, loans. The trouble is, a hundred billion dollars in troubled asset relief ain't what it used to be. After all, this is no longer merely a subprime problem. The figures being batted around are mere chump change when you consider that the financial sector probably has $1-2 trillion in losses on recently-lent money.

The solution, of course, is a little hair of the dog that bit you - namely, leverage that puppy up. But due to an apparent disdain for any actual government profit on these bailouts, the government has instead opted to protect money managers from downside so they'll have a decent shot at hitting the sorts of bonuses they received in the years prior to the crash.

It breaks down like this. First, the government will partner up with XYZ Hedge Fund or money manager. Now let’s say there's a billion dollar loan portfolio at ABC Bank currently worth about $800 million (we hope…it may turn out to be worth $200 million). Each party – the government and the Hedge Fund - will pony up about $50 million to buy the depressed loans from ABC Bank (because that was the problem…since the bank instructed the mortgage lending department to "Always Be Closing," regardless of who signed on the dotted line or what overpriced shoebox they happened to be buying).

But that’s only $100 million. Where is the next $700 million coming from? Why, from investors, of course. Wondering who would lend money to purchase risky mortgage securities at a low enough interest rate to actually make some money? That’s where the government steps in and backs up any borrowing with FDIC insurance. This is sort of what the government is now doing with many troubled banks and GE – telling debt buyers they'll cover the losses. The government may even make the loans needed to buy the $800 million dollar portfolio.

So let’s say the value of the portfolio falls from $800 million to $500 million. The hedge fund will only lose the original $50 million. They won’t owe the loan back. They can "walk away," similar to someone who bought a condo with hardly any money down only to watch it later plummet in price. Unlike said condo flipper, however, the hedge fund’s credit won’t get dinged, and the lenders won’t come after them, since the FDIC will make good on the losses.

So what if the $800 million grows to $950 million? Said hedge fund will split the $150 million dollar profits with Uncle Sam: $75 million in upside and $50 million in downside for the Hedge Fund, $75 million in upside and $750 million in downside for the government.

On Wall Street, that’s what we call Asymmetrical Risk. Particularly for the government.

So why bring Wall Street in on the action at all? Why doesn’t the government just buy the troubled assets themselves, as it originally intended (only with more borrowed FDIC-backed funds?) Supposedly, we need someone to price these securities so the government doesn’t get ripped off (admittedly, a likely scenario, and one that's almost required if the banks are going to get enough money to get back to even.)

But then, we have fund managers price stocks and bonds for us in our model portfolios. That’s what we pay them often less than 1% to do – and that’s a small individual account. Why not just pay Wall Street a small management fee to manage the portfolio for the government, similar to a pension fund? Who knows. Perhaps the government just doesn’t want to appear to be nationalizing this much of the financial services industry or taking on this much risk. Having some Wall Street paws in the mix makes it look more "free market" with shared upside and downside. We get the distinct sensation the government is more concerned with how things appear than how they'll actually work out. Of course, in light of the recent near-mob mentality surrounding the announcement of the AIG bonuses, perhaps they have a point.

Why the government doesn’t just lend people money to go buy homes, with no fear of losses beyond a small down payment, as a way to support the actual declining assets – homes - that caused the mess in the first place, is still unknown. Even if banks could resume lending, it's unclear if consumers want to resume borrowing now that they've suddenly been made painfully aware of the concept of real estate downside. Apparently, the producers responsible for various HGTV programs haven’t yet received the memo about housing prices.

Anyway, this is the sort of insanity we’re now dealing with month to month in the markets. We can’t complain, though, because some of our new buys are benefiting from these plans. For now, at least.

We used this downward spiral to make some more changes to the portfolio, detailed in our portfolio commentaries a few days ago. The goal of this trade was to sell our successful inverse commodities ETF (after an over 300% return), cut back on some recently added closed-end funds that are no longer a bargain, and to increase our overall stock allocation slightly.

This is not our last move up the down market. We could see our stock allocation increase significantly in our more conservative portfolios if the market continues to fall and hits S&P 500 levels last seen in the mid 1980s instead of just the 1990s. Don’t laugh (or cry). It’s possible.

On a plus side, stocks are now officially cheap. The trouble is, that value could quickly evaporate if the economy goes into a true Depression-like death spiral. It’s worth noting that in the last real depression the GDP dropped around 25% adjusting for inflation, but fell closer to 50% in current dollars. This is like the current GDP going from 14.2 trillion to around 7 trillion. It may not seem like a 50% slide when you adjust for a huge drop in prices (we had massive deflation in the Great Depression) but stocks more closely follow nominal GDP than real GDP, which partially explains the near 90% wipeout in the Dow from the peak in 1929 until 1933. The other explanation was the massive run-up in stocks in the years immediately preceding the crash, something we didn’t see before this crash but did see before the 2000 crash.

While the market has plenty of upside for the next 10 years from the S&P 500 below 700 and the Dow below 7,000, it is entirely possible that this could be the once-in-a-lifetime market event that truly destroys wealth and the business of wealth management. In our opinion, there were too many fund companies, exchange-traded funds, private equity firms, venture capitalists, hedge funds, and other brilliant money management companies appearing on the scene during the last 30 years of largely up markets. Something had to clean all the fee collectors out of mix, and a 50%-80% correction in asset prices could do the trick.

The negatives are largely fear itself at this point. The economy and stocks are going to exist on confidence for the next few years, and it is a variable that is difficult to manipulate this late in the collapse of confidence, even with trillions of dollars stimulus.

One reason we may not be at the absolute bottom – the Shangri-La for contrarian investors like ourselves – is fund investors are still adding money when the market seems to rebound, as they did in January (just in time to lose big in the following few weeks). We would still like to see a mega liquidation of perhaps even $200 billion or more in a month by fund investors for us to put all our chips in.

On a quite positive note, doomsaying is now a growth industry, a sure sign close to a bottom. Harry Dent Jr, futurist and publisher of "The Roaring 2000s" (Oops) recently penned the “The Depression Ahead”. Apparently these people are optimistic at Dow 14,000, pessimistic at Dow 7,000. Go figure. Making money from hot sellers is a rare feat. Even Peter Schiff’s timely book, Crash Proof" should be called “Crash Prone” when you consider his actual advice of buying foreign stocks and precious metal mining shares was a recipe to underperform the S&P 500 since the peak, a problem noted in a recent Wall Street Journal article.

You could make a fortune doing the opposite of successful investment books. If Dow 36,000 was a good sell signal, consider “Hot Commodities” as another. All these depression scenario books mean investing for a depression is not much of an idea going forward.

What is likely happening is the stock market (and housing market) is returning to low valuations. Over much of the last three decades stocks have had elevated valuations – relative to book value, earnings, sales, GDP what have you. This was the anomaly. Through most of recorded investment history stocks were cheap, like they are now.

Mathematically stocks have historically been probably a little too cheap, but this is why investors earned roughly 11% a year in stocks. Expensive investments lead to poor returns. Cheap investments yield solid returns. Over the last 30 years investing has become too popular – everybody was in on the game, with thousands of intermediaries offering their expert advice and products for a fee.

In theory stocks should be more expensive. They grow earnings and dividends, they can get bought out or merge at higher prices, are good long-term inflation hedges, and generally outperform all other investments (until everybody realizes how great stocks are like in 2000 and then you have a decade of destruction).

What is wrong with this theoretical valuation model for stocks – promoted in the last bubble by Dow 36,000 and Harry Dent, and in the more recent bubble by experts like economist Jeremy Siegel, Ph.D in The Bullish Case for Stocks? The problem is the economy is risky and susceptible to panic. Moreover, there are outright frauds that scare investors, and sometimes companies do such flagrantly stupid things that they can wipe out a 100+ year old institutions in a few months. Sometimes the hardest hit companies will start out looking cheap with low P/E ratios and high dividend yields.

Throughout much of our nation’s investing history people were scared of stocks (and to a lesser extent real estate). Gradually their fears subsided to the point where stocks and homes got expensive. Most professionals will tell you real estate is low risk/high return, and that over time buying always beats renting. The same economists recommending stocks in 2007 will tell you real estate wasn’t overpriced in 2005 "Housing Still Has Sturdy Foundation".

The great mistake is that real estate may be a better deal than renting over a lifetime at almost any price, but in the real world there are a number of risks that may make homeowners sell at inopportune times at prices 10-50% below where they should theoretically be. This ‘chaos’ risk means some caution should apply and homes should be cheaper then they mathematically are worth to reward taking on this risk. Stocks can be equally destructive. There are now scores of retirees who just took 50%-70% hits to their all-stock portfolio because stocks supposedly were always the smart move at any price.

The correct answer is somewhere in the middle of irrational exuberance and irrational pessimism towards investing. We recently passed through this middle ground in valuations and may be on the express train to irrationally cheap valuations. From here on down it doesn’t matter when you get in, if you have the time you will be rewarded – though the same risk of losing significant money in the short-run applies.

Why then didn’t we hold off and go all cash in 2007 rather than buy on the way down? Sure we fell much less than the S&P 500, but we still fell. The answer is we could have remained at elevated valuations for the next 30 years, all the while complaining about prices and earning nothing after taxes in cash. The only solution in our opinion is to be conservative near the top and aggressive near the bottom, since you never know exactly when this means you will lose some money on the way down.

This current environment could scare investors out of the market for ‘the long run’. We should now enter a period of a decade or more of valuations on the lower side of history. The game is about to get a whole lot more rewarding now that others are quitting or just have less money to invest. We are more excited about the potential future returns than at any time since the lows in 2002.

Having learned over the years that diversifying into various investment categories – international, small cap, natural resources, etc. – lowered downside risk, investors have been spreading their money around more than ever.

Top-selling investment books are often good indicators of what not to do with your money, as readers of Dow 36,000 can now attest. Before the 2008 debacle, authors penned best sellers on commodities, diversification, and portfolio building. Readers of such popular advice convinced themselves that this time the bear market wouldn’t bite.

But there was simply too much money pouring into too many areas for the markets not to collapse. After all, everybody couldn’t be right. The fund industry launched hundreds of new products – mostly ETFs – in an attempt to offer more diversification and targeting of portfolios than ever before. When was the last time we saw such a plethora of new fund launches? Right before the 2000-2002 crash. An arrival of new funds also heralded the arrival of two other bear markets – one in the 1970s and one that led up to 1929.

More Money = More Problems

Although the number of investing ideas climbs in overheated markets, the number of good ideas does not. This problem has grown over the past century because the world is richer following years of wealth creation. The trouble with this scenario? Greater wealth does not necessarily make for more quality investment opportunities.

The 2008 market crash destroyed more wealth than any before it (1929 the possible exception) because a large number of asset types fell sharply, including real estate, in which tens of trillions of dollars is stored globally.

The crash led to sharp selling of mutual funds – notably near the end of last year following the majority of the fall (hopefully). Some $230 billion dollars came out of stock mutual funds in 2008 – about 5% of assets - a huge chunk, historically speaking. More money left the market in the final months of ’08 than during the very bottom of the market in 2002.

Buckets of money have been poured into money market funds, in spite of recent troubles in that area (when a very large and famous money market fund "broke the buck" and actually began losing money for investors.) There's now more money in money market funds (around $4 trillion) than traditional stock funds (not including balanced funds).

Not only is this a remarkable statistic in and of itself, it also means it's very likely stock funds will become the place to be over the next few years.

Our optimism, as demonstrated by our increasing allocation to stocks in recent months, is tempered by the nagging fear that this might be the big one – the market and economic event so ugly it puts 50% or more of the money managers out of business.

Finance has grown too big, a point we noted a few years ago in our newsletter. Today's investors have grown weary of the roller coaster ride. If 2009 is as bad as 2008, we won’t need so many employed by the business of investing because there won’t be as many investors left.

As much as we’d like to see the overpaid investment bankers who created and sold now near-worthless mortgage securities forced to get a real job (good luck today…,) the probability of that happening is probably pretty low.

As for our own performance, while we're happy to have booked another S&P 500-beating year in all of our model portfolios, things could have been better.

Our portfolios' downward plunges ranged from 8-25% (compared to the S&P 500’s 37% hit.) Since early 2002, when we started our model portfolios, our total return is between 26% and 71%. The S&P 500 is down 10.75% for the same period.

Broadly speaking, our biggest mistakes were underweighting government bonds and cash (particularly in our more conservative portfolios) and a lack of good counter market funds in our more aggressive model portfolios.

We were also so excited to see investors finally bail out on stock funds that we moved into stocks and high-yield junk bonds a bit too early. We should have remembered from 2002 that you often have months to go from when the selling goes into overdrive before the rebound takes place. Plus, this time we're coming off a real estate bubble that makes the tech stock bubble look quaint by comparison.

Government bonds did very well in 2008. While we made money in bond indexes , we should have allocated a little differently, because government bonds were very unpopular. In fact, most pundits and experts recommended shorting government debt. The trick here is that government bonds are always fairly unpopular with fund investors. Wall Street doesn’t actively market them as ‘finished products’ since it's hard to rationalize an expert’s advice in picking, much less an expert's high fees and commissions. Why own a government bond fund with a 1% expense ratio anyway? Wall Street likes products that can handle high fees. That's one reason Bernie Madoff was so popular with intermediaries…

On the more aggressive side, we were disappointed by our funds that shorted stocks. Broadly speaking, there are no good funds that short stocks. There are a few acceptable ones (we’ve owned some). The inverse funds are suitable only for short-term trading, not longer-term strategies like shorting real estate, as we have for over a year now.

Call us old-fashioned, but when we shorted real estate in 2008 – the worst year for real estate-related investments on record – we expected to make money. The trouble is, these leveraged engineered short funds are designed to move in daily inverse to some benchmark index, not over long periods, which is what we want. If the index moves a certain way, you can actually lose money on a short fund, even if the index is down for the month, as was the case with a short emerging markets ETF we owned during one month last year.

Gripes aside, we have some short funds that were up around 300% and greatly reduced the downside from our long positions. We’re working to fine-tune this strategy – perhaps with more active trading – though if the market continues down, there may not be much more opportunity to short.

Here’s looking forward to 2009, and another year of our stock-heavy portfolios beating the S&P 500. Let’s see if we can make it 7 out of 8.

“I will not fall for the NEXT bubble;”
“I will not fill my client’s portfolio with popular, high commission investment products;”
“I will not automatically assume any investment that triples in price will continue to go up;”

and sadly, even:

“I will not park 90% of my client’s money with a guy who has an unverified and mysterious money making machine because it may turn out to be a Ponzi scheme.”

No the investment community looks at the new year as an opportunity not as a time to reflect and prevent future errors, but to make prognostications about the future. Unfortunately such forecasts are significantly less likely to occur than ‘eating less and exercising more’ and only slightly more likely to occur than ‘This year I will date a super model..

As we don’t want to shake up this status quo, it is time for us to make our ownpredictions.. Unlike most prophets, however, our past predictions have been pretty prescient:

2008: China is in a bubble about to burst

2007: All the new fund launches mean stocks are going to underperform for the next few years

2006: Long term interest rates are not going up

Of course, we’ll stand behind all of our other musings that were not made at the beginning of the New Year, like our ‘Fannie Mayday’ article from 2004 (which offered plenty of advance notice before the Government’s bailout), and our more recent “Peak Oil” article two months prior to $140 oil – the very peak of the commodity bubble.

But enough about the past- if we were truly brilliant our model portfolios would have been up in 2008 instead of down (though markedly less than the S&P 500). This year we’re going to touch on some broad ‘macro’ issues, things to watch out for as the year unfolds.

Deflation makes inflation seem like a walk in the park

Investors have (until recently) spent mostof the last few decades worrying about two things: skyrocketing interest rates and a substantial increase in inflation. Why else the flood of adjustable rate and commodity-oriented or ‘real return’ investment products? Can you think of ONE investment product engineered by Wall Street to offer investors salvation from deflation?

Maybe investors remember the 1970s market but not the 1930s market. Maybe investors just like to worry about more recent problems – Lord knows Wall Street mostly invents products that would have been great ideas had they existed a few years ago.

Well, interest rates have continued to slide – just a few days ago the yield on the ten year government bond dropped down to about 2% before rebounding, scorching those who recommended ‘shorting treasuries’ these last few months. Why the continued conundrum? Oil at $140 and fears of ‘stagflation’ were a fantasy that diverted billions into money losing ‘Jim Rogers’ style commodity investments. Deflation has been the real danger all along.

Deflation is a general decline in prices, and can be far more damaging than inflation. Imagine you’re making $150,000 and year and you buy a home for $500,000 with a $400,000 loan only to see the home and your income decline by 20%, while your loan balance remains at $400,000!

Deflation hurts debtors. In the extreme it doesn’t even benefit creditors because the debtors can’t make payments - much like an adjustable rate loan is great to the creditor if rates go from 4% to 6% because the payments will go up, but not so great if the rate goes to 25% because then the payments to the creditor go to zero. Worse, with deflation, the asset behind an asset backed loan is falling in value.

This deflation bugaboo is one possible explanation for the rush to government debt (besides the well documented flight to safety). At least Uncle Sam can make the payments (so far, so good).

Deflation deflates stocks as well. What value is a $100 billion market cap company that used to earn $5 billion a year when they can now only earn $2.5 billion because of general price declines? About $50 billion – and that’s if investors panic and other economic problems related to deflation don’t push the company down to $20 billion in value.

Everything is cheap unless the economy cheapens

Most experts now agree, stocks and bonds (except treasuries) are really, really cheap. We’d agree too, except for our natural fear of conventional wisdom. Perhaps the stocks and bonds are correctly priced, the economy is expensive.

While it hasn’t happened since the Great Depression, it is possible the economy could contract by double-digits. Maybe we don’t need so many car dealers and retailers in the new world order. Heck, we once had dozens of different U.S. car companies.

If the economy doesn’t shrink, stocks should do fine. But just because the economy hasn’t shrunk much in decades doesn’t mean it won’t. Heck, many things happened in 2008 that hadn’t happened in decades – commodities plunging 50% in a few months for one.

Popular investment ideas will continue to destroy capital

The Rogers quote we like is from Will, not Jim, “It isn't what we don't know that gives us trouble, it's what we know that ain't so.”

2008 was the year that disproved some bad investment theorems that had gained widespread acceptance just in time to destroy some serious money. 2008 investment lore included such zingers as:

A diversified portfolio always lowers risk and increases returns
Commodities are an uncorrelated asset class that smoothes outs the bumps and offers upside when stocks and bonds sink
Gold and gold mining stocks are the perfect hedge against financial catastrophe
America is a nation in decline, move out of the U.S. dollar
Real estate has never fallen nationally
Emerging markets have decoupled from big countries like the U.S. and can deliver solid returns to investors even while the U.S. sinks
Buying companies with borrowed money today is much smarter than it was in the 1980s

Real Estate Crash Year Four: It Ain’t Over Until the City That Packaged and Sold Real Estate Securities Collapses

New York City real estate is currently ‘only’ down about 12% from the peak - as opposed to a near 50% haircut in Miami, Vegas, and some other warm places, but there is almost no amount of government support that can keep a brand new million dollar one bedroom condo from falling to a mere $500,000 when Wall Street sheds more jobs than a automaker running out of lifelines from the government.

Bailouts Go From Trickle Down To Trickle Up

2009 is the year bailouts will move firmly from the supply side of the economy (loans to banks, car companies, etc.) to the demand side (money to consumers, not producers). With a world teetering on deflation from lack of what very dull people would call aggregate demand, this may make some sense – if government plans for a better tomorrow ever make any sense at all.

Unfortunately 2009 will also be the year where the strings attached to getting a handout go away. A well structured bailout would carry egregious enough terms that only the truly destitute would apply – in fact many currently healthy banks did not take government money.

Bailouts go to the needy. Handouts go to anybody.

With housing, an example of a well structured ‘hard to swallow’ bailout would be something like offering homeowners a lower interest rate and lower principal mortgage in exchange for a higher capital gains tax rate on the eventual sale of that home and turning the mortgage liability into a federal obligation that cannot easily be ‘walked away from’. Such terms would keep most homeowners not in serious jeopardy of losing their home far away.

A handout would be a freeze on foreclosures, co-pays by the government on mortgage payments (don’t worry its coming) and other monies that punish renters and those that didn’t load up on no-money-down condos in 2005.

In 2009, as bailouts become debtor welfare, a (debt laden) friend in need is a friend indeed. A banker in need is a fiend in tweed…

In closing, 2008 is the year (by our own back of the envelope calculation) that has turned more billionaires into millionaires than any year in history. 1929 may have turned more millionaires into thousandaires, but we’ll never really know for sure.

And all those old urban myths from the Depression that professional investors and other high fliers committed suicide when the market tanks. Well it (gulp) turns out there is some truth to those stories…