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Finding Value in a World of Misdirected Liquidity

The issue with writing a newsletter rooted in the common sense of value investing is that though the circumstances of our economic landscape are ever adjusting, the long-proven principles of wealth management do not change. Thus, in "frothier" times such as these, common sense becomes less common and can begin to be viewed as passe by the readership. Human nature inherently ebbs and flows with the misdirected exuberance and despair of the crowd (herd mentality). Moreover, human nature is restless and seeks change at what is often the worst possible time. Often, the clarion call of remaining patient and conservatively positioned in an overheated, overvalued market can be drowned out by the excitement of the most recent market direction. The pain of the last recession becomes a distant memory, and people begin to believe that this time really is different. Investors begin to feel as though they are "missing out" or being "left behind," and here I am, still writing the same boring things about remaining patient, waiting for value, and not getting involved in overvalued investments.

So, with that being said, I am tired of all of that "be patient" stuff! I want to shake things up with a more exciting approach. I have decided to chuck those conservative, long-term principles of wealth management out the window. So here goes...

...NOW is the time to INVEST! Don't Miss The Gravy Train! In this letter, I will teach you my SIX EASY STEPS to GET RICH QUICK. I will also let you in on a little known secret the big boys of Wall Street don't want you know! Do you want to print money FOREVER without having to lift another finger? I'll show you how! Finally, I will share with you a Silver Mining company located in Timbuktu that has found the 36 hour cure for cancer and has a well-known Billionaire placing a huge bet on its success. This penny stock is poised for MAJOR GAINS in the NEXT 12 MONTHS! Don't miss out...

...only kidding! I just had to get that out of my system. I am so tired of all of the trash put forth as "investment advice" that regularly buffets our clientele. At worst, these are scams intended to rip investors off; at best, they are severely misguided cheerleaders of unproven, unprofitable "strategies" to "get rich quick." I think I will stick with long-proven principles of wealth management, and I will make sure that this letter continues to encourage you to do the same.

Bottom line: Fundamentals remain very weak. The temporary liquidity created by the Federal Reserve through QE2 and the elevated misperception of market health took the stock market to the exact overvalued price range I cited in the last newsletter. As the misperception of recovery is introduced to the reality of a weak underlying economy, I anticipate very little remaining upside in the markets and a lot of downside that we will begin to experience right around the corner and throughout this summer. While I am not sure whether we will begin this downward move this May or whether there remains enough exuberance to carry us a little higher through August, I believe rather strongly that we are very near the end of this rally in terms of price and time. The impact of a major risk reversal will be farther reaching than just the stock market, so buckle up!

The rest of this letter will cover the economic impact of excessive liquidity and positive consumer sentiment, the effects of a major risk reversal, and the differing economic outlooks that may exist due to market and Fed reactions to this potential liquidity crunch. Finally, I will wrap up with an update on some of the current positions we have been taking to protect our downside from shorter-term deflation, prepare for longer-term inflation,and take advantage of the higher return opportunities that have been created in this recession.

What Happens When Liquidity Replaces Value?

At the end of 2010, I predicted that the market would probably rise into the first quarter to the mid-12,000s for the Dow and to the mid-to-upper 1,300s for the S&P. I also predicted that we would see the markets start to head lower towards the end of the first quarter. That drop was on time, starting towards the end of February, but short lived, only dropping 6.4% and lasting through March. I do not believe that this first drop relieved the downside potential or overvaluation prevalent in this market. Instead, it gave renewed confidence to investors that "this rally had legs," correcting the drop and rising to the upper range of the last newsletter's estimate. So what has fueled this recent surge?

This is a market driven by a consumer sentiment that has begun to hit all-time highs of exuberance and bullishness. The Federal Reserve encourages this behavior by standing ready to spike the punch bowl if there is the faintest hint of any economic hangover. Though it may last a bit longer, itis neither the foundation of a new bull market nor the reflection of an improvement in market valuation. Instead, it is the extension of irrational excitement, facilitated by excess liquidity (read: Fed creating credit out of thin air and devaluing the dollar), which is then "validated" by the rise in unison of many asset classes across the globe. We are reaching the end of this market move and there are major red flags worth noting.

Retail investors sat on the sidelines through the first year and a half of the latest rally, cynical of the market's movements following the March 2009 lows. Hindsight being 20/20, this would have been the ideal spot for a shorter-term stock buy if any were to be made. Instead, retail investors waited until just about 6 months ago, after the markets experienced 73-80% in gains from the lows, to start piling back into stocks at much higher and more overvalued market levels. What validated their unfortunate timing? The market prices themselves. Investors did not want to miss out anymore. So they are getting in towards the end of the rally, just in time for the smart money to exit and leave the retail investors holding the bag.

This unfortunate phenomenon of bad timing is illustrated in Figure 1 below, which shows net inflows of stocks and bonds. When investors place more money into stocks than bonds, the area chart spikes above 0. When bond investing outpaces the volume of stock investing, the area chart spikes below 0. Though it took more than 3 years to have investors favor stocks over bonds again, the switch back finally occurred just this past November, and the timing could hardly be worse.

Figure 1
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Net Mutual Fund Flows Data from the Investment Company Institute:
S&P 500 Data is sourced from

Given the fact that the last point at which investors favored stocks to this degree was the period right before the recession and extended stock market drop, this recent rush by retail investors to add stock exposure is a major sign that we are near a market top. Since the recent price action in stocks, gold, silver, oil, agricultural commodities, and junk bonds(to name just a few of the major asset categories) has been fueled primarily by excess liquidity and overextended consumer sentiment, what happens when that liquidity becomes scarce and consumer sentiment retracts to the other extreme? The answer: a flight to safety, a strengthening of the Dollar, and a violent price correction of those asset classes that benefited the most from excessive liquidity created by artificially low interest rates and intentional Dollar devaluation.

US Dollar: Death or Dearth?

Though investors may agree that many asset classes may be overdue for a correction, they cannot fathom the prospect of a temporarily strengthening US Dollar. With the Fed's printing and the government's borrowing and spending, how could the Dollar do anything but go down? While I sincerely believe that the Dollar's longer-term prospect is an ongoing, deliberate devaluation (inflation) that will continue to take the Dollar to ever lower levels of value, the reports of the Dollar's near-term death are greatly exaggerated.

Figure 2
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US Dollar Data Sourced from The Federal Reserve Board:

For all of the media attention the Dollar's demise is attracting, the Dollar is approximately 5% higher than it was back in the lows of April of 2008 (see Figure 2)--which was the last time the Dollar was supposedly on the brink of a death spiral into hyperinflation. From the lows in 2008, the Dollar spiked more than 20% back into the upper 80s, reflecting a deflationary liquidity crisis and the market crash of 2008-2009. Then, the effects of the Stimulus and Quantitative Easing 1 temporarily relieved some deflationary pressure by providing shorter-term liquidity in an illiquid market, sending the Dollar 15% lower from its recent highs. These inflationary effects wore off through the summer of 2010 and culminated in the Flash Crash and additional signs of deflation in the housing and bond markets, spurring a 17% increase in the Dollar in approximately 6 months. Rumors and then the reality of Bush tax cut extensions,along with Quantitative Easing 2, infused additional liquidity into the system to temporarily stave off the deflationary headwinds, sending the Dollar back down 17%.

Though it sells more newspapers to hail the end of the Dollar as we know it, it is far more likely that the Dollar is simply reaching the bottom of a trading range that has been in effect for more than 5 years. Given the fact that the entire world is convinced that the Dollar is doomed, now would be the ideal time, in my contrarian way of thinking, to build positions that benefit from a temporary resurgence of Dollar strength and avoid positions that react negatively to its strength. Mind you, I do not believe that deflation is here to stay--inflation WILL eventually return with a vengeance and the Dollar will continue its historical path of devaluation--but until we get through this extended deleveraging cycle, the ongoing risks of deflation will be with us. Deflation leads to a dearth of Dollars, not the death of the Dollar, and it will not deal kindly with those who are unprepared for its destructive effects.

Figure 3 below shows both the deflationary and inflationary effects of the Dollar's trading range. As the Dollar weakened, stocks continued their rise. As the Dollar strengthened, stocks dropped precipitously.

Figure 3
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US Dollar Data Sourced from The Federal Reserve Board:
S&P 500 Data is sourced from

Now that we are poised for another bout of deflation and Dollar strengthening, it is highly probable that the market will reverse course and head lower. Deflationary spikes tend to be more violent than inflationary trends. Therefore, as in the crash of 2008-2009 and the Flash Crash of 2010, it would behoove investors to not expect much of a warning from the markets when it is time to exit. Consider this your fair warning. Now would be the time to either exit the markets to sidestep the downturn or to place stops or trailing stops in all of your equity and commodity exposure. If it is liquid, tradable, and benefits from a weaker Dollar, I believe that it will be susceptible to a deflationary spike.

The Shorter-Term View (A Potential Framework for the Next 6-18 Months)

The Battle of the "Flations": I laid out much of the theory and definitions of inflation, deflation, and stagflation in my first JRW newsletter. At that time, I was amazed by the Fed's commitment to buy over $300 Billion of our government's debt. Little did I know that we would see Quantitative Easing 2 and a doubling of those purchases over the last several months. This just goes to show the incredible power of deflation--it has been able to absorb most of the excess liquidity created by the Fed and the government through multiple quantitative easings, stimulus programs, and bailouts (all of which are highly inflationary in and of themselves).

Figure 4
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A little under two years ago, I predicted that instead of experiencing inflation or deflation, we would experience the confluence of inflation and deflation, which would result in stagflation (see Figure 4). In that letter I wrote, "Stagflation is the combination of deflationary economic stagnation/contraction and inflation of the money supply at the same time. Stagflation occurs when the government attempts but fails to reverse an economic downturn by inflating the money supply. The result is a depressed economy AND a devalued currency." I believe that this continues to describe exactly what we face today. The economy remains weak despite the government's ongoing efforts to create liquidity by inflating the money supply. That which we do not need continues to decrease in price,and that which we cannot live without continues to rise in price due to the government's attempts to devalue the Dollar in order to spur recovery.

Though I believe that inflation will win the war in the long run, deflation will win many of the battles in between. The Dollar trading range and the overwhelmingly negative sentiment towards the Dollar are pointing towards a contrarian rebound in its strength. I believe that this Dollar resurgence is in the early stages and that the larger move will likely occur sometime over the next several months--and that stocks, junk bonds, commodities, etc. will be negatively impacted by this Dollar move.

Depending on the size of the market correction caused by this Dollar resurgence, the Fed may step in to introduce QE3. Congress may introduce another stimulus, bailout, or tax cut. Due to these types of reactionary policies,we may see another inflationary period much like the last 6-9 months that follows this market correction. I believe that we will see this trading range and market volatility continue (See Figures 2 and 3) so long as the causes of deflation are prevalent and so long as the government and the Fed are committed to battle these deflationary forces with inflationary policies.

This ongoing tension and trading range is the easier call.The long-term call that inflation will eventually be reestablished as the primary trend is also an easy call, given that 96% of all of human history has been ruled by inflation. So long as the forces of deflation are prevalent, the difficult medium-term call to make is whether or not we will have a sustained deflationary recession patterned after periods of the Great Depression and the crash of 2008-2009 OR an inflationary stagnation (i.e., sustained stagflation)much like what we experienced during the 1970s. A much-less-likely scenario that I hope for but do not believe to be likely would be a moderate-to-high inflation coupled with a slow but sustainable economic recovery. Since hope is a faulty foundation for investing, let's see what the evidence is for the first two scenarios and just be pleasantly surprised if the third scenario becomes our reality.

The Medium-Term View (A Potential Framework for the Next 1-5 Years)

Deflationary Forces: Until we flush the system of the majority of bankruptcies, foreclosures, credit defaults, credit write-downs, etc.--and until we make real, sustained progress in unemployment and wage growth--the risk of deflation is not off the table, and inflation is unlikely to take off unabated.

Inflationary Response: The Fed knows these deflationary forces well and is committed to introduce policies that will combat these forces by attempting to devalue the Dollar through lower interest rates and credit creation. For better or worse (worse, I assure you), the Fed would rather create inflation in its battle against deflation than face deflation in order to avoid inflation. When the Fed and Congress work together to introduce inflationary policy, they can be quite effective in the short run(see the effects of each round of stimulus and quantitative easing in Figure 2 and note that these policies occurred at or around the same time in each period to battle the effects of deflation).

Since deflation is here to stay until our economy's massive deleveraging cycle reaches the end of its course (i.e., when the majority of people, companies, banks, cities, and states have finally gotten rid of the debts they cannot afford to pay) and since inflation depends on the arbitrary policies and timing of the government, deflation is currently the constant and inflation is the variable. For inflation to have a fighting chance in the presence of deflation two primary conditions must be met concurrently. 1) There must be a unified policy commitment between the Fed and Congress AND 2) the policies introduced must remain effective to create additional credit that produces a material inflationary result. As explained below, both of these conditions are on very fragile ground and cannot be taken for granted.

  1. With regard to a unified policy commitment, the Fed is committed to inflation (as a part of its explicit policy and mandate), and Congress is committed to be reelected. Most of Congress frankly does not understand the inflation/deflation tension and thus will be more likely to be guided by the fluctuations in the stock, bond, and housing markets and by the political mood, whims, and herd mentality of the public at large. Therefore, Congress is the wildcard in terms of policy commitment. Should it become political suicide to extend another stimulus, bailout, spending, or debt ceiling increase--or to allow the Fed to autonomously devalue the Dollar without oversight or control--it is highly likely that Congress will reverse course,take on a more anti-inflation tone, and hamper the government's policy response to the effects of deflation. The public backlash that may eventually sway congressional support is clearly growing with each new proposal of stimulus and quantitative easing.
  2. With regard to policy effectiveness, even if the Fed and Congress remain consistently committed to the same inflationary policies, this does not mean that these policies will remain effective in avoiding deflation. The Fed is openly admitting recently that each round of quantitative easing and stimulus is becoming less effective in spurring economic "growth" and inflation. I suppose that this should be expected when we attempt to reverse a massive deleveraging cycle with more debt!

A Primarily Stagflationary Scenario: If the government continues the attempt to avoid the consequences of our excess with additional inflationary policies, this will likely result in longer bouts of stagflation and a delay of the deflationary recession that lies ahead. Basically, we will face a path that repeats or strongly resembles the last 5 years with increased volatility, economic weakness, greater instability, and wild price swings in the Dollar, commodities and asset prices. Our government debt will skyrocket as we will attempt for a time to backstop, bailout, and reverse the financial distress of people,companies, cities, and states. In this scenario, interest rates are likely to go up as creditors become concerned about the higher debt levels assumed by consumers and governments alike.

The risk would be a deeply depressed economic and employment base, higher-priced consumer staples in a lower wage environment, a debt burden that is unsustainable and that created a drag on our future growth, and higher taxes to pay for the additional interest and debt carry costs assumed in the bailouts and stimulus programs.

The reward would be that all of these inflationary policies would potentially dampen and spread out the effects of a deep recession so they are not experienced all at once. In the long run,this will result in greater instabilities as private debts will not be dealt with, but will instead be shifted to public balance sheets. As Europe is painfully discovering, bailing out companies and banks quickly turns into bailing out countries.

A Primarily Deflationary Scenario: If the government does not or cannot continue along its inflationary warpath (for the likely reasons of political suicide or impotence),we will face a nearer-term deep but shortened deflationary recession akin to the one experienced in 2008 and 2009. We would experience price decreases across the board in needed commodities and especially in superfluous ones.There would be widespread defaults, bankruptcies, foreclosures, write-downs,etc. The system would be flushed of overcapacity and inefficiency, and prices would correct to a level that would naturally induce (or, might I dare say,"stimulate") consumer purchases. (Imagine that, buying things we can afford!) Interest rates would likely remain depressed as investors will pay a premium for perceived safety.

The risk would be a recession that will over correct--perhaps causing even weaker companies to fail that might have otherwise survived in an inflationary environment. This would be a very deep, painful recession as it will be correcting much of the excess leverage that fueled our "growth" from 2001-2007.

The reward will be a MUCH shorter recession and a much stronger eventual recovery built upon a more stable base of growth. Much of the debt overhang that weighs down the typical consumer, as well as our local and state governments, can be restructured or even wiped out in bankruptcy. Our Federal government debt would not need to grow exponentially to falsely and ineffectively "stimulate" the economy.

Most Likely Scenario: My guess is that the Fed and Congress will fight deflation tooth and nail against deflation with inflationary policies. IF (and that is a big IF) we are temporarily "successful" in our inflationary endeavors, this will result in wild swings from deflation to inflation, seen in ongoing price spikes in the items that we need (food, energy, health, etc.) while the economy struggles to produce anemic growth (measured as "growth" rather than "contraction" in only nominal terms). Deflation will still continue to rear its ugly head, resulting in wild swings back from inflation to deflation. Essentially, the next several years will look very much like the last several years (deflationary swing down in 2007 through the beginning of 2009 => inflationary swing up until the summer of 2010 => deflationary swing down into the fall of 2010 => inflationary swing up until the spring of 2011).

A decade later, we will have likely taken several round trips to or even beyond the highs and lows of our most recent trading range (6,500-13,900 on the Dow and 666-1,450 on the S&P 500) without making any real progress. The likely result will be another lost decade for investors in many asset classes. The effects of the recession will not be avoided but will simply be spread out over a longer period of time, leaving our economy weaker much longer than necessary and saddling our state and federal governments with tremendous burdens of debt intended to stimulate the economy back to strength. Commodities and consumer necessities will become grossly overpriced in nominal terms, placing an ongoing damper on economic growth and unnecessarily redirecting trillions of additional dollars of capital from productive investment towards survival. Retail investors will be stuck with either dismal interest rates on their savings or volatility that would cause a seasoned trader to experience nausea.

In light of the congressional wildcard and longer-term policy ineffectiveness, I do not believe that we will be able to indefinitely avoid the consequences of the excessive debt binge we experienced from 2001-2007. Eventually, I believe that we will probably still end up dealing with the massive deflationary recession we were trying to avoid in the first place, causing much of the prior excess to be destroyed in a combination of bankruptcies, debt defaults, write-downs, foreclosures, bailouts, etc. We will just have a lot more wasted time, bureaucracy, debt, unemployment, excess capacity, etc., not to mention a MUCH deeper eventual recession.

Don't Jump Yet!

After a somber section such as the last, you may be reading the rest of this letter from the safety of your new bomb shelter, armed with enough food, water, and ammunition to get you through the pending apocalypse. It might surprise you to know that not despite of, but because of all of the bad news, we are downright excited. More now than ever, we are seeing incredibly discounted investment opportunities that we and our clients are provided due to the market distress. We have formulated and executed a very clear plan throughout this recession on behalf of our clients and we have positioned ourselves in some of the most opportunistic investments that we have seen since the RTC days in the early 90s. We have been acquiring cash-flowing investments for 20-50 cents on the dollar and far below replacement cost!

We have been targeting significantly discounted, income-producing assets that were affected severely by the deflationary liquidity crisis of 2008-2009.Our approach is paying off, and we are now reaping the fruit of our initial acquisitions.We have currently stabilized and added tremendous value to the distressed assets that we purchased just last year. Given the economic landscape, it looks like this opportunistic window will be available to us for at least the next 12-24 months.

JRW News and Updates: Since the writing of the last newsletter, we have closed and begun stabilization of five more bank-owned/opportunistic assets for our clients, with one more just about to come out and several more coming down the pipeline. We continue to facilitate alarge number of 1031 and 1033 exchanges, and we have been blessed with many of your referrals to clients looking for estate and retirement planning or a place to invest their cash and IRA capital. Due to several of your suggestions, wewill be launching a client services email update that will summarize any important information having to do with any investments you have made with JRW. Needless to say, we have been busy!

Please do not hesitate to let us know if there is anything we can do to better serve your needs. If you have any particular questions about this newsletter or other related topics, please feel free to contact me via email at or on my office line at (877) 564-1031 ext. 112. If you would like to review currently available investment opportunities, or if you would like one of my past newsletters or PowerPoints, feel free to contact Susana Dryden, our Director of Client Services, at or her office extension of 144.

Best Regards,

Joshua Ungerecht - Chief Investment Officer - JRWInvestments, Inc.

Written By: Joshua Ungerecht