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Copyright 2009, HS Dent Publishing

January 2, 2009

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HHSS DDeenntt

In brief: A U-shaped bottom continues with manypotential reverse head-and-shoulders patternsforming. We appear to be breaking out of a shallowright shoulder on many charts generating a new buysignal especially now that the Dow broke above 9,030late today, 1/2/09. The markets look like they could

get quickly overbought here so that it is more likely we will rallyback to recent highs between 9,650 and 9,800 and then see anothercorrection from mid- to late January into February back to 9,100 orlower before we head towards stronger resistance around 10,700 –10,865. Hence, there is likely to be a second buy signal ahead.

We are probably seeing a hybrid of our previous Scenario 1 and 2patterns. A further meltdown of the banking system as in Scenario2 is not happening, but the recession rapidly continues to deepen,with at least minor deflationary trends likely into the summer. Atthat time we are likely to see a rebound that could be stronger ormilder with some inflationary trends and a strong bounce incommodities. However, the recent break at $38 in oil largely rulesout new highs predicted per Scenario 1. But oil appears to bemaking a major reversal higher after trading down as low as $32with the high volume rally to $44 on 12/31/08 with follow throughto $46 on 1/2/09. We advise buying oil on pullbacks, especially ifwe see $41.50 near term. We are more likely to see a bounce tosomewhere between $80 and $110 and possibly to as high as $130to $147 if we see major problems in the Middle East in late 2009 toearly 2010 as we expect. Tensions are already building betweenIndia and Pakistan and between Israel and Hamas. Will Iran haveto cause problems just to get oil prices back up to avoid a financialcollapse?

The real depression, with major bank failures and very deepunemployment and deflation, will come between mid-2010 and mid-2011, with aftershocks likely well into 2012 or even early 2013.Between now and then we are likely to see the Dow rally to 10,850to 11,650 between April and July 2009—and then another crash ofthe magnitude we just saw will follow between late 2009 and late2010. The markets ultimately will fall again as consumers run outof steam and as the U.S. government finds itself pushing on a string

Summary forecasts for the coming year

The Economy: Sliding Fast andWorldwide

Recalibrating the Spending Wave

New Strategy: Fed Targets LowerTreasury and Mortgage Rates-Disaster forDollar?

Oil Breaks $38, Making New HighsUnlikely but Still a Great Hedge Againstthe Dollar

Stock Scenarios for 2009 and Beyond

Bond Markets Gone Wild!By:Rodney Johnson, President

Book Review and Commentary: TheAge of Aging

By: Charles Sizemore, CFAFor Cities and States, It's About To GetUglier

By: Charles Sizemore, CFASector Allocations and Updates

By: Rodney Johnson, President

Feature ArticlesThe Economic Guide for Effective Financial Decision Making

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New Buy Signal as Dow Breaks above 9,030:Choppy Rally to 10,700 to 11,650 by April toJuly 2009; Crashing Dollar Likely to Trigger

Reversal of Stimulus and Next Crash

New Session of Demographics SchoolMarch 6-7, 2009 in Tampa, FL!

Renaissance Hotel International PlazaSee Page 32 For Details!

On Sale Now!!

Buy Harry Dent’snew book through

Amazon.com.

© Copyright 2009, HS Dent Publishing

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harry s. dent, jr.

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January 2, 2009

and/or running out of ammunition while the dollar ultimately crashes,if the government just keeps stimulating with abandon—and that seemsclearly to be the plan! If we do see substantial inflation and commoditypressures, then that will curb the government’s ability to keepstimulating itself out of this inevitable depression.

The year 2009 will be the year of “hope,” with Obama as itscheerleader. But such hope will be dashed as we move into 2010,despite massive but irresponsible efforts by the government tostimulate the economy. This deflation and deleveraging wave isbigger than the government can stop, and its position iscompromised by high foreign debts and extreme budget deficitsand domestic debt. But more importantly, the baby boomgeneration is set to decrease its spending more dramaticallybetween early 2010 and 2011 and long forecast deflation trends aredue to set in from their accelerating retirement, only to beexacerbated by rising unemployment. A reckless stimulus planshould quickly take its toll on the U.S. dollar by late 2009 to early2010 and force the government to reverse its policies, whichmeans deflation will resume on a greater scale in 2010.

Summary forecasts for the coming year:1. The Dow rallies to 10,700 to 11,650 between April and July2009 before falling to 3,800 to 5,000 by late 2010.

2. Oil rallies to $80 to $110 and maybe higher between October2009 and May 2010 before falling to $10 by late 2012.

3. The CPI falls to -1% plus by August 2009 and then rises intoearly 2010 before falling to -10% plus by mid-2011.

4. 10-year Treasury rates rise in 2009 to as high as 4.8% by earlyto mid-2010 and then fall again between mid-2010 and 2012 tonear 1% on the 10-year Treasury bond.

5. Unemployment reaches 9% to 10% by the end of2009, on the way to 15% to 16% by mid-2011 or2012.

The Economy: Sliding Fast andWorldwideIn the last issue we noted a divergence between theWeekly Leading Index in Chart 1 and the yield curve. Therapid deterioration of the economy continues to supportthe Weekly Leading Index and its forecast of a recessionthat is somewhat worse than the recessions of 1974 and1982. Note that this indicator finally paused recently andmay finally be starting to head up again, and it should ifthe markets have bottomed and are heading upward formonths as we expect. If it does not, that would certainly Chart 1

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harry s. dent, jr.

www.hsdent.com

January 2, 2009

not bode well for the economy and this stock rally. Joblessclaims in Chart 2 have recently risen to more serious levels(586,000 in late December) than in the 1990-1991 and2001 recessions after staying closer to 500,000 for months.They will certainly rise substantially in the months ahead.Japan recently has reported dismal industrial productionand export numbers as well, and China continues to slowmore toward 4% to 5% growth rather than 6% to 8%,indicating a worldwide downward deceleration. TobinSmith at ChangeWave has good monitors of consumer(Chart 3a) and business activity (Chart 3b), and both showa rapid deterioration in the U.S. economy.

The housing markets continue to fall both in price and insales volume, despite record low mortgage rates now near 5%. However, most mortgage applications are forrefinancing, not for new purchases (Chart 4). So, as

Copyright 2009, HS Dent Publishing

Chart 2

200,000250,000300,000350,000400,000450,000500,000550,000600,000650,000

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Jobless Claims

Source: US Dept of Labor

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Overall Consumer Spending

Source: Change Wave Research Chart 3b

Overall Corporate Quarterly Survey

Source: Change Wave Research

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Mortgage Applications

Source: Investor’s Business Daily


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harry s. dent, jr.

www.hsdent.com

January 2, 2009

occurred in Japan in the 1990s, lower interest rates donot mean rising home purchases when a large generationis aging. The months’ supply of new homes (Chart 5a)and existing homes (Chart 5b) are still very high, bothover 11 months’ supply, despite falling overall inventoriesdue to low sales levels. Perhaps the most telling sign isthe rapid deterioration in auto sales, including even thoseof Japanese automakers, who have more than amplecredit to extend. Tightening credit clearly has been amajor factor in slowing home and auto sales, but whenthe Japanese see auto sales slow by 30%, it indicates thatconsumers are either really scared, really tapped out, orboth.

Recalibrating the Spending Wave

Given the growing depth of the current recession, we arereevaluating the lags on our Spending Wave andconsidering whether we actually saw a peak long term indemographic trends of consumer spending in late 2007.First, let’s start with a little history. There has alwaysbeen an ironclad correlation between the double peak inthe stock market (adjusted for inflation) in late 1965 andlate 1968 and a 44-year lag on the Birth Index (withdouble birth peaks in 1921 and 1924). When we firstconstructed the Spending Wave in 1988, we assumed a46-year lag for the 1980s forward, in line with rising lifeexpectancy and average age at marriage. That actuallyput the projected peak for our economy in late 2007. Onpage 16 of The Great Boom Ahead, we stated that “thenext great depression would occur between 2008 and2023.”

But in the mid 1990s, we started moving the lag forward 1 year everydecade until it reached a peak in spending at age 48 in this decade,around late 2009. We had better information from the ConsumerExpenditures Survey, which clearly showed a double peak between age46 and age 50—or an average of age 48. This is not meant to be aprecise indicator, but instead a broader one. What we really have in thepast decade is a plateau of Baby Boomer births peaking between 1957and 1961 (1959 on average) and a peak in spending between ages 46and 50 (average of age 48). If you put those two averages together youwould get an overall peak in spending more around late 2007 than late2009, but also would get a broader plateau between late 2003 and late2011. If we assume that the real peak in spending occurs at age 46 and

Chart 5a

Months’ Supply of New Homes


Chart 5b

Months’ Supply of Existing Homes



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January 2, 2009

moves downward to sideways until it falls off after age 50,then this peak occurs around late 2007 rather than late2009.

Chart 6 assumes a current 46-year lag, with a lag of 44years in the 1960s and lags of 45 years in the 1970s and1980s. We keep the peak at age 46 during a down periodin the 2020s and then raise it to 47 in the 2030s and2040s and 48 in the 2050s forward. This slightly revisedchart correlates better with some key cycle trends wehave, including a rebound into late 2017, which nowcorrelates more with the minor birth rise between 1968and 1970.

Note in Chart 6 that, adjusted for inflation, stocktrends are likely to move sideways for many decadesas we see the maturation of the first generation thatis not larger than the last. Equity investors will see anew environment wherein they have to focusoverseas to see strong appreciation long term, incountries like India, and wherein domestically youbuy solid companies that generate solid cash flow anddividends in return rather than never-endingappreciation. We have been saying for years that the1990 top in Japan was not likely to be seen again inour lifetimes. It is possible that the Dow will notexceed or will not much exceed 14,280 in ourlifetimes—and this forecast is more likely once thenumbers are adjusted for inflation.

If this new 46-year lag is more correct, then the greatestfalls in consumer spending will hit in 2011 and 2012, making thegovernment’s efforts to stimulate more and more fruitless. Even if thecurrent 48-year lag is more correct, then Baby Boom spending wouldstart to drop off more broadly (as opposed to declines only in homespending) from 2010 onward. If we see a weaker response to such astrong stimulus program in late 2009 to early 2010, then we will startto assume that the 46-year lag is more accurate for the SpendingWave—and again this would indicate that the economy will stay weakinto 2011 to 2012. If the past 48-year lag is more accurate, then weshouldn’t see weakness until around early 2010 and the economy wouldstay weak into 2013-2014 before starting to bounce. Either way, ourinflation forecast in Chart 7 continues to show that Baby Boomerretirement (as opposed to slowing in spending) will shrink the workforceand will lead to rapid increases in deflationary trends from early to mid

Chart 6

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Source: HS Dent

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harry s. dent, jr.

www.hsdent.com

January 2, 2009

2010 onward. Our more accurate short-term inflation indicator also showsinflationary pressures turning deflationary around early to mid-2010.

With demographic spending trends weak from 2010 or 2011 forward anddeflationary trends strong from 2010 onward, there is simply no way thatthe government can stop the deflation of the real estate, commodity, andstock bubbles nor the deleveraging of the banking and credit system. Thegovernment is assuming that this is a short-term crisis when instead it is amassive long-term crisis. Baby Boomers are not only set to spend less andretire faster, but now they will be forced to save more as the assets thatthey thought that they had for retirement are all deflating fast. Deflationforces more saving and less spending and borrowing. In turn, less spendingand borrowing generates a deeper downturn, greater deflation, and lessability for banks to lend.

In the 1990s and early 2000s, Japan went through the same cycle of a bubblein real estate and stocks colliding with a long-term peak in generational spendingtrends. The big difference is that Japan had the luxury of deflating their creditand bubbles slowly: (1) because the rest of the world was booming, which kepttheir export industries strong, especially with the government keeping the yenlow in support through stimulus programs, and (2) because they were a netcreditor to the world, creating less dependence on outside credit. Despite theslower, more gradual deflationary process in Japan, their bubbles still deflated60% to 65% in real estate and 80% in stocks.

Bubble booms always end up in deflation and deleveraging. We have seen noexceptions to that in history. What is clear to us is that this downturn endsup with the deflation of real estate, commodities, and stocks—and thedeleveraging of the banking and credit system. It’s just a matter of how theU.S. and other governments play it out. The U.S. government is the largestnet debtor to foreign nations, has a huge and growing budget deficit (andnational debt), and will go through this process during a worldwide collapsethat it helped to create with its subprime and derivative crisis. What isclear is that, unlike Japan, our deflation process will happen rapidly, notgradually.

The question now is: how does this play out? In our new book, the originalpremise was that the U.S. government’s massive stimulus program would createa rebound in late 2009 to early 2010 but that such a rebound would come withstrong inflationary pressures and would fuel a final bubble in commodities alongwith a continued collapse of the U.S. dollar. However, the break in oil pricesbelow $38 in December 2008 as well as deflationary forecasts from the bondmarket (more ahead) make a scenario of strong inflation less likely—although weare still likely to see inflationary pressures rise and a very healthy bounce incommodities.


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harry s. dent, jr.

www.hsdent.com

January 2, 2009

Deflationary forces clearly have begun even earlier than our indicatorshave suggested, but the U.S. government has stemmed their tide thusfar with massive injections into the banking system and economy. Thegovernment has thus far proven to pull out all of the stops in favor ofstimulation vs. deflation, as they know how painful that will be, giventhe quick dose we got in mid-2008 with a near-meltdown in banking.Their latest plan seems to be to buy government debt, includingTreasury bonds, to keep long-term interest rates low and, hence, tokeep mortgage rates low. Thus far, low rates have not spurred homesales but just refinancing, as we showed above.

What such an aggressive stimulus program is most likely to do is tofinish off the U.S. dollar—especially during the likely modestrecovery and rebound process between late 2009 and early 2010.The worst scenario for the dollar would be massive issuance ofTreasuries to stimulate with only modest growth and inflationpressures to raise future prospects and interest rates that attractinvestment flows.

New Strategy: Fed Targets Lower Treasury andMortgage Rates—Disaster for Dollar?

In the early part of the 1930s downturn, the Fed and Treasury were notnearly as accommodative and the Smoot-Hawley Tariff Act, withdramatically rising tariffs, brought greatly increased tradeprotectionism at the wrong time. However, from 1933 onward, duringRoosevelt’s presidency, the Fed got more accommodative, keeping short-term and long-term Treasury rates low, despite a rising CPI after 1933.This was a way to both stimulate the economy and to support the farmand housing markets (farms were defaulting more back then). Recently,the Fed not only cut short-term rates to a range of 0.00% to 0.25%,effectively pursuing a Zero Interest Rate Policy (ZIRP), but they also

announced that they would be buying governmentagency debt and are considering purchasing long-termTreasuries to keep rates low. This has caused Treasurybond rates to plummet to close to 2% on the 10-yearbond and 2.50% on the 30-year bond and has created awide spread between Treasuries and corporate andmunicipal bonds (Chart 8). Recently, corporate bondsbegan overreacting to default risks, creating some near-term opportunities, while U.S. Treasuries probably arenear lows in yields in the near term, making themincreasingly risky. This was approximately as low asyields got in the late 1930s and early 1940s—veryextreme for this early in the deflation cycle!

Chart 8

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harry s. dent, jr.

www.hsdent.com

January 2, 2009

If the Fed pursues its policy of buying U.S. Treasuriesto keep rates down, then the opportunity to lock inhigher long term rates will come more into play in thecorporate and municipal markets. If the Fed does notbuy U.S. Treasuries or purchases them for someperiod of time and then stops, there may come a timewhen the bond markets question the U.S.government’s ability to honor its own bonds and debt.At that time, Treasuries could spike, creating a majorbuy opportunity in long-term corporates andmunicipals on a lag, as occurred in early to mid-1932.

Chart 9 shows how even municipal bonds now yield morethan Treasuries, which is a very rare occurrence. Thedeflation and default scare is creating a flight to qualityin Treasuries (short term and long term). Yields are likelyto rise in the coming year on Treasuries but will likelytrend downward on higher yield corporates as the defaultrisk declines substantially in the coming months andinflation risks rise more modestly. The real opportunity toplay long-term bonds is likely to come in the midst of theeven deeper downturn and deflation spiral that probablywill occur between mid-2010 and mid-2011, whencorporate and municipal yields will spike further andeven Treasuries are likely to spike as investors worryabout the U.S. government’s ability to honor its growingdebt. The dollar could end up at .50 Euros or lower, orthe Euro at $2.00 or higher. How low may Treasuries gonear term and how high in the next year or so?

In a special update on December 5, 2008, we showed atwo-decade 10-year Treasury bond channel from Don Hayes, one we hadmonitored in the past. That channel showed that we were close to testing thebottom trend-line at around 2.25% to 2.35%. However, we redrew that channelmore accurately with both weekly closing and weekly high/low data. Chart 10shows the most detailed channel with high/low close data, which suggests that10-year T-bond yields could get as low as 1.80% to 1.90% near term and thatthey didn’t actually break the channel recently.

Hitting the bottom (which we have likely already come close enough togiven the recent rally in yields to 2.40%) of this 10-year Treasury yieldchannel should signal an important turning point, with the marketsswitching from worrying about deflation and the depth of the downturn to

Chart 9

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Chart 10

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harry s. dent, jr.

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January 2, 2009

anticipating the recovery from the massive stimulus programs.That would help to confirm our present buy signal for stocks,commodities, and TIPS (inflation-protected Treasuries) and a sellsignal for long-term Treasuries and the U.S. dollar. The top of thebond channel in early 2010 would come closer to 4.8%. Thatprobably is the target for rising 10-year Treasury bond yields in thenext 12 to 18 months, which would mean that Treasury bond pricescould fall nearly as much as stocks did in the crash of 2008. Thisis the next bubble to burst. If we break above the top side of thischannel, it would suggest a strong inflationary environment and areal panic spike in yields. That is not as likely to occur at this pointgiven the extent of deflationary trends that has already set in.

The Fed’s surprise announcement on December 17, 2008, that theywould support the government bond markets caused a sudden drop inyields that brought us closer to the bottom of this channel—on theanticipation of the Treasury buying bonds in the future to keep yieldsand mortgage rates low. The question is, how much will the Treasuryactually do of this? If they do, the biggest impact is likely to be the rapiddevaluation of the U.S. dollar. Such a policy literally creates dollars outof thin air to purchase Treasuries and thus raises both the moneysupply and the Fed balance sheet. Since August 2008, the Fed hasexpanded its balance sheet from $0.9 trillion to $2.2 trillion, or $1.3trillion!

You can argue that the Fed can do this as long and as much as it wants,but that argument ignores that we are a major net creditor to the world.Major trading partners from China to Japan to Saudi Arabia own a lotof our dollars, Treasuries, and equities. (How many sovereign wealthfunds put money into banks last summer?) How much can you devalueyour currency before it loses it reserve status and there is a “run” on theU.S. dollar? How much can you buy your own Treasuries to cover yourbudget deficit when the rest of the world and investors are unwilling? Ina downward economy, our trade deficit eases, but in a rebound it risesagain. How will the U.S. finance its trade deficit if the dollar is falling?Just as banks can’t keep creating credit and lending when there is a runon their deposits, the U.S. government can’t just keep creating dollarsand Treasuries if there is a worldwide run on them. There are already$10.6 trillion of U.S. Treasuries outstanding with another few trillioncoming in the next year or so!

The Achilles heel of the U.S. is its massive budget deficits andforeign debt. Continued stimulus and buying of U.S. Treasuries canonly mean that the dollar falls and ultimately could collapse orseriously threaten to collapse. That means higher import andcommodity prices, higher inflationary pressures at least to some


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January 2, 2009

degree—and ultimately a limit to how much the Fed and Treasurycan stimulate without a run on the dollar! If a run is threatened,the Fed will be forced to allow Treasury yields to rise to attractfunds, especially in a rising inflation environment again. Such areversal in stimulus will be met with almost immediate deflationaryconsequences, given the fundamental demographic trends aheadand the extreme leverage in the banking system, especially fromearly 2010 forward.

In other words, as soon as the Fed and Treasury are forced to stop theirmassive stimulus program, the economy is dead – especially if therebound to such massive stimulus is on the weak side as a strongerrecovery would bring more economic strength and higher interest rates!We are saying that this will come sooner rather than later, given thedebt trap that the U.S. government is in. The cure for excessive debt andleverage simply cannot be more debt and leverage.

The most important points we have tried to make in the last year arethat the government has no way out and that this deflationary processis ultimately both necessary and good, albeit very painful. By allowingdeflation and deleveraging, we lower our cost of living and doingbusiness. Real estate and borrowing are a big cost of business and ourcost of living. Our assets and paper wealth will fall in such a process, asthey did in Japan, but our standard of living can also go up to offset aslower economy in the decade ahead and lower assets to generateincome for retirement. However, borrowing more and lowering the valueof the dollar in the process only creates higher costs for all products andmaterials imported from overseas, higher interest costs, and higher realestate costs, which will lower our standard of living more than need be.In the end, asset values will deflate back to fair value anyway; we merelycreate more debt to be painfully washed out by continuing to borrow tostave off a crisis in excess borrowing.

If this were just a short-term crisis and the economy was set togrow again with another demographic wave of spending andproductivity, a reasonable government stimulus plan could work, asit did in the early 1990s. But this plan is not reasonable and thedemographic trends point strongly downward after early 2010!

Also, note the curious relationship between the dollar and the stock andcommodity markets. The dollar was falling as the markets continuedupward in 2007. When they started crashing more after May 2008, thedollar started rising. One of the reasons is that massive sell-offs inforeign stocks and commodities by hedge funds and investors create ademand for dollars to settle those trades and vice-versa when stocksand commodities are rising. Hence, everything here points to a falling


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harry s. dent, jr.

www.hsdent.com

January 2, 2009

dollar ahead: a rebound in stocks and commodities, a dramaticallyrising budget deficit, a rising trade deficit when the economy starts torebound, and continued Fed support through buying Treasuries.

That means that emerging markets and commodities are the bestplay for the anticipation of and/or actual rebound for the latterpart of 2009, along with the beat up financial sector in the U.S.Long-term Treasuries have the greatest risk, while corporate andmunicipal bonds have increasing upside as the rebound isanticipated (given falling default risks that outweigh risinginflation risks), although the best play there probably is stillcoming from mid-2010 forward. The U.S. dollar is clearly the otherlikely big loser.

In the next section, Rodney Johnson will take a deeper look into thevolatility, changes, and opportunities in the bond markets.

Oil Breaks $38, Making New Highs Unlikely butStill a Great Hedge against the Dollar

It was almost too good to be true. We had oil around $40 just abovestrong support at $38 with an upside as high as $147 to $180 and astop loss at $38. However, oil broke below $38—leaving the only strongsupport at $18, and finally at $10. After falling as low as $32 on12/19/08, oil appears to have finally bottomed as it broke up stronglyon high volume on 12/31/08. We now have gotten a new buy signal inoil. Investors should be buying on any pullbacks from here forwardespecially around $41.50 if we see that level near term. July 2008 nowlooks like a clear peak in the oil bubble at $147. There is still selling byhedge funds as this peak came much later than that in stocks inOctober 2007. But oil is both a great hedge against a falling dollar in thenext year or so and a hedge against war or terrorist activities in theMiddle East—and the risks are clearly rising there, especially with aminor war between Israel and Hamas in Gaza. OPEC countries like Iranand Venezuela that are not allies of the West have budgets that simplydon’t work at oil prices under $80. Hence, these countries may causetrouble in one way or another just to get oil prices back up. Rememberthat we have a rough terrorist cycle that peaks every 8 or 9 years and isdue to rise into late 2009 to mid-2010 after the peak in late 2001. It’sjust that now we have to look for other signs of a bottom in theanticipation of a buy opportunity in oil, as it continued to weaken morethan advance recently.

A buy signal for oil, natural gas, gold, and silver is confirmed by thebreak above the neckline of the reverse head-and-shoulder patternsin stocks. We should see oil prices moving to $80 to $110 andpossibly higher by late 2009 to early 2010.


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January 2, 2009

Natural gas is another energy sector that looks likely tobreak up sharply over the next year, but may pull backto slight new lows first. Gold and silver are a great hedgeagainst a falling dollar and should also be a part of thegeneral rebound in commodity prices. We expect gold tomake new highs between $1,200 and $1,600, but thegains are not likely to be as strong as oil, which wouldmore than double by merely going back up to $80. Welike silver even better than gold, as it is undervalued vs.gold presently. Chart 11 shows our new projections foroil in a modest recovery scenario, while Chart 12 showsthe projections for a stronger recovery and/or Mid-Eastcrisis.

Stock Scenarios for 2009 and Beyond

Stocks continue to look as though they put in their panicsell-off into October 2008 and their lows in November. Wehave continued to see the expected U-shaped recoverywith many potential reverse head-and-shoulder-patterns,suggesting a right shoulder and final buy target to be putin around late December. What we got was a moreshallow right shoulder than expected and now aconfirmed break out of the pattern that is bullish for thenext few months, although near term overboughtreadings may limit the rally at first. The ultimate B wavetarget would be at strong resistance around 12,200, butthat would be too obvious and a bit ambitious given theseverity of this downturn. Assuming that the A wave orfirst major bottom is in at 7,450, the whole decline thusfar has been around 6,830 points on the Dow. A 50%retracement would mean a bounce of 3,415 points to around 10,865. A62% retracement would mean a target more around 11,670. After a 13-month decline, the bounce probably would last for either 5 months onthe shorter side or 8 months on the longer side. That would put the nexthigh between April and July 2009.

We have also been assuming that we have seen an A wave downwardwith a B wave to follow into mid 2009 and a C wave to complete into late2010 and/or mid-2012. But if we look back at the long-term realities inChart 6, the next long-term bull market could be a long B wave that onlyretests or slightly exceeds the 2007 long term peak or major 5-wavehighs of 14,280. At a minimum, the next bull market is likely to countas a B wave when adjusted for inflation. In fact, we could see the first60- to 70-year bear market since the South Seas and Mississippibubbles that peaked in 1720 in Europe, with an ultimate bottom in

Chart 11

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Source: Bloomberg

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Source: Bloomberg


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www.hsdent.com

January 2, 2009

1784, or 64 years sideways to downward. The next bullmarket peak could be near 14,000 in the late 2050s, andthen we could see a longer term C wave into the nextdepression scheduled on our cycles for the 2070s. Late2007 to around late 2074 would represent a 67-year bearmarket very much like 1720 to 1784, which ended in agreat depression of the 1780s. If this is the case, we couldbe seeing an extended A wave downward into as late asmid-2012, as we show in Chart 13.

In this scenario we assume that the recent 13-monthdecline was wave 1 and that we will see a 50% 8-monthretracement rally into July 2009; then another equalmagnitude 13-month 3 wave downward into August2010, a 38% 8-month retracement into around April2011, and then a final 13-month decline to slight newlows around May 2012. This is obviously an “idealized”scenario using likely Fibonacci ratios for declines andtimelines.

If we look more near term, we continue to see and expecta rounded bottom with now what looks like a shallowright shoulder leading to a choppy but more-concertedrebound around Obama’s pledge to restore the economyand around the massive stimulus plans. Obviously, it willtake time to tell how much the stimulus plans will impactthe economy, as it will take 12+ months to see the impactof the plans at all. Even if there is only a very modestresponse by late 2009, it will take that long for themarkets to understand that the stimulus will not workeffectively enough given the strong deflationary trends inmotion and that scenario would likely see the biggest

crash in the dollar—or for the markets to see commodities andinflationary pressures accelerating and the dollar beginning to crash,but a bit less so if the rebound is stronger.

At present, the markets seem to be making a final judgment as to howdeep the recession and deflation will go at this stage and as to how likelywill be a substantial rebound from the stimulus. We saw a clear panicand peak in the Volatility Index (VIX) in October, with lower volatility onthe sell-off into November and the present one into late December. Wehave seen the bond market anticipate at least a minor level of deflationof 1% or so for 2009 with the spread between TIPs and 2-year Treasuries(Chart 14). We are seeing the Treasury Channel in Chart 10 nearing thelow end, which suggests that the markets are getting close toanticipating the worst of the downturn and are about to beginanticipating the rebound.

Chart 13

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Chart 14

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Core Inflation Implied By TIPs Spread

Source: Bloomberg


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www.hsdent.com

January 2, 2009

Chart 15 shows the reverse head-and-shoulders patternthat formed in the NYSE Index, which has occurredsimilarly in the Nasdaq and the Russell 2000 (smallcaps). The right shoulder of the NYSE has been shallowerthan normal and is now breaking up above the necklinegenerating a potential buy signal. The projection, nowwould be around 7,200, with a somewhat higherextended rally possibly higher to follow months down theroad. The target for the Nasdaq would be around 1,980 –2,000.

Many other charts appear to have formed a less idealreverse head-and-shoulder pattern as they did not rallyquite to the ideal neckline. If we had rallied to around9,400 on the Dow in early December we would havecompleted a more ideal head and would have sinceformed a shallow right shoulder, more like the NYSE inChart 15. As we show in Chart 16, we can slant theneckline above the 9,800 high and have a head alreadyformed with the shallow right shoulder to follow and abreak up and buy signal on January 2. The projectionfrom here would be around 10,700, very close to our 50%retracement target of 10,865. We either could see a topthere around April or an extended bounce that lasts intoJuly or so and goes as high as the 62% retracementtarget around 11,670.

Chart 17 also shows another set of indicators thatconfirm a potential buy signal and similar upside targets.The Dow is just breaking above its 50-day movingaverage for the second time, which generates a buy signalthat would be better confirmed if we can break aboverecent highs of 9,026. The most likely resistance orupside target would be the 200-day moving averagewhich is presently at 11,000 trending down towards10,700 – 10,800 by April. The S&P 500 is breaking aboveits 50-day moving average as well and its 200-day movingaverage target would be around 1,120.

The break above the neckline of numerous reversehead-and-shoulder charts generates a newintermediate term buy signal. Such a buy signal wasfurther confirmed by a clearer break above the 50-daymoving average and a break above recent highs of9,026 on the Dow. Hence, investors should be buyingon any near term pullbacks. If we see a pullback near Chart 17

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Source: Bloomberg

Chart 16

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NYSE CompositeReverse Head-and-Shoulders Pattern

Source: Bloomberg


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www.hsdent.com

January 2, 2009

term to around 8,760 on the Dow that would be ideal,but perhaps not likely. The best sectors to buy at thispoint in rough order of risk and return would be oil(USO), financials (XLF), emerging markets (EEM),China (FXI), small cap growth (IJT), silver (SLV), gold(GLD), natural gas (UNG), S&P 500 (SPY), corporateBAA bonds (HYG) and Inflation-Protected Treasuries(TIP).

Natural gas looks like it may make a new low just below$5.00, so it should make sense to wait on that one beforebuying. The fly in the ointment comes from our short-term oscillators in Charts 18a and 18b which bothsuggest that we are still more overbought than oversold,and hence we may see another correction from higherhighs somewhere between late January and Februarybefore we reach our first targets likely in April. Thatwould generate a second buy signal if such a correctionoccurred.

The most likely scenario now would be that we see a“January effect” bounce in the first half of Januaryand possibly into the inauguration back up to 9,650 –9,800, and then a pullback to around 9,100 on theDow before heading up towards 10,700 - 10,865 inApril or beyond. Again, aggressive investors can buyon the present break above 9,030 on the Dow and/orany pullbacks to as low as 8,760. More conservativeinvestors may want to wait for the next advance andpullback and buy closer to 9,100 after we get moreoversold indicators again. We are expecting a longer

term sell signal for more conservative investors between 10,700and 10,865 around April, and possibly higher targets near 11,650as late as July for more aggressive investors.

Chart 18a

NYSE McClellan and 21-Day Oscillators

Source: Hays Advisory

Chart 18b

Nasdaq McClellan and 21-Day Oscillators

Source: Hays Advisory


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www.hsdent.com

January 2, 2009


The bond market appears to have gone crazy. Almostno one is issuing bonds except the U.S. government,which is flooding the market with a volume of bondsunheard of during peacetime, and yet yields onTreasuries are the lowest they have been in over 50

years. Municipal bonds, which with rare exception are tax free, areyielding significantly more than Treasuries. This simply should not be.Municipals almost always yield less due to the huge advantage of theirtax-exempt status. Both corporate bonds and municipal bonds haveseen their yields skyrocket, especially the riskier bonds. The reasons,which we will cover below, are numerous, but the result is a potentiallyexcellent investment opportunity over the course of the next year.

The Bond Markets Seize Up

The events and revelations of the past year have caused manycasualties. One of these is the smooth operation of the bond and creditmarkets. Traditionally, when bonds of like maturity and credit qualityare compared, municipal bonds have the lowest yield because you payno tax on the interest payments. Treasuries are next because they are“risk-free.” Corporate bonds have the highest yield of the group,although the yield spread between high-quality corporate bonds andTreasuries is generally modest. As the economic cycle ebbs and flowsfrom growth to contraction, yields move up and down, but the basicrelationship among the different types of issues remains the same.However, over the past five months this relationship has been turnedupside down.

Bonds are as straightforward as investments come. Yougive the borrower money up front, and in return they payyou periodic interest payments, in addition to paying youthe original investment amount at maturity. The hardpart is determining what issuer is credit-worthy enoughto pay you back. Through the years two ancillarybusiness lines have developed that have made bond-buying a little easier. The first is bond insurance(AMBAC, MBIA, FGIC, and now Berkshire Hathaway),whereby the bond issuer can purchase insurance, whichguarantees the timely payment of principal and interest.This is typically done in the municipal bond market. Thesecond is the rating agencies (S&P, Moody’s, Fitch, etc.),which assign ratings from AAA down to C; AAA is thebest, anything above BBB is investment grade, andanything below BBB is “junk”. This system of ratingbonds gave the buyers or investors a quick way to assesscredit quality and to compare bonds among variousissuers.

Chart 19

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Spreads of 10 Year Corporate and MunicipalBond Yields vs Treasuries 1996 - 2008

Source: Bloomberg

Bond Markets Gone Wild!


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January 2, 2009

During 2008 many things that seemed improbable if not impossible cameto pass. Continuing on the deterioration that started in 2007, manymortgage-backed securities lost a tremendous level of value quickly.What made this unusual was that these issues had been rated AAA bythe rating agencies. As they lost value, the rating agencies lowered theirratings of these securities not by a notch or two, but by four or fivenotches at a time. Holders of these securities felt that they had beengiven extremely poor information about the credit quality of theirholdings, given that the ratings were able to fall in value so fast. Thisstory repeated itself in every market: corporate, mortgage-backed,municipals, etc. Holders of bonds became frustrated with the ratingagencies, to the point that the agencies are now all but irrelevant. Whowould rely on them?

At the same time, bond insurance companies began to feel the effects oftheir decisions to insure some of the mortgage-backed securities thatwere issued over the last seven years. As these issues lost value andsome defaulted, the insurance companies were required to increase theirreserves and/or make payments. This caused the paying ability of theinsurance companies to be called into question, which led to their ownratings (most of them were AAA) being downgraded dramatically. Thebond insurers had vastly underestimated their potential liability. Thisagain led to a tremendous amount of frustration with the rating agencies,because they had obviously done poor due diligence on the insurancecompanies, as evidenced by the quick downgrades from AAA to A1 orBBB+ in some cases.

These events left bond buyers in the position of having to become theirown analysts, determining who was capable of making good on apayment stream of principal and income for many years into the future.In a stable market, this might not seem so daunting. Will the state ofCalifornia make good? How about General Electric? But in thisenvironment, where a calamity seems to be waiting around every corner,bond investors see potential disaster in every purchase.

Shrinking Pool of Investors

Traditionally, bonds are purchased by conservative individuals, pensionplans, insurance companies, investment banks, commercial banks, andcorporations. The financial chaos of the last year has removed many ofthese buyers, leaving individuals as the main group still participating.Firms that engaged in bond trading, like the investment bankingcompanies, have severely curtailed their trading operations or, like UBSwith their municipal bond desk, have ended the trading altogether. Thishas created severe bottlenecks in liquidity, because there are fewer placesfor bonds to be housed or inventoried as they wait for buyers.

Spreads At Historic Levels

The difference between the yield of Treasuries and of corporate bonds,and the difference between the yield of Treasuries and of municipalbonds, currently is very high. Chart 19 shows this spread expressed asa percentage of the Treasury yield from 1996 through this year. While


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the spreads do change over time, they tend to stay within a band. Thenoticeable exception before 2008 is 2003, when the U.S. invaded Iraq. Thisexception was due to the Treasury prices spiking (yields on Treasuries dropping)dramatically for a period of time before coming back to a more normal level bythe end of that year. Right now, several things are occurring that are causingthe tremendous spread. The Fed is manipulating long Treasury rates (as HarryDent discussed above), causing these rates to be much lower than theyotherwise would be. Also, as we described in this section, a confluence of events(lack of liquidity, lack of confidence in ratings or insurance, and uncertaintyabout issuers) is causing corporate and municipal bond markets to force priceslower and yields much higher. Recently, the city of Philadelphia priced aninsured, general obligation bond issue that included a 30-year maturity with acoupon of 7.125%, priced at a discount to yield 7.25%and this was tax-free. Inthe 40% tax bracket, this is equivalent to a 12% yield that could be locked in for30 years! Currently, the 30-year Treasury yields 2.6%, so this Philadelphiabond, on a taxable equivalent basis, yields almost 10 percentage points more.

Investors now have an opportunity to purchase bonds at yields that areexceptionally favorable, because of all of the dislocations in the market. Eventhough we expect some inflation in the next year, it could be that we will seeTreasuries go up in yield because they have been held to such low levels andthat we will see corporate and municipals come down in yield as some of theuncertainty leaves the markets and the credit system begins to function morenormally. You would not want to purchase just whatever yields the most,however. You have to be somewhat selective. The key is to look for municipalbonds that are backed by dedicated revenue streams from essential services,like water and sewer or electric services. If the traffic is strong enough (long-term existing infrastructure), toll roads are also worth considering. In corporatebonds, look at companies that will benefit from the infrastructure push that iscoming in the years ahead—those companies that supply large constructionprojects, or those that make the materials used in construction.

When it comes to bonds, it is good to keep in mind that there is no “bondexchange,” or clearing place where an orderly market is regulated, as there iswith stocks. When you buy a corporate or a municipal bond in the secondarymarket, usually someone holds that bond in inventory. Because of the severechallenges in the market that we discussed above, not many people want to holdbonds in inventory, so if you have to sell your bonds right now you could belooking at a significant cut in price. To get an idea of the difference between thebidding and asking prices on municipals, if you have the CUSIP number (thestandard identity number for bonds) of a bond, you can visit the EMMA(www.emma.msrb.org) website and see the trading history of that bond. Forexample, a Brazos River TX Water Revenue Bond 4.00% coupon maturing in2019 is offered at a price of 93, which is a 4.90% tax-free yield, or 8.2% taxableequivalent yield at a 40% tax bracket. At the EMMA website, it is reported thatthis bond traded at 100 in April and 79 at the beginning of December and is nowaround 90. It is precisely this gyration of pricing that is creating this currentlong-term opportunity.

The Next Potential Wave

As the markets return to some level of normal functioning and the cloud ofuncertainty as to how this economic storm will play out subsides, we see yieldson corporate and municipal bonds falling. When it becomes clear which issuerswill survive, the declining default risk will bring yields down substantially, while


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inflation risks probably will grow more modestly. Next, we should see at least a modestdecline in yields on corporate and municipal issues, as a recovery is anticipated forlate 2009 or early 2010. However, we anticipate that at some point the Fed will haveto allow interest rates to rise so that yields on Treasuries match the perceived risk ofthe investment, especially as the dollar starts to crash and/or as the economy lookseven more perilous as we move into 2010. When this happens, it is very likely thatthe yields on corporates and municipals will rise again in step with the Treasuries andit is also likely that we will see highs in yields greater than we have seen recently.Hence, what we have is the possibility of two opportunities to purchase bonds atattractive yields—one now, and one when Treasuries rise in yield and fall in price. Thebest long-term opportunity should occur during the next crash and downturn whendefault risks rise even on Treasuries and rise even more so on corporate andmunicipal bonds, probably between early 2009 and late 2010—and possibly as late asearly to mid-2011 for municipals.

By Charles Sizemore, CFA

As we enter 2009, we recommend that you grab a copy of GeorgeMagnus’s The Age of Aging. Mr. Magnus is a senior economic advisor atUBS, and his new book is probably the best “big picture” analysis ondemographic trends that we have seen since Philip Longman’s The EmptyCradle. Magnus’s work is a fine complement to our own research, and itdeserves a place on your bookshelf.

In the pages that follow, we’re going to quote Magnus on various topics and comparehis views to our own and to those of other commentators whom we follow.

On the History (and Future) of Retirement

In the preface to the book, Magnus writes,

Many of the premises on which modern welfare programs were established havechanged or soon will. Retirement pensions, for example, were designed to allowpeople to stop working and enjoy their last few years in relative comfort whilemaking way for new, younger workers. Today, although pensioner poverty isbecoming a growing problem…retirement is for many an extended period ofstate-supported or company-financed leisure, which was never anticipated….

Book Review and Commentary: The Age of Aging


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To address these challenges over the next decade or two, it is probable that the role andinfluence of the state, and what is demanded of it, will expand.

There is no question that the concept of retirement has fundamentally changed over the years.Today, it is viewed as a true entitlement, something that is “owed” to retirees who have spenttheir lives working and paying Social Security taxes or union dues. But as Magnus points out,it was not always this way.

In the preindustrial economy, “retirement” did not exist at all. Traditionally, you worked onyour farm until you were physically too weak to do so any longer, after which point you eithermoved in with one of your children or you “retired” to a hospital. You certainly didn’t play golfor take long walks on the beach.

Pensions were a product of the Industrial Revolution, but they were not originally considered abenefit to the worker. In fact, they were designed to gracefully remove older, more accident-prone workers from dangerous positions that put the company at risk. For example, railroadsconsidered it unwise to let 70-year-old workers with failing vision handle heavy machinery orman the engine of a locomotive. The objective was to make room for younger workers, not toreward the elderly for a lifetime of service.

For a variety of reasons, including union activism, the labor shortage during World War II, andthe general increase in prosperity in the post-war era, retirement has evolved into what it istoday: a period of extended leisure, often lasting 20 to 30 years or more, that one enjoys afterleaving the workforce.

Now that the largest generation in history is ready to enjoy these benefits, the concept ofretirement may have to change again, becoming less generous to avoid bankrupting futuregenerations. In a service- and information-based economy, elderly workers are no longer a“safety liability,” meaning that the original rationale for the creation of pensions no longerexists.

However, at the same time, the Baby Boomers are right to expect the entitlements that werepromised to them decades before. We expect the political debates in the coming decades to bedominated increasingly by intergenerational conflict. Unfortunately for the youngergenerations, voter turnout tends to be much higher among older voters, and the Boomers hadnumerical superiority to begin with.

On Societal Change and Falling Birthrates

Echoing Phillip Longman in The Empty Cradle, Magnus explores some of the sociologicalfeatures of demographic change in Chapter 2. Magnus writes,

…[T]hink how family life has changed over the last 100 years and tended to lower fertility.With the introduction of social security and insurance systems, the benefit of having manychildren for support declined, and this would have contributed toward lower fertility.Compulsory education and a rising tendency for young people to enter university raisedthe cost of having children and had the same effect on lowering fertility. Perhaps thebiggest social change of the last 50 years, though, has been the opening of employmentand income opportunities to women—in which arguably the pill played a role. With these,the “cost” of having children has also risen in that having children or more children ofteninvolves giving up access to a more lucrative career or stream of income. It is whateconomists call the “opportunity cost” of children or, put another way, the income orlifestyle we give up to stay at home and look after children.


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Longman wrote extensively about the opportunity cost of children in The Empty Cradle,and Mark Steyn offered his own somewhat off-color remarks on the subject in AmericaAlone. In an information-driven economy with increasing returns to education, it takesa lot of money to raise a child and to prepare her or him for career success (close to onequarter of one million dollars according to U.S. government estimates, which don’tinclude the cost of university education). It also takes a lot of time, which, along withmoney, is a scarce commodity. This brings us to yet another author on the subject,Brink Lindsey, whose book Age of Abundance is also a good study on the causes andeffects of changing demographics.

In Lindsey’s words, the processes of urbanization and industrialization transformed thefamily from a unit of production to a unit of consumption. On a family farm, childrenprovide cheap labor. But to a machinist or mill worker, a child is an expensive mouthto feed. This became ever more true in the post-war era of mass affluence in whichyoung people spent longer and longer in formal education.

In The Age of Aging, Magnus informs us of a new acronym for these young people:“Kippers” (kids in parents’ pockets eroding retirement savings). These adult children inquestion are not necessarily lazy, they are simply a product of the times. Many simplydo not have the means to support themselves through their educational and early careeryears without taking on crushing levels of debt. This was particularly true during theyears of the real estate bubble, when home prices far exceeded average incomes.

We can see this same process of family transformation from a unit of production to aunit of consumption happening in the developing world, and we’ll return to that themelater.

On Demographics and Economic Growth

So, what do aging demographics mean for economic growth? Focusing on projecteddemand, HS Dent reached the conclusion long ago that an aging society implies slowinggrowth and falling prices. Most other analysts (such as Dr. Jeremy Siegel) have focusedon projected supply, using forecasted changes in the working age population to predictoutput. This outlook reflects a supply-oriented bias among the neoclassical economiststhat dominate the profession. We’ve picked this argument apart at length in othernewsletters, but to summarize here, we believe that the supply-side argument, which issummarized by Say’s Law (“supply creates its own demand”) is fundamentally flawed ina post-bubble world of aging demographics and excess supply. Increasing supply in theface of stagnant demand does nothing more than lower prices. In other words, it createsmore deflation, which is the last thing you could possibly want.

Magnus’s approach is something of a middle ground between the HS Dent demand-focused analysis and the supply-focused analysis favored by academia. Magnus echoesthe HS Dent view that an aging society consumes less, which leads to a stagnanteconomy with falling prices, like that of Japan since the early 1990s.

However, Magnus explores the supply side, too, and some of his comments areinsightful. In chapter 4, Magnus discusses in layman’s terms the production functionmemorized by every freshman economics major. We will spell it out here ineconomistspeak:


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Production function: Q = L x * K y * A, where

Q = Total economic output,

K = Total stock of capital (for example, buildings and machinery) available,

L = Size of the labor force, and

A = Productivity, computed from technology and efficiency.

This is also called total factor productivity.

So what does this gibberish mean in the real word? Our GDP is a function of the labor andcapital employed, with productivity enhancements providing a turbo charge. Magnus points outthat L, the size of the labor force, will be stagnant or falling in the years to come. And withsavings rates likely to be down, so will K, as there will be less funds available to loan to financecapital expenditures. That leaves A, productivity, which was the primary driver of Americangrowth throughout the 1990s and 2000s. So, can productivity rise fast enough to compensatefor a decline in labor and capital?

We think not. The information revolution made possible by the Internet and by wirelesscommunications has transformed our economy, and there will continue to be incrementalenhancements going forward. But much of the “heavy lifting” has already been done. Laptopcomputers, mobile phones, and Blackberries are now ubiquitous among traveling professionals.The HS Dent S-curves for computers and mobile phones have all more or less leveled off abovethe 90% penetration mark. It’s hard to see much in the way of growth here.

New gadgets no doubt will add incrementally to productivity, but the next “big” leap is probablyyears if not decades in the future. Revolutions don’t happen every day.

On Immigration

Numerous analysts, us included, have pointed to the benefits of immigration. Rodney Johnsonexplored this topic at length in the October 2005 issue of the HS Dent Forecast(http://www.hsdent.com/content/Member/NL-2005-10x1.pdf). While we generally support anopen immigration policy, we are also realistic. New migrants typically do not have the earningand spending power of native workers, at least not for several years. Also, the amount ofimmigration that would be needed to sustain economic growth at precrisis levels also would befunctionally and politically impossible and would bring a host of other problems related toassimilating group that large. As a solution to America’s aging crisis, immigration is simply notviable.

Magnus largely shares our views, dedicating an entire chapter to immigration issues.Summarizing his views, he writes,

However, there at least three major problems with the theory. First, as noted, the scale ofimmigration required to offset native demographic trends and the loss to economic growthis extremely large and unrealistic—certainly as things stand today politically. Second,these positive effects of immigration [such as higher birthrates] may be much more short-lived than they are made out to be, so that immigration doesn’t really offer a stable, long-term solution. Third, sooner or later, high immigration may also involve costs to the host


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society too, including those of dependency, welfare, social disharmony, andpressure on infrastructure and social facilities.

For a more detailed look at the subject of immigration, see our review of Jason Riley’sLet Them In, found in the July 2008 issue of the HS Dent Forecast(http://www.hsdent.com/content/Member/NL-2008-07x1.pdf).

On Taxes

The subject of taxation will be a hot-button issue once President-elect Obama takesoffice. The government is running up mind-boggling debts, and those debts can only bepaid one way: taxes.

Magnus summarizes the unfortunate choices facing America’s next Congress andPresident:

Tax decisions will have to be tackled with great caution. If you raise taxes topunitive levels on inheritance, wealth, and other forms of capital, the effect is todiscourage savings when saving is exactly what you want people to do. If peopledo not save enough, there might not be enough investment, and this could putupward pressure on interest rates. If you raise income or social security taxes toan excessive level, it will discourage companies from hiring people from working,when more labor effort is precisely what you want. The major alternative is a shiftin the tax system from these kinds of taxes to higher or new consumption taxes,such as a value-added tax or a sales tax. But these are regressive—sinceeveryone pays the same tax, they’re unfair to less well-off people.

There are no easy answers here. The tax man is coming. Our advice is to do everythingyou can to shelter your assets from him. This means using every tax deferral at yourdisposal, such as IRAs, 401(k)s, and variable annuities.

On Emerging Markets

Magnus’s comments on India sound as if they could have come out of our own piece onthe country from the September 2006 issue of the HS Dent Forecast(http://www.hsdent.com/content/Member/NL-2006-09x1.pdf):

India’s demographic advantage is not the only reason for optimism. Unlike otherAsian economies, including China, India’s path to development has had a muchmore domestic, as opposed to export focus. If Western economies were to cooldown under demographic pressures in the next several years, India wouldnot be as exposed as, say, China [Emphasis HS Dent]. Moreover, India’s moredomestic development pattern has emphasized personal consumption, services,and high-tech (as opposed to low-skill) manufacturing. So, this young, consumer-oriented, and service-based economy looks remarkably like that of the UnitedStates.

Interestingly, Magnus points out that India’s demographics are not uniform. The“American” economy is concentrated in the more technologically advanced southern partof the country, while the north is still dominated by low-productivity agriculture. Believeit or not, like America, southern India is aging rapidly! The large cities of Mumbai and


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Chennai, for example, have below-replacement-level fertility rates. Overall, the fertility rate inthe north is about twice as high as that in the south.

Like HS Dent, Magnus is much less optimistic about the prospects of other emerging markets,such as China and Russia. For the same reasons that we discussed in the March 2007 andMarch 2008 newsletters (http://www.hsdent.com/content/Member/NL-2006-09x1.pdf,http://www.hsdent.com/content/Member/NL-2007-03x1.pdf) and elsewhere, China andRussia are quietly chugging along toward a demographic disaster.

The effect of the One Child policy is that China will grow old before it fully has the chance togrow rich. Even if the Chinese Communist Party reversed the policy today (which they haveshown no indication of doing), there is nothing that can be done about the cresting of theChinese Spending Wave around 2015.

Russia’s situation is even worse. Due to high emigration out of Russia, rampant alcoholism,poor health, and an abortion rate that is actually higher than that of live births, Russia’spopulation is practically evaporating. Magnus describes the desperation of the Russiangovernment, exemplified by Vladimir Putin’s offer of $10,000 to each Russian woman who bearsa child. When the usually steely-eyed Putin gets on national television to smile and softly praisemotherhood and family, the situation must truly be grim.

Concluding Remarks

We are living in unprecedented times. Never before in human history have we had to face thespecter of entire countries growing old and shrinking by lifestyle choice. As Japan’s experiencein the 1990s vividly illustrates, the road ahead will be a hard one. Understanding the changescoming—by reading the works of Magnus, Longman, and of course, HS Dent—can help you toprepare.

By Charles Sizemore, CFA

In a presidential election year, there is a lot of talk about the national debt, the budget deficit,and, of course, the economy. The collapse in home prices and the subsequent meltdown of thefinancial sector have led to a cornucopia of assorted federal “bailouts” that are likely to totalin the trillions of dollars once all is said and done. Americans are right to worry about the long-term fiscal health of the federal government. Unfortunately, that is just the beginning. Whilefederal tax receipts no doubt will be down due to the collapse in corporate profits and capitalgains income for individuals, it is the state and local governments that face a full-blown crisis.

For Cities and States, It’s About To Get Uglier


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California Governor Schwarzenegger has already declared a “fiscal state of emergency”for his state, and we do not believe that he will be the last governor to do so.

We have maintained an ongoing commentary on this for the past few years, and weconsider this a long-term issue. This article could be considered a “sneak preview” ofsome of the themes we expect to cover over the course of 2009. In the pages that follow,we’re going to summarize the primary drivers of the crisis. Also, we will give severalexamples of the crisis as reported by the financial press. Finally, we will give some hardnumbers on the extent of the crisis and offer our thoughts.

What is the Crisis?

Already, we can identify several key points driving the fiscal crisis:

State and local governments are facing an income crisis due to the collapse in homevalues and to the subsequent decline in property and transfer taxes. The collapse inauto sales and the decline in spending in general have also reduced sales tax revenue,the other major source of funding for states and municipalities. Unlike the 2000-2002downturn, in which rising home prices and the associated rise in property taxescompensated for other losses in revenue, in 2008 every major source of revenue wassharply lower and is not projected to recover any time soon.

While revenues have plummeted, expenses have stayed the same. In fact, in manyinstances expenses have risen, such as in the case of unemployment benefits. Theproblem is that many states and municipalities are required by law to balance theirbudgets, meaning that taxes must be raised and spending must be cut. This is theopposite of standard Keynesian countermeasures and is a painful course of action totake during a major recession.

The unrelenting bear market that has sent virtually all non-Treasury assets lower hasabsolutely decimated the funding status of public pensions, many of which hadhealthy funded statuses at the end of 2007. U.S. and international stocks, bonds, realestate, commodities, and alternative assets such as hedge funds all have takenextraordinary losses due to the global deleveraging of the financial sector. We won’tknow the full extent until early next year, but early press releases from large systemssuch as California’s public employee retirement system (CalPERS) indicate that it won’tbe pretty.

Even while the governments’ ability to pay their retirees has become impaired, theliabilities themselves are as big as ever. In addition to the measures taken to meetcurrent operating needs, cities, counties, and states will be forced to raise taxes and toreduce services further in order to meet pension obligations.

The Timeline of a Crisis

While the seeds of this crisis were planted long ago, it was the collapse of the creditmarkets in October that brought it into full bloom. Consider the following progressionof headlines, starting in October:

“Financial Crisis Takes a Toll On Already-Squeezed Cities”New York Times, October 7, 2008


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Writing for the Times, Susan Saulny reports that:

All over the country, parks are being sold, fees for routine services are going up and cityworkers are being laid off… This is the first time for at least two decades that all threemajor general tax sources—property, taxes, and sales—have all declined at the same time.

The scary part is that this is only the beginning. We may never see toll booths on the publicsidewalk, but expect to pay a lot more in taxes and fees while getting a lot less in return.

“No Money to Pay the Bills”The Economist, October 11, 2008

The Economist outlines the degree of Mr. Schwarzenegger’s crisis. With tax receipts down for thenow-familiar reasons and with the bond markets paralyzed,

The world’s eighth biggest economy…is finding it hard to raise enough money to pay thebills….If the credit markets gum up even more than at present, the state may seek relieffrom the Federal Reserve or from its enormous public-employee pension funds.

This should send a chill down the spine of any would-be retiree. Desperate for funds, a statecan “request” that its public pensions float it a loan. Sending a formal letter to SecretaryPaulson, Governor Schwarzenegger already has requested emergency funding from the federalgovernment, as there were simply no funds available in the private sector credit markets. GivenCalifornia’s history of budget crises and tax revolts, this is not likely to be the last time that wesee a headline like this. We will return to the California front shortly. First, we’ll take a look atthe other coast.

“New York Teeters On The Edge Of Unprecedented Fiscal Crisis”The Business Sheet, October 28, 2008

This article was posted by Jay Yarow on www.businessheet.alleyinsider.com. Not shockingly,as the nerve center of global finance, New York is facing challenges above and beyond those ofother states. Mr. Yarrow reports:

New York Gov. David Paterson said Tuesday that the recession, overspending by thestate and Wall Street’s meltdown will result in a record $47 billion deficit overthe next four years. He says the current budget’s shortfall is $1.5 billion and the nextfiscal year beginning April 1 will include a $12.5 billion deficit. A month ago, the currentdeficit was estimated at $1.2 billion.

You read that correctly: New York’s state budget deficit just went up by a factor of 10. NewYork City has already begun to talk of significant tax hikes. Life is about to get veryuncomfortable for New Yorkers.

Moving into November, we see a continuation of this theme.

“Local Zeroes”The Economist, November 13, 2008

The first places to run into trouble were those hit by the downturn in the housing market.Arizona, Florida and Nevada built too many unaffordable houses in the middle years ofthis decade. When mortgage rates reset, they suffered an epidemic of foreclosures. As


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prices plunged and buyers disappeared, revenues from sources as diverse asdevelopment fees and sales taxes on bathroom taps dropped.

Of course, as the Economist points out, much of this crisis was completely avoidable:

Long before local governments had revenue problems, they had spendingproblems. They have guaranteed their employees lavish pensions andtoughened criminal codes in such a way that prison populations have risen fast.Public spending in New York state has increased by more than 40% in the past fiveyears; in California, general-fund expenditure has more than doubled since themid-1990s.

It is now obvious that those spending increases will have to be painfully reversed. As theNew York Times writes,

“Facing Deficits, States Get Out Sharper Knives”New York Times, November 17, 2008

The astonishing decline in revenues is without modern precedent here, butCalifornia is hardly alone. A majority of states—many with budgets already full ofdeep cuts and dependent on raiding rainy-day funds or tax increases—arescrambling to find ways to get through the rest of the year without hacking apartvital services or raising taxes... The plunging revenue—the result of an unusualassemblage of personal, sales, capital gains and corporate taxes fallingsignificantly—[has] poked holes in budgets that are just weeks and months old…

In addition to the “here and now” effects of the crisis, there are other, more long-termeffects as well. As the Times explains, business cannot expand and take on new workerswithout access to credit. Furthermore, the businesses of tomorrow that are still nothingmore than business plans in the heads of their would-be founders are not started. Thismeans lower growth in the future as well as lower growth today.

Writing for The Wall Street Journal, Steve Malaga had some rather choice words for our“spendthrift” states:

“Our Spendthrift States Don’t Need a Bailout; Governors Need to Learn to UseFat Years to Prepare for Lean Ones”Wall Street Journal, November 18, 2008

Last year at this time, many governors and state legislators were imploringCongress to let them spend more money by expanding the State Children’s HealthInsurance Program… [which] would have meant hundreds of millions in additionalstate spending…. Today, governors and state legislators are singing a differenttune. Unable to pay their bills as tax revenues shrink, they’re imploringWashington to bail them out.

Oops. One of the problems with Keynesian economics is that it is never actuallypracticed. Governments follow Lord Keynes’s advice during the hard times, usingdeficit spending as an attempt to stimulate demand... but they conveniently ignore thesecond half of his plan: during boom times, use surpluses to pay down debts andbuild up emergency funds for the future.


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Later in the editorial, Mr. Malanga attacks an issue near and dear to HS Dent: state pensionand health care funding. This is a topic we covered in detail in The Death of Pensions specialreport, and it’s one that we will return to several times in the coming years. This may be thesingle biggest crisis-within-a-crisis facing the states and the nation as a whole. As Mr.Malanga continues:

For years, state and local politicians have bought support from public sector unions bypromising big benefits... States have collectively racked up some $731 billion inunfunded liabilities for pensions and other retirement benefits…

In this age of $700-billion bank bailouts, the $731 billion in unfunded liabilities may not seemlike a big deal. But rest assured, when your property tax bills rise by leaps and bounds whilethe value of your home continues to fall and when your local sales tax rate potentially doublesor triples, it will seem like a large liability indeed. Unlike General Motors or Chrysler, statescannot simply file for bankruptcy and kick their pension liabilities to the Pension BenefitGuarantee Company.

They can file for municipal bankruptcy, but that does not automatically absolve them of theirpension and health liabilities. Governments have taxing power, and they may be forced to useit whether the voters agree to it or not. We may soon see a scenario in which tax rates are raisednot by the state legislature or city council, but by a bankruptcy judge.

The saga continues in December, and it gets even worse. A year into a crisis to which few peoplesee an end in sight,

“Mayors Get in Line for U.S. Funds”Wall Street Journal, December 8, 2008

A delegation of mayors, including Michael Bloomberg of New York and AntonioVillaraigosa of Los Angeles, plans to ask the federal government to distribute fundsdirectly to cities instead of going through state governments. The group is set to present alist of more than 4,600 infrastructure projects that they say are “ready to go.”

Given the condition of state finances, it’s not shocking that some cities are looking to cut outthe “middle man” and go straight to Washington. Meanwhile, Chicago is in such dire straits thatthe city is selling its assets to meet its current expenses. The Chicago city council voted to sellthe city’s parking meters to private investors, forgoing 75 years worth of meter revenue for alarge payoff today:

“It’s Official: Chicago Parking Meters will be Private, Pricier”Chicago Tribune, December 5, 2008

City Hall could spend more than half of its $1.2 billion check within a few years, but aprivate company that agreed to pay that huge sum to lease Chicago’s parking meters nowwill get to collect the cash for the next 75 years.

Not surprisingly, the costs to consumers will be rising, quadrupling over the next month.Neighborhood spots that cost one quarter per hour will cost $1 per hour and will increase to $2per hour by 2013.

Chicago’s meters may very well be a harbinger of things to come. States such as Indiana andNew Jersey already have debated selling large public assets such as toll roads to the privatesector. The city of Chicago itself also has a recent history of such maneuvers, leasing theSkyway for 99 years to investors.


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Selling long-term assets in order to meet pressing current needs may seem practical atthe time, but what happens when you run out of assets to sell? Is this not a larger-scaleversion of a home equity loan in which a homeowner “extracts equity” from his propertyto spend on a new TV or a vacation to the Caribbean? Long after the TV is obsolete andthe tan from the vacation has faded, the debts remain.

One can’t help but wonder whether cities and states might come to regret selling theirassets rather than tightening their belts and cutting spending instead. Regardless, we allknow how this ends: taxpayers can look forward to higher taxes and fees coupled with alower level of service. We can expect this to be played out at every level of government.

Meanwhile, it appears that the bond agencies finally have acknowledged the obvious:

“California’s Debt Downgraded as State’s Budget Crisis Deepens”Financial Times, December 12, 2008

California yesterday prepared to suspend $5bn in financing for schools, roads,power projects and levee repairs as the state’s mounting budget crisis ledStandard & Poor’s to downgrade some of its short-term debt…and warned it maydowngrade a further $54bn in debt… With the bond markets effectively closed,California has had to use funds earmarked for infrastructure to cover short-termspending obligations.

The FT mentions also that the state of Illinois postponed a $1.4 billion bond sale, andthat S&P indicated that it might cut Illinois’s credit rating as well, fearing that thecorruption charges facing the state’s governor will prevent Illinois from addressing itsprojected $2 billion budget deficit. We doubt seriously that Illinois will be the last stateput on the watch list.

Looking Forward

We have watched this crisis evolve over the course of 2008, particularly in the fourthquarter. Unfortunately, we expect much of the same in 2009. Looking at Chart 20, wesee that some state budget deficits make the Federal budget deficit look downrightresponsible by comparison, which is saying a lot. The complete list is available athttp://online.wsj.com/public/resources/documents/st_DEFICIT_20081201.html.

California’s budget deficit is an almost unbelievable31.1% of its general fund. The state’s revenues are barelycovering two thirds of its expenses. Arizona, which istraditionally a bastion of small-government conservatism,comes in second at 25.9%.

Not surprisingly, four of the top five offenders were thestates where the housing bubble (and subsequent burst)were most pronounced. New York, New Jersey, andMassachusetts are also near the top of the list, which isto be expected given their dependence on the financialservices industry. It’s the appearance of the southernstates of Alabama, Virginia, South Carolina, Georgia, andMaryland that is more surprising.

Chart 207.0%$1,100 $248 $808 Maryland

8.7%$1,800 $1,600 $245 Georgia

8.9%$2,900 $400 $2,500 New Jersey

9.0%$274 $150 $124 Maine

9.2%$2,600 $1,400 $1,200 Massachusetts

11.4%$6,400 $1,500 $4,900 New York

11.7%$804 $554 $250 South Carolina

12.8%$2,200 $974 $1,200 Virginia

15.0%$1,200 $458 $784 Alabama

19.9%$5,100 $1,700 $3,400 Florida

20.1%$1,500 $575 $898 Nevada

24.5%$802 $372 $430 Rhode Island

25.9%$2,600 $700 $1,900 Arizona

31.4%$31,700 $9,500 $22,200 California

Gap as % of FY2009 General Fund

Total FY2009 Budget Gap (in $millions)

Additional mid-year gap (in $millions)

Gap before budget was adopted (in

$millions)State

States in CrisisState Budget Deficits

Source: Wall Street Journal


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Also not surprising is that the states are looking to Washington for abailout. The leadership of the National Governors Association hasalready had meetings with Congress and with President-elect Obama todiscuss possibilities, generally revolving around public infrastructureprojects that they hope will create jobs.

On some level, this makes sense. If the money is going to be borrowedanyway, then it makes sense to borrow it at the lowest possible rate.Right now, the federal government has the ability to borrow larger sumsat lower interest rates than do the states.

However, it is not fair to the states that have been responsible in keepingtheir budgets more or less balanced or even in surplus that theircitizens’ federal tax dollars will be used to bail out the less responsiblestates. For example, Oklahoma’s budget deficit for 2009 is projected tobe a manageable 1.7%. Is it fair for Oklahomans to subsidize the likesof California or New York, both of which have much higher medianincomes than Oklahoma?

In the bailout culture being cultivated, the responsible are being taxedto support the irresponsible, whether we are talking about Citigroup,General Motors, or the California state government. This is alreadybreeding resentment, and we probably are just getting started.

Furthermore, it is not altogether clear that the shower of federal moneyfor state infrastructure will accomplish what it is designed toaccomplish. Falling back on a familiar example, Japan spent moneyrecklessly all throughout the 1990s in an attempt to stimulate aneconomy that looked a lot like ours does today. The results were mixedat best, but the debts remain: Japan’s government debt isapproximately 130% of its annual GDP, a number that past generationswould have considered shameful. And thus far no economic boom hascome along to allow Japan to grow out of that debt. Given Japan’sdemographics, it may never come at all.

The bottom line is that we face significant challenges ahead, and thereare no clear answers. Allowing the free market to work, as manyconservatives and libertarians would like, would almost assuredly leadus to a reenactment of the Great Depression, complete with severeconsumer price deflation and an unemployment rate two to three timeshigher than ours today. But the “bail out anyone and everyone”approach currently being used will, at best, give us a 1990s Japanscenario, along with a mountain of government debt to saddle the nextgeneration. So, do we take our medicine now (surgery withoutanesthesia would be a better metaphor), or do we let the crisis becomea chronic disease that hobbles us for decades into the future?

Regardless of what course of action we take to close the current budgetdeficits, the colossal elephant in the room remains: the unpayablepension and health liabilities owed to public employees.

There are no easy answers here, just a lot of uncomfortable questions.


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The bailout shored up the banking system, but failed tocreate the flow of new credit. The slow thaw of the creditfreeze and the slowdown of consumer spending kept anypotential rallies over the past several months at bay. Ourmove to cash in the first week of October (70% for

aggressive and 75% for moderate) kept a significant portion of capitalout of the way of volatility.

As we begin 2009 we are focused on areas that seem to have the greatestpotential for gain in what should continue to be a period of economicuncertainty and hurdles. With the Treasury printing dollars, hardassets should be a strong investment sector which will also helpemerging markets, and as we get used to this new economicenvironment the default risk on non-treasury bonds should subside forpotential capital appreciation. In addition, we see China adjusting tofocus more on its internal capabilities, having already lost 70% on itsstock market. As the country continues to grow, it still offers significantopportunity for the year ahead. The financial sector, coming off of a rout(and deservedly so) in 2008, has one of the best technical patterns asHarry Dent described above.

The allocations for the first quarter of 2009 are as follows:

Aggressive

25% Precious Metals10% Emerging Markets10% Financials10% China20% Energy10% Small Cap15% Bonds – Corporate

Moderate

15% Precious Metals10% Emerging Markets10% Financials5% China10% Energy10% Small Cap20% Large Cap10% Bonds – Corporate10% Bonds - TIPs

Sector Allocations and Updates

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