Back in June of 2008, we wrote that the US stock market -- then at 1,377 on the S&P 500 -- was priced for poor returns. We were talking about prospective long-term returns, but as everyone knows, the market experienced an epic crash beginning just a few months later.

In late October, after the S&P 500 had plummeted more than 38% to under 849, we posted an update arguing that the US market was now priced for good (though not great) returns.

The following thoughts on the economic stimulus and its potential outcomes are excerpted from a letter to clients sent out on April 20, 2009.

---

The Stock Rebound

You may have noticed that stocks in general have made quite a rebound over the past couple of months. As I write this, the S&P 500 has moved up nearly 35% from its early-March lows. Also beneficial to our portfolios, the dollar has dropped pretty sharply over that same period and many of the inflation-hedge themes we favor have done quite well.

Which is all very nice. But will it be sustained? Our emphasis on fundamental analysis and long-term returns mitigates the need for us to make short-term predictions. We try anyway.

As a first step in answering that question, let's have a look at: The Stimulus.

In our prior article on the government's willingess and ability to create inflation, we noted that Japan is often held up as an example of a country that was unable to inflate despite having a fully paper-based monetary system. But while the crash of Japan's credit-fueled stock and real estate bubbles resembles our own situation, the monetary policy responses in each case have been markedly different.

It's true that the Japanese authorities did not create any enduring price inflation after their credit crash. But a quick look at the data shows that this is because they opted not to do the one thing that can reliably create eventual inflation: rapidly grow the supply of money in circulation.

The modern-day monetary system employed in the United States is based on currency that can be created at the bureaucratic touch of a button. In charge of that button is a group of people with a firmly entrenched belief that deflation is the worst of all possible monetary outcomes.

We believe that this state of affairs is simply incompatible with the existence of the type of protracted "deflationary spiral" about which it has become all the rage to worry. Deflation is a choice in the current monetary regime, and it is a choice that our government simply cannot make.

Back in June we wrote an article entitled "US Stock Market Priced for Poor Returns" in which we argued that stock market valuations are predictive of long-term returns when measured in such a way as to smooth out earnings volatility. As evidence, we presented the following chart comparing quintiles of market valuation against average 10-year forward performance (please see the original article for an explanation of our methodology):

While we invest in many sectors and asset classes, the recent steep selloff in precious metal mining stocks inspired us to write an article focusing in on that particular sector's long-term fundamentals. The resulting piece was emailed to clients on September 16, 2008 and is excerpted below.

Back in March, we pointed out some important similarities between the current financial environment and that of the 1970s.

Aside from gratuitous decades-old pop culture references, the main focus of the article was on real short-term interest rates, which we approximated by subtracting the year-over-year CPI inflation rate from the Fed funds rate. At the time, real rates by this measure had just turned negative, meaning that the Fed funds rate was actually lower than the rate of CPI inflation. We thought this an important development because the real Fed funds rate provides an indication of the tightness (or lack thereof) of monetary policy.

Checking back in on those real interest rates, we see that they have proceeded further into negative territory and now rest at -3.6%.

---
The following is taken from a letter to investing clients written on the evening of Tuesday, July 8. 
---

The Bear Market Continues

You may recall from our last investment update that we were unconvinced by the stock rally that was then taking place. This is what we said at the time:

By early March, the stock market (as measured by the S&P 500) had declined nearly 20% from its peak. Since then, however, it has made a big comeback and is now down less than 10%. Is the downturn over?

We are skeptical.

In early 2007 we wrote an article summarizing the risks in the U.S. stock market. The article cited a study by legendary value investor Jeremy Grantham in which it was shown that, on average, long term stock market returns have corresponded quite well with valuations at the time of investment.

Here we reproduce Grantham's study with updated data and a variation or two, followed by some thoughts about where we are now in the markets and what to do about it.

Remember last year when we made fun of the financial media for raving about the completely meaningless fact that the Dow had crossed a round number? The following image was captured from the CNN homepage on April 25, 2007:

Commodities have endured a steep selloff over the past couple of weeks, a fact that has prompted vast hordes of market analysts to proclaim, with absolute certainty, that the "commodities bubble" has burst.

We find the whole situation to be a bit ridiculous. After all, the large majority of these very same analysts were entirely unable to identify the hugest housing bubble in the recorded history of the world, and before that, most of them were unable to identify the hugest stock bubble in the recorded history of the world. As a matter of fact, many of them have spent the past several years warning about an imminent collapse in commodity prices (which didn't happen) at the very same time that they were denying the aforementioned hugest-ever real estate bubble and assuring everyone that home prices would keep rising (which also didn't happen).

Have they now suddenly started getting it right?

We've believed for quite some time that the current period bears much resemblance, economically speaking, to the 1970s. Consider the following trends, all of which took place in the 1970s and are doing so again today:

• The stock market remains range-bound over the long term as inflation eats away at real stock valuations.
• Real bond yields remain very low and sometimes go negative.
• Gold, commodities, and other inflation-hedge investments are in a multi-year bull market.
• The Federal Reserve is continually behind the curve on fighting inflation.
• On weekends I wear plaid Sansabelt slacks and a mint-green polyester jacket with lapels so enormous that I am occasionally borne aloft during strong winds.

We can add another similarity to the list: the term "stagflation" is now showing up all over the news again.

---
This article is adapted from a letter to investing clients originally written on January 9, 2008.
---

Going into 2007, we already knew that whenever the economy slows down, the government floods the system with money in an attempt to "reflate" asset prices and economic activity. This is accomplished via monetary policy, which when all is said and done effectively entails printing money, and fiscal policy, which effectively consists of the government spending money it doesn't have. We knew this would be the policy response because that's exactly what the powers that be did during the prior downturn, and because those actions were considered to have been a huge success in keeping the prior recession mild (despite all the imbalances that the reflation efforts eventually induced).

What we didn't know was just how panicky and violent the policy response would be at the very first sign of trouble.

Global stock markets sold off hard on Sunday night (the US markets were closed on Monday so they couldn't react), and then sold off even harder last night. This morning, the Federal Reserve announced a surprise intra-meeting rate cut of .75%, bringing the Fed funds rate down to 3.5%. (Of course, this is one of the most widely anticipated "surprises" we've ever witnessed, but never mind that.)

Beyond all the dramatic headlines, there are a few very instructive details about today's move.

We have some thoughts on what may take place in 2008, but first we want to review the major predictions and observations we made in 2007.

Looking back over the articles we wrote last year (of which there were embarrassingly few -- something we intend to change in 2008!), the major themes we discussed largely turned out to be correct.