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This article is adapted from a letter to investing clients originally written on January 9, 2008.
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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. We were constantly amazed throughout the year at all the costly bailout proposals and at the aggressive monetary policy easing in spite of high inflation, a plummeting dollar, record oil prices, near-record gold prices, and a stock market near all-time highs. It became clear that Congress and the Fed cared only about stoking short-term economic growth and bailing out financial markets, and that they cared little about preserving the purchasing power of the dollar.

We think that the the aggressive reflation efforts, along with the resulting surfeit of money chasing financial assets, were the reasons why non-housing-exposed stocks held up better than we expected in the face of last year's credit crunch. This is a lesson we have to take with us into 2008: if they pressed down on the monetary accelerator this hard when things were relatively good, what will they do when times get really tough?

We may be about to find out. An economic slowdown is already underway and we could well experience a recession. This is a real risk factor for stocks, especially considering that (as we've long discussed) the stock market as a whole is fairly expensive. At the same time, given the actions and economic philosophy of those in charge, we know that a recession or even a threat of recession will be met by an absolute onslaught of money flooded into the system.

Using the past as our guide, we can expect the following results from the reflation campaign:

1. It will prevent the downturn from being very severe, effectively easing the short term pain in exchange for exacerbating problems in the future. (Someday "the future" will arrive and this trick will stop working, but for reasons too complex to go into here, we don't think we are there yet -- and even if we are, our portfolios are well positioned for this eventuality).
2. It will fail to revive the weak areas of the economy (i.e. housing and structured finance) but will instead stimulate the areas that are already thriving. (This is why the stimulative efforts during the last go-around failed to pull tech stocks out of the abyss, but instead caused a housing bubble).
3. It will cause inflation in goods, financial assets, or both.
4. It will cause the dollar to weaken against other currencies (assuming those specific currencies aren't already overvalued or aren't being debased even faster than the dollar).

The interplay between the housing-led slowdown and the above reflationary side-effects will likely be the big factor in the markets in 2008.

Investment Strategy for 2008

Between the looming slowdown, the lousy market performance in recent months, and a generally overvalued stock market, it is tempting to just stay on the sidelines. And in deference to these facts we do have some money that is effectively sidelined in investments that don't correlate with the stock market.

But at the same time, we have to think a step ahead. We know that the monetary onslaught is coming. We suspect, per item 1 above, that the authorities will paper over the problems and keep the downturn from lasting too long or getting too deep. We also suspect, per item 2, that the reflation will do little to help the housing or financial sectors, but that it will goose the sectors that are still doing okay. We suspect, similarly, that the downturn will be deep and protracted in some areas, but mild in the areas with good fundamentals. We know, per items 3 and 4, that the value of our cash is going to be falling -- not against everything equally, but certainly overall. And finally, we know that timing the market is really hard, and that you should always have at least some exposure to the investments you think are in a long-term bull market!

Putting it all together, it's good to have some money on the sidelines, but it's also crucial to have exposure to the asset classes that will benefit from the serial reflation campaigns that effectively define the current monetary system. These include:

• Stocks in companies that produce "stuff" that people or businesses need, including commodities, industrial materials, consumer staples, and so on. The simple reasoning is that while money can be created with a few keystrokes, stuff cannot, and the latter is likely to maintain its value while the value of the former's value continually erodes.
• Precious metals stocks, because we expect precious metals to attain an increasingly larger premium as confidence in the dollar and the global monetary system declines -- the inevitable result of the "print your way out of every problem" approach that is now universally accepted in policy circles.
• Foreign stocks -- not just for benefit of getting our money into another currency, but because there is greater value and economic growth potential in countries that don't have a huge debt overhang like we do. This includes both developed markets and emerging markets, many of which are still comparitively inexpensive.
• And let's not forget our "sideline" assets, which would probably hold up well even in a broad stock downturn: carefully chosen foreign bonds and currencies, certain market-hedged investment vehicles, and some cash.

Our 2008 strategy is, in short, to have our money invested across all of the above categories. A broad stock downturn could certainly adversely impact the assets we own, but it's important to distinguish between temporary downdrafts in sectors with good fundamentals and permanent losses sectors with poor fundamentals. In the case of the former, a big downdraft can even be a welcome (if not exactly enjoyable) opportunity to increase exposure at more attractive prices.

Either way, we will be well positioned when the inevitable reflation campaign really gains traction and, we suspect, drives many of our favored asset classes to new highs.