Volume XI, No. I

As January of 2011 draws to a close, we continue to tread carefully through our greatest economic and financial crisis since the Great Depression. Recent months find the optimists gaining traction as the economy and the stock market both perk up, leaving the pessimists brooding in the corner waiting for an opportunity to assert themselves. Will the ongoing violent demonstrations in Egypt give them their chance?

While the optimists and pessimists battle it out, rather than taking sides we’ll do our best to stay calm and find those rare nuggets of truth that help us develop the knowledge and understanding we’ll all need to survive and even thrive – no matter what the world dishes out this year.

So to begin 2011 on the right foot, we sifted and sorted through past nuggets to come up with some important lessons we believe will be especially helpful in the coming year. Let’s start with the basic lessons; then we’ll move on to how to apply those lessons practically.

Just when the optimists were calling for strong economic gains this year, riots are breaking out in the Middle East. All of a sudden, we face the possibility of disruption of oil shipments. Reduced oil supply isn’t good for the world’s economy.

While we’re tempted to say that the drama of today will turn out to be merely another item in someone’s 2011 "highlight" video eleven months from now, we really can’t be sure. Tunisia and Egypt aren’t the only countries who’ve been living under autocratic governments for decades. It could be that the cat is finally out of the bag and there may be no getting it back inside. We’ll just have to wait and see.

But let’s not forget that this all started over food. The demonstrations in Tunisia and Egypt weren’t entirely unexpected. As food prices began to rise last year, it was only natural to expect unrest, maybe even riots in countries where the bulk of the population spends a large portion of its income on food even when prices are low. After all, when food prices spiked in 2008 riots broke out in dozens of countries. And as prices began to rise yet again in 2010, the feeling was that it was only a matter of time until food riots started up yet again.

What was unexpected was how quickly things evolved into demands for regime change. Just ask Tunisia’s ex-president, if you can find him; or Egypt’s President Mubarak as he tries to calm the crowds who have taken to the street to demand his resignation.

And so we derive our second lesson:

Indeed, this is one lesson that serves you well no matter the year, but it should be particularly useful in 2011. It seems we’ve reached the point where many people have packed the disastrous events of 2007 and 2008 in a neat little box labeled "Out of Sight, Out of Mind." It’s a mistake.

No, we’re not siding with the pessimists here. The point is not to let your guard down.

Now for our third lesson:

One of the reasons we’re not bothering you with one of those "Top Predictions for 2011" declarations is that you wind up committing yourself to positions that may or may not pan out.

For example, if you tell everyone the dollar’s going down in 2011, you’ve made a commitment. So what happens if circumstances change, as happened at the beginning of 2010, when the dollar turned up in the face overwhelming negative predictions? Do you think pride might have gotten the best of you, causing you to stick to your guns to avoid admitting you were wrong?

Lesson #1 – Neither an Optimist Nor a Pessimist Be

Most of us have a natural disposition toward either optimism or pessimism. Neither one helps when it comes to money.

Remember Ben Bernanke’s sunny assurances that the American economy was so strong it would continue to grow even after the sub-prime crisis hit us? Could his prediction have been farther from the truth? Contrast this with now-famous hedge fund manager John Paulson.

Paulson had his analysts carefully and objectively scrutinize the available data and concluded that sub-prime debt was toast. And for a few years before the crisis hit, he slowly built a position betting that sub-prime would eventually be seen for what it was: garbage. When the dust settled at the end of 2008, Paulson personally made about $4 billion.

Meanwhile, when all hell broke loose in 2007 and 2008, the pessimists were in their glory. Calls for a new Great Depression if not the end of the world as we know it rang out. People whose investments shrank to 50% or less than their original value sold what was left and hunkered down in cash.

Paulson, on the other hand, built positions in – among other items – banks, many of whose stock prices had collapsed. While cash returned next to nothing, Paulson recently announced his personal gains for 2010: $5 billion.

Okay, it’s an extreme example. But the take away should be obvious. And while we didn’t make billions avoiding the tug of undue optimism or pessimism the last few years, we did OK. And so can you, if you learn this lesson.

Lesson #2: Expect the Unexpected

This one’s a bit tricky. For example, for some people, the housing collapse that started in 2006 was totally unexpected. On the other hand, many of us thought houses were way over-priced by 2003. In fact, a real estate index created Yale professor Robert Shiller – the Case-Shiller Index – pretty much confirmed what had begun to seem obvious: home prices in most of the U.S. were hitting nosebleed levels. And, indeed, most people who bought a house anytime from 2003 on were virtually guaranteed to lose money.

So to get the most out of this lesson, you have to remember that what’s unexpected to one person may not be so unexpected to another.

One way to use this lesson to your best advantage might be to remember that none of us – even John Paulson – can know everything all the time.

Another way would be to realize that, even when you’re right, you still may not know exactly how things will play out. Using our real estate example, many who thought houses were overpriced were not prepared for the extent of the collapse. Ever since house prices began heading down in 2006, we’ve been reading how house prices are "stabilizing" or "bottoming." Unfortunately, prices have continued down right through 2010 – so much so that this housing collapse has even surpassed the housing decline caused by the Great Depression. While 2011 may very well be the year when things finally do turn around, we’re keeping our expectations in check.

Lesson #3: Stay Nimble and Avoid "Committed Relationships"

Let’s use the European debt crisis to illustrate how to apply this lesson. What began as a Greek problem quickly moved to Ireland and now appears to be spreading to Portugal, Spain and Italy. As a result, we’ve heard calls for the collapse of the Euro – until it turned around again.

Then there’s the Fed’s decision to pursue their "QE2" policy of money printing causing dollar bears to declare the imminent collapse of the dollar: really?

The Euro and the US dollar keep bobbing up and down. One rises for a few weeks as the other sinks; then the steps are reversed. As the dance continues week after week, the optimists see both currencies ultimately holding each other up, while the pessimists see a macabre dance of death.

All along, we simply sit in the gallery to gawk at the spectacle, doing our best not to get our pockets picked.

In fact, staying nimble and avoiding a "committed relationship" for or against the dollar or the Euro has paid off. We thought – and still think – the dollar’s got a shaky future. Yet we made money betting on the dollar as it rose relative to other currencies in the first half of 2010. Meanwhile, our long-term view of the dollar’s ultimate destiny hasn’t changed.

While we hope these lessons help you make wiser financial decisions in 2011, there’s one more idea we’d like to leave you with before we sign off for the month. We’ll start with something we wrote in last January’s letter:

And so we come to what we believe will be the most important theme for the coming year, possibly even the coming decade: money.

What do we mean? We’ll explain by examining the idea of throwing money at problems.

Throwing money at any problem rarely works. Anyone with business experience – or even personal experience – probably understands this.

But when the Fed decides to throw money at problems, it’s different. It’s not like it has a pot of dollars squirreled away somewhere for a rainy day to tap into when a problem arises. What the Fed does is it creates the money out of nothing.

Now don’t think it’s only our central bank, the Fed, which prints money to solve problems. Central banks all around the world – from the Bank of England to the European Central Bank to every central bank in Asia, South America, even Africa – have been indulging in an orgy of money creation for years. Let’s illustrate our point using the Middle East riots we talked about earlier.

While these have evolved into calls for regime change, the fact is the root cause was higher food prices. But don’t higher food prices have more to do with supply and demand rather than money? At least that’s the commonly accepted explanation.

Indeed, most of the analyses we’ve come across focus on food price increases the usual way: an increased demand for food bumps up against a limited supply of food. And certainly, an ever-increasing demand caused by the growth of the emerging market countries in Asia, South America and Africa puts upward pressure on prices. Add to this various other factors like lower crop production due to extreme weather conditions and the problem grows even worse.

So what does this have to do with central banks and money creation?

Well, if the problem were simply one of supply and demand, eventually the increased demand would cause producers to increase supply to meet the rising demand. And then prices would stabilize. Indeed, that may be how this plays out in the coming months.

But what if these price shocks are only the beginning of an ever-increasing rise in food prices – and the prices of all commodities – around the world for months, maybe years to come?

If that happens, we have to turn to the world’s central banks and their money creation for an explanation. We find the world’s central banks have been engaged in a form of currency competition since around the year 2000.

In fact, the new millennium brought what were then called "competitive devaluations" of all currencies. What goes on in competitive devaluations is that central banks print up a ton of their own currencies to keep them cheap compared to other currencies. They devalue their currencies so that the prices of the products they export to other countries remain competitive.

The proof of this worldwide currency competition is found in the price of gold. Starting around the year 2000, the price of gold began a rise that hasn’t abated since then. While the gold price started rising against the US dollar at first, eventually it rose against all the world’s currencies – without exception. Consistent with that fact, is the fact that the price of food in terms of gold – indeed the price of all commodities – since 2000, has fallen about 50% over the last ten years.

As the prices of agricultural commodities have fallen against gold, they have risen against all other currencies. And so the rise in food prices we’re seeing now is part of a bigger pattern, a larger trend, that’s been playing out for some time now. That larger trend, originally called competitive devaluation is now taking the form of a currency war. And currency wars typically lead to trade wars. Yes, in spite of all the talk about avoiding trade wars, unless something radical and unexpected occurs, trade wars always follow currency wars. And trade wars will potentially create serious consequences for food prices around the world.

Given this longer-term trend, it’s not really the price of food that’s the problem. It’s the collapsing purchasing power of the US dollar and the other world currencies that’s now working behind the scenes to potentially cause a food crisis – maybe even an energy crisis. And all this is essentially caused by the policies of central banks around the world – policies that include, indeed rely on, the creation of money out of nothing.

Okay, it’s a lot to throw out there at the end of a letter. But we’re just trying to illustrate what we mean when we say that "money" will be our big theme this year. We hope you see why. We also hope that continuing our discussion of money will help you to pursue the kind of strategy you will need to survive and thrive in 2011 and beyond.

Next month we look at the greatest sustained uptrend in the history of modern markets. It’s one that virtually no one seems to have noticed. You’ll learn why none of your financial planning or your investment strategies can possibly succeed if you choose to ignore this incredible trend.

To a successful 2011,

P.S. – With a new Congress in session, it’s time for the rubber to meet the road when it comes to cutting back on our out-of-control government spending. Will they succeed? You can find some creative ways for the government to save money on my personal blog. I’ll also be talking about how the U.S. faces a world of increasing competition from not only China, but all the emerging economies in Asia and around the world. Come join the fun!

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com