I received an interesting email out of the blue yesterday from Archie Kangethe, a Vice President at Morgan Stanley Smith Barney.

Good Morning Mish,



If you have time please check out the chart below from Dr. Kelly at JPMorgan. The data from the US government would lead me to believe we are in the lower left quadrant, but my daily life leads me to believe we are in the upper left. If we are indeed in the upper left and the markets were to perform as it did in the past; commodities and cash could do well.



I would love to read your thoughts.



Archie P. Kangethe

Vice President-Wealth Management

Financial Planning Specialist

Financial Advisor

MorganStanley SmithBarney

2Q 2011 Guide to the Markets

Total Private Payroll

Forward Earnings Estimates

GDP - The Great Depression vs. The Great Recession

US Headwinds

Expiring unemployment benefits



Cutbacks in state budgets

Rising taxes in many states

Congressional focus on cutting the deficit

Pent-up demand for autos is exhausted

Renewed housing slump

Massive housing inventory

End of QEII

Gas prices over $4

Global Headwinds

Rising interest rates in Europe

Renewed sovereign debt crisis in Europe

Rising interest rates in China

Regime change in China in 2012

Unsustainable growth in China

Property bubbles in Australia, Canada, China

CPI 1960-2011

CS-CPI vs. CPI-U







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Four Quadrants of Inflation

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Prices a Poor Measure of Inflation

Four Quadrant Inflation as a Method of Investing

Can it Be that it was all so simple then?

Or has time rewritten every line?

Four Quadrants a Poor Investing Model

It fails to consider in valuation It fails to factor in cycles of PE-expansion and PE-Contraction

Valuations Matter

Annualized Rates of Return for Select Years







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Note how much the starting PE valuation matters. Someone who started investing in 1929 received an annualized rate-of-return of 0% for two full decades, even if they religiously reinvested dividends every year.



However, someone investing in 1982 received an excellent annualized rate-of-return for two full decades (12% for the first decade and 9% annualized for 20 years).



Note year 2000. Starting valuations were the highest in history. It should not have been a surprise to discover that 10 years later, the annualized rate-of-return was -2%.



Bear in mind, the Case-Shiller normalized PE for the year ending 2010 is 23. Does that bode well for the next decade?



Cycles of PE Compression and Expansion







Over long periods of time PE ratios tend to compress and expand. Unless "it's different this time", history says that we are in a secular downtrend in PEs. From 1983 until 2000, investors had the tailwinds PE expansion at their back. Since 2000, PEs fluctuated but the stock market never returned to valuations that typically mark a bear market bottom.



Moreover, demographically speaking, the current decade not only starts with very rich valuations, but also comes at a time when peak earnings of boomers have passed. Those boomers are now heading into retirement and will need to draw down savings, not accumulate large houses and more toys.



Of course, the market can of course do anything this year (or the next few years), but history strongly suggests that stock market returns for the next 10 years will be lean years, perhaps negative years.

Commodities Analysis