There is too much debt throughout the developed economies, and not enough growth to service that debt.

Phase I – Japan
About twenty years ago the giant real estate and stock market bubble in Japan began to deflate.
At its peak, Japanese real estate was so overvalued that the Imperial Palace grounds in Tokyo, which is 0.7 square miles, had a value greater than the entire state of California which has 163,600 square miles. When compared to the U.S. and European stock markets, the Japanese stock market was ten times as highly valued on earnings. Over the past twenty years, Japan has been through a major financial catharsis. The banks which made bad real estate loans in the 1980’s have been gradually restructured, and the stock market remains well below the highs it reached in 1990.
Phase II – U.S.

In 2007, the second leg of the developed economy de-leveraging began when the U.S. real estate lending bubble burst. This real estate deflation led to huge write-downs for the banks and other financial institutions which dealt in real estate loans and derivatives, nearly crippling the financial system. U.S. banks that lent on real estate or companies or that bought derivatives were badly hurt and had to be bailed out by a major government capital infusion.
We expect that the leverage inherent in the derivatives market will be legislated against in the U.S., and much of it will eventually move offshore. Many ancillary issues, such as bond ratings honesty, accountant culpability helping banks hide leverage in offshore companies, banks betting against their clients, and other issues will be part of new legislation and changes in the U.S. financial system.
In any case, the restructuring and de-leveraging will continue for at least another few years in the U.S. The good news is that U.S. companies are not over-levered. In fact, they hold a large amount of cash and liquid assets, and have been conservative in husbanding their cash flow. Therefore, U.S. stocks are not nearly as over-valued as Japanese stocks were twenty years ago. We do not expect a long term stock market decline in the U.S.
Phase III – Europe

This year’s European sovereign debt crisis has long been in the making. Europe must de-lever its public sector, which has grossly over-promised and over-borrowed to in order to provide public employees a standard of living that they have not earned, and that the governments could not afford. Awakening to this reality, and the cutting of a bloated public sector will continue for at least ten years. We anticipate many European countries will repudiate or partially repudiate debt, restructure payment terms, and cut the standard of living by as much as twenty percent for the average European.
The good news is that in Europe, like the U.S., has a corporate community that is not over-levered and has been conservative in protecting its balance sheet. This corporate liquidity will allow European stock markets to avoid the major problems that bedeviled the Japanese stock market for two decades. However, we do not see European stocks rising rapidly, if at all.
1. Buy gold and gold shares on dips. Gold should represent strong core of one’s investment strategy. We believe that gold investments can protect investors from a meltdown of sovereign debt in Europe. Europeans will continue to add to their gold positions, as will Indians, Chinese, and wise investors worldwide.
2. Sell short the Pound Sterling and Euro with a long term horizon, and use rallies to put out shorts on these two currencies.
3. Buy stocks in countries where growth is solid and the markets have corrected. Our current favorite market after its recent decline is China. Please see our letter from last week on our website for more a discussion of why we think the current pessimism about China is overstated.
Other Areas to Watch-
We are waiting for further declines before we buy Singapore, Korea, Malaysia, Indonesia, India, Brazil, and some other favorites.

We recommend that investors buy high yielding oil shares, especially Canadian companies with 7% to 8% yields. Oil prices have pulled back in recent weeks. We believe that if oil prices go below $60 per barrel, it will cause OPEC to cut production, and prices will rise.

Japan, the U.S., and Europe will have a hard time growing for the next decade.
Although Japan’s stock market is no longer overvalued, they have demographic issues that keep the economy from being able to grow. The population is aging and the Japanese do not allow immigration. Creating economic growth will be challenging, thus Japan is not one of our favorite markets.
Europe is not among our favorite markets either as their economies will struggle to grow. Even though some European corporations have good cash flow, conservative balance sheets, and Europe’s exporters should benefit from a weak Euro, we suggest that investors look elsewhere for investments. If an investor insists on buying shares in Europe, they should seek high dividends and export earnings.
The U.S. is not a favorite market of ours. Investors should buy only on dips, be selective, and look for good income, strong balance sheets, and strong earnings growth generated from internal cash flow. Focus on companies that can grow without borrowing.
In the U.S., we favor energy, exporters to Asia, and tech companies which are benefitting from mobile internet, cloud computing, and other advances in technology.
Thanks for listening

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