A review of major factors that will impact 2009, our view of markets\' prospects.

1.
Review of 2008 & Outlook for 2009
PART 1: DEFLATION
ECONOMICS The argument for deflation goes something like this:
Deflation or Hyperinflation?
i. Unserviceable debt leads to distressed sales,
ii. distressed sales leads to price declines, and
A former boss once told me that every moment
iii. Such declines destroy pricing of most if not all
presents a choice to either invest or consume. I
commodity‐like goods.
interpreted his remark as a “friendly needle” to get back
_____________________________________________
to work and did so, somewhat embarrassed that I’d let
΅ Therefore, in the great unwind of excessive debt
a little polite conversation with co‐workers turn into a
accumulation; deflation is the most likely course for the
full blown aimless “bull‐session” that went on far too
economy.
long. The realization of over‐consumption often begins
with embarrassment and regret. This experience is a To test the validity of this argument, we should examine
microcosm of the state of the U.S. economy today. if there are supporting facts for the premises and if the
There is too much debt and too many steps between conclusion is logical given these facts. First, we look for
the payment of debt and the proceeds disbursement to evidence that debt is unserviceable and if so, where we
the ultimate lenders. What passed as reasonable debt are in the process of reducing levels to levels that can
management and financial innovation is now correctly be serviced.
viewed as errant and irresponsible.
Unserviceable debt ultimately shows up in
delinquencies on payment which roll into non‐payment
The answer to a period of too much consumption is to
and finally re‐possessions and charge‐offs. Delinquency
“get busy” with finding ways to create additional value
data from the Federal Reserve’s Bank Charge Off and
in order to pay off those obligations. Households need
Delinquency Rates shows residential real estate
to start businesses that create jobs, which innovate the
delinquencies at 5.11% for 3Q2008, the highest rate
economy with better goods and services, or find as
recorded and rocketing up from levels in the 1%‐2%
many jobs as each person can handle in order to
rate over the last four quarters by ever larger jumps in
provide a level of income that exceeds consumption
the rate each quarter. In other words, the news
and debt service resulting in a reasonable savings rate.
became shockingly bad and then got to numbing levels
However, the answer most economists seem to obsess
of accelerating deterioration in the third quarter, the
over is to figure out how to stiff the lenders. This comes
latest data point. This may be the biggest reason
in two flavors: refuse to pay (i.e. default, leading to
economists are saying there is no silver lining.
deflation as assets are sold) or pay with debased funny‐
money (i.e. hyperinflation).
The purpose of this article is to explore the premises
and conclusions for deflation and hyperinflation to
determine their plausibility as we look to 2009.

2. U.S. RESIDENTIAL MORTGAGE DELINQUENCY HOUSEHOLD ECONOMICS
RATE
Billy and Sue Average have a monthly income of $4,000 and
pay $938 per month in financial obligations split between
their house ($610) their truck ($200) and their personal debt
such as credit cards ($129). If the rate they are paying on
their house is 6% on a conventional 30 year mortgage, then
we figure their mortgage is for just over $100,000. If they
refinance at the fixed rate available on December 18, 2008 of
5.19% on a conventional 30 year mortgage, their monthly
costs for their house drops to $557 before any refinancing
costs. Thus so far, the Federal Reserve’s actions create a
potential $50 benefit or 1.25% benefit in their monthly
budget. This can easily get squeezed out by more punitive
terms on their credit cards. If the other mortgage owners in
The historical levels of debt in relation to income may
the United States did the same thing, they’d lower the overall
signal where we are in the process of unwinding debt.
Financial Service Obligation ratio from 14.0% to 13.14%.
We look to the Federal Reserve’s Household Debt and Thus, current rates are very helpful, but a drop of another
Financial Obligation Ratios to gauge debt in relation to 1.0% in mortgage rates is probably needed to achieve more
income. The news here is grim: homeowner’s sustainable debt service, absent changes in take home pay.
household financial obligations took 18.17% of income
However, before we give up on Billy and Sue, we should
at 4Q2006 the peak, compared to 3Q2008 figure of
remember that their cost of filling the truck with about 85
17.64%, an average since 1980 of 15.42% and a low of
gallons of fuel per month fell from about $350 to $150.
13.33%. (If those numbers look low, it is because it
They’ll likely spend a portion of this windfall but save most of
includes approximately 1/3 of households that own it because they weren’t able to sleep when it cost $350 per
their homes free and clear and have numbers near month to keep the truck going and they’re anxiety is above
zero.) In other words, if getting back to the long term average. Our postulate that consumers react to windfall
average is the goal, then we are less than 20% done mostly with savings is a departure from the past and strictly a
with the task of getting there through September 30th, hunch. We base our hunch on the increase in credit card
debt as gasoline prices rocketed upward and believe savings
2008.
rates for most households went negative. We also view the
spike in delinquencies by an unheard of 1.0% to 5.1% in
3Q2008 as related to this and likely to moderate.
FINANCIAL OBLIGATIONS OF US HOMEOWNERS AS A
PERCENTAGE OF EARNINGS Moving to the next two premises, we need to see that
distressed sales lead to price declines and that those
declines begin to affect most goods. More specifically,
we need to see general price declines that show up in
consumer prices, not in financial markets or in the
prices of investments such as housing. (There seems to
be no argument that housing and financial asset price
deflation has occurred.) The Department of Labor’s
monthly Consumer Price Index for All Consumers Fell
1.7% in November 2008 versus the previous month and
rose 1.1% compared to November 2007. The entire
decline from the previous month related to energy
costs, which fell 17%. Thus, based on the facts available
today, a generalized deflationary environment has not
yet occurred.

3. CONCLUSION REGARDING DEFLATION be absorbed by the economy. The result is either
mis‐investment into unproductive activities that
Deflation is limited to basic commodities, that create future bad debt charge offs, or the Federal
consumers will not react so much to stimulus plans as Reserve is simply “pushing on a string” cutting rates
they will to lower debt service costs, and that the road with no discernable positive effect on subsequent
from a propensity to consume beyond one’s means to activity, as General Bonkers indicates in the
fiscal rectitude will be a long one. We haven’t seen a following news flash:
data point that proves out any notion that the rise
problems servicing debt has stabilized, but we found
some solace in looking at an average couple’s monthly
budget and the cost of gasoline, which swung to their
favor in the past few months. That said, the economy
(like me and perhaps others) has been over‐indulging
and has decided to stop it. It may make us cranky and
uncomfortable, but we shouldn’t lose sight that we just
started doing a good thing that has real benefits.
PART 2: HYPERINFLATION
The argument for Hyperinflation is often some variant
(Though irreverent and at times grossly offensive,
of the following:
The Onion is a must read in these anxious times!)
i> Inflation is always and everywhere a monetary
The chart below shows that monetary base has
phenomenon
grown but on the surface casts doubt on the
ii> A massive increase in the monetary base has
contention that it is out of control. It is updated to
occurred
November 30, 2008.
__________________________________________
NARROW MONEY (M1) GROWTH YEAR ON YEAR,
΅ Therefore, as the economy fails to absorb the S.A.
slosh of money in the financial system,
hyperinflation is inevitable.
The first premise is a quote from Milton Friedman in
A Monetary History of the United States, 1967‐
1960. Those who accept the statement are most
likely in the Monetarist or the Austrian school of
economic thought, while those that reject it are in
the Keynesian school. A Keynesian believes
government spending and actively managing
monetary policy smoothes out the gyrations of The main problem with growth in high single digits
capitalism’s business cycles and adds value. presently is that it has to be compared to economic
Friedman’s view is that such government growth rates (about ‐6.0% for the 4Q2008) to
interference distorts and prolongs the adjustment determine how much money growth will be
process and subtracts value in part by destabilizing absorbed into the economy and how much will
money as a store of value. slosh into either financial markets (creating asset
bubbles) or the real economy (creating inflation).
I am most closely aligned to the Austrian School,
This is a huge point (not my own), worth reading
concerned that narrow money growth that cannot

4. several times to take it in. Dr. Frank Shostak of MF CONCLUSION ON HYPERINFLATION:
Global pointed this out to me and then showed me
NOT NOW HONEY, I HAVE A HEADACHE
the calculations behind it. My tests of his statement
showed it has uncanny ability to precede turns. We’ve changed our thinking about hyperinflation
Furthermore, a look at his past newsletters shows twice now. Once thinking it was imminent as the
they scream sell and buy signals that precede major government announced ever more fiscal stimulus
market turns. However, as a trading rule, the coupled and massive monetary stimulus, then
instability around the time lag between this signal thinking it was impossible because of all the slack
and economic and market turns makes its practical (i.e. output gap.) It is not imminent unless the
use difficult for me to implement. In a long/short capital markets unfreeze. Slack does not make
world, the market can indeed remain irrational hyperinflation impossible because the Great
longer than you can stay solvent. For those of you Inflation of the 1970s we studied over Christmas
who want to give it a go, you should realize the M1 break had periods of considerable slack.
money stock figure has to be modified into a Pool of
We have a considerable headache of managing
Funding figure and the time lags to the economy
through a lack of liquidity to pay down or service
and financial markets are different. I’m not about
debt that has to be worked through before the
to tell you how to replicate that because I wouldn’t
Keynesian policy mix of today, vitiated by changing
want to jeopardize Dr. Shostak’s business. What I
propensity to consume and collapsing monetary
will say is the model makes a ton of sense and
velocity shows its pernicious effects on money as a
converted me to the Austrian school of thinking.
store of value. For now, take two aspirin and get
We look at the monetary base intuitively using facts plenty of rest.
that suggest a temporary preference for holding
money balances rather than a spring‐loaded signal
that the economy is about to begin spending down
those balances with new investments and
consumption. We look at bank balance sheets we
conclude they are still lending, but mostly to
Commercial & Industrial borrowers who used to
borrow money in the commercial paper and
corporate bond markets, and who had the foresight
to negotiate letters of credit for scenarios such as
this. For everyone else, credit has tightened and
those who can hoard precautionary cash balances.
It is only when the freeze up of credit markets
dissipates that we need to worry about an economy
spring‐loaded for inflation. So the time lag
between excess money growth and future
distortions to markets and the economy is, in our
view, especially unpredictable at this time.

5. The present trailing 12 months P/E of 16.8 X (Index 863,
Equity Market Outlook trailing earnings of $51.37 to June 2006) looks better
than recent history, but still quite far from the levels
Valuation that suggest a multi‐year bull market can be built from
it.
Price/Earnings Ratio
The preceding chart also illustrates why we think value
The equity market, as represented by the Standard &
investing on a top down basis is often frustrating.
Poors 500 Index, is not attractive on the basis of trailing
Imagine you correctly concluded in December of 1974
12 months earnings. The table below compares the
that the market was absurdly valued at 7.71 times
market Price/earnings ratio to available history from
trailing earnings. By December of 1978, the market was
Standard & Poor’s:
trading at 7.79 times, and in March of 1980 it would
reach 6.68 times earnings. So for five years and a slew
Standard & Poors 500 Index Valuation
of lost clients or a lost job, you’d have to endure an
unrewarding market before being proven spectacularly
50.0
40.0
correct for the next 20 years.
30.0
20.0
10.0
If we look to forecasts of earnings, the table below
0.0
shows the projected Price/earnings ratio is attractive
1 2/3 1 /19 3 6
1 2/3 1 /19 3 9
1 2/3 1 /19 4 2
1 2/3 1 /19 4 5
1 2/3 1 /19 4 8
1 2/3 1 /19 5 1
1 2/3 1 /19 5 4
1 2/3 1 /19 5 7
1 2/3 1 /19 6 0
1 2/3 1 /19 6 3
1 2/3 1 /19 6 6
1 2/3 1 /19 6 9
1 2/3 1 /19 7 2
1 2/3 1 /19 7 5
1 2/3 1 /19 7 8
1 2/3 1 /19 8 1
1 2/3 1 /19 8 4
1 2/3 1 /19 8 7
1 2/3 1 /19 9 0
1 2/3 1 /19 9 3
1 2/3 1 /19 9 6
1 2/3 1 /19 9 9
1 2/3 1 /20 0 2
1 2/3 0 /20 0 5
based on bottom up (i.e. each company in the S&P 500
is forecast, with the resulting forecasts summed and
Quarterly from 1937 to June 2008
adjusted to an index forecast) operating earnings but
based on top‐down forecasts (i.e. models of the
12 MO P/E 10 year Average
economy and other factors are used to project total
The P/E ratio based on trailing earnings has to be used index earnings) the market still looks unattractive:
with caution because earnings become depressed in
STANDARD & POOR'S INDEX SERVICES
recessions and rise unsustainably at peaks.
Nevertheless, I was surprised to find that trailing P/E as S&P 500 EARNINGS AND ESTIMATE REPORT
a Global Asset Allocation rule worked almost equally as
well as forecast P/E in allocating capital to foreign Data as of the close of: 12/23/2008
markets. As I ruminated on that, I came to two S&P 500 close of: 863.16
Dividend yield (last 12 months: Nov,'08) 3.30%
judgments:
Dividend yield (indicated rate) 3.09%
1. What is true for many of the parts does not
have to be true for the whole. If the index is OPER AS REPORTED OPER
well diversified, the cross currents of EARNS EARNS EARNS
company/industry fundamentals and the law of P/E P/E P/E
large numbers seem to produce an aggregate (ests are (ests are (ests are
bottom
signal that is useful. up) top down) top down)
2. A market whose earnings are depressed
because of falling earnings can be just as
ESTIMATES
dangerous as one whose price appreciation
12/31/2009 10.49 20.43 14.89
looks excessive in relation to earnings power.
09/30/2009 11.47 21.04 15.65
The risk of adverse events such as bankruptcy
06/30/2009 12.34 21.35 15.39
and the impact of exogenous shocks are much
03/31/2009 12.89 19.75 14.49
greater in the falling earnings market.
12/31/2008 13.20 17.96 13.84
09/30/2008 (99% actual) 13.32 18.78 13.32
Source: Standard & Poor’s

6. We view the bottom up forecasts as less reliable in a Economic Momentum
recessionary environment because stock analyst
forecasts are largely fed by corporate executives, who One of the best indicators of future economic
are loathe to guide to numbers that might lead one to momentum is the OCED Leading Economic
question their financial position in relation to bank Indicators. Brian Gendreau of ING showed me a
covenant violations. In the bull market of the 1990s, it particular method of working with this data that is
was more accurate to use the bottom up forecasts. historically a useful prediction tool for Global
Tactical Asset Allocation. Based on his
DIVIDEND YIELD
methodology, the economic momentum of the
United States shows accelerating deterioration.
Dividend yield is a more fashionable way of looking
There is simply no let up in the indicators that turn
valuation lately because the dividend yield of the
first that suggest the economy will stop
market now exceeds the yield on 10 year US
contracting. Germany is simply falling off a cliff,
Treasury bonds for the first time in 50 years. If we
deteriorating much more rapidly than the United
use a simple one stage dividend discount model we
States. Japan’s rate of deterioration is only slightly
find:
worse, while the United Kingdom and Canada are
Price (863) = ($26.67/Required Return, S&P 500 – about equal in the rate of sliding indicators.
Growth rate in dividend to perpetuity)
Perhaps the most worrying series I found in this
If we assume a growth rate into perpetuity of data is that China is sliding even faster than
about 4%, a long run Nominal GDP growth Germany. The risk to social unrest is significant
forecast, we can solve for the Required Return, and building. The implications for investment
S&P 500 to compound at 7.09%. That compares to would be that China’s large reserve balances of US
a present 10 year US Treasury yield of 2.07% bonds could be at risk as they spend whatever
making the Equity Risk Premium 5.02%. That’s not resources are available to mitigate the impact of
a bad level relative to history and suggests long the slowdown on the ruling party’s power. Already
term investors will get rewarded. However, the a large (16 trillion renminbi) fiscal stimulus package
level of the Equity Risk Premium looks unattractive has been announced, but like the US, they may
when looking at investment corporate bond employ “ad hoc” solutions that grow in size.
spreads (2.68% spread for Aaa debt, 6.05% spread
Pool of Funding Analysis
for Baa debt), and preferred stocks yielding high
single digits to, well, yields that suggest a dividend
Narrow money measures of the near term
cut is just around the corner. It is therefore not
prospects for the economy suggest that help is on
surprising that Mohammed El‐Arian of PIMCO
the way, but it will take several months before it
suggests “going up the balance sheet” (i.e.
begins to transmit into the economy. The current
investment in corporate bonds instead of direct
rate of money expansion year on year coupled with
equity investments.) Going long preferred and
declining Nominal GDP suggests that large money
corporate bonds and shorting stock may become a
balances are being accumulated that will ultimately
very popular trade.
find their way back into markets. Narrow money
In conclusion, despite a sizable sell‐off, the supply (the Pool of Funding) growth began to
argument for owning stocks based on valuation is accelerate in the summer of 2008 and has
weak. There are plenty of remaining risks and continued to do so ever since. Prior to that, the
other alternatives may have a better risk‐reward pool of funding was highly stressed, suggesting
trade off. negative returns. If the time lags hold to historical
levels, the year would pan out with a weak first

7. quarter, a remainder of 2009 that has fits and Conclusion
starts of improvement, and significant ramping
upward returns in the final quarter of 2009 and We hope that by providing several angles on the
into the first quarter of 2010. It sounds like a good current state of play in the equity market that we
script! provided perspective that may be of interest to
you. As always, we continue to invest using our
Technical Analysis trading rules that are technical in nature. We
thank our investors for their continued trust in us
Trend analysis is producing positive returns and will continue to work to earn that trust again
because investors are still catching up to the new in 2009.
reality of global debt deleveraging. However, our
read of oscillators suggests there has been an
overreaction to recent negative news. Moreover,
Respectfully Yours,
the risk of a painful reversal for trend followers is
high because the distance between current market
levels and the long term trend lines is too great.
David F. Cooley, CFA Patrick J. Kennedy
Our proprietary combination of these indicators
suggests remaining in cash for the near term.
We are optimistic that we’ll spend a significant
portion of 2009 on the long side while occasionally
selling into rallies during the “base building”
process that markets often go through before
beginning a sustainable rally. One of the risks we
face in 2009 deals with how we respond to
movements near our trend line or whether
markets have a large “melt‐up” scenario that
catches us short. One of the opportunities we face
in 2009 could come from sideways motion that
works well with the oscillator tools we use to
measure entry and exit points.
This review and summary should not be viewed as a
solicitation offer or construed as investment advice.
The contents of this article are views and opinions
presented by FirstPoint Advisors and their principals.
Please visit our website for further information on our
firm and investment strategies:
www.firstpointadvisors.com
Contact Information:
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Cleveland, OH 44116
Phone: (440) 356‐1884
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