The $1,300 trillion derivatives market is an indicator of gross abuse of a system originally intended to hedge risk through the separation of risk and rewards associated with a security from the underlying security. Now $1,300 trillion is several times the global GDP and global market capitalization - is this indicative of the extent of leverage of the system? And if yes, how will it affect the real economy?

The $1,300 trillion is a notional value; it is the gross value of all trades. The actual exposure is normally measured by the net credit equivalent; i.e. the gross value less trades amongst counterparties which cancel out. The net credit risk is normally one fiftieth of the gross exposure; i.e. potentially $27 trillion. Now not all of this will go bad. Assume a default rate of 10% (which is higher than the maximum default rate of 8.74% during the Asia crisis) and assume a 25% recovery (below 26% in Asia crisis and 40% in the history of default); we have a potential net economic loss of $2 trillion; not nice but possibly manageable.

The US package makes $750 billion available in addition to $1.5T in guarantees of senior notes; in Britain GBP 500 billion is being made available; in EU Euro 1.16 Trillion has been made available; in total the amount now available exceeds a fairly conservative estimate of the losses which will arise. The problem is that the exposure starts rising from $27 trillion towards its gross value if there are insolvent counterparties involved in the trade. It is for this reason that I am of the firm view that the derivative market must be legally unwound so that only the real economic risk protected remains and that transaction should be fully reflected solely between a person with an insurable interest and the insurer. Part of the derivative market covers a real economic activity. Where someone owns a security and wishes to cap risks, it sells future reward potential to an interested buyer in exchange for a premium and an assurance that downside risks will be met by the buyer. When the value of the underlying instrument collapses, there should be a transfer of wealth from one party to the other. The size of the market is indicative of derivative transactions which go well beyond true economic activity.

For example, if the someone who owned a security wanted to over the economic risks associated with ten times its holding, while passing the economic rewards associated with ten times its holding to the protector, what we have is real economic activity of one tenth of the transaction and a speculative bet amongst fools for nine tenths of the transaction. If we have a counterparty that transacts to benefit from a default event where it has no exposure to the underlying security; we have a speculative trade; a bet amongst fools.

When a liability arises, the protecting institution has to pay. In order to pay, absent adequate capital, assets are sold at distressed values. The buyer of distressed assets will gain in the future as the acquired asset pays back more than the price paid for the distressed asset. If the price realized from sale of distressed assets is below the liability, the protecting bank needs additional capital to pay on its obligation, or it goes insolvent. Insolvency solves no problems, indeed it escalates the problem. Since nothing good comes out of insolvency, a government rescuer can either buy the protecting banks assets at a slight discount to a realistic expected value, thus providing the bank with funding to pay out its obligations and maintain its capital adequacy. Alternatively, it can provide capital to the protecting bank, which will allow the protecting bank to hold its assets to maturity; it will also provide a source of funds from which the bank can pay out on its commitments.

With counter party risks so high, it is not surprising that banks will not lend to each other. Credit to the real economy suffers, because a bank will fund its debt to a corporate or individual borrower partly by debt and partly from capital. Because credit markets have ceased up, there is really no ability to lend; only one lender remains on the market and that is the lender of the last resort. To unfreeze the credit markets, the counter party risk needs to reduce. To do this, the derivatives market needs a colossal unwind. By now it should be clear that institutions do not and never had the financial muscle to honor the gross transaction values to the tune of $1,300 trillion. The market size needs to shrink to a level where insured risks include only situations where the underlying security of owned by the insured party. If the unwind is not voluntary, it should be enforced. After all, a speculative bet amongst fools is a transaction where one party insures a risk with no insurable interest; and that should not be legally permissible.

Now Warren Buffet is amongst my favorite people; if I owned shares in Berkshire Hathaway, I could make a case for having an insurable interest in his life because of the risks to the share values on the event of his death. If no one sold me cover, I could protect downside through derivatives. Since I do not own shares in Berkshire Hathaway, I have no insurable interest in his life; nor do I have a right to protect against an event of loss in value of Berkshire Hathaway shares.

Once the counter party risk is lowered, credit markets will unfreeze. The governments can then work on rescue packages which inject capital into banks allowing them to honor real economic losses while holding their assets to maturity. There is no fear that capital infused will be used to pay out on the speculative bets amongst fools, because that bet will have been unwound.How will an unwinding of leverage in the derivative markets impact the real economy? I think not at all, because by now it is quite clear that the protection is not worth the paper it is written on.

The healing process has begun, much remains to be done, but the way nations of the world have responded it is clear to me that the economy will respond. Perhaps an anaemic response for the next couple of years but then the price for a massive abuse of the system has to be paid for; chances are the price will be paid over a few years instead of all at once. The bad news is that nations will be over-leveraged as will consumers & financial investors; corporates are in relatively good shape but will suffer spill over effects while the leverage unwinds. Once it unwinds, there are major China and India growth drivers to provide a multi decade growth opportunity. Yes growth may be somewhat slower compared with the recent past, but it will be sustainable and that is what counts for a healthy economy in the long term. People need to get over the instant gratification investing style.

The U.S. economy is headed for two quarters of negative growth in the first half of 2009, according to 43 forecasters surveyed by the Federal Reserve Bank of Philadelphia. The forecasters project that real GDP will contract at an annual rate of 5.2% in the first quarter and 1.8% in the second quarter of 2009. The survey participants expect economic recovery to begin in the third quarter of 2009. On a year-over-year basis, growth is expected to be -2.0% in 2009 and 2.2% in 2010. See chart above.

Valuations have now been driven into the ground. In my view, there remains a 12.5% downside to recent intra days lows. It is a time when it is scary to invest; yet it is likely to be amongst the better investment opportunities through 2015. Two portfolio's can be viewed at http://www.maxkapital.com/USIndiaPortfolio.pdf.

The aim of these portfolios is to pursue capital growth, on the theme that growth once unleashed following economic reform, cannot be stopped. The BRIC's will continue to grow; that is irreversible. What might change is the manner in which growth is financed. Compared with the past, I see higher levels of equity and lower levels of debt financing growth; the project quality will improve and the growth risks will decline as management will be more focused on ensuring return on equity is more than cost of equity.

How long will it take for growth to renew - why it will never stop. High growth will likely renew during 2010. This delay is not only necessary, it is healthy. BRIC Corporations have grown at a breathtaking pace over the past five years; time is required to consolidate the gains before re-commencing the process of building upon those gains.

Key sectors which will benefit are Energy, Basic Materials & Industrials. I tend to look at Basic Materials & Industrials as a single sector because of a high degree of sector co-dependence. Accordingly I am heavily overweight all three sectors. I also remain significantly overweight healthcare because that is a sector in which I see great 2 decade potential; it is the area which will outperform after the infrastructure of nations has been built. Financials is my main underweight sector, and this is because while stocks do look cheap, I have been unable to find a way of valuing an enterprise in the present market; if I do not understand valuations, I avoid the sector. I would love to buy Citi at $9 because I feel the franchise in itself is worth that much, but after seeing several masters fail, I will not risk it just yet. I am also underweight Staples on valuation and Discretionary because the sector is driven by the US consumer, who is in trouble and likely to remain so for a while yet.

Other than looking at Basic Materials & Industrials as a single sector, I also look at Ultilities & Telecom as a single sector; like water, waste, gas, electricity; today telecom is more a less a necessity; since it is a service everyone requires and several provide, I see it as no different from a traditional utility. I also do not view IT as a unique economic sector. I allocate IT 50% to discretionary spending with the remainder being pushed out to economic sectors. The reasons I do this are noted on the US & India Portfolio file.

In putting together the portfolio, the primary objective is capital growth over the course of an economic cycle (5 to 6 years). Total stocks have been kept at under 16 simply because I do not believe an individual can reasonably follow more than that number of stocks. If you do not follow your stocks (including hearing the conference calls, reading press releases, reading SEC filings etc.) closely, you should start; investing is neither art, nor science; it is simply a reflection of hard work coupled with the ability to manage risk.

A secondary objective, is to try and secure yield of near 6.5%; this should help keep our nerve during these volatile times! 6.5% is selected mainly because it reflects the long term market returns; so any capital gains eventually made are pure out performance.

For the US Portfolio, most of the companies selected are included on the recently published Dow Global Index. The India Portfolio includes several from the Dow Jones India Titans Index. In the US Portfolio, several companies are European; the dividends are paid out annually or semi annually for AXA, NOK, SI and Vodafone. These companies declare and pay dividends in a functional currency other than the US$. The dividend per share used is the most recent dividends converted at present exchange rates; for this reason, the US$ dividends are lower than what you will see on most websites; the US$ has strengthened considerably over the last year. MT & BP are also not US; however since they declare and pay dividends quarterly in US$ no adjustment or estimate is necessary.

CCL is included on this list because I feel it is a good long term play. However, with its dividend being suspended, I expect the share to trade down to near $12; this level represents 65% of book value (excluding goodwill and intangibles).

What is missing on this list is (1) Food Plays; this is an area of fundamental long term strength. MON, MOS, POT can be considered. I have not included any as the capital appreciation and dividend yield do not look attractive as in other sectors. Yet, I believe these companies belong in a good multi decade portfolio. (2) Water Plays; to date, I have been unable to find any solid companies which will be able to address water resource management. This is an area which is very important with the demographics of the population in India & China growing as they are.

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Since writing CCL & FCX have been dropped. Added in place is M & RTP.

The Real Index If the S&P Comp is restated to 2008 price levels, 2008 has had a real index decline of 48%. This is the worst level of decline during the period from 1929 to 2008. The next worst decline in the real index occurred during 1931 (40%) followed by 1937 (38%) and 1974 (36%). Both 1937 and 1974 marked market index lows as the following years were up 17% and 21% respectively. During 1931, the index was 10% lower during 1932, but 1933 was 29% higher than 1931.

The Great Depression Did you know that the S&P Comp fell from a high of 21.40 in 1929 to a low of 6.82 in 1932? If you restate the index values at 2008 index price levels, the real index fell from 170 during 1929 to 108 during 1932. During this period, deflation prevailed; long interest rates were in excess of 3% and real interest rates averaged 8.9%. Real GDP fell by 23% during these times; real earnings fell by 68% from a high of 20.32 during 1929 to 6.51 during 1932. Valuing the real earnings of 6.51 during 1932 at the 11.61 multiples prevalent in the market place today would result in a real index level of 75.60 for 1932. The real index value back in 1932 was 108. Put differently, the market today would need to trade at 1146 to reflect valuations equivalent to those prevalent during 1932. Valuations today are more pessimistic than the most severe market dislocation during the past century. The Oil Shock Did you know that the S&P Comp fell from a high of 106 in 1968 to a low of 67 in 1974? If you restate the index values at 2008 index price levels, the real index fell from 663 during 1968 to 294 during 1974. During this period, inflation prevailed and peaked at over 11% during 1974; healthy disinflation (not deflation) occurred for the next few years. Long interest rates averaged of 6.65% during 1968 to 1974 and real interest rates averaged 0.88%. Real GDP fell by 1.6% from 1973 to 1974; real earnings fell by 18% between 1974 and 1975. Valuing the real earnings of 39 during 1974 at the 11.61 multiples prevalent in the market place today would result in a real index level of 453 for 1974. The real index value back in 1974 was 294. Put differently, the market today would need to trade at 520 to reflect valuations equivalent to those prevalent during 1974. History is a Guide Historic market dislocations are a guide to what might occur in more recent dislocations. But always keep in mind that what actually occurs depends more on the future outlook at the time of dislocation. What to expect in the future? National Debt On the negative side we have debt to GDP running at near 70% compared with 50% on average since 1929. This level of leverage will partly limit the national ability to fiscally stimulate the economy. Yet, will a 70% debt to GDP ratio all is not lost. The ability to inject fiscal stimulus may well be unpopular but it can be done to rescue an economy. We fight different wars today; during the build up to World War II, the debt to GDP ratio rose from 30% during 1941 to 116% during 1945. Some might also consider the rising debt to GDP ratio as healthy; during a time when the private economy de-leverages, the overall debt in the economy can stay unchanged as the nation increases leverage. GDP & Demographics The 15 year average demographic growth in the United States has been 1.09%; during the same period real GDP growth has been 2%. Since 1929 the average annualized demographic growth in United States has run at 1.16%; real GDP has grown at 3.25%. Going ahead, demographic growth should slow to nearer 0.85%. Since the US economy is mature, over the long term, US real GDP can be expected to grow at 1.5%. Earnings Since 1929 the average annualized demographic growth in United States has run at 1.16%; real earnings have growth at 1.56% and real GDP has grown at 3.25%. The real index has grown at an average annualized rate of 1.38% which is below earnings growth; this is not surprising since an average earnings payout since 1929 has been 48.75% (last 5, 10 and 15 years have been 35%, 38% and 39% respectively). It is also important to note that earnings have grown at a mere 47% of real GDP growth. Looking at United States on a stand-alone basis, real earnings growth of at least 1% annualized can be expected and one would expect the real index to grow at a similar rate. In this day and age, it is quite foolish to look at United States on a stand-alone basis. During 1974, what was absent was a future earnings growth catalyst; which is probably why the relative valuations were worse than present. During the Great Depression years, relative valuation probably never got as bad as it is today, because the long term domestic growth expectations remained elevated following the rapid industrialization and reform which occurred during 1870 to 1916. Today, globalization presents a huge future growth catalyst; and this is the main reason I believe the markets are significantly mispriced. Over the last 15 years, the Great Chinese Expansion has led to annualized real earnings growth of over 5% in the United States. During the Great Chinese Expansion, over the last 15 years, real earnings in the United States have grown at 244% the GDP growth rate. What is important to note is that since 1929 real earnings have grown on average at a rate of 47% of the average growth in real GDP; contrast this with 244% now and you see the massive positive impact globalization has had on the United States. Long term the Great Chinese Expansion will continue; industrialization and reform takes near on 50 years, so the Chinese expansion is at the middle stage; a powerful time. Some moderation in growth can be expected because of the high base effect; however, the reduction caused by slowing growth in a larger Chinese economy, will be more than offset by new growth drivers – Brazil, India and Russia. For United States real earnings growth, I would look for at least 1% driven by the domestic economy and a further 1.5% driven by global growth drivers; in total real earnings can be expected to grow at 2.5% annualized for the next several decades; that is 5.5% to 6.5% growth including inflation. Inflation Another important consideration is inflation. Average annualized inflation since 1929 has run at 3.26%. Over the last 15 years inflation has been driven down to 2.74%; the reason is simple – China the Factory of the World. This positive is now over. The currency in China will strengthen and long term average inflation levels can be expected to rise to 3% to 4% range. In the very near term (12 months), inflation can be expected to dip from 4.45% presently to 2%; de-leveraging in the private economy will provide a healthy dose of disinflation before inflation reverts to its long term natural level of 3% to 4%. Interest rate On average, since 1929 interest rates have been at 5.25%; inflation adjusted inflation rates have been 1.92%. Over the last 3 years they have averaged 4.29%/0.80%. Over the past 5 and 10 years they have averaged 4.27%/1.13% and 4.63%/1.87% respectively. This lowering of long term inflation adjusted rates in the recent has been unhealthy; it has occurred because of the ability to use derivatives to “insure” risk. I would look for real interest rates to increase to 2% - i.e. a 5% to 6% long term rate including inflation. Index Levels If we accept a starting point for $69 as average real normalized earnings level which can be grown at a 6% rate (including inflation) in perpetuity; then an investor looking for a 12.5% return (including dividends) should put money to work at 825 levels.Select Econometrics can be viewed at http://www.maxkapital.com/USEconomicData-MarketDirection.pdf.

Some of the best investors in the world who have recently become bullish, at least for the short/intermediate term:

• Warren Buffett , “Buy American. I Am.” The New York Times, October 17: A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

It is likely, that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

• Jeremy Grantham, “Reaping the Whirlwind”, GMO Quarterly Letter, October 2008: On October 10th we can say that, with the S&P at 900, stocks are cheap in the US and cheaper still overseas. We will therefore be steady buyers at these prices. Not necesarily rapid buyers, in fact probably not, but steady buyers.

• John Neff, “Former Vanguard guru is buying stocks”, Philadelphia Inquirer, October 15, 2008:... an awful lot of things are available at a friendly price. It’s the kind of market I’d take advantage of.

• Barry Ritholtz, “10 Bullish Charts, Signals, Indicators”, The Big Picture, October 10, 2008: Today, we look at specific data and charts that can provide some insight as to how extreme these present levels are. All these suggest to us that we are increasingly close to a bottom that can be purchased for an upside trade of 20-30% from these levels.

• John Hussman, “Why Warren Buffett is Right (and Why Nobody Cares)”, Weekly Market Commentary, October 20, 2008: The best way to begin this comment is to reiterate that U.S. stocks are now undervalued. I realize how unusual that might sound, given my persistent assertions during the past decade that stocks were strenuously overvalued (with a brief exception in 2003). Still, it is important to understand that a price decline of over 40% (and even more in some indices) completely changes the game.

• Steve Sjuggerud , “I Never Thought I’d Get Such a Great Opportunity....”, Daily Wealth, October 21, 2008: I didn’t think I’d see this situation in my entire investment career.....I never thought I’d be able to buy stocks as cheap as they are right now. It’s a time of exceptional value....

• Todd Harrison, “Have we seen the 2008 trading low?”, MarketWatch, October 15, 2008: It’s my opinion that we’ll look back at last week as the 2008 trading low (not to be confused with a market bottom) before a harsher downside comeuppance arrives next year.

• Michael Panzner, “Bear Market Rallies”, Financial Armageddon, October 8, 2008: As someone who has been around markets for a while (with plenty of scars to show for it), it is hard for me to look at the level of extreme pessimism and the number of indicators flashing ”oversold” in today’s equity markets and not think prices are probably due for one of these periodic, hope-breeding rebounds.That doesn’t mean I’ve turned bullish, of course. Just realistic.

• Doug Kass, “Buy It Like Buffett”, TheStreet.com, October 20, 2008: Investors (not traders!) eyeing the intermediate-term outlook should now begin to feel like an oversexed man in a harem, as this is the time to start buying stocks.

I don't think the financial crisis is over....far from it, infact. However, I do think that the current economic situation presents a unique opportunity for the acquisition of stocks, particularly for those new to the game. It's starting to look like we are turning the corner, and slowly we are starting to see more and more green on the board. As has been shown in the past during times of economic crisis, things can take months or even years to fully recover. Right now, my guess is that we are pretty close to the bottom. I predict that the economy will dip and rise, probably dramatically on occasion, for another couple of weeks, but the DOW will hit 10,000, the NASDAQ will hit 2,000 and the S&P will hit 1,000 by the end of the year. Invest now in the companies you know are not going anywhere....and don't look at them until January. See what happens! And a general rule of thumb that I like to employ - never invest any money you can't afford to lose.

When the U.S. government announced today (10/13) that it would invest up to $250 billion in the banking system - taking an ownership stake in a range of banks, from the big boys like Citigroup and Bank of America to smaller banks and thrifts - investors responded positively. The Dow saw an 11% gain, 936 points, and markets all over the world responded similarly as governments in Germany and France announced plans in the same vein as the U.S. government's investment.

Does the one day bounce mean the bailout has turned the corner? The first week after the legislation was announced saw stock prices plummet consistently, but now that the government has made it clear that it will not allow more banks to fail, it seems investors have begun to come back to the market. And there are certainly plenty of blue chip stocks to be had at bargain prices if you believe that last weeks declines were the result of fear and panic, rather than a true correction of inflated prices in response to the burst of the housing bubble.