The following is taken from a letter to investing clients written on the evening of Tuesday, July 8.

The Bear Market Continues

You may recall from our last investment update that we were unconvinced by the stock rally that was then taking place. This is what we said at the time:

By early March, the stock market (as measured by the S&P 500) had declined nearly 20% from its peak. Since then, however, it has made a big comeback and is now down less than 10%. Is the downturn over?

We are skeptical.

At this point, it certainly looks like the economy is nearing or (more likely) already in a recession. Unemployment is on the rise, spending is down, and consumer sentiment is in the dumps, to name but a few of the recession-indicating things that are taking place. And we know that the housing situation -- which has been a big contributor to the slowdown thus far -- shows no signs of getting better any time soon. All in all, the odds favor the conclusion that a recession is underway.

Recessions always lead to bear markets, and if that was a recessionary bear market, then it was just about the mildest recessionary bear market ever. How likely is it that a recession induced by the collapse of history's greatest real estate bubble, taking place at a time of fairly high stock valuations, will also be accompanied by one of history's mildest recessionary bear markets? It's possible, we suppose, but not too likely. So we remain cautious and continue to keep a lot of our money on the metaphorical sidelines.

In retrospect, it looks like our skepticism was justified -- the market peaked less than two weeks after that email was sent and has now surpassed its prior lows. From last October's peak to Monday's low, the S&P 500 has lost 20%.

And there may be more to come, as all the concerns outlined above are still in play. To that list we can add a couple more as well. A big concern to us right now is the equity analyst community is estimating a powerful earnings rebound later this year. To provide one example, there were $15.54 worth of earnings per share of the S&P 500 in the first quarter. But S&P is estimating that the second half will average $18.94 of earnings per share -- a 22% increase! We just don't see this happening with the securitized debt crisis, the housing bust, weak job creation, and high inflation all at work. Those optimistic earnings estimates are a big part of the reason that we remain cautious.

We can also add a more long-term consideration, and one that should be familiar to many of you: the fact that, despite what you read in the papers, the overall stock market is actually quite expensive. We wrote a whole website article on the topic, but the very short version is that when stock valuations are measured in a manner that adjusts for the ups and downs of the business cycle, US stocks are currently priced for poor long-term returns. As we mentioned, this is a more long-term consideration, and it's important to realize that it concerns "the market" as a whole and that some sectors are priced to do far better than others. However, it's worth keeping in mind and it certainly doesn't make us eager to rush into the stock market given everything else we've mentioned above.

An Oil Bubble? No Way...

We have been bullish on oil for a while and we remain so for the long term. Producers are having trouble ramping up new supply -- despite rising prices, global oil production did not increase at all between 2005 and 2007. And the monetary environment of negative real rates and purposeful currency debasement is overwhelmingly positive for limited-supply resources such as oil.

But even in long-term bull markets, prices get ahead of themselves. After all, while the fundamentals are positive, it's not like they've changed so radically over the past six months. Even with good fundamentals, we've never seen an asset price rise so far, so fast as oil has without enduring a severe correction at some point. We doubt that oil is any different, so we think that the oil price could undergo a sharp decline at some point. It may have started already, but then again the correction may begin from an even higher price later this year -- one never knows.

However, while all the pundits who couldn't recognize a housing or stock bubble if it fell on top of them will doubtless come out to proclaim the end of the oil bubble, we think they will be wrong yet again and that such a price drop will be temporary. Even with the demand destruction that's taking place as people cut back on their energy usage, the fundamentals as described above are still quite good (and of course, if prices drop people will start using more energy again).

More to the point, this is not the final stage of a bubble as so many claim. We know what it looks like at the top of a true bubble. Everyone is bullish. Skepticism is very rare and is met with a combination of pity and anger. The mainstream media features endless articles about how the bull market will never end. Profiles of unremarkable people who "made it big" in the bull market abound.

In contrast, I will paste in something I saw on the web just the other day. I was looking at the Yahoo! page for a natural resources mutual fund, and happened to glance down at the most recent articles that mentioned the fund. The following were the top three articles on the list:

• Trim Your Energy Holdings -- at Kiplinger.com
• Don't overdo it on the energy sector -- at MarketWatch
• Oil and energy sector funds are a bad buy for most investors now -- at MarketWatch

Once again, those were the top three articles pertaining to a fund that invests in natural resources. My friends, that is manifestly not the kind of thing that happens anywhere near a bubble peak.

One last point on oil. As commodity expert Jim Rogers points out, there have been three oil price corrections of between 40%-50% since the oil bull began earlier this decade. That means that oil could fall to $75 per barrel and it would still be a routine correction as far as the long term bull market is concerned.

We think there will indeed be a very steep correction in the oil price at some point -- but we don't think it will be the end of the oil bull when it happens. That's a misunderstanding we hope to take advantage of when the time comes.

Too Much Money

Isn't it funny how enormous bubbles in stocks and home prices were attributed by the authorities to "fundamentals," while rising oil prices are blamed on those evil speculators? All three effects have a cause in common: too much money and credit sloshing around looking for a home. That's inflation, plain and simple. When the inflation goes into financial assets, everyone loves it, but when it goes into an important resource, people suddenly aren't so happy and the powers that be -- those that are responsible for the inflation -- look for a scapegoat.

In all of the above cases, the mainstream has failed to spot the monetary aspect of the price rises. People come up with all kinds of explanations for these huge price increases, but they rarely mention the sheer mountains of paper currency that have been created over the last decade. We feel that the surfeit of money -- not wealth, mind you, but paper money -- is and will continue to be an important part of the rise in all commodity prices. We also feel that as people finally start to realize this, they will increasingly turn to gold as a store of value. It hasn't happened yet in earnest, and we don't know when it will, but we retain rock solid confidence that precious metals will be a big beneficiary when the truly dysfunctional nature of today's global paper-based monetary system becomes more widely appreciated.

Oil and the Economy

On that note, we've often discussed in the past that we weren't able to get too gloomy because the government will bend over backwards to support the financial markets and "reflate" the economy via increased debt, currency debasement, and industry bailouts. This is terrible policy, by the way, but it's the way things work these days and we must be realistic about it.

However, skyrocketing oil and food prices have made their job a lot tougher. First, much of the stimulus they provide is offset by higher prices and especially higher prices of foreign goods such as oil. The stimulus check doesn't help so much if it goes straight to your gas tank. Second, rising prices make it tougher for the Fed to keep monetary policy as loose as they'd like.

So, rising food and energy prices make the reflation a lot tougher. They are still doing it, of course -- the Fed recently started "talking tough" on inflation but then went on to keep rates at 2%, far below the inflation rate. And this comes from the NY Times today -- parenthetical comment is ours:

"The chairman, Ben S. Bernanke, also said that the Fed was considering extending its [supposedly short-term] program of low-cost overnight loans to the nation's largest investment banks into next year."

Wow, who could have seen that one coming? Oh yeah: everyone.

That said, the price rise could eventually put a limit on just how loose monetary policy can get. On the other hand, as discussed above, some of these prices may be due for a correction. Should this happen, the Fed will of course declare victory on inflation (as if they had anything to do with it) and keep pressing down on the accelerator.

So yes, rising prices do put the reflation effort at some risk, and this is a development we are watching closely. However, between a likely energy price correction and the Fed's stubborn unwillingess to recognize the inflationary effects of its own policies, we believe that the reflation campaign will be given precedence in the end.

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