August 2010 Issue: Key Points

We first wrote about deflation and liquidity traps back in May 2001. For the past few years, one of our scenarios has included a period of deflation, followed by the return of high inflation. Our fundamental view has been that three powerful deflationary forces would ultimately prove too strong to resist -- the entry of an export-oriented China into the world economy, the displacement of jobs by increasingly sophisticated technology, and the inexorable rise of aggregate debt/GDP ratios in developed economies. Today, you can't pick up an investment periodical without reading about competing and contradictory forecasts that either deflation or higher inflation are just around the corner. Over the past fourteen years, we have learned that when your views become mainstream, it is time to re-examine them. For that reason, this month we take a closer look at deflation, including what it is, what causes it, why it is dangerous, the chances that the United States will soon enter a period of deflation, and its potential impact on asset class returns. We conclude that there is a 50% chance that the U.S. will enter a period of mild deflation, and that, since theory and experience suggests it may be an alternative equilibrium condition, it will last longer than many people expect.

Deflation is one of the four critical challenges we believe the world faces today. The others are excessive leverage, insufficient and imbalanced aggregate demand, and increasing questions about the legitimacy of multilateral and domestic political institutions. These four challenges are characterized by complex interrelationships, and potentially non-linear effects. Put differently, they have considerable potential to surprise us if they depart from the "business as usual" or "we'll muddle through" assumption that seems to be the conventional wisdom today. This month's economic update examines the current state of affairs with respect to the leverage and aggregate demand challenges. We conclude that the evidence suggests a downside surprise is significantly more likely to occur than a relatively benign "muddling through" scenario. Next month we will examine the consequences of our developing views on leverage, demand and deflation for political legitimacy.

This month's product and strategy notes include a review of new research of interest to investors and their advisers, a preliminary look at new tail risk hedging products, and an examination of the poorly understood consequences of the arrival of The Borg: the growing use of very sophisticated trading algorithms.

| Product and Strategy Notes: New Products (CBOE - Skew Index), Citi's CLX, UK JP Morgan UCITS; New Research for Advisers and Investors; Implications of the Borg | Table: Fundamental Asset Class Valuation and Recent Return Momentum | August 2010 Issue: Key Points | This Month's Letters to the Editor: Who Would You Invite to Dinner?; How Should One Evaluate II's Asset Class Valuation and Economic Updates?; How Did You Identify the Three Regimes You Use in Your Analysis - High Inflation, High Uncertainty and Normal Times? | August 2010 Economic Update: Too Much Leverage and Too Little Demand | Investor Herding Risk Analysis | Overview of Our Valuation Methodology | Uncorrelated Alpha Strategies Detail | Feature Article: The Risk of Deflation and Its Impact on Asset Class Returns | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Global Asset Class Valuation Updates Detail through July 30, 2010 |