I was at dinner with some friends and the conversation turned to the topic of undiscovered investment opportunities. One of my nominations for undiscovered investment theme was life extension technology. In October 2009, the respected medical journal Lancet published a study indicating that given the trend of progress in life extension strategies, people born in the year 2000 in today’s major industrialized countries will likely live to 100.

What does that mean for investors? Who are the winners and losers under such a scenario?

The mark of a good fundamental analyst is the ability to dig and look for data points that the rest of the market hasn’t really focused on. So it is with great interest that Jeff Matthews, who often has good fundamental insights, indicated that the economy may be improving or poised to improve because of extremely low inventory levels that he is seeing on a bottom-up basis. In addition, FedEx (FDX) had reported improving volumes back in September, another sign of economic improvement.

Matthews concluded that this argues for buying transportation stocks and went on to speculate that this was one of the reasons why Buffett wanted to buy Burlington Northern (BNI):

Ahead of Obama’s visit to China, the markets have been abuzz with a statement from the People's Bank of China that it will consider “changes in international capital flows and the trends of major currencies”. This is a departure from the broken record mantra of keeping its currency “basically stable at a reasonable and balanced level”. These statements have created speculation that China is ready to either revalue the RMB upwards or allow it to float.

Analysts have said for years that China will start to move when it is ready. So why now?

I normally have a live and let live attitude toward other people's market analysis. Once in a while, I come across research that seem so misguided that I feel compelled to speak up.

A blogger recently posted an intriguing bit of analysis on a discussion group that I subscribe to and it was entitled 10% Unemployment: A Remarkable Signal for Stocks. He shows the chart below and concluded that “[h]istorically the stock market has performed exceptionally well after unemployment has peaked.”

I see that Richard Bookstaber is moving to the SEC. Good for him! I hope that this is the start of some adult supervision by the regulatory authorities. Consider what Bookstaber had to say about the banking system in an older post on his blog:

The last thing a bank wants is a competitive, efficient market, because then it would not be able to extract economic rents. So the incentives are to create innovative products that reduce market efficiency, not enhance it.

What more do the stock market bulls want? The latest statement is as dovish as you can possibly ask from the Fed [emphasis mine]:

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

Nicholas Nassim Taleb, the author of The Black Swan, has been talking about the states of Mediocristan and Extremistan. The two concepts have been described as follows:

"Mediocristan" and "Extremistan" are two world domains. In the former, extremes exist but are inconsequential, in the latter, extremes are not expected, but play a massive role. In the former, the ordinary plays a massive role. In the latter, one's wealth can change massively in a second.

As the markets wait this week for statements from the FOMC and other central banks around the world, here is what I am watching for in the central bank announcements.

How worried is the Fed about inflation?
Central bankers don’t speak off the cuff. Paul Volcker once joked that when he went out to dinner, he felt compelled to say “I’ll have the steak but that doesn’t mean I don’t like the lobster.”

As the S&P 500 began to weaken last week, there has been a cacophony of voices declaring that this is The Correction. The questions in a lot of investors’ minds are:

• Are we starting a major correction?
• If so, how far down are we going?

Personally, I believe that the market’s fundamentals were too overstretched for this to be a minor pullback and I concur with the assessment that the bears are taking control of the tape. The tone of the instant euphoria over Thursday's one-day rally of 2% is a contrary bearish signal that this market has further downside in the weeks ahead.

The inflation or deflation debate remains highly bifurcated, with many prominent investors and economists on both sides.

Nobel laureates among the deflationists
In the deflationists’ corner, we have Nobel laureates Joseph Stiglitz, Paul Krugman (who has argued vehemently for the deflation case) and prominent bond manager Bill Gross. To paraphrase their case, the deflationists believe that the combination of too much debt, massive wealth destruction, a weak American consumer and high unemployment, which restrains labor’s bargaining power, makes a case for a re-run of the Japanese Lost Decade experience highly likely. In the face of these deflationary pressures, the classic macroeconomic solutions of fiscal and monetary stimulus are not going to be very effective.

As the S&P 500 tests resistance at the 1100-1120 zone, which is the 50% Fibonacci retracement level, it is useful to think about market tone.

How the market reacts to news is often a useful guide to future direction. When the bulls were in full control of the market action, a downgrade by a single analyst on Wells (WFC) wouldn’t have taken the market down dramatically in the last hour. When the bulls were in full control, news that the Chinese economy had grown by 8.9% would have been an excuse for further advances and not pullbacks. Moreover, the widespread skepticism over China’s official statistics would have been swept under the rug.

I wrote about the possible social backlash of the financial crisis back in April. Given the uproar over the size of the Goldman Sachs (GS) bonus pools, it’s time to revisit the topic and the picture isn’t pretty.

Simon Johnson, former chief economist at the IMF, recently reiterated his views on the effects of the financial crisis on US income inequality by saying, in effect, that America is becoming a banana republic:

I finally got around to reading the interview with Neil Howe, the co-author of The Fourth Turning. In the book, he outlines his approach to generational research:

We think that generations move history along and prevent society from suffering too long under the excesses of any particular generation. People often assume that every new generation will be a linear extension of the last one. You know, that after Generation X comes Generation Y. They might further expect Generation Y to be like Gen X on steroids – even more willing to take risk and with even more edginess in the culture. Yet the Millennial Generation that followed Gen X is not like that at all. In fact, no generation is like the generation that immediately precedes it.

The headline read Bullard warns on inflation, unemployment. On the weekend, St. Louis Fed governor James Bullard warned on the risks of inflation. The press release reads that:

Bullard also expressed concern that inflation risks in the medium term may be higher than widely believed. He said that too much emphasis is being given to the idea that the recession implies that the output gap is currently quite large, minimizing the risk of inflation.

I have expressed my concern about the state of the equity market before, but indicated that the bulls appear to remain in control despite the poor fundamentals. In a post entitled the most hated rally in Wall Street history, Barry Ritholz wrote last week that:

Most bull moves do not end when they are hated, they come to a halt and reverse when they become over-owned and over-loved.

I see that Bill Miller made it to the cover of Barron's this week. His fund, LMVTX, has made a remarkable comeback after several years of poor performance.

Miller sticks to his guns
Given the headlines I thought that it would be a useful exercise to analyze Miller’s macro bets and see what he did to achieve his returns this year. The chart below shows the fund’s exposure to the Financial sector. Miller had been known to be a big believer in Financials and had been overweight the sector going into the Lehman crisis and out. The bet in the sector was responsible for the freefall in returns but the recovery of the sector also contributed to his turnaround in 2009. Click to enlarge images

Miller’s critics might accuse him of being a stopped clock, but the next chart, which shows his fund’s exposure to the cyclical sector, indicates that he was prescient in his timing. LMVTX began to increase its cyclical exposure in mid-2008, pulled back and then went all-in with its pro-cyclical bet in early 2009. That bet has paid off handsomely in 2009. The timing of the cyclical bet was remarkable given the low level of turnover the fund has historically exhibited.

In investing, market participants need to think through the implications of an investment theme before taking action.

Here is a case in point. There are headlines everywhere about gold prices hitting all-time highs. While that is certainly true when gold is viewed in US Dollars, it is not true when you look at gold prices in euros, Yen or other currencies.

Mebane Faber has a great post on the topic of hedge fund cloning. He is correct in saying that you invest in hedge funds as pure alpha vehicles (hence the high fees), not because of their correlation characteristics.

Consider the following thought experiment. If I showed you a fair roulette wheel where the house has no advantage and I told you that I was going to bet a controlled amount once a day on a spin and invest the remainder in T-Bills, such an investment would be uncorrelated to virtually any asset class that you can think of and would have highly diversifying characteristics, but would have no alpha.

Martin Wolf has an article entitled Why narrow banking alone is not the finance solution. He writes that one of the solutions proposed by John Kay in a pamphlet for the London-based Centre for the Study of Financial Innovation to the banking crisis is to create “utility” banks and “casino” banks. Regulate the “utility” bank, Kay says, and let the “casino” bank take risks.

Wolf then goes on to criticize this approach: