Thoughts From The Frontline : China

The Statistical Recovery

John Mauldin — Sat, 25 Jul 2009 05:24:00 GMT

The Return of Muddle Through*
Can China Lead the Global Recovery?
The Statistical Recovery
The Last Bear Standing
New York, Maine and Tulsa

A lot of bullish commentators are talking about a recovery being in the works, and they may very well be right. But it is not going to look like any recovery worthy of the name. This week we look at what I will call The Statistical Recovery. But first we take a look at what China is doing, as we continue our look at the rest of the world and ponder whether it is time to brace ourselves for an extended bout with the Muddle Through Economy*. (And yes, there is an asterisk.)

Quickly, and importantly, tonight we are releasing the first in a new series of quarterly Conversations entitled Geopolitical Conversations with John Mauldin and George Friedman. We believe that these new Conversations will help you better understand not only the global political landscape but also how it affects the financial umbrella that we are under. In this first Conversation, we talk about the "exogenous" risks to the markets (those from outside the markets themselves) posed by the geopolitical world.

George and I are going to make it a regular quarterly gig. We will offer this service, which will be priced separately, at some point in the near future. Now, here is the important part: all current subscribers and anyone who subscribes now will receive these Geopolitical Conversations free, as a thank you. (Current members can log in now.) If you have not yet subscribed, you can do so and receive a discount, by clicking the link and typing in the code JM47 to subscribe for $149. This is a large discount from our regular price of $199; plus, we are including the bonus Geopolitical Conversations that are worth $59.

Further, we will post a separate interview next week that I have obtained permission to use from my friends at Casey Research, and which I personally found very valuable. When we launched Conversations, we promised eight interviews a year. We are now at six, and next week I will record the seventh with housing experts John Burns of John Burns Real Estate Consulting and Rick Sharga of Realty Trac, the two leading experts on housing in the country. There is SO much uninformed, simplistic misinformation in the media about housing that I thought subscribers might like to know what the real situation is.

When you subscribe, all of the past Conversations are there for you to review. I am going to make sure subscribers get way more than their money's worth. You don't want to wait another day to subscribe. And now, let's jump into this week's letter.

Can China Lead the Global Recovery?

China is growing by about 8% a year, which is amazing on the surface of it, as their exports are down about 20% (more in some sectors). How can that be? I continually read about how China is going to lead the world out of its global funk. And 8% growth in GDP does seem pretty strong. But we need to look a little deeper.

If I told you that the next US stimulus package would be $4.5 trillion dollars, mostly given to banks that would be forced to loan out the money quickly, do you think that might jump spending and GDP in the short term? Would you start looking for a few bubbles to be created? What about the dollar?

That is the equivalent of what China is now doing. The volume of credit that is flowing into China is equivalent to one-third of their GDP. Banks that already have large problem-loan portfolios are now lending even more, in a very short time frame. China has severe capacity-utilization problems, as trade has sharply fallen; and the US consumer is unlikely to return to anywhere near the level of consumption that was the case in 2006.

The Chinese stock market is up 85% this year, and commodity and real estate prices are rising. And no wonder: the money supply shot up 28.5% in June alone. That money is looking for a home. My friend Vitaliy Katsenelson has written a very perceptive essay for Foreign Policy magazine, talking about the nature of the current growth in China.

"But don't confuse fast growth with sustainable growth. Much of China's growth over the past decade has come from lending to the United States. The country suffers from real overcapacity. And now growth comes from borrowing -- and hundreds of billion-dollar decisions made on the fly don't inspire a lot of confidence. For example, a nearly completed, 13-story building in Shanghai collapsed in June due to the poor quality of its construction.

"This growth will result in a huge pile of bad debt -- as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much."

I am going to quote at some length from Simon Hunt's latest note. He travels very frequently to China and is one of the world's true experts on the copper market. If you want to know something about copper, ask Simon. Copper, we are told, is the metal with a PhD in economics. If copper prices are rising, then the economy is booming. And historically, that has more or less been the case. But there may be reason to believe that PhD may be no more useful this time around than a regular Ivy League degree.

"The world community has come to see that China is its savior. Growth picked up sharply in the second quarter, but it is based on fixed asset investment and renewed speculative activity in the real estate sector. It is not what the actual GDP or IP [Industrial Production] numbers will show that matters, but the quality of that growth. Money is cheap with loans and credit freely available, so much so that China risks developing new bubbles in the stock and commodity markets and real estate. Speculation is based on the simple premise that prices must rise. Foreigners as well as domestic participants are feeding this frenzy, especially in metal markets.

"The frenzied loan and credit growth is unlikely to be cut back until the fourth quarter at the earliest. It is not this year or next which worries us, but post 2010. What will China do when the world economy gets hit with its next big leg down?

"There is no better example of this speculative activity than what is being seen in the copper market. It is easy for global merchants, hedge funds etc to ship cathode into China and warehouse it outside the reporting system, so fuelling investors' sentiments that copper demand in China is soaring and at the same time draining copper from the rest of the market.

"It is not so much industry which is doing this buying in China, but individuals, financial institutions and even small companies divorced from the copper industry who are buying and holding the metal because copper is a store of value and prices will go up is the common response. We updated our numbers for the first half of this year. They are truly staggering. Over 1 million tonnes of cathode is sitting in China mostly outside the reporting system as a punt on rising prices." (Emphasis mine)

If it is happening in copper it is likely to be happening in other commodity markets as well. If you are trading the metals, you should be aware that a quick drop could happen if demand falls off due to there being a glut of supply coming back onto the market.

Why would China engage in what seems from our shores to be very risky behavior? Because from their point of view it makes sense. It is not a lot different in concept than what the US or England is doing to stimulate their economies. The scope and size are different, but China also has a much different problem. They are attempting to soften the transition from an economy dependent on the US consumer to one that is more balanced. Will they be successful? The answer depends on what they are actually trying to do. You could (and should) also ask whether Bernanke will be successful when he decides to remove reserves from the economy. Avoiding financial Armageddon may be the measure of success in both countries, with the reality that there will be some pain, no matter what.

Who Ends Up with the Old Maid?

But the important news out of China this week was the assertion that China was getting ready to use its massive $2.2 trillion reserves. From the Financial Times:

class=MsoBodyTextIndent>"Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, Wen Jiabao, the country's premier, said in comments published on Tuesday. 'We should hasten the implementation of our "going out" strategy and combine the utilization of foreign exchange reserves with the "going out" of our enterprises,' he told Chinese diplomats late on Monday. Mr. Wen said Beijing also wanted Chinese companies to increase its share of global exports. The 'going out' strategy is a slogan for encouraging investment and acquisitions abroad, particularly by big state-owned industrial groups such as PetroChina, Chinalco, China Telecom and Bank of China."

This is a very big deal, and from the Chinese point of view, quite smart. Right now they are stuck with $2 trillion in US Treasuries, agency paper, etc. They can't sell their dollars without really hurting the dollar, thereby forcing the renminbi to rise and hurting their own exports. But they, and much of the world, feel that the US is pursuing policies that are going to be harmful to the value of the dollar and therefore to China's largest reserve exposure.

What to do? Take those dollars and buy physical assets. Companies, natural resources, maybe a few small countries. (To my Chinese readers: that's a joke, although some in the West worry about that.)

In the card game called Old Maid we played as kids, the loser was the one who ended up with the "Old Maid" at the end of the game. For the past decade, the Chinese sent us "stuff" and we sent them dollars in the form of electrons. They in turn invested those dollars in our debt so we could buy more stuff. It was a form of vendor financing.

And now the Chinese have apparently decided to pass the Old Maid of the dollar on to other parties, who will sell them their assets for dollars. Seriously, did anyone not think they would do this? Massively selling the dollar, which so many conspiracy-theory types keep saying they will, was never really a rational option. But using those dollars to acquire productive assets? Very smart, very rational. If you figure out what they want to buy and get there first, there are profits to be had. Attention should be paid.

$2.2 trillion in reserves and growing can cover a lot of economic sins and bad bank loans. It can buy time for the companies with too much production capacity in China to find new customers. Will it be a smooth ride? Of course not. There will be a lot of bankrupt companies and a lot of angst among the entrepreneurial class. That is part of the process. But in five or ten years, China will be larger and stronger than it is today. Count on it.

That being said, is it likely China will pull the world out of its current slump? Not for a while. China is just 7% of global GDP. Even if they grow at 8%, that only adds 0.5% to global growth, and it is likely that we will see global GDP shrink by 2.7% in 2009. Look at the chart below from my friends at Hayman Advisors.

A few side observations on the above graph. China is roughly as big as the other three of the BRICs (Brazil, Russia, and India) combined. Russia and Brazil are in recessions. Also, note that it will be decades before China's economy is as big as that of the US, even with growth of 5-6% a year more than that of the US. Will it eventually be as big? Of course, and it should be; tt has four times more people.

Will it matter? Not a bit. Does Denmark care that the US or Germany is bigger? Not that I can tell. Does Dallas care if New York is bigger? You just deal with the reality in front of you and try and make the most of what you have. If you focus on the other person or country, you lose sight of your own goals.

Further, I rather doubt that China will be growing by 8% a year in 15 or 20 years. Like all large economies, they will start to experience slower growth. And they will have their own demographic problems in a few decades as a result of the "one child" policy. Every country has to deal with its own specific issues.

That being said, will there be opportunities in China and other emerging-market countries? You bet. I rather think that the developing world will be where the real opportunities will be as the world figures out what the New Normal will look like.

And now, let's look at a few issues the US will have to deal with.

A Statistical Recovery

"I've been down so long it looks like up to me," went the song of my youth. The recessions is not quite two years old. Every day we are hit with increasing unemployment, lower incomes, rising taxes, and more - a relentless stream of bad news. We wonder whether it will ever end. And the answer is that of course it will. And it may be ending now. But this is going to feel like a very different recovery from what we normally think of as recovery. It will be more of a statistical recovery than a real one.

The easiest way to explain that concept is to look at the following graph. At one point, housing construction was over 5% of GDP. Now it is around 2.5%. The graph shows how much a shrinking home-construction industry has reduced GDP each quarter for the last two years.

Without going into a lot of detail, housing construction may be at a bottom, or at least there is less room to fall. Instead of housing subtracting 1% (or more) from GDP each quarter, it may become a nonfactor as a bottom is reached. Does that mean recovery? No, it just means that things aren't getting worse. We are finding that level of the New Normal.

Ditto for inventories. At some point, you have to restock the shelves. Rail shipments are down by almost 20% from last year, and UPS package volume is down 4.7%. And as Dave Rosenberg pointed out this morning, that is from last year's already depressed levels. As Alan Blinder noted today in the Wall Street Journal, at some point you finally get to bottom. Housing, inventories and business investment stop subtracting from GDP, and the GDP stops shrinking.

And as I pointed out a few weeks ago, the fact that we are buying less from outside of the US (imports) may show economic weakness, but from a statistical point of view that is positive for GDP.

All of this means that we could see – actually, we will see – a positive GDP number at some point. Those of bullish persuasion will talk of recovery. But for the 10%-plus people who will not have a job next year, it is not going to seem like a recovery. Nor for the additional 7% (at least) part-time employees looking for full-time work.

Go back to 2001. We had "the end of the recession." Bulls were out in force, trying to talk up the market. But unemployment still rose for almost a year. And the stock market noticed. The market did not really take off for well over a year, and actually continued to slide into 2002.

The Last Bear Standing

Notice in the chart below that unemployment continued to rise until the first quarter of 2003. And that is also when the stock market took off. Those who see green shoots need to think about that. Meanwhile, the market is clearly telling us that it sees nothing but blue skies in the future. I truly marvel at this rally, but I continue to think it is a bear-market rally. The weakest, high-beta names are rallying the most. This rally does not seem to be the basis for a sustained bull market. That being said, Richard Russell has removed the bear from his letter and put in a bull. I may be the last bear standing.

The media tells us earnings are coming in above expectations. But expectations have been lowered so much that the target is much easier to hit. Even then, the "upside profit surprises" are coming from cost cutting, which is not sustainable as a profit center, at least not if you are trying to grow the business. And laying off employees, while perhaps good for the profits of one company, is not good for the overall economic business environment.

The Muddle Through Economy*

This is going to be a long, jobless recovery. Hours worked per week are at an all-time low. As noted above, part-time work is very high. Employers, when things actually start to turn around, and they will, will first give current employees more hours and then expand the hours of part-time workers. There will be few new jobs for a long time.

Because our population is growing, between 130-150,000 new jobs are required each month to keep unemployment from rising. Initial and continuing claims suggest we are currently losing at least 300,000 a month.

(As an aside, the media talks about initial unemployment claims falling. That is actually not true. Unemployment claims are in fact quite high and rising, but the seasonal adjustments make them look smaller. Normally, this would not be a big deal. But the summer seasonal adjustment assumes a normal automobile manufacturing market, with layoffs in July. The layoffs came much earlier this year, distorting seasonal adjustments.)

Higher and persistent unemployment, lower incomes and wages, higher savings rates, capacity utilization at 50-year lows and still falling, rising home foreclosures, a deleveraging financial system, etc. are not the stuff of "V-shaped" recoveries. Throw in that Moody's estimates that US banks will have to write off $400 billion in 2010, and it's a very weak recovery indeed that shapes up for next year.

It's the return of The Muddle Through Economy*, which is better than what we have had, to be sure. But that asterisk is there for a reason. Congress and the Obama administration are seemingly hell bent on a massive tax increase. If that happens, it will push a fragile recovery back into recession. It will look like the twin recessions of 1980-82.

It will be a difficult investing environment, to say the least. If buy-and-hold is not your favorite style, there are alternatives. Quick commercial: my friends at CMG have a platform of alternative managers that can be tailored to your specific needs. These are traders who have weathered the storms of this last decade. These are individually managed accounts, with daily liquidity. You really owe it to yourself to see the managers on their platform. The link to their form is http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

I am encouraged by the fact that the radical health reforms look like they might not pass. The health-care system clearly needs a major overhaul. Let's hope that we get it right.

In a future letter, I am going to talk about taxes. I am concerned that we are going to raise taxes now to very high levels, and not leave any room for the tax increases we are going to desperately need in the middle of the next decade to pay for entitlement programs. That will mean a VAT tax and tax increases on the middle class. Again, not good for the economy. But enough for today. Time to hit the send button.

New York, Maine, and Tulsa

Next week I am going to take a few days off and head for a beach somewhere, along with my summer reading list. I will get back for one day, and then with my 15-year-old son head for New York for an evening dinner with Art Cashin, Ron Insana, and George and Meredith Friedman. That should make for interesting conversation.

Then off the next morning to Maine, after shooting a few spots with Aaron Task and Henry Blodgett at Yahoo! Tech Ticker. CNBC and Steve Liesman will be at the Shadow Fed fishing event, and it looks like I will do a few minutes with him, as they plan to do an hour-long special with many of the investment writers, economists, and analysts who will be there. I am really looking forward to that trip.

And then back home for a few weeks before going to Tulsa for Amanda's wedding on the 22^nd. Amanda was a competitive cheerleader for a long time, and she is bringing that drive to the wedding. If there is deflation in this country, it is not in wedding costs. Two weddings in two years has me breathing hard. And two more to go, although right now it looks like that might not be soon. And if the job market will help out, Amanda and Allen (her fiancée) and her twin sister Abbi intend to move back to the Dallas area after the first of the year, which will mean I'll have all seven kids close to me again. I really look forward to that.

We tend to get together as a family for brunch at least every other Sunday, and it's a fun day for me. Lots of love and laughing -- and now babies. And more on the way! There is a bull market in my joy in my kids, that's for sure. And now it really is time to hit the send button, as I am off to the local pub to have a drink with #2 daughter Melissa. She is going to have to have her gall bladder removed, and Dad likes to check in now and then. Have a great week, and enjoy your summer before it goes away,

Your doing better than Muddle Through analyst,

John Mauldin

The Trend May Not Be Your Friend

John Mauldin — Sat, 18 Apr 2009 04:43:54 GMT

Thoughts on the Continuing Crisis
Dressing Like an Economist
The Trend Is Your Friend Until the End of the Trend
What Is Money?
MV=PQ
Newport Beach, Orlando, and Home

Two weeks ago I presented my thoughts on the current economic situation at my 6^th Annual Strategic Investment Conference in La Jolla (co-hosted with Altegris Investments). The speech was well-received, at least to judge from the comment forms. So this week and next, we are going to revisit that talk (with a few edits). Let's start with a little set-up to explain the first few paragraphs.

My speech was Saturday morning. On Friday, I wore a nice grey suit with a Leonardo tie. For those who know about Leonardo's, they are "statement" ties. I should note that Tiffani picked the tie out for me about ten years ago and persuaded me to wear it. It took some getting used to. It is 16 silk-screened colors, bright blues and pinks and grays, the central feature of which is a very vivid parrot. It is not subdued.

When my good friend George Friedman of Stratfor gave his speech on Friday, he commented rather derisively about my taste in ties, which got him a few laughs. This did not bother me too much since, while George is a brilliant geopolitical analyst, his sense of sartorial style is not exactly top-drawer. So now, let's jump into the speech.

Dressing Like an Economist

Three years ago I was here at our third conference, and my daughter Tiffani came to me in the middle of the conference and said with a very serious face, "Dad, we've got to have a talk." Oops, we have to have a talk? This was her "You've done something wrong" face. But I didn't know what I had done. Had I been speaking with my zipper down? Was something I said wrong? So I said, "Well, let's go talk right now." And she says. "No, we can do this when you get home." And I said "No, now."

So we go to another room, and I ask, "What's wrong?" And she says, "Dad, the partners wanted me to come and talk with you." Oh God, I think, what is it?

Now, Art Laffer (he of the napkin and Laffer Curve fame) had spoken earlier at that conference. If any of you have ever seen Art speak, Art dresses to the nines. He gave a speech with which I did not agree. It was brilliantly delivered, but he was just wrong. But he looked really good being wrong.

So Tiffani says, "Dad, the partners want me to talk with you. You dress like an economist. You are supposed to be a guru. We've got to get you some new clothes." And it was true, I had not bought many new clothes for years.

So this is my guru suit. Somebody at least has some sartorial taste -- Tiffani and others picked it out. You can see the evidence of true style and taste by the way she dresses, can't you? And she picked out the tie, too. (And I should point out that the one person in George's family with outstanding taste, his wife and partner Meredith, liked the tie as well.)

Thoughts on the Continuing Crisis

Ok, with that out of the way, let's talk about some of my thoughts on the continuing crisis.

This cartoon is pretty much where we are right now. The consumer is shell-shocked. That pot of gold has now become just a pot. The 401k's are now 201k's. People are trying to figure out how to go forward. Let's go back and get some sense on how we got here and what the landscape looks like and what I think the future will look like.

By the way, I started writing this speech at 1 o'clock yesterday because everyone else was saying what I was going to say, so my friend Kerri helped me create this PowerPoint yesterday. I'm making two classic mistakes that every speaker should never make, and they are: number one, if you are not a morning person, you should never speak first thing in the morning, but I had to trade places with Dennis Gartman; and number two, you should never make a speech to your most important audience that you haven't made somewhere already. So we'll see how it goes, but you guys are all my closest friends, okay? So cut me some slack.

In the beginning there were banks, and the banks were without form or regulation. That lack of regulation begat panics. You had the panic of 1807, then the 1827 panic and Andrew Jackson got rid of the Bank of the US. Then you had the panic of 1873 and the panic of 1907 And over time, the powers that be, not wanting to have any more panics, created first the Federal Reserve and then the FDIC. After World War II, there were basically no more worries about bank deposits. The FDIC covered them, and we entered a new era of "stability." This did not repeal the business cycle and prevent recessions, but it did stop major bank runs and banking panics. We can clearly have financial crises, but they will be different than those of the Depression.

The Trend Is Your Friend Until the End of the Trend

Stability, though, as we were taught by Hyman Minsky, leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits, because we human beings learned to trade and invest by dodging lions and chasing antelopes on the African savannah. We now chase momentum and dodge bear markets. We are hard-wired to look around at our circumstances and predict trends far into the future.

We take the current trend and we project it forever. But the one thing we know about trends is that they are eventually going to end. The trend is only your friend until it ends. Trends are notoriously fickle. That stability breeds instability. Calvin Coolidge said in early 1929 that "In the domestic field, there is tranquility and contentment and the highest record of prosperity in years." The trend ended. "Apres moi, le deluge."

Now, so what happened in 1929, after this era of stability? The bubble burst and the stock market crashed.

By the way, I thought one of the great headlines in the papers from those days was, "The deluge of panic selling overwhelms the market. 19 million shares changed hands." 19 million shares changing hands caused the crash in 1929! That's about a minute today. Okay, before the Great Depression, Coolidge was telling us, at the end of his presidency, that everything was cool, and then we got Hoovered. They tried to balance the budget, and they didn't really provide any stimulus. We got Smoot-Hawley. Given the massive implosion of capital and the closing of banks, there clearly was not enough growth in the money supply. Government and the Fed just did a lot of wrong things.

So at the height of the Depression, in 1933, as Roosevelt was coming into his first term, we had 25% total unemployment; 37% (!) of non-farm workers were unemployed; 4004 banks had failed; $3.6 billion in deposits was lost. That's like trillions in dog years, okay? At least in 2009 dog years. You end up with bread lines, and the stock market just keeps going down, down, down (with a few marvelous bear-market rallies – maybe like what we are seeing today?).

Roosevelt comes along and we get the New Deal. He applied massive stimulus. By the way, his stimulus hired people. He put them to work building parks and the Tennessee Valley Authority. They were building a lot of infrastructure. He didn't put it into Democratic wish lists and permanent wealth transfers and welfare and special-interest agendas to increase the overall budget beyond what we could ever hope to actually pay for (without even more radical tax increases), which the Obama Administration is clearly doing. We'll get to the effectiveness of current policies in a moment.

Then let's look at what he did in 1937. With the economy somewhat on the mend, he tried to balance the budget, raise taxes, reduce deficit spending. And what happened? We had another deep recession and unemployment jumped back up to 20%. It was hard to pull that stimulus back out. And it's particularly dangerous to raise taxes in a weak economy.

Most of the people in this room are old enough to remember the Blue Screen of Death. Remember, you would be typing along on your computer and all of a sudden you would get this screen, saying, "You have an impossible error." (Okay, what's an "impossible" error? Clearly something happened that was possible.)

And the only thing you could do was just unplug the thing. You couldn't even turn it off -- you just had to unplug the computer. It was the Blue Screen of Death. Well, that is kind of what World War II was for the world. We unplugged the world economy, and then we started from a new base. We hit the reset button. We were at lows everywhere in the world; places were in a mess. So we began to grow from there. The bebt supercycle started. For all the recessions and bear markets, a new stability ensued, and debt and leverage began to grow.

We'll revisit that point in a moment. We are doing just what I do in my regular e-letter: I'm going to take three or four ideas, and at the end I'm going to try and tie them all together. Let's see how successful I am.

What Is Money?

Let's talk about what money is. For some people it's M-1 or M-2, and they worry that the money supply is growing too much. For some people it's gold; gold is the only real currency. I think those ideas each have their place, and there's some truths to them, but they focus us on the wrong thing.

It's a bit misleading to talk about money supply, because what money really is is roughly $2 trillion of cash and then $50 trillion in credit. Because what do the banks do? They take deposits in and then they borrow money to leverage them up. I take my credit card and I spend with it. I borrow against a house. I have an asset that rises, and I borrow against it.

We have two trillion dollars of actual cash propping up $50 trillion in credit. If we all decided to settle and pay off everything, we couldn't do it because there is not enough cash. There would be massive asset deflation. We, as a nation, are levered 25 to 1, or we were. Now, that $50 trillion is in a real sense the money supply because that is what we are all pretending is real money. I lend you money and you pretend you are going to pay me back. Then you pretend he [pointing at another attendee] is not going to call your debt for cash, and we are all going to keep the system going. Because if we all try to pay each other back at once, we are all collectively -- and this is a technical economic term -- screwed.

So we keep the system going. Now, where are we today? We are at the Great Deleveraging. We are seeing massive losses and destruction of assets, on a scale that is unprecedented. There was massive destruction of assets during the Great Depression, which caused a lot of problems, and we are seeing the same thing today. We are watching trillions simply being poofed (another technical economics term – which will drive my poor Chinese translator crazy!). We are watching people pay down their credit lines, which is one way of saying the supply of money and credit is shrinking.

This is not just in the US, but all over the world. Because when you start adding European cash-to-credit, and Japanese cash-to-credit, and Indonesian and Chinese cash-to-credit, it becomes multiple tens of trillions, and we are watching a goodly portion of that credit be vaporized. So we -- individuals and businesses -- are trying to find that $2 trillion in real cash and get some of it to pay down our debts. We are reducing that massive leveraged money supply down to some smaller number. We are hitting the Blue Screen of Death. We don't know what it is going to reset to, but we have permanently seared the psyche of the American consumer, and it is going to get reset to some lower number, about which I will speculate in a minute.

Now to give you some idea of how important credit was in our recent period of economic growth – and I keep using this slide, but it is an important slide because it shows you what would have happened in the economy without mortgage equity withdrawals. The red lines are what GDP would have been without MEWs. Notice that in 2001 and 2002 we would have had negative GDP for two years, that's 24 months. It would have been as long as or longer than the current recession. Not quite as deep, because we had the Bush stimulus and Bush tax cuts at the time. The Bush tax cuts were very important in keeping the economy rolling over in 2001 and 2002.

But notice that the recovery for the next four years would have been under 1%. We would have had under 1% GDP for four years running, without mortgage equity withdrawals, without people being able to spend more. That doesn't even count the leverage we increased on our auto loans, on credit cards -- you saw the two charts that Louie [Gave] and Martin [Barnes] used yesterday about the growth of credit, and we are now seeing it in reverse. Do you think George Bush would have stood even a small chance of being reelected without mortgage equity withdrawals?

Quarter 1-2006 we had $223 billion in mortgage equity withdrawals. Quarter 2-2008 it was $9.5 billion. Is it any wonder we were in recession by 2008? By the third and fourth quarters there was no money to keep the treadmill going That $50 trillion in credit was shrinking fast. We were imploding it. Further -- just as a little throwaway slide -- if you look at 2010 and 2011, we are getting ready for another huge wave of mortgage resets.

Now, we've gone through the last wave and we saw what happened; it created a lot of foreclosures. We are not out of the woods yet. It is going to be 2012 before we sell enough houses to really get back to reasonable levels, because we had 3.5 million excess homes at the top. We absorb about a million a year, it takes 3 years, that's kind of the math.

[Skipping some attempts at humor that you had to be there to get] ... By the way, this AIG thing and the bonuses, that's so bogus. I mean, the 40 people that created the problem were gone, they go to 40 other people and say, stick around because we've got to have somebody who actually knows what these things are to try and unwind it, and we'll give you a bonus. Some of them worked for a dollar against getting that bonus, and now we've told the world that a contract isn't a contract in the US of A, for a lousy 160 million dollars. No bank is going to want to play with the US again, because you don't want to be hauled up in front of Barney Frank.

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever physically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: "Deflation, we can't have it." So let's move along to the next point, and then I'm going to tie them all together.

MV=PQ. This is an important equation; this is right up there with E=MC². M (money or the supply of money) times V (velocity, which is how fast the money goes through the system -- if you have seven kids it goes faster than if you have one) is equal to P (the price of money in terms of inflation or deflation) times Q (which roughly stands for the quantity of production, or GDP)

So what happens is, if we increase the supply of money and velocity stays the same, if GDP does not grow, it means we'll have inflation, because this equation must balance. But if you reduce velocity (which is happening today), and if you don't increase the supply of money, you are going to see deflation. Now, we are watching, for reasons we'll get into in a minute, the velocity of money slow. People are getting nervous, they are not borrowing as much, either because they can't or because the "animal spirits" that Keynes talked about are not quite there.

To fight that deflation (which we saw in this week's Producer and Consumer Price Indexes) the Fed is going to print money. A few thoughts. The Fed has announced they intend to print $300 billion. That is different from buying mortgages and securitized credit card debt -- that money (credit) already exists.

When they just print the money and buy Treasuries, like the $300 billion announced, they can sop that up pretty easily if they find themselves facing inflation down the road. But that problem is a long way off.

But sports fans, $300 billion is just a down payment on the "quantitative easing" they will eventually need to do. They can't announce what they are really going to do or the market would throw up. But we are going to get quarterly or semi-annual announcements, saying, we are going to do another $300 billion, another $500 billion.

When we first started out with TALF and everything, it was a couple hundred billion here and there, and now we throw the word trillions around and it just drips off of our tongues and we don't even think about it. A trillion is a lot. It's a big number. And the total guarantees and back-ups and all this stuff we are into -- I saw an estimate of $10-12 trillion. That's a lot of money.

Understand, the Fed is going to keep pumping money until we get inflation. You can count on it. I don't know what that number is, I'm guessing $2 trillion. I've seen some studies. Ray Dalio of Bridgewater thinks it's about $1.5 trillion. It's some big number, some number way beyond $300 billion, and they are going to keep at it until we get inflation.

Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the LIBOR market because they are worried about credit risks? If that happens, it does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. If the Fed creates money which is simply deposited back with the Fed, then there is effectively no money creation. We are still faced with deflation. The Fed has got to somehow get it into the financial system. They've got to figure out how to create some movement.

Will it create an asset bubble in stocks again? I don't know, it could. Dennis [Gartman] talked about being nervous yesterday. I would be nervous about stock markets, both on the long side, as I think we are in a bear market rally, but also there is real risk in being short. Bill Fleckenstein will be here tonight. He is a very famous short trader. He closed a short fund a couple of months ago. He says he doesn't have as many good opportunities, and basically he's scared of being short with so much stimulus coming in. So it's going to work, at least in terms of reflation, but the question is when. A year? Two years?

(This is about as good a break point as I can find in the speech, so we will end here and take it up again next week.)

One note from today's data on deflation. The headline in the Wall Street Journal says China grew at 6.1% last quarter. That doesn't sound bad. But what was not in the story is that nominal growth was just 3.7%. The other 2.4% was because of deflation. To get real (after-inflation) growth you subtract inflation and/or add deflation. Growth in China is slowing down more than the headlines suggest.

Newport Beach, Orlando, and Home

I am writing this somewhere over Canada as I fly back from London. I always try and stay up on the way back so I can get on local time quickly, although I did not get enough sleep this trip. I will need to catch up this weekend. It will be good to be home.

This Thursday Tiffani and I leave for Newport Beach to attend Rob Arnott's annual conference. Each spring Research Affiliates brings together a rather special group of analysts and money managers to work through current economic issues. Harry Markowitz, Burton Malkiel, Mohammed El-Erian, Paul McCulley, and Peter Bernstein are just a few of the luminaries who will be there. I think Rob invites me for comic relief. And just like Jeremiah, he always serves some mighty fine wine (a few of you will get that).

Sunday I get back and then leave Monday to go Orlando to speak at the national Chartered Financial Analysts conference. My assigned topic will be the "state of the union" for alternative investments. If you are attending, you might want to drop into the session, as it will be at the very least provocative and for a few people rather controversial. I think the whole industry is at a crossroads, and we are going to see some real changes in the coming years.

And then? I am home for awhile. I told my London partner Niels Jensen that I would show up for his 50^th birthday party in mid-July, and maybe try to take a vacation then. And Amanda gets married in Tulsa in August. And of course the annual Maine fishing trip in early August. Oh, and Freedom Fest is penciled in for July 11, in Vegas. But not much travel in May and June, at least not yet.

Copenhagen and London were a whirlwind this week. I ended up getting asked to do CNBC Europe for about 30 minutes on a wide range of topics. I really like their Squawkbox crew. And it was good to spend time with the team at Absolute Return Partners. We had some very thought-provoking client meetings.

There is a lot of change getting ready to happen in my business, and I am grateful that it all seems to be for the good. I will be making a few announcements over the next few months that I am quite excited about. There are a lot of people in the finance world (and the world in general) that are really struggling, and I appreciate the support of my clients, my partners, and you, gentle reader. You are why I write this letter. Well, maybe you and my one million other closest friends -- but we both know it is really for you.

It's time to hit the send button, get my bags, drive home, get a good meal, and find my own bed. Have a great week!

Your happy to be home analyst,

John Mauldin

The Swiss Start Their Engines

John Mauldin — Sat, 14 Mar 2009 14:03:26 GMT

Where Have My Earnings Gone?
The Land of the Setting Sun
The Swiss Start Their Engines
My One True Nightmare
New York, Vegas, and Happy Birthday, Tiffani

This week we look at the Land of the Rising Sun. Japan is going through major upheavals, and they will have consequences all over the world. And what are those wild and crazy Swiss central bankers up to? It's time for another round of competitive devaluation. And of course I have to look at the recent Barron's cover story, about how stocks are cheap. There's a lot to cover.

But first, and quickly, I just wanted to take a moment and remind you to sign up for the Richard Russell Tribute Dinner, all set for Saturday, April 4 at the Manchester Grand Hyatt in San Diego - if you haven't already. This is sure to be an extraordinary evening honoring a great friend and associate of mine, and yours as well. I do hope that you can join us for a night of memories, laughs, and good fun with fellow admirers and long-time readers of Richard's Dow Theory Letter. The room is filling up and there will be a very large crowd.

A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. You are going to be able to rub shoulders with some very famous analysts and writers. If you are a fellow writer, you should make plans to attend or send me a note that I can put in a tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven't, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don't procrastinate. I wouldn't want any of you to miss out on this tribute. I look forward to sharing the evening with all of you.

Where Have My Earnings Gone?

Barron's probably jinxed the stock market by stating why they think the Dow won't fall to 5000, although we do have what I hope is the start of a nice bear market rally. Part of their reasoning is that stocks are cheap. They assign a price to earnings (P/E) ratio of a lowly 13, based upon 2009 estimated earnings of $51 in operating profits, which they suggest is historically low. And I agree that 13 is toward the low end and would represent a good long-term buying opportunity - if indeed it was 13.

Actually, if you want to get really bullish, go to S&P's web site and look at their estimated earnings for 2009. They calculate a P/E of 10.89 on 2009 estimated operating earnings.

As I have written over the years, the long-term P/E studies all use "as-reported" earnings, or earnings that are reported on tax returns. Operating earnings are of the EBBS variety, or Earnings Before Bad Stuff (or whatever you want to designate as the BS component). Companies like to tell us to ignore all those "one-time" writedowns, which seem to happen a lot more than once these days.

Going back a few decades, operating and as-reported earnings were very closely aligned. That relationship began to change in the mid-'90s, as management wanted to make a more bullish case, which certainly helped with their stock options. And the difference between operating and as-reported earnings is now wider than ever.

The difference between estimates for 2009 operating and as-reported earnings is almost exactly 100%. Which means that analysts are projecting there is going to be a lot of Bad Stuff in 2009 to be written down. The table below is a cut and paste from the S&P web site, where they calculate the earnings for the S&P 500. Notice the difference between the P/E ratios for operating and as-reported earnings. The latter P/E is based on the previous 12 months and used Thursday's price, so if you calculate it today it would be slightly higher.

Did you notice the as-reported estimated earnings P/E for the quarter ending September 30, 2009? In the 20 years of data on the web site, the highest it ever got to was 46, in the last recession. That P/E of 181 is because of the negative earnings for the 4^th quarter of 2008. Of course, this assumes that earnings estimates don't keep being revised downward, which is not a safe assumption. They have been revised downward every quarter for almost two years. Seemingly, past projections are not indicative of future results.

Now, to be fair, using the extremely bad earnings of the recent past as a one-time metric is not altogether indicative either. Robert Shiller of Yale uses ten-year average earnings to smooth out the business cycle, and this would give you a P/E of about 13.

My good friend Ed Easterling uses a different methodology to project earnings, involving the historical relationship between GDP and P/E ratios. This is based upon the historical fact that earnings more or less rise at the level of GDP plus inflation. This is a mean-reverting chart, as earnings cannot grow faster than GDP for too long, and also acknowledges that rough patches like the one we are in now will not last, and earnings will rebound. Using his methodology we end up with a P/E just south of 13.

So, I know a lot of you have stayed in the market the whole time it has been falling and are now wondering what to do. If you have a ten-year time horizon you probably can buy here and do OK. But I wouldn't. I think this market is going to have more problems as we confront the real possibility that we will get some really poor earnings for the first and second quarters. The economy is simply weak, and that weakness is hitting more and more companies. From exporting companies to the big international firms, a global slowdown is hitting almost everyone. Even hospitals are being challenged. We could see a real bear market rally lure investors back in, just to crush their hopes this summer.

Markets go from high valuations to low valuations and back again over long periods of time. I believe that we have a long time to go in the current secular bear cycle. As I have written for years, this one began in 2000 and could last until the middle of the next decade. While we will see a "bottom" in stock prices at some point, maybe even this year, we have a long way to go to get to a really low P/E ratio.

Big secular bull markets happen when P/E ratios drop below 10 (and even lower). That acts just like winding a spring. When it is let loose, it explodes for a very long time. There is another bull market in front of us. I would rather be patient and rely on an absolute-return style of investing for now. If I miss the first part of this run, so be it. I see more risk than reward in this latest run-up.

The Land of the Setting Sun

Japan has been in a malaise for 20 years. And just when it looked like the country might turn around, the bottom has seemingly fallen out. Japan's economy shrank a slightly revised 3.2% in the last quarter of last year, confirming the sharpest contraction since the oil crisis in 1974, and economists warn of further contraction in the next two quarters.

The Japanese economy, mired in its worst recession since World War II, is forecast to shrink a further 2.5% in the first quarter of this year and another 0.4% in the second quarter, a Reuters poll shows.

But if you look at the underlying data, it's even worse. Let's turn to a recent letter from my good friend and favorite data maven, Greg Weldon. (www.weldononline.com)

Japanese exports have fallen 54% in the last 6 months, an average of $40 billion a month, or down over a quarter of a trillion dollars. Greg notes that past 6-month changes in exports in Japan were hardly ever up or down more than a trillion yen. This is four times that level, about 4 trillion yen. To get a visual view, look at the graph below. That is called falling off a cliff.

The decline in exports is about 45% year over year. Japan is one of the countries that has run a very large trade surplus, allowing them to buy lots of dollars and lend a great deal of money. Their banks have been an engine for growth worldwide, but especially in Asia. And the graph below shows that trade surplus turning into a large trade deficit of 952 billion yen, or somewhere over 9 billion dollars.

To give that some perspective, the US trade deficit came in today and was "only" $36 billion, the lowest level in six years, mainly due to lower oil prices, as our exports have been shrinking as well (more on that below). The US economy is roughly three times the size of Japan's (and Japan is the world's second largest economy); so $9 billion is no small sum of money, relatively speaking.

(Quick note - while looking for that number on the web, I came across this tidbit in the China Daily. They project that the GDP of China will surpass Japan's next year.)

Inventory-to-shipping ratios in Japan are rising by over 50%, as industrial production is down more than 10% and likely to fall much further. Japanese auto exports are down 63% in just four months. Auto exports have literally fallen off a cliff, as inventories have doubled.

No surprise, Japan is promising even more government support programs, and aid to industries of all sorts. This from a government that has over 140% of debt to GDP, about twice that of the US. And their rapidly rising credit default swap rate is not helping. Who would have thought of Japan as a credit risk? Three years ago, almost no one. Now, rates are 30 times higher.

Japan's economy is driven by exports. And those exports were crushed as the yen rose in buying power and Japan's exports became less competitive in the last quarter, with calls for intervention to bring the yen back to a level where their industries can be more competitive. Look at the chart below of the Japanese yen versus the US dollar. (The moving average is 90 days.)

Note that less than two years ago the yen was over 124 to the dollar, and fell last quarter to below 87, and has risen back to 98 today. Think about the Japanese auto manufacturer. Two years ago he could sell his car in the US (or wherever) for $30,000 and get 3,750,000 yen. Today, that $30k only gets him a little under 3,000,000 yen. Think his costs dropped 20%? Think he can raise prices 25%?

If you sell machinery, you are competing with companies, countries, and currencies all over the world. If your currency rises, you are less competitive, or your profits have to fall.

Japan has problems, and not just in manufacturing. The population of the country is now literally shrinking, as they have the highest proportion of elderly people and the lowest proportion of children. By 2050, 70% of the labor force will have disappeared. While Toyota is the world's largest car company, auto sales in Japan peaked 18 years ago. Supermarket sales have fallen every year for the last 11 years. This is a country in a long-term decline, with massive debt. While there is still a lot of economic power there, it is not the country of the future. Unless they figure out how to grow their population, it will be a long slow slide.

The Swiss Start Their Engines

About five years ago Greg Weldon (mentioned above), a big NASCAR fan, introduced the idea of a competitive devaluation raceway among Asian countries trying to make sure they could compete against each other to produce "stuff" for the US consumer, with each "car" drafting the other as they went around the turns, trying to get a competitive advantage by manipulating their currencies.

Today, I heard a new engine roar, one that I have never heard before. It is a deep-throated and powerful new entry into the devaluation race, and one that will have large ramifications for world trade. Gentle reader, this is huge, and we visited Japan first to give you some idea of the problems all over the world, for indeed we could have picked any number of countries and told as sad a tale.

But who would have picked Switzerland? Yet we read this morning, "The Swiss franc posted its biggest weekly decline against the euro since 1999 after the country's central bank sold the currency to halt a 7.6 percent appreciation in the past six months.

"The franc was also near the lowest level versus the dollar in three months after the Swiss National Bank's (SNB) first solo intervention in foreign-exchange markets since 1992. The SNB also said yesterday it will buy corporate bonds as it cut the benchmark three-month Libor target rate to 0.25% from 0.5% to revive the economy."

This is tectonic. It is a game changer. First, they did it before the upcoming G-20 meeting. They clearly felt they could not wait. And they moved the currency big-time. Look at the chart below of the Swiss franc against the euro. The far right bar jumped 7 big "handles" in a few hours. (A handle is trader talk for a unit of movement.) Currency markets have been violent of late, but this is huge. Currencies are supposed to move at a glacial pace, not by 4-5% in a day!

The Swiss economy will slump by as much as 3% this year, the most since at least 1975, the central bank said yesterday. Price pressures evaporated in recent months as oil prices sank, the franc strengthened, and domestic demand dropped. Prices will probably decline this year and inflation will be "very close to zero" in 2010 and 2011, the SNB said. The franc's appreciation made Swiss products less competitive in Europe and the US, where deepening recessions were already curbing demand. (Bloomberg)

The story goes on to talk about numerous Swiss businesses that simply were not competitive with the rise in the value of the franc against the euro. With their economy slumping, with deflation knocking at their door, they clearly felt the need to act. Note they plan to buy corporate bonds to inject money into their economy. The Swiss, being frugal, don't have that many bonds, so the central bank may have some trouble finding enough to stimulate their economy - thus they are clearly prepared to use the currency tool in the cabinet to help stimulate their economy.

The last time a G-10 nation intervened in its currency was in 2003 when Japan tried, and oddly failed, as their currency had risen about 6% a year later. That caused me to write back then that their central bank established a new level of central bank ineffectiveness, because they could not figure out how to destroy their own currency, even when they wanted to.

The point is that such interventions by major developed countries are rare. Whatever their reasons, the Swiss have opened Pandora's box. Do Senators Schumer and Graham now start talking about that major currency manipulator, Switzerland, and start to introduce bills to punish them? Will Secretary Geithner come before a Congressional committee and call the Swiss currency manipulators? If not, then how do we deal with China?

Because China can now say, with some justification, that if the Swiss can manipulate their currency to make themselves more competitive, then why is it wrong for us? And how long do you think it will be until Japan tries once again to push the yen lower, with its export industries in tatters? And Korea? Taiwan?

You can almost hear the announcement over the loudspeakers: "Gentlemen, start your engines!"

My One True Nightmare

Let's be clear. As bad as things are, and they will probably get worse, I am a believer in free markets and the ability of people to figure out their own paths. And it is 300,000,000 people in the US and billions worldwide, each acting in their own interest, that will bring us back to a growing global economy.

But there is one thing that worries me above all else. For over six years I have been writing that the one thing that could truly derail the world economy is protectionism. Nothing would be more deleterious in today's global economy.

And that brings us to this stark note I read today on Bloomberg. It sent chills down my spine: "American exports have slumped at a 44% annual pace in the most recent six months of data, with imports shrinking 51%, probably the most since the Great Depression, according to Morgan Stanley analysts. The figures may add to pressure on the Obama administration to rework international agreements and include protections for US workers and the environment."

The US steel industry is planning to bring anti-dumping charges against foreign steel. India just raised steel tariffs. It seems like every day I read that someone somewhere is calling for their particular industry to be protected, bailed out, or subsidized. And it is not just the US. It is happening all over the world.

Right now, it is just small amounts and nothing that will rock the system. But these things can get a life of their own. If the Swiss can move to take their currency lower, then there will be a score of countries that will ask why they shouldn't be allowed to do the same. And the one currency they all want to be lower against? The dollar. Even though our economy is in shambles and consumer spending is falling, it is still a huge spending machine. And every export-growth-led country wants a piece of it.

We are getting ready to run a huge, $3-trillion deficit, and the Fed is going to print a lot of money and inject it into the economy. There is real reason to worry about the strength of the dollar. And yet, the dollar is the weakest currency except for all the others. As much as we in the US worry about the fall of the dollar, it could rise over the coming year.

That is going to put a lot of pressure from a lot of sources on President Obama, who ran as a populist. Here is hoping that his advisors steer him away from starting a round of trade protectionism that could beggar the world, just as Smoot-Hawley did 75 years ago. This bears watching closely.

New York, Vegas, and Happy Birthday, Tiffani

I will be in New York next week for a few days, and hope to have dinner with Art Cashin. I have a lot of meetings scheduled. Details are firming up. Then it's Doug Casey's "Crisis & Opportunity Summit," March 20-22 in Las Vegas, where I get to be the resident bull! Click to learn more about the Summit.

I will then go to La Jolla for my own Strategic Investment Conference, April 2-4. It is sold out; but as I mentioned at the top of the letter, you can still get tickets to the Richard Russell Tribute Dinner.

And today, Tiffani, my oldest daughter and business partner, is 32. She is holed up in the wilds of Kentucky working on our book. It is hard for me to express how great it is to be working with her. As all my partners know, she really does run the business, letting me do what I do and giving me the time to research and write to you.

And just to brag a little, here is a picture of my four girls. Dad is very lucky. And maybe this is just a little reason I remain so optimistic in spite of everything.

Time to hit the send button. Have a great week, and remember that we will all get through this together. That is what friends are for.

Your ready for some down time analyst,

John Mauldin

Time for a Reality Check

John Mauldin — Sat, 14 Feb 2009 20:04:49 GMT

Time for a Reality Check
World Trade Is Falling Off a Cliff
European Bank Losses Dwarf Those in the US
Geithner: "You Can't Handle the Truth"
Earnings Will Get Even Worse
Orlando, Colorado Springs, New York, and Las Vegas

It is not just the US that is in recession. The world is slowing down, and rapidly. This week we quickly survey the rest of the world, and then come back to the US. We follow up with the implications for corporate earnings worldwide, and specifically address my speculations about earnings forecasts for 2009.

World Trade Is Falling Off a Cliff

Let's start with some charts from my friend Simon Hunt, out of London. The following chart shows World Merchandise Export Values and World Industrial Production falling off a cliff. This is the worst such period since the end of World War II. And as the data we will examine next indicates, it is likely to get worse. Simon notes that consumer spending is about 60% of world GDP, and it is not just in the US that spending is slowing down. Consumers all over the developed world are in shock, as assets such as stocks and houses, real estate, and commodities fall in value. Unemployment is rising.

We think that almost 2,000,000 lost jobs in the last three months in the US is a catastrophe. China lost a reported 20,000,000 jobs in the last quarter, and migrant workers came back to the cities after Chinese New Year to find factories and jobs simply gone. Unemployment is rising rapidly in Europe, as the demand for goods has clearly been falling since last October.

This means that inventories are too high, not just in the US but in factories all over the world, and that production is slowing down. Look at the recent US trade deficit. Many market analysts rejoiced that it dropped to a six-year low, just below $40 billion. But the internal numbers were not as positive. Exports are dropping faster than imports, as seen below. "After growing in every quarter during the last three years, real goods exports fell 34.9% at an annual rate, the worst performance in more than three decades." (www.dismal.com) And a falling deficit means that US consumers have to save more to balance out less foreign buying of US debt. There is no free lunch.

Let's look at a little bit of insider economics trivia. The US government first estimated that GDP last quarter was a negative 3.8%. I wrote when that number first came out that it would be revised downward.

When the government makes its initial forecast of GDP one month following the end of a quarter, it has to estimate what exports and imports were for the last month of the quarter. There is simply no data. For the 4^th quarter of 2008, they estimated that the trade deficit would be about $34.5 billion, in line with what most economists thought. As it turns out, each $1 billion represents about 0.1% of GDP. So being off about $5 billion from the actual total of $40 billion subtracts another 0.5% of GDP from the previous estimate of -3.8%, taking it to a -4.3%.

Further, the government makes estimates about inventories which also affect GDP. When final numbers on real inventories come in, it will also add to the negative GDP estimate. Expect GDP to be in the range of a negative 5% for the 4^th quarter, and the current quarter is likely to be almost as weak.

In the US, the leading economic indicators (LEI) continued to decline, but the leading indicators in the rest of the world were often much worse. (The chart below is again from Simon Hunt.) These are results from the OECD's analysis of the leading economic indicators for a variety of countries. Notice in particular how poorly Russia and China are doing! Also remember that the LEI is about how the economy is expected to be doing in six months, not what is going on right now. This argues that there is no real global turnaround in the picture before the end of the third quarter, at the earliest.

China has seen its year-over-year exports drop by 17.5% and imports by 43%. These are not signs of a healthy economy. That being said, China is massively increasing bank loans and other stimulus-type spending to try and offset the effects of the global downturn. But putting 20 million people back to work in a short time is a daunting task.

Japanese GDP was down by 9% (!) last quarter. Many of the largest corporations are seeing exports drop by 20-30% and are engaged in massive layoffs, larger proportionally than in the US. The euro area economy dropped by 6% in the 4^th quarter, led by an 8.2% contraction in Germany (JP Morgan). I could go on and on, but the news is the same. The global economy is in a deep and worsening recession.

European Bank Losses Dwarf Those in the US

In a few paragraphs I am going to put up a chart from Nouriel Roubini's RGE Monitor on the size of US bank losses, and in a few pages I'll comment on the Geithner "plan" for rescuing US banks. We have indeed dug ourselves a very deep hole here in the US.

But European banks may be in far worse shape. Bruno Waterfield of the London Daily Telegraph reports to have seen an eyes-only document prepared by the European Commission for the finance ministers of the various EU member countries. The problem revealed in the report is an estimated write-down by European banks in the range of 16 trillion pounds, or about $25 trillion dollars! The concern is that bailing out the various national banks for such an unbelievable amount would push the cost of government borrowing to much higher levels than we see today.

As my kids would say, "Really, Dad, you think so?" Europe is somewhat larger than the US, so think what my gold-bug friends would say if the US decided to borrow $25 trillion to bail out US banks. The dollar would be crucified! The euro is going to get a lot weaker if bank problems are even half of what the report says they are. The British pound sterling is already off almost 30% and, depending on what the real damage is to their banking system, it could get worse.

Waterfield reports, "National leaders and EU officials share fears that a second bank bail-out in Europe will raise government borrowing at a time when investors -- particularly those who lend money to European governments -- have growing doubts over the ability of countries such as Spain, Greece, Portugal, Ireland, Italy and Britain to pay it back.

"The Commission figure is significant because of the role EU officials will play in devising rules to evaluate 'toxic' bank assets later this month. New moves to bail out banks will be discussed at an emergency EU summit at the end of February. The EU is deeply worried at widening spreads on bonds sold by different European countries."

Part of the problem is that European banks were far more highly leveraged than US banks. Some banks were reportedly leveraged 50:1. And they lent money to Eastern European projects and businesses which are now facing severe financial strain and plummeting local currencies.

Let that number rattle around in your head for a moment: $25 trillion. Even $5 trillion would be daunting. But the problem is that Europe does not have a central bank that can step in and selectively save banks from one country without taking on all euro zone member-country banks. Yet, as noted above, some countries may not have the wherewithal to save their own banks. It is reported that some Austrian banks are hoping that Germany will step in and help them. Given Germany's problems, they may have a long wait.

Now, let's look at what Nouriel Roubini (www.RGEmonitor.com and professor at NYU) estimates for US banks losses. He puts the figure at some $1.7-1.8 trillion out of a total of about $3 trillion (I think) in total financial system losses. And Nouriel's base assumptions are not all that bearish, given what we know: a 5% GDP contraction and 9% unemployment, with housing prices down another 20%. All those estimates are quite plausible.

And a quick promotional plug: my next recorded "Conversation" will be with Nouriel and his staff in a few weeks. See the link at the end of the letter to make sure you get your copy.

Geithner: "You Can't Handle the Truth"

The critics were quick to pan Treasury Secretary Tim Geithner's bank bailout plan as being weak on details. Which was true. There wasn't much substance in his speech. But let me offer a contrarian view. Geithner and the team around him may not be entirely tone deaf. They are very smart people and are surely in contact with major Wall Street figures, and would know that the lack of detail would disappoint.

Pretty much everyone knows the scene from A Few Good Men, where Jack Nicholson tells Tom Cruise, "You can't handle the truth!" (www.youtube.com/watch?v=8hGvQtumNAY)

What if the number that the Treasury and the Fed are looking at is a lot more than the remaining $350 billion in the TARP program? As in another $1 trillion more, or even the $1.5 trillion that Roubini says may be out there (and other independent analysts, like David Rosenberg of Merrill, say there may be another $2 trillion in losses). Can you imagine what the market reaction would have been if they had announced that this week? The Dow down 400 points would have seemed like a Sunday walk in the park. Congress would be screaming, and the chances for the stimulus package to pass would have materially diminished.

I don't think we know the real extent of what it is going to cost to shore up the banking system. But the consensus among the financial leadership is that we have to fix the credit system no matter what the costs, or risk a repeat of the Great Depression. That is the essence of what Irving Fisher taught us some 75 years ago, when faced with a deflationary debt crisis.

Time for a Reality Check

Reality check: The "stimulus" that President Obama will sign Monday is a band-aid. If Irving Fisher, who by some accounts was our finest American economist, was right, such a stimulus is useful in that it helps those who are unemployed and replaces some lost consumer spending; but the real work that must be done is to get the credit system flowing again. I don't have the space to go into that economic debate tonight, but it is at the core of the problem. It is Keynes vs. Fisher, von Mises vs. Friedman. It is, as Lacy Hunt says, "The Grand Experiment." After 70 years, we are going to see who is right. My money is on Fisher. It is not an experiment that is going to be fun to live through; but when we have the next debt deflation in 70 years or so, our grandchildren may know what to do.

We will see another stimulus package, probably by the end of the year. This time it will hopefully provide real stimulus. Much of the current version is simply an increase in federal spending that will be hard to rein in. And please, I am not being partisan. That is the analysis of many of Obama's advisors. And it goes back to the debate I mentioned. Keynes would argue that it is in fact stimulus. The other three economists would have differing views. And like I said, in a few years we are going to know who was right.

But the heavy lifting is going to be done by the Fed. Watch their balance sheet expand. And watch Treasury and the FDIC come back and ask for massive amounts of money to take over very large insolvent banks. Stay tuned.

Earnings Will Get Even Worse

Last week I said that 2009 as-reported earnings estimates for the S&P 500 would be dropping. 2008 earnings had dropped to $29.57 as I wrote the letter. They are now down to $28.60. One of my favorite analysts is David Rosenberg of Merrill Lynch. His forecast for reported earnings for 2009 is now down to $28. That puts the P/E for the S&P 500 at 30.

He also projects "operating" earnings to be $55 for 2010. And, as he writes today:

"For those looking for a silver lining, at least we are going to have a deeper bottom to bounce off. Applying a classic recession-trough multiple of 12x against a forward EPS estimate of $55 would imply an ultimate low of 666 on the S&P 500, likely by October if our estimate of the timing for the end of the official downturn is accurate."

That is a 20% drop from today's close of 829. That is not what you will hear from "sell-side" managers who want you to invest in their mutual funds and long-only management programs.

I noted the problem with the rest of the world earlier. 40% of the earnings for the S&P 500 are from outside the US. It is hard to see how those earnings are not going to be deeply affected. Let me reiterate my continued warning: this is not a market you want to buy and hold from today's level. This is just far too precarious an economic and earnings environment.

Given the probable ongoing bad news from financial and consumer stocks, plus the depressing news on bank losses coming down the road, why take the risk?

Orlando, Colorado Springs, New York, and Las Vegas

This Monday I fly out to Colorado Springs to look at a very intriguing high-tech start-up. As gloomy as this letter was, there are so many cool opportunities to get involved with new companies with truly world-changing technologies. Maybe it is just serendipitous, but I am seeing more exciting possibilities than I ever have.

On Friday I am off to Florida for a conference sponsored by Cain, Watters & Associates, and then back home for a few weeks (maybe) before I head to New York in mid-March and then to Las Vegas to be with Doug Casey and friends at his "Crisis & Opportunity Summit," March 20-22. Doug and his associate David Galland have really put together a great line-up. If you are interested in gold and natural resources, this may be a conference you want to attend. I always enjoy being with Doug and David, as they are old friends. And it is interesting to be at a conference where I am the "bull." Click to learn more about the Summit.

I mentioned the edition of "Conversations with John Mauldin" I will be doing with Nouriel Roubini. And the one I did with Lacy Hunt and Ed Easterling, where we talked about the economics "Great Experiment," is up! We recorded it two weeks ago, and I thought it went very well for an inaugural talk. The complete audio and transcript are already in the Membership Library. We are getting very favorable reviews. Multiple readers have let us know that the first Conversation was worth their entire year's membership. I am quite pleased with the first transcript and the response to it. After the release of banking data in early March, I will do a Conversation with good buddy Chris Whalen and a few real banking experts, on where the US banking system really is. I will offer it as a bonus to those who have already subscribed, as it will be more me asking questions than a real Conversation. I expect it to be very informative.

The regular price for a yearly subscription is $199, but you can subscribe now for $109 and still get access to the timely Conversation with Ed and Lacy. Don't wait, as I am sure my staff will only keep raising the price. To find out more, just click on the link and put in code JM75, which will give you the discounted price. https://www.johnmauldin.com/newsletters2.html

And for organizations that would like to purchase a discounted multiple subscription for all their brokers or partners, just drop Tiffani a note at conversations@2000wave.com and she will get back to you.

It is late and time to hit the send button. Have a great week, and enjoy the holiday weekend in the US!

Your on the lookout for more opportunities analyst,

John Mauldin

Some Things That Just Should Not Be

John Mauldin — Sat, 13 Dec 2008 05:01:52 GMT

Things That Should Not Be
I'll Pay You to Hold My Cash
Pushing on a String
Free Money with that Credit Default Swap?
Oil Does a Strange Contango Dance
The Tragedy of Bernie Madoff
Goodbye to the Ballpark

There are things in today's markets that are simply astounding. They should not exist, yet they do. Why should US bills trade at negative interest? How can oil be trading at all-time highs in terms of spreads over the next year? Bank debt and bonds are trading at discounts not to be believed. Want some free money? I show you a trade that gives you (almost) just that. Fed funds at zero? Are we starting to push on a string? We'll cover all this and more in this week's letter.

But first a quick commercial. Not all money managers and funds have had losses this year, even though it may seem like it. My partners around the world can introduce you to some alternative funds, commodity funds, and managers which you might find of interest as you rebalance your portfolio at the end of this year. You owe it to yourself to check them out.

If you are an accredited investor (net worth over roughly $1.5 million), you should check out my partners in the US, Altegris Investments (based in La Jolla) and my London partners (covering Europe), Absolute Return Partners. If you are in South Africa my partner there is Plexus Asset Management. You can go to www.accreditedinvestor.ws and fill out the form, and someone from their firms will be in touch. All three shops specialize in alternative investments like hedge funds and commodity funds, on a very selective basis. We will soon be announcing new partners in other parts of the world. And if you are an advisor or broker, you should call them (or fill out the form) and find out how you can plug your clients into their network of managers.

If your net worth is less than $1.5 million, I work with Steve Blumenthal and his team at CMG. I suggest you go to his website, register, and then let them show you what the blend of active managers on his platform would have done over the past few months and years. These are primarily managers who will trade a managed account (using various proprietary styles) in your name, and are quite liquid. Again, if you are an advisor or broker and would like to see the managers on the CMG platform and how you can access them for your clients, sign up and let Steve and his team know you are in the business. The link is http://www.cmgfunds.net/public/mauldin_questionnaire.asp. And now back to the letter.

I'll Pay You to Hold My Cash

In the last few weeks we have seen 30- and 90-day US Treasury bills trade every now and then at a rate of negative interest. That means someone is willing to pay for the privilege of having their cash in US Treasuries. This simply should not be. Why would anyone want to do this? Is this a sign the system is broken? Are we that scared?

Not really. There are some explanations for this seemingly bizarre behavior. First, banks are driving down the interest rates toward zero. Because their audits come at the end of the year, they want to be able to show a very liquid and pristine balance sheet. And what better way to do that than short-term US Treasuries? But that gets us near zero, not below. (And as noted below, the effective Fed funds rate is at zero, not the posted 1%.)

As David Kotok of Cumberland Advisors noted in a post: "We cannot find a single investor or institution or organization that would volitionally buy this T-bill at zero interest, let alone a negative yield. We have polled firms and agents and portfolio managers. We've asked people who range from sophisticated, high-net-worth individuals to multi-billion-dollar institutions. None would do it. We have asked professionals and skilled and trained consultants. All answer 'not me.' Foreign currency traders would not do this trade; they have other ways to hedge or structure without buying a negative yield.

Another possibility is market manipulation or a pricing error. Not this time. All evidence points to the negative yield as seeming to be a market-driven price. This is a real puzzle on the surface."

I have spent more than a little time over the years looking at alternative fund prospectuses and back-room operations, and have been involved in a consulting role for a few funds. Let me tell you how I think interest can get below zero in a perfectly rational market.

Let's say you are trading futures or other leveraged products. You don't need to put up all the money in order to buy a futures contract on oil or the S&P 500. You simply have to have a typically small amount of margin money at the clearing broker, depending on the nature of the contract. Many funds are required by their organizational documents to hold their cash in short-term Treasuries for liquidity purposes. They have no choice but to buy Treasuries. Some of these funds are quite large, and when they come to the market they come, as we say, "in size."

If you are a trader on the other side of the trade and can make a little extra for scalping such a fund, then you do it. It doesn't happen often, but it can and does happen when the demand for liquidity is as high as it is today.

I also called my long-time friend Art Bell, whose eponymous firm Arthur Bell and Associates audits a rather large number of commodity and hedge funds. He is one of the best in the business. He confirmed that he knew of at least one fund that had bought Treasuries at a negative interest rate, not because they were forced to but because they wanted instantaneous liquidity in case they got margin calls on some of their trades. They did not want to be forced to sell something at a larger loss than they would normally take, just because they did not have the cash. The very small negative interest was the price they willingly paid not to be put in the position of taking larger losses on a trade in a forced sale. Sounds like smart risk management to me.

I bet if we checked around we would find more than a few funds and managers who for one reason or another are willing (or forced to) buy Treasuries at negative interest rates. Such is the way in today's surreal investment world. Art says that if this current environment persists, funds will find an alternative, such as third-party collateral deposits, rather than leaving deposits at a brokerage firm.

Pushing on a String

Speaking of zero interest rates, the posted Fed funds rate may be at 1%, but the actual market is trading at very close to zero. That means that banks can get money that is effectively free. The Fed meets next week in what was supposed to be a one-day meeting but which has now been scheduled for two. Guess they think there is a little more to talk about.

The Fed will cut rates next week. But with the effective real market rate now at zero, what difference does a cut make? I hope they do the right thing and go ahead and cut at least 75 basis points, if not more. That would stop the speculation and let them move on to quantitative easing and other allied policies, which we will explore in some future letter. Whether they should pursue some of the more radical policies is open for debate, but it is more important today for us to figure out what they are going to do and adjust our portfolios correctly than to debate policy.

As an aside, if it looks like Bernanke and Paulson are making all their policy moves "on the fly," it is because that is exactly what they are doing. As would any person in their respective offices. There is no playbook with a set of standard policies and procedures that can be used in case of a credit crisis. They have to make up the plays as the game progresses, much as we did in pick-up football games as kids. "John, go long and make a left cut at the trashcan. And try not to drop it this time."

There are very few real rules and laws, and Bernanke and Paulson have shown a willingness to ignore them if they seem to get in the way. This is a very pragmatic group that is trying to keep the economy from imploding. They only have a few theories and some loose analogies to what happened in Japan and maybe the US in the 1930s as guidelines. But those times had such major significant differences that it is hard to make a direct inference as to what did and did not work. As Yogi Berra is alleged to have said, "In theory, there is no difference between practice and theory. In practice, there is." And when theories meet the rough hand of the market, they will be changed.

We are getting to ready to run a grand experiment on many theories in the world of economics. Will Ben and Hank (soon to be Tim) get it precisely right? And what is precisely right? Does the avoidance of a second Great Depression mean success? Will anyone be grateful? We all have seen pictures of Paulson looking so very tired and worn. I actually feel sorry for him. Who would want that job? I know this will not sit well with many readers, but I think he has done about as well as could be expected given the circumstances. Look at the previous Treasury secretaries under Bush. No disrespect to Mr. O'Neill or Mr. Snow, but would you really want someone with so little exposure to the capital markets in the current position? Compared to so many Treasury secretaries over the past 30 years, we are lucky to have Paulson at this time.

In any event, Paulson is pouring water on the fire as fast as he can. I doubt that Tim Geithner will do any different. If Geithner has a play book for avoiding deflation and depressions, he has not shared it with anyone. They will still be making the plays up as they go along next year. I just hope they call the right plays.

Free Money with that Credit Default Swap?

Today there are bonds you can buy and get the interest coupon, and then purchase a credit default swap (insurance) on the loan that is less than the interest you will get on the loan. Assuming you have a creditworthy seller of the credit default swap, it is risk-free money. You can make almost 1% on the spread! Lever that up a few times and it becomes interesting. (Except that you can no longer get money to really leverage it enough.) This should not be. Then why is it?

Because "... assets everywhere are being dumped in favor of cash, and corporate bonds are no exception. Second, corporate bonds are no longer that attractive as collateral for funding because counterparts are demanding more onerous terms in exchange for lending out cash in return." (The Financial Times)

The corporate bond market is assuming an Armageddon Scenario. Barclays Capital writes that one would have to assume that US GDP will contract by 15% to make sense of the current bond spreads.

My friend and partner Nick Rees at Absolute Return Partners in London dropped me this note (emphasis mine):

"Leveraged loans had a particularly rough month with the average senior secured loan losing over 20 points in value and now trading in the mid 60s. The sell-off was largely driven by forced liquidations as hedge funds face substantial redemptions in the run-in to New Year. This is how crazy the loan market is: The worst ever default rate for senior secured loans is about 8%. If you assume a 35% annual default rate and a 50% recovery rate, your IRR to maturity is now in excess of 22%, using no leverage whatsoever. Either this is the investment opportunity of the century, or equity markets have seriously underestimated the economic downturn, and things are likely to get a whole lot worse for equity investors."

Formerly stable credit funds that are mark-to-market are posting horrific numbers. Many of them have closed redemptions until the market comes back. Selling a fully secured loan at 60 cents on the dollar makes no sense; and many investors are happy the funds have closed, as forced selling by other investors would lock in their losses when the loans will surely recover much of the current markdowns over time. But forced selling by some funds mean that all funds have to mark down the loans to today's value. Mark-to-market in this context is appropriate but it is still hard on your psychology while you wait, and especially as loans seem to keep dropping in value.

Oil Does a Strange Contango Dance

The oil market is said to be in contango. The definition of contango is: "A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. It is the opposite of backwardation."

This morning West Texas Intermediate January oil futures prices were (courtesy of Dennis Gartman) $45.80. This rises to $52.28 by just April. A few day's ago, Dennis reports, the spread between the first and fifth futures months had risen to $8.06, the highest ever. When oil was at $147, the spread was an average of $3.25, or about 2.5%. You can buy January 09 crude futures at a stunning 34.5% lower than January 2010.

That means if you could find a place to store that oil, you could lock in a guaranteed 34% profit, less the cost of storage. Sounds like easy money. This is just something that shouldn't be. But what this tells us is that storage for oil is very tight. Oil producers are leasing very large ships to store excess oil, as they cannot find places to store it on land. Storing oil on ships is expensive, so that cost of storage gets figured into the price of oil a year out.

The OPEC nations are not cutting back by any significant amount. Oil is backing up in the system. It is quite possible that oil could go a lot lower in the next few months as the world reels from a global recession, and that means the demand for energy will be down. Oil below $30? Without production cuts that is certainly in the realm of possibility.

As an example, let's look at how shipping is holding up. The graphs below picture a rapidly deteriorating shipping business. Korean exports fell by 18% and Taiwan's by 23% year-over-year ending in October. China's shipping is rumored to be down by 3% on a valuation basis and by 7-8% on a volume basis. Prices in China are actually starting to fall, and Chinese authorities may soon have to deal with deflation.

China is in a situation eerily reminiscent of the US in the very early 1930s. A large trade surplus, far too much production capacity, and falling exports with a whiff of deflation. Hopefully they have studied what we did wrong and will not copy it. But we should pay attention.

This is not a world economic environment that is friendly to oil producers. Could oil fall below $30? It could if producing countries do not start to cut back on production. But many of the larger producers need as much money as they can to keep the lid on civil unrest.

Deutsche Bank and a private consulting firm called PFC, based in Washington, have determined that Venezuela needs the price of oil to average $97 a barrel to balance its accounts, while in 2000 that South American country only required the price to be $34. Look at this chart, courtesy of Dennis Gartman. It shows the price of oil that various countries need to balance their budgets.

Russia will need $70 oil. These countries are going to need to produce and sell what they can, which is in conflict with the need to control production and move prices higher.

So far, the OPEC nations are not cutting back any significant amount of production compared with the destruction in demand. Oil is backing up in the system. Energy economist Philip Verleger suggests that OPEC should execute an "astounding 7.7 million barrels per day" just to restore market balance today. Global demand is down by over 5 million barrels a day to 81.6 million barrels a day. Non-OPEC countries produce almost 50 million barrels of oil. OPEC produces roughly 31 million, plus there are some other OPEC sources of about 5 million barrels equivalent in natural gas liquids. Thus, Verleger says OPEC oil production needs to drop by almost 25%, to somewhere under 24 million barrels a day. Think Iran or Venezuela will cut that much, given their need for cash to fund their regimes? Will Russia join OPEC and cut production? It will be interesting to watch Iran and Venezuela in the coming year scramble to maintain power.

It is quite possible that oil could go a lot lower in the next few months. Demand could fall further. If we are truly producing an extra 5 million barrels a day, the excess supply could be at all-time highs within a few months. Longer term, I still think oil is going higher; but it could be wild ride, and the longer term is now a lot further off. I would not want to be long oil for the next few quarters, until there is some serious growth in demand and some cuts in production.

The Tragedy of Bernie Madoff

And speaking of things that should not be, yesterday I was talking with a few fellow money mangers on a conference call when the news came that Bernie Madoff had been arrested and his fund was missing at least $17 billion, and maybe losses were as much as $50 billion. This is so very, very tragic, as it is not just large investors with well-diversified portfolios who lost here. Many smaller investors around the world had significant sums of money with Madoff. Far too many were not as diversified as they should have been. Some of the stories already surfacing are of horrific personal losses to investors and retirees who have no way to come back from such losses.

The fact that Madoff will spend the rest of his life in jail in no way compensates for the loss of so many people whose lives have been seriously impacted. It is just so terribly sad.

Madoff is a topic that comes up very often in alternative investment circles. I have been talking about his fund with friends at various conferences for almost a decade. "How does he do it?" we wondered. His fund posted steady 1-1.5% monthly returns since 1996, with only a few losing months in all that time. Supposedly he was doing something called split strike conversions. Some speculated that he was actually front-running trades in his market-making business. (Interestingly, regulators who looked at his market-making business never investigated the fund to see if he was doing just that, although I believe there were suggestions and other hints to them.) But arbitrage traders in the same arena could never figure out how he did it, and many were openly sceptical. Everyone, even the smartest trading shops, had losing months and quarters. But not Madoff. The fund was a complete black box and no one knew exactly what he did. Oddly, I have never met or known of anyone who has ever met a trader who came out of Madoff's shop. I run into resumes of ex-traders at various other funds all the time. No one knew what he did, even employees in his (what seems to be legitimate) market-making business, which was walled off from his investment funds. This was a man who was once chairman of the Nasdaq Stock Market. He was trusted and looked up to.

There were signs if you looked for them. The lack of transparency, for starters. The fact that he did his own trades with his own firm and made commissions on them. There was no prime broker where the real assets could be seen. How do you run a $17 billion fund without a room full of traders? I have been on the trading floors of smaller funds, and there are scores of people. A fund that size should have a football field-sized trading floor. Even if it was computerized, there had to be programmers. And lots of them. And where were the geniuses who designed these programs? Jim Simons at Renaissance has hundreds of support staff for his operation. He is one of the best, and he has losing periods. The "auditors" of the Madoff fund was a firm that was located in one 13x18-foot room. For a $17 billion dollar fund? Really? Real audits take lots of manpower.

That being said, a lot of smart people invested in the fund. They trusted Bernie. And anyone who looked at those returns had to be a little tempted. After all, weren't regulators looking at it? (The answer is no.)

Now we know how he made those returns. It was a Ponzi. Except this may have been larger than Enron and ultimately more damaging to more people than any scandal in the past. I remember writing a few years ago, in response to an article in Forbes about some minor hedge fund frauds, that all the losses of all the hedge fund frauds combined did not equal an Enron or WorldCom or just the plain old loss in a few larger companies in the Nasdaq in 2000-2002. I can't say that now.

Note to my fellow alternative industry participants: There is going to be a rush by Congress to regulate hedge funds. The SEC tried to regulate hedge funds a few years ago but had to back away when the Supreme Court said they did not have the authority. When the stories come out over the next few weeks (and I have heard some that really cause me heartache), there will be hearings in Congress. Rules will be passed. Quickly. And they should be.

Instead of fighting regulation as many did last time, we should recognize that this is a war that cannot be won and bow to the inevitable and at least get a few benefits from regulation, like the ability to publicly post past performance (although given the carnage of late, that is not as attractive as when I suggested it a few years ago!). I am regulated by FINRA, the NFA, and the state of Texas. We have had an average of one audit a year by some regulator for the past five years. My firm is small and it does cost a lot, but it certainly does not keep us from operating and growing our business. And I must (grudgingly) admit it does keep us on our toes. So let's sue for whatever terms we can in what should be recognized as a total surrender. And then move on.

When I was a young man I wanted to grow up to be a science fiction writer. The real world has turned out much stranger than I could dream at that time. There are just so many things which should not be.

Goodbye to the Ballpark

For most of the last 15 years, my office has been in right center field of the Ballpark in Arlington, home of the Texas Rangers, the local professional baseball team. The entire center field in the Ballpark was made into an office complex, which has worked out very well for all. I can walk out on my balcony and watch the games and have as many as 25 friends into my office to watch with me. It has been the ultimate little boy's office, and I have enjoyed it. There have been many good times here.

But tonight we are packing up, and tomorrow we'll move the office to Dallas, where I will work in my home along with my small staff. More and more of what we do is now done elsewhere, so we don't need as much room. Not only do we save a very significant amount of money, Tiffani and I also save over an hour a day in commuting. As we began to think about it, that is about 225 hours a year, or almost five weeks of time. And the one thing we both need is more time. At the end of the day, it was the time savings. The office has been worth the money, I think. (I still have a few months on my lease and control the next five years, so if you are interested I would be glad to show it to you.)

There is a part of me that is a bit nostalgic, as I have spent so many Friday evenings here writing this letter to you, even when games were going on. I shall return, as I have friends in the office complex here. But that being said, I am really looking forward to the walk down the hall being my daily commute.

I am hitting the send button a little early, as they are literally going to take my computer in a few minutes. Monday I enjoy the new office for an hour before flying to Phoenix for a day, but back home Tuesday night. Then Friday I am off to New Orleans for a long working weekend with Tiffani, where we will do some real work on our next book, Eavesdropping on Millionaires. The deadline is rapidly approaching and we need to focus!

Have a great week! And remember to think about all the good times! And believe there will be lots more.

Your turning the page of life one more time analyst,

John Mauldin

The Economy Gets a Margin Call

John Mauldin — Sat, 15 Nov 2008 22:05:00 GMT

The Economy Gets a Margin Call
Where Have All the Consumers Gone?
Why Is the Dollar Rising?
Can We Actually Muddle Through?
The Potential for a Large Stock Market Rally
Is GM too Big to Let Fail?
New York, Moving, and Another One Leaves the Nest

As long-time readers know, my daughter Tiffani and I are interviewing millionaires for a book we will be writing called Eavesdropping on Millionaires. This has been one of the more personally impacting projects of my life, as the stories we hear are so very provocative. I hope we can transfer to readers of the book at least half of the impact we are personally experiencing. But at the end of each interview, we let the interviewee ask me questions. Often, they are along the line of "Do you really think we will Muddle Through?" Sometimes they ask in need of assurance and sometimes they simply think that my stance is somewhat naïve. It is something of an irony that I am called a perma-bear in some circles and a Pollyanna in others. The Muddle Through middle has been lonely of late.

So, this week I take another look at my Muddle Through stance. We look at some of the recent data on unemployment and retail sales, think about the implications of a falling trade deficit and a rising US government deficit, speculate about the potential for a serious stock market rally, and also comment on the potential for a GM bailout. There is a lot to cover, so let's jump right in.

Where Have All the Consumers Gone?

Retail sales and prices of goods imported to the US dropped by the most on record, signaling the economy may be in its worst slump in decades. Purchases fell 2.8 % in October, the fourth straight decline, the Commerce Department said today in Washington. Labor Department figures showed import prices dropped 4.7%, pointing to a rising danger of deflation, and a private report said consumer confidence this month remained near the lowest level since 1980. (Bloomberg)

Circuit City filed for bankruptcy and Best Buy said sales were down and gave even lower guidance for Christmas. Nordstrom's cut its profit forecast for the third time this year.

It is a perfect storm for retailers. Consumers are having a negative wealth effect as stock and housing prices have plunged, taking almost $20 trillion out of US consumer assets. Unemployment is rising and consumer confidence is at the lowest levels since the last major recession in 1980-82.

The unemployment numbers which came out this week were particularly grim. Jobless claims on a seasonally adjusted basis were 516,000 newly unemployed. But that masked an even deeper actual number of 540,000. The largest previous number for this week was back in 2001 and was 420,000. Actual weekly numbers can be volatile, but such an increase is certainly disconcerting.

I should point out that as of the end of September there were 3.3 million job openings, down slightly from August. It is not as if there are no jobs being created or available. But as pointed out last week, the number of people looking for work for over 8 months is high and rising fast, so there is a serious mismatch of the jobs available and the desire or ability of people to take them.

Continuing claims are now at roughly 3.5 million individuals who are getting unemployment insurance. Let's assume that each week we lose an average of 400,000 jobs. That is 20 million jobs a year. That means the US economy for the last year has created 16.5 million jobs (very roughly). So there is some robustness in the economy even as we slide deeper into recession.

But what happens if we see the number of new unemployment claims start to rise to an average of 500,000 for a period of time? Without more job creation, that would mean an increase in unemployment of 1,000,000 people in just 10 weeks. This week we have seen an increase in continuing claims of 141,000 from just last week. That, gentle reader, is very grim if it were to continue. Unemployment is likely to continue to rise throughout most of 2009, closing in on 8%.

This time of year should see some seasonal rise as retailers begin to hire for Christmas. But with retail sales down and facing the likely prospect of negative growth in Christmas sales for the first time ever, seasonal employment is evidently not responding. More comments on this below as I take up the Muddle Through economy.

Why Is the Dollar Rising?

The trade deficit is dropping slowly, from over $60 billion in July to $56 billion in September. Import prices fell and imports were down by 5.6%. On a less positive note, exports, which had been one of the bright spots in the economy, fell by 6%. The trade deficit would have been another $3 billion less if Boeing had not been on strike.

Oil prices were an average of $104 a barrel in September. For November prices will be closer to $65, down at least one third. That means the possible trade deficit for November could be a lot closer to $40 billion, the lowest since 2003 and well off the highs of almost $68 billion a few years ago.

Why is this important? Two reasons. First, it means that a lot fewer dollars are now going into the world economy. And demand for dollars is rising as the world seeks a safe haven in the current global recession, so it should not be a surprise that the dollar is rising.

The surprise is the violence, the amazing rapidity of the rise. We are seeing movements in currency prices in a week that would normally be a year's worth of volatility. It is a sign of the severity of the crisis, of the wariness of traders, that prices are so volatile.

Second, it also means fewer dollars will be coming back into the US to finance the rising government deficits. As Woody Brock (one of my favorite economists) in a recent essay points out, this is counter-intuitive, but it is nonetheless true. Dollars which go abroad must eventually find a home, and that home is going to be in US assets of some kind, usually government bonds.

Some worry about China or another large country might stop buying US bonds with their dollars. They worry that they might want to increase their holdings of euros, for example. But what that means is they take the dollars and sell them to someone who has euros. Then that country has dollars that they must then do something with. It is not as if the dollars disappear.

The only way for China (and/or the world) to really reduce their dollar balances is to stop selling products to the US consumer or to buy US assets like stocks or real estate or wheat, thus bringing the dollars back to the US.

But what in practice happens is that China and most Mideast countries on a net basis buy US government-backed debt. But if there are fewer dollars going abroad, that means there are fewer dollars to buy newly issued debt. And our government is issuing new debt at a rather startling rate.

The estimates for the deficit next year are close to $1 trillion. But if the trade deficit is "only" $500 billion, that means that the appetite of foreigners for US debt will be less than half what is needed to finance the deficit. Where does the difference come from? US citizens and corporations, primarily banks, are going to have to buy the difference or the Fed will have to monetize a portion. Or rates on longer-term debt could go high enough to entice foreigners to buy US debt.

Higher rates would be a drag on the US economy and especially the housing markets and would also cost the taxpayer a lot in additional interest-rate expenses. Total government debt is now $10.5 trillion, with the public (including non-US holdings) having $6.3 trillion. The average interest rate paid on that debt is 4.009%, and for fiscal year 2008, which ended October 31, the interest expense was $451 billion. Add another trillion and the interest paid would soon rise to $500 billion.

The US will face a serious problem in 2009. Tax revenues are going to take a very serious fall. Remember when capital gains taxes would produce a few hundred billion? Not in 2009. And income taxes will drop as unemployment expenses rise. The perceived need for government stimulus will be offset by the problem of funding the deficit. Resorting to monetizing the debt is a nuclear option. Expect even more volatility in the currency and interest-rate markets next year.

Can We Actually Muddle Through?

In addition to the above, let me list a few problems I have highlighted in the past few months. Roughly 3% of GDP growth for 2002-2007 was from Mortgage Equity Withdrawals and other debt. That stimulus is gone. Consumers are going to start saving once again, taking money from a consumer-spending-driven economy. Taxes are likely to rise, not only at the federal but at the state and local levels, as governments of all sizes are faced with growing deficits and needs. Financial institutions are deleveraging at a very fast pace. It is, as one friend told me, as if the economy at large is facing a massive margin call.

Given all of the above problems, how is it possible that we can Muddle Through?

In January of 2007 I forecast a mild recession beginning in late 2007. I was early. In January of this year, I still thought the recession would be more like that of 1990-91. Clearly, I was an optimist. It is now likely that we will see a recession as deep as 1974. This quarter is likely to see a negative growth number of 4% or more. That is deep by any standard. And I do not think that the economy will begin to actually grow before the third quarter at the earliest. It is quite likely that 2009 will be negative for the entire year, and possibly for all four quarters.

We are, as I have said, hitting the reset button on consumer spending. We are going to some lower level of consumer spending, and corporations and government are going to have to adjust their budgets. Corporate earnings will be under pressure for some time to come.

But, and this is a big but, this too shall pass. At some point we will hit a bottom. Just as irrational exuberance led us into foolish actions, we are now becoming too pessimistic. The pendulum will swing. Minsky taught us that stability breeds instability. The more stable things are, the more comfortable we are with taking risk, which ultimately creates the conditions for a normal business-cycle recession. This time, we took on a whole lot more risk than usual and are facing a deeper recession.

But the opposite is true as well. Instability will breed stability. It is, as Paul McCulley calls it, a reverse Minsky moment. We will adjust to the new environment by becoming more conservative. And that new conservative environment will bring about a new stability, albeit at lower levels. But it will be a level from which we can begin to grow once again. It has been this way since the Medes were trading with the Persians.

And here is where I may not have been clear, as the conversations mentioned at the beginning of the letter have called to my attention. My thought is that Muddle Through is the period after we are finished with the recession. I think that the future recovery when it comes will be a lot slower and longer in getting back to trend growth than normal. It will be a Muddle Through, slow-growth economy. I expect that period to now last through at least 2010. The credit crisis and the housing bubble are not problems that can be quickly or easily fixed. It will take time.

The Potential for a Large Stock Market Rally

Everyone knows that there are large amounts of hedge fund redemptions being processed. Some blame the current vicious sell-off on forced hedge fund sales as they have to meet these redemptions at the end of the quarter.

This brings up an interesting possibility. My guess is that the large bulk of that money is going back to institutions that will need to put the money to work. Where will they deploy it? If they are projecting 7-8% total portfolio returns, they cannot put that money in bonds. My guess is that it will go back to other hedge funds or into long-only managers. This money will start to go to work in mid- to late January. We could see a very large rally the first quarter of next year. For traders, this will be a chance to make some money. I think it will be a bear market rally, as the recession will still be in full swing, and we could see a pullback when that money gets fully deployed. But it will be fun while it lasts.

As traders begin to sense that possibility, we could see a serious year-end rally as well. Would I bet the farm? No, but I offer up the idea as a possibility. And I know a lot of people have large short positions that have made them a lot of money this year. Maybe it is time to think about taking profits.

And now a few thoughts on the possibility of bailing out GM.

Is GM too Big to Let Fail?

(Let me say at the outset I am truly sorry for those who have lost their jobs or are facing the possibility of a job loss, whether at GM or any other firm. I have been there, as have most people at one time or another.)

I wrote in 2004 that GM was essentially bankrupt. They owed more in pension obligations than it seemed likely they would be able to pay, without major restructuring of the union contracts. I was not alone in such an assessment, although there were not many of us. Now that assessment is common wisdom.

Bloomberg today cites sources that claim a collapse of GM would cost taxpayers $200 billion if the company were forced to liquidate. The projections also called for the loss of "millions" of auto-related jobs. GM, Ford, and Chrysler employ 240,000. They provide healthcare to 2 million, pension benefits to 775,000. Another 5 million jobs are directly related to the three auto companies. GM has 6,000 dealerships which employ 344,000 people. According to a recent study by the Center for Automotive Research (CAR), if the domestic automakers cut output and employment by 50 percent, nearly 2.5 million jobs would be lost and governments would lose $108 billion in revenue over three years. (Edd Snyder at Roadtrip blog)

How did we get to a place where the market cap of GM is a mere $1.8 billion and its stock price has dropped from $87 in early 1999 to $3.10 today? (See chart below.) Where Rod Lache of Deutsche Bank has a "price target" of zero for GM? "Even if GM succeeds in averting a bankruptcy, we believe that the company's future path is likely to be bankruptcy-like," Lache wrote.

The litany of reasons is long. At the top of the list are union contracts which mandate high costs and pension plans which cannot be met. Then there is the problem of many years of poorly designed cars, although they are now getting their act together. We can also discuss poor management and bloated costs, like paying multiple thousands of workers who are not actually working. GM is structured for the 50% market share they used to command, whereas now they only have 20%.

Wilbur Ross, a well-known multi-billionaire investor, was on CNBC saying that allowing GM to go bankrupt would throw the country into what sounded like a depression. Of course, he does have an auto parts company which supplies GM; so he, as my Dad would say, does have a dog in that hunt.

Ross said that we as a nation are to blame for GM's problems (I am not making this up) because we do not have a national industrial policy. The US allowed other automotive companies to build plants in states that had lower labor costs, and that is the reason GM is uncompetitive. GM pays an average of $33 an hour, and those selfish other companies pay a mere $19 plus a host of benefits.

Ross evidently believes that because some states have lower taxes and right to work laws, that it is the responsibility of the taxpayer to give GM a certain type of immortality rather than suggest GM deal with its problems directly. I assume that Ross also sides with the French when they suggest that Ireland should raise taxes so they will not have to compete with Ireland for business. Such thinking is nonsense and is also unconstitutional.

Let's all acknowledge that having GM go bankrupt would not be a good thing. But it is not the end of the US automotive industry, nor even of GM. Let's think about what a GM bankruptcy might look like. In a bankruptcy, the debt holders line up to come up with a restructuring plan so that they can maximize the return of their loans or obligations. The shareholders get wiped out, but with GM down over 95%, that has largely been accomplished. That process has happened with airlines, steel companies, and tens of thousand of other companies. It is called creative destruction.

First, let's understand that the real owners of GM are the pension plans, as I wrote in 2004. They are the entities with the largest obligations and the most to lose. They are the biggest stakeholders in a successful GM. Giving them the responsibility for making a new, leaner, meaner GM with realistic union contracts would be rational; otherwise they would lose most of what they have.

Factories need to be closed. Auto sales are down to 11 million cars a year, the lowest since 1982, which was the last major recession. Automotive companies sold cars at such low prices in the last few years that sales went to 16 million a year. But the cars that have been sold will last for a long time. Few people are going to buy a new car when the old one is working fine, especially in a recession and a Muddle Through economy. Further, does GM really need eight automotive lines, some of which have been losing money for years?

A restructured GM with realistic costs could be quite competitive. They have some great cars. I drive one. It is four years old and so good I am likely to drive it for at least another four.

At some point after the restructuring, the pension plans could float the stock on the market and get some real value. If actual pensions need to be adjusted, then so be it. While that is sad for the GM pensioners, is it any sadder than for Delta or United Airlines or steel company pensioners who saw their benefits go down? For the vast majority of Americans, no one guarantees their full retirement. Why should auto trade unions be any different?

Taxpayers in one form or another are going to have to pay something. Unemployment costs, increased contributions to the Pension Benefit Guarantee Corporation, job training, relocation, and other costs will be borne. So, it is in our interest to get involved so as to minimize our costs, as well as help preserve as many jobs as possible.

Sadly, I think it is likely that a Democratic majority next year will quickly pass a bailout that will not solve any of the longer-term problems. Obama evidently wants to appoint an "automotive czar;" and the name being floated is the very liberal Michigan former Representative David Bonior, whose anti-trade and pro-union positions are well known. This is appointing the fox to guard the hen house. It is not a recipe for the restructuring that is needed.

The bailout for GM is a bailout for the trade unions and management (who not coincidentally both made large contributions to the Democratic Party and candidates). US consumers are simply going to buy fewer cars in the future. That is a fact. Spending $50 billion does not address that reality. That $50 billion can be better spent by helping workers who lose their jobs. Without serious reforms a bailout will simply postpone the problem, and there will be a need for more money in a few years. And do we think that the management which got GM into the current mess is the group to bring them out?

And as to the argument that "We bailed out Wall Street, so why not GM?" it doesn't hold water. What we did and are doing is to try and keep the financial system functioning, so we don't see the world economy simply shut down. But don't tell the 125,000 people who have lost jobs on Wall Street that it was a bailout. That number is likely to go to 200,000. No one thinks that a restructured GM would see anywhere close to half that number of job losses.

Do we protect Circuit City? Sun just announced plans to lay off 6,000 workers. Where is their bailout? Citibank announced 10,000 further job cuts today. This is a recession. And sadly that means a lot of jobs are going to be lost. GM workers should have no more right to their jobs than a Sun or Citibank or Circuit City worker.

Now, would I be opposed to a bridge loan to help in the transition? No, because a viable Detroit is good for the country and will cost the taxpayer less in the long run than if we have to pick up their pension benefits. But any money must come with realistic reforms that put in charge new management and a realistic cost structure so GM can compete.

New York, Moving, and Another One Leaves the Nest

Today, while I am writing this letter, my #2 son Chad is moving out, to an apartment not far from me, but still no longer in the house. He is 20 and eager to be on his own. He has recently taken a job at Best Buy, while trying to decide what to do next. I am happy for him, as you can clearly see the anticipation on his face. Six down and one left. Trey, the youngest, is 14, and I suppose the day will come when he too decides it is time to be on his own. That is what we as parents hope for. But there is a part of me that will miss Chad being under my roof.

Thanksgiving is coming up and I am making plans, not just for the usual big dinner but also for moving that weekend to another home not too far away. I will move my office into the same house in mid-December. The savings will be substantial, but the savings in commute time will be even more valuable. I will miss this Ballpark office, though.

I will be in New York next month (December 4) for Festivus, a holiday fundraiser sponsored by my friends at Minyanville.com. If you are there, be sure and look me up. It will be a fun weekend, as there will be dinners with friends, and Barry Habib (of the Mortgage Market Guide and one of the show's producers) has arranged for tickets to the musical Rock of Ages.

It is quite late. For some reason, this letter was harder to write than usual, but even letter writing comes to an eventual end. Have a great week.

Your ready already for recovery analyst,

John Mauldin

General Motors

Whatever Happened to Decoupling?

John Mauldin — Sat, 16 Aug 2008 04:52:00 GMT

A Mid-Year Correction
Whatever Happened to Decoupling?
The UK Starts to Slow
A Recession by Any Other Name
What's a Central Banker to Do?

The old mantra was that if the United States sneezed, the rest of the world would catch a cold, as the US was seen as the main driver of world growth. That was then. Economists and analysts began to argue that China and the developing markets were starting to provide a consumer base for the world. And Europe's new and growing markets would be able to stave off problems from abroad and stay on their own growth path. The world, we were assured last year, would not suffer from problems in the US economy.

Today, we look at evidence that this might not quite be the case. And if it is not, those who look for diversification in global markets may be disappointed. Also, I quickly look back at my January forecasts and feel it may be time for a mid-course correction. It seems I may have been a little too optimistic. It should make for an interesting letter.

But first, a quick commercial. I spent two days at the Caves Valley Golf Club outside of Baltimore with good friend and business partner Steve Blumenthal, the president of CGM. He has developed a platform of money managers who can take direct accounts, and I recommend that readers interested in outside money management take a look at them. Normally, to take a look at the managers, we have you sign up to get a "pass" to take a peek behind the curtain. We decided we would change that policy, at least for this week. If you would like to look at a manager I think quite highly of, you can click on this link to see a few details about him. http://www.cmgfunds.net/sys/docs/118/ARS%20Scotia_new.pdf (Remember, past performance is not indicative of future results.) If you would like to talk with Steve or his team about this manager or the others that are on the platform, simply click on the following link, fill out the form, and they will call you. http://www.cmgfunds.net/public/mauldin_questionnaire.asp

And as always, if you have a net worth of $1.5 million or more and are interested in hedge funds, commodity funds, and other alternative investments, you can go to www.accreditedinvestor.ws and one of partners from around the world will show you what is available on their platforms. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

A Mid-Year Correction

I wrote in my January 4 letter the following predictions:

"So let's get to the predictions. I think that we are in a recession for most of the first half of this year, and that we begin a slow recovery in the second half. It will be a Muddle Through Economy for at least another year after that. That would suggest that most companies will come under serious earnings pressure. If history is any indicator, that means we should see a bear market in the first half of this year. How deep will depend on how fast the Fed cuts, but I don't think we are looking at anything close to the bear market of 2000-2001. Still, I wouldn't want to stand in front of a bear market train.

"Consumer spending is going to slow, and it will be slower to rebound, for reasons outlined above. That will also make the recovery in the stock market a little slower. But I expect to become bullish on the market sometime this summer, if not before. I'm looking forward to it."

To be blunt, that optimism now seems misplaced. I think we are likely to stay in recession for perhaps the rest of the year and well into 2009 before we start a very slow recovery. It is not time to get bullish on stocks, as I have been writing for the past few months. Earnings are going to continue to come under pressure, and earnings are what drive the stock market over the long term. We could see total S&P 500 as-reported earnings drop below $50. You do the math. Even with a 20 multiple, that does not yield a pretty picture.

I think we are going to test the recent lows and then watch the market go lower as the market gets disappointed in the earnings from the third quarter, and re-test those lows again. We are in for an extended period of Muddle Through, while we wait for the housing market to find a bottom and the credit crisis to abate. Banks and other institutions have written off about $500 billion. There is at least another $500 billion to go. The amount of capital that is going to need to be raised is astronomical, and it is going to be very dilutive to current shareholders.

I did predict that the euro would top out against the dollar this summer, and that looks to be the case, although the dollar went lower against the euro than I thought it would when I forecast $1.50 about 4-5 years ago.

Whatever Happened to Decoupling?

I was reminded of an article by Desmond Lachman of the American Enterprise Institute (by Leo Kolivakis of www.pensionpulse.blogspsot.com). Lachman wrote these very prescient words last January in a paper called "The Myth of Decoupling." Quoting:

"Sadly, the 'decoupling' thesis has little support in theory or in practice. Its proponents overlook the fact that during the past five years the U.S. economy grew faster than all the other G-7 economies. During that time, America's economy remained the principal generator of global aggregate demand, accounting for around one-fifth of global imports and 25 percent of global production. This evidence suggests that, as in the past, if the U.S. economy sneezes the rest of the world will catch a cold.

"... A number of the shocks presently affecting the U.S. economy are global in nature, and are already slowing European and Japanese growth. The credit crunch flowing from America's subprime woes is causing a global increase in market interest rate spreads and a global tightening of bank lending standards. This is hardly surprising: almost half of all U.S. asset-backed subprime mortgage securities were distributed abroad.

"... The 'decoupling' optimists are ever hopeful that China's rapid growth, together with the rest of Asia's emerging market economies, will offset any U.S. economic downturn. But they tend to forget that Asia is filled with export-dependent economies: in some countries, exports to the United States alone [emphasis mine] account for more than 10 percent of annual GDP. The "decouplers" also forget how relatively small these Asian economies still are, at least in relation to the G-7 industrialized economies. Even the vaunted Chinese economy is barely 15 percent the size of the U.S. economy."

We are now seeing the major economies of the world go into simultaneous recessions and in many of them elevated inflation as well, giving way to stagflation. Let's first take Europe. Today we learned that "GDP growth is easing in a number of European economies as highlighted by national accounts figures out during the week. The flash second quarter GDP data for the euro zone noted a 0.2% q/q contraction, following a 0.7% expansion in the first three months of the year. This was primarily the result of a 0.5% downturn in the region's largest economy, Germany, and a 0.3% contraction in second biggest, France." (www.economy.com) The chart below shows the latest data results.

And it's not just Germany and France. "Preliminary data suggest the Italian economy also contracted 0.3% during the quarter, the Netherlands reported no growth, and Spain grew at its slowest pace since the 1993 recession, with a minimal 0.1% expansion. The Spanish government fears recession in the second half of the year and called for emergency discussions on Thursday to deal with the situation. Latvia and Estonia also contracted in the second quarter, with Estonia reporting a technical recession after also shrinking in the first three months of the year. While no flash estimate is available for Ireland, the economy is on the brink of recession."

Inflation in Europe is running at 3.6%. Since the European Central Bank has just one mandate, and that is to provide for a stable currency, it will be difficult for them to ease this year.

The UK Starts to Slow

The Bank of England is forecasting a flat (0%) GDP over the next year. The United Kingdom is probably already in recession, but the problem is that the central bank is going to have difficulty cutting rates, with inflation at 4.4%; and that problem may get worse, as major energy suppliers like British Gas are announcing price increases of as much as 35%. Producer prices in the UK rose by 10.2% in July. The head of the British central bank, Mervyn King, is forecasting an inflation of 5%.

And in Asia? Real GDP declined 0.6% in the second quarter in Japan. Chinese stocks are forecasting trouble, as stocks are down more than 54% this year and 60% since the peak last year. And it is not just China. Stock markets all over Asia are in serious decline, although my friends at GaveKal note that Chinese stocks may be seriously oversold and a buy from here. I think I would wait until we see just how much a prolonged US slowdown will affect Asian economies and exporters. And inflation pressures are evident all over Asia. Producer prices in China are rising more than 10%. Inflation is at 12.4% in India, a 16-year high.

Inflation in the US? Data came in this week that was rather shocking. July CPI rose by 0.8% in July and 5.5% year over year, and core inflation on a three-month basis (less food and energy) rose by 3.4%.

A Recession by Any Other Name

Remember the comfort the bulls took in the fact that GDP when first reported was a positive 0.6% in the fourth quarter of 2007? Now is has been revised to a negative 0.2%. As I have repeatedly said, GDP numbers will be revised downward in this part of the cycle, but maybe a few years after the fact when real data and not estimates are available.

Let's look at this piece from David Rosenberg, the North American Economist for Merrill Lynch. He does a good job of telling us why GDP estimates that suggest the economy is not on recession may not reflect the facts on the ground.

"You'll miss a lot of action waiting for GDP to go negative. More to the point, if you're waiting as an investor for GDP to actually turn negative, you're going to miss a lot of action along the way. I think the best example is to just go back to Japan. They had a real estate bubble that turned bust and they had their own credit contraction back in the early 1990s. Guess what; Japan didn't post its first back-to-back contraction of real GDP until the second half of 1993. By the time the back-to-back negative that people seem to be waiting for happened, the Nikkei had already plunged 50%, the 10-year JGB yield rallied 300 basis points, and the Bank of Japan had cut the overnight rate 500 basis points, which said a thing or two about the efficacy of using the traditional monetary policy response of cutting interest rates into a credit contraction (as we're now finding out here in the US)."

Dating the recession is a very scientific process:

"The point is we can't make the assumption that we've avoided a recessionary condition in the economy, just because we have so far managed to avoid back-to-back quarters of negative GDP. I'm just telling you as the economist that it is basically irrelevant. The only body that officially makes the call on the broad contours - when the recession started, when it ends, when the expansion starts, when it ends - is the National Bureau of Economic Research, the NBER. It's a very scientific process. It's not a gut check or a judgment call.

"We should actually be welcoming the recession call. When they make the determination - it's very interesting, by the way - when they make the announcement that the recession began, when they actually date it for us, traditionally we're a month away from the recession actually ending. The announcement, in fact, is going to be a rather cathartic event, something we should actually welcome happening, but so far they are still taking their sweet time in making the proclamation.

"Four factors used to determine recession:

1) Employment

"The NBER relies on four different variables. The first is employment. Now I've told you before; employment is down seven months in a row. Does employment go in the GDP? The answer is no. Is it correlated? Yes. Does it help grow the business cycle? Of course.

2) Industrial production

"The next variable is industrial production. Does that go into GDP? The answer is no. Does it help grow the business cycle? The answer is yes. This is a number that comes from the Fed. The GDP comes from the Commerce Department. It's a very important variable.

3) Real personal income net government transfers

"The next variable, the third one, is real personal income excluding government transfers. This metric is now down four months in a row. Does personal income go into GDP? The answer is no; of course, it doesn't. GDP is all about spending. Personal income goes into gross domestic income, which is another chart of the national accounts.

4) Real sales activity

"The fourth variable and the only variable that actually feeds into GDP is real sales activity in manufacturing, retail and wholesale sectors.

"A Recession probably started in January. When I take a look at these four key indicators that define the broad contours of the business cycle, they all peaked and began to roll over sometime between October of last year and February of this year. I am convinced that when the NBER does make the final proclamation, it will tell us that a recession officially began in January. Of course, to any market person, this would make perfect sense, because of when the S&P 500 peaked. It did a double top into October, right when it usually does, before a recession begins.

"This recession won't end before mid-2009, in our view. Now I'm just giving you the rearview mirror. What's most important to you folks is let's look through the front window and see when this recession is going to end. The tea leaves that I'm reading at this point in time show that this recession is not ending any time before the mid part of 2009, which would mean that, if you're looking for, not the Mary Ann Bartels intermediate bottoms, but the fundamental bottom, I don't think you can expect to see it before February or March of next year, if I'm correct on when this recession ends. Historically the S&P 500 troughs four months before the economy actually hits its bottom point."

I agree with Rosenberg. And if we see a recession lasting into 2009, then earnings are going to be under a lot of pressure. Buying index funds today could be very risky to your portfolio.

What's a Central Banker to Do?

Central bankers everywhere are faced with a serious dilemma. Do they raise rates to fight inflation, cut rates to stimulate their economies, or sit tight and hope that prices moderate as the world economy slows? Hope is an interesting strategy for a central bank, but it may have come to that.

In short, the world has not decoupled, but is more closely intertwined because of the global financial community. Housing problems and excesses in California (and the rest of the US, the UK, Spain, etc.) affect banks in Europe and Asia and the US simultaneously.

You cannot have a worldwide recovery until the financial crisis in the major lending institutions is dealt with. A functioning banking system is the lubricant for a world economy, and the banking industry is cutting back on loans and tightening the standards by which they do make loans. Look at these survey results from Northern Trust:

In reality, it is not just mortgage lending that is getting tighter. Every survey done on any type of lending worldwide shows bankers are setting tougher standards; and most are simply lending less, partially as a result of shrinking capital ratios. Until lenders have adequate capital to be able to make loans, it will be hard to see anything other than a very tepid recovery sometime next year.

Look at the graph below. The spread of the difference between US 10-year treasuries and a 30-year mortgage is the highest in over 22 years. In May of 2007 it was 1.37%. Today it is 2.53%. The historical average is 1.68%. That means a mortgage costs almost 1% a year more than it would under a normally functioning market. That reflects that lenders are having trouble finding investors who will buy their mortgages, and of course it makes housing less affordable and puts off the day when inventories will again be reasonable.

Bottom line is that there is a long way to go before either the world economy or markets will be seen as functional. I continue to believe the data suggests we are still in a secular bear market and that valuations are not anywhere close to signaling a new bull market. Paying attention to daily market movements to confirm your bias one way or another is pointless. Daily market moves are random noise.

Pay attention to the fundamentals like earnings and valuation. In this type of market, you should be looking for absolute-return types of investing rather than relative-value index funds. And absolutely avoid anything linked to the US consumer or financial stocks unless you have some special knowledge of a specific situation. There are more write-downs and earnings disappointments to come.

Weddings, Baltimore, and South Africa

As noted above, I met with Steve Blumenthal and wealth manager Cliff Draughn at the Caves Valley Golf Club on Wednesday and Thursday this week for a quick trip to talk business and get in my first real game of golf in over two years. This maybe is the most beautiful course I have ever played, and Cliff was a great host. Oddly, as the game went on, I started to get some twinges in my right arm, but I thought it was just a little stiff from not playing golf for so long and tried to work it out. By the 17^th hole I just couldn't follow through as the pain in the forearm was too much, and so I called it quits. The pain continued through the night coming back on the plane. And this morning I woke up to find my right forearm and up to my middle inner bicep was one ugly bruise. Not sure what happened. That is a first for me. But I worked through the pain and finished the letter tonight.

I will be in Cape Town, South Africa, on September 21-23 to do a speech. I will go back to Baltimore to attend my good friend of 25 years Bill Bonner's 60^th birthday party the first weekend in September. He is the one of the best pure writers I know. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on the following link: http://www.dailyreckoning.com/rpt/mauldin.html

The wedding was a spectacular success, and I know Tiffani and Ryan will post pictures and video when they get back from South Africa. I have to confess that when I saw Tiffani she was so beautiful that I actually teared up, and then we both got misty-eyed. It was a very special moment. I surprised myself getting so emotional.

As I was walking through the dining area before the wedding, I noticed that they had put out a treasure chest on one of the tables. I assumed that it was for putting gifts into. As I walked by, I tried to lift the lid. Turns out it was a very realistic looking cake and I put my thumb through the top of the "lid." Tiffani had personally designed every aspect of this wedding, and I had just left a very large impression on one part of it. When I sadly told Tiffani, she just laughed. She said it was such a "Dad thing" to do and made the night perfect. I just wish the Dad things I do weren't so embarrassing. Oh, well.

As I did my toast, right before the fireworks, I welcomed Ryan into the family as Tiffani's six brothers and sisters, plus in-laws, gathered around. Part of it went something like this. I mentioned to the crowd that Tiffani had been responsible for the total design of the tables, decorations, dinner, the flower arrangements, the (very) elaborate cake, etc. No detail went by without her input. And then I added:

"Ryan, the bad news is that you have married a lady who, just as she organized this wedding, is going to pay attention to every detail in your life, making sure you stay on your toes. I know that from personal experience from working with her for ten years. But the good news is that she will also make your life as beautiful as this wedding. You have my treasure. Take care of her."

Your still misting up analyst,

John Mauldin

The Return of Muddle Through

John Mauldin — Fri, 28 Sep 2007 08:13:00 GMT

The Return of Muddle Through The dollar reaches new lows. The housing market shows no sign of a bottom. Oil almost touches $84 before backing off. Interest rates go up after the Fed cuts. So naturally the stock market keeps climbing. But then, consumer...(read more)

The Fugu Ultimatum

John Mauldin — Fri, 10 Aug 2007 08:07:00 GMT

The Fugu Ultimatum In the early fall of 1998, I remember being on a flight to Bermuda from New York. I was upgraded and sat next to a very distinguished looking gentleman. He was going to a conference about re-insurance and I was going to speak at a large...(read more)

The Birth/Death Ratio

John Mauldin — Fri, 13 Jul 2007 08:03:00 GMT

The Birth/Death Ratio Is the economy slowing down or is it getting ready to go on a new tear? Judging by the run-up in the Dow, the answer is a major turnaround for the economy in the last half of the year, from the close-to-recession numbers of the first...(read more)

Blame It On Stability

John Mauldin — Fri, 22 Jun 2007 07:57:00 GMT

Introduction This week we look at length at an outstanding new book just hitting the bookstores by good friend Paul McCulley (of Pimco fame), called Your Financial Edge . The main themes will give me an opportunity to weave in a few thoughts about some...(read more)

Be Careful What You Wish For part2?

John Mauldin — Fri, 15 Jun 2007 07:55:00 GMT

Introduction Be careful for what you wish, because you may get it, and sometimes as H. L. Mencken wrote, you get it good and hard. The collective brain deficit trust, otherwise known as the US Congress, wish for the Chinese to revalue their currency upwards...(read more)

The US Mortgage Market - Overexposed and Overrated

John Mauldin — Fri, 25 May 2007 07:53:00 GMT

Introduction This week we look at the US mortgage market to see what fallout there is from the subprime mortgage woes. It is both less of a problem and/or more of a problem, depending on your perspective, as I predicted it would be last year. Score one...(read more)

China and the Hedge Fund Dragon

John Mauldin — Fri, 09 Mar 2007 08:31:00 GMT

Introduction s week we look at the possible latest entry into the hedge fund world, The People's Republic of China; review the cockroach principle of subprime mortgages; and investigate the possibility of whether we need more derivatives and not less...(read more)

Do Trade Deficits Matter?

John Mauldin — Fri, 16 Dec 2005 06:18:00 GMT

Introduction "I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than a policy foresight that will force change...(read more)