Thoughts From The Frontline : Consumer Spending

The Best of Times

John Mauldin — Sat, 24 Oct 2009 02:52:00 GMT

It's The Best of Times
The Elements of Deflation
It's More Than Half Full
Argentina, Brazil, and Uruguay

What's a Fed to do? We get talk about tightening and taking away the easy credit, but we got the fourth largest monetization on record last week. This week we examine the elements of deflation, look at some banking statistics that are not optimistic, and then I write a reply to my great friend Bill Bonner about why it's the best of times to be young. I think you will get a few thought-provoking ideas here and there.

But before we get to the main letter, I want to recommend a book to you. I am on a 17-day, 12-city speaking tour. It is rather brutal, but I did it to myself. However, one of the upsides of traveling is that I get quiet time on airplanes to read books. I am working my way through a very large stack of books on my desk. One that caught my eye - and I'm glad it did - is a book by Tom Hayes called Jump Point: How Network Culture is Revolutionizing Business. Hayes writes about how we are getting ready to experience a cultural change every bit as profound as the Industrial Revolution. He argues that as the 3 billionth person gets online sometime in 2011, it will shift the dynamic of how we interact as businesses and consumers. We get to 5 billion by 2015. The mind boggles.

Clearly, it is already changing things, and I am not sure if I buy Hayes' thesis that 3 billion is a magical number, though it is great marketing. That being said, I found something on almost every page that I underlined or highlighted. This book made me think about the future in ways that my kids already get but Dad doesn't.

I like to read books about "important stuff" by people who have done a lot of thinking about their subjects, and who can write easily and fluidly and communicate their thoughts without weighing me down with unnecessary verbiage. Hayes has done that. (I am sure some of you, my patient readers, wish I could be better at that!)

No long review here. Go to Amazon and read the reviews. One writer wrote: "I gave the book 5 stars not because it was perfect -- I think Hayes's enthusiasm sometimes makes him jump to conclusions - but because there are so many ideas and observations here that it would take ages to put something like this together from other sources."

I agree. If you are in business, any business, you need to read this. As an aside, I will insist that all my partners worldwide get this book and read it. You can go to Amazon.com and buy the book. And Tom, if you get this (and I bet one of your friends will forward it to you), call me.

The Elements of Deflation

One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation.

I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, "Yes." And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don't think that the Fed monetizing debt of all kinds won't eventually be inflationary, I answer, "We better hope so!"

Let's quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure.

The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future.

Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing.

Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, "Where are we going to get business-investment spending when banks aren't lending and capacity utilization is at an all-time low?" This, of course, leads the Keynesians to jump in and say, "The government has to step up and jump-start consumption!" Which means more debt. Wash. Rinse. Repeat.

The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas.

Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.)

Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write.

And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of.

And let's just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money.

As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive.

The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to "print money" to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can't imagine these people will recklessly monetize US debt. You don't get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?)

Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke's reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that.

Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the '70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits.

It Is the Best of Times

Now let's change the topic. My friend Bill Bonner, of Daily Reckoning and Agora Publishing fame, recently wrote about his mother. Bill also turned 60 recently. I wrote to him about the similarities between our mothers. Both were born in hard circumstances, on farms that had no indoor plumbing. They joined the WACs and met their husbands. They struggled raising families. Bill and I both grew up in rather humble circumstances (to put a mild spin on it).

That exchange caused Bill to write about the future our kids face. He has six kids and I have seven. He has graciously allowed all my kids to invade his chateau in rural France (where they mingle with his kids), and has invited us back next summer. I think Bill is the best writer, the best "turner of a phrase," in the business. I often feel like a house painter standing in front of a Rembrandt when I read his work.

But Bill is a tad pessimistic. He makes me look like Larry Kudlow. He wrote (among other books) Financial Reckoning Day, which has just been updated and is now titled Financial Reckoning Day Fallout: Surviving Today's Global Depression. It makes for some interesting reading. Get it with Jump Point.

Now to the point. As I said, Bill wrote about the future our kids face. I will repeat what he said and then respond. Bill's thoughts:

"We sat in a cab yesterday, stuck in traffic in central London. We watched people walk by and wondered. What are they thinking about? What do they want out of life? What do they think of themselves?

"There were hundreds of them...different shapes...different sizes. A businessman in a pin-striped suit, briefcase in hand, concentrating on his sales report; he almost stepped in front of a motorcycle. A salesgirl, grotesquely overweight...yellow hair streaked with brown...wishing she hadn't had so much to drink the night before. A lawyer daydreaming about his secretary. A man who would have rather been fishing...still in his waxed coat. A woman annoyed about something. A heavy construction worker, his legs splayed outward as he walked. A tense young woman who dared not look up. A woman worrying about her son. A man thinking about buying a new car. One man trying to remember a line from a song he learned 30 years ago. Another talking to herself. One looked like a doctor taking an afternoon stroll. Another was stark raving mad.

"All of them walking along...from one place to another...shuffling along...the living towards the dead.

"We were thinking of our children. What a different world they grow up in. And yet, it is still the same too. A man might have been stuck on a London street 50 years ago...and hundreds of years ago he might have watched the same shopkeepers and carpenters walk by, each caught in his own thoughts like a fly in a spider's web.

"Our old friend John Mauldin wrote to say that his mother's experience was not much different than ours. She joined the WACs during the war...met John's father...and then nature took her course.

"But both John and your editor had a big advantage in life. We both caught the upswing.

"Not so with our children. They inherit a different world. America was the world's leading nation in the '50s and '60s. And it was growing in power and wealth - rapidly. We grew up with it. Things were getting better and better...we were sure we'd live much grander, richer, and more exciting lives than our parents. The sky was always the limit!

"Now, America is in decline. China's economy grows while hers declines. The Far East has savings, while she has none. The Asia nations are net exporters, making huge profits...while American industries are judged too old, too expensive, and too highly regulated to compete. Americans have debt up the kazoo, while their competitors have little. A young person in America has to look forward to supporting 70 million retired baby boomers...and paying for their drugs, their food, their wars, and their bailouts.

"For our children - ours and John's - the situation on a personal level is different too. Coming from poor families, we could look forward to much more wealth and material success than our parents ever knew.

"We came back to Ireland this week for a reason that our parents would never have dreamed of. Your editor has set up a family office. It is a very modest affair by family office standards. The typical family office manages a fortune of $100 million, according to The New York Times. We may not even be on the same planet with these rich families; but we are in the same universe. That is, we try to think about...and manage...our wealth as rich people do...as a family legacy or an endowment, not as a retirement fund.

"What wealth we have accumulated - even if it is paltry - will be held by a family-owned corporation. Then, the corporation, run largely by the adult children, manages the assets - from our base in Ireland.

"Your editor, freed from the responsibility of managing his own money, will be free to wander and think...like a vagabond, a gypsy, a refugee, an itinerant mendicant...forced to sup on whatever is at hand and take lodging wherever he can find it - but favoring the Four Seasons and Chateau Margot when they are available.

"Whatever else this does, it puts the children in a very different situation from their parents. Instead of starting out with nothing, they're starting out with something. While this would seem to be a big advantage to them, it has huge hidden disadvantages. Like America itself, they are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the "Morning in America" that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives.

"'From shirtsleeves to shirtsleeves in three generations,' say the French. The grandfather begins without a coat. His grandson ends that way.

"But what to do? Spend it all now...so the children begin with the same clean slate we had? Move to Brazil or India - countries with more obvious upside?

"In the deep, cosmic end, it probably doesn't matter. The advantage to starting out on an upper rung of the ladder may be about equal to the disadvantage of having to worry about falling off. Who can know?

"Every man has to play the cards he's been dealt. What else can he do? He may have a humpback or a beautiful voice. He may have had a hard upbringing or a soft head. He may have a fortune worth of poetry in his soul but not a dime in his pocket. As far as we can tell, every young man starts out even. Each one begins life in the same place - where he is. And every generation takes what it is given, and makes the best of it.

"The real advantage in life is having the gumption to get on with it; no one knows where that comes from."

It's More Than Half Full

Ok, Bill, let's review those wonderful days from whence we sprang, so fraught with the advantages of having nothing. So potent with opportunity. It was the middle of the '70s when we started our careers. Inflation was high and rising. The Soviets were seen as a major threat. Japan was beating our brains out and buying everything, even if nailed down (like Pebble Beach and New York skyscrapers). I had to borrow money at 15% (or more) to buy paper in order to meet customer demands for printing. And guess what? The banks got into trouble and called loans willy-nilly. (My bank even called my mother and threatened her to pay off my loan - against written agreements - and she did. Evil sons of bitches. The more things change... And that bank did fail, I report delightedly! Not that I hold a grudge.)

There were multiple successive and ever-deeper recessions. Gold was rising and the dollar was seen as a joke. Howard Ruff (a good friend to both of us when we were starting out!) and almost every newsletter writer were telling people to buy gold and freeze-dried food to protect themselves against a near-certain economic, if not apocalyptic, catastrophe. Unemployment was high and rising for a decade.

The correct answer to the question, "Where will the jobs come from?" back then was, "I don't know, but they will." And that is the correct answer today.

In 20 years, no one will want to come back to the halcyon days of 2005. Our kids (all 13 of them) are getting ready to live through what will be the most exciting period in human history. There will be a century's worth of change, measured by the standard of the 20^th century, just in the next ten years, and then we will double that pace in the next ten after that. Medical miracles will mean our kids and grandkids will live a lot longer than their dads, although I intend to be writing well into my 80s, like our mutual hero Richard Russell.

There will be whole new industries developed in the US. How do I know that? Follow the money. The rest of the world spends a fraction of what we do on research and development. Where do you go if you are looking for venture capital?

Do I care if the Chinese and the "developing" world are far better off, relatively speaking, than the US in 20 years? Not a whit. Good on them. I hope they make discoveries and inventions and grow new businesses that benefit us all. But we are not going into some long dark night. We, and our kids, get to choose how we respond to what is the reality of the day.

Our nation had to almost hit the wall in 1980 before a Volker could come along and force us to take the pain of recession to beat back inflation. And we will have to come perilously close to the wall this time before we take action as a nation. Way too close for comfort. Maybe you are right, and we have a soft depression. I hope not; but even so, the world will be better, far better, in 20 years, with far more opportunities than today.

It was not fun starting new businesses in the '70s and early '80s. But we did. I remember coming to Baltimore and being (literally) afraid to get out of the car to visit your offices in the slums. But that was what you could afford. A far cry from the chateau in Ouzilly.

I lived in a small mobile home. Tiffani was born there, and we converted part of the kitchen to be her bedroom. (Yes, I was white "trailer trash.") But I got up every morning just like you did and killed as many alligators as I could. The rest had to wait 'til the next day.

And that is the legacy our kids have. They know what it is to wade into the swamp every morning. Never quitting. In thinking about this, you may be the father I respect the most. You have raised your kids to be multilingual children of the world. What a work ethic. How did you get them to scrape window shutters at your chateaus? (I actually saw this, and my kids marveled. Thereafter I threatened to make them go live with you when they didn't behave!)

You have given your kids the opportunity to follow their dreams, even demanded that they do so. And such dreams they (and mine) have. Will they succeed? Who knows? But they will go at it with gusto, in a world with more opportunities than you and I ever imagined 40 years ago. And, oh boy, were we optimists back then. How else could we have done what we did? If we believed the rhetoric that the world was coming to an end, would we have dared to venture out?

You cannot have raised your kids to be such bold adventurers without instilling in them a certain high level of optimism. I am going to out you, Mr. Bonner. You present yourself to your readers as a bona fide end-of-the-world pessimist. But you are a really and truly a closet optimist. Your whole business empire (and what an empire it has become!) is based on finding people who are optimists, in the sense that they think they can actually get people to send them money for what they write. Which they do! Even if it is to read why the world will come to an end, which thankfully it never does.

You are right in this: it is personal gumption that makes or breaks us. There are those who started out with less than we did (hard to imagine but true) and made a lot more. And there are those who started out with far more and made less. But there are very few who are happier than either of us. Or luckier.

Our kids? It is not the times that dictate the man (or daughter!), but the response of the man which dictates his own time. Today promises a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it.

And as our kids do just that, and as the millions of kids of those who read us do so, and the billions of kids who are just now getting ready to bust loose all work to achieve their dreams, the world is going to be a far more fantastic place. Smooth ride? Not a chance. We didn't get one; and in thinking through history, there have not been many smooth rides. Why should we think that will get any better? Our kids will just have to live with our generational (and individual) iniquities, government debt and all, and figure out how to master their own fates. But if I had a choice to take the '70s or today? In less than a heartbeat I would choose today. And I bet you would too!

(Side note: You can subscribe to the Daily Reckoning and read more of Bill's great prose. Warning: it is bearish, but lively and fun.)

Argentina, Brazil, and Uruguay

Tonight I am in Orlando, where I spoke at the Commonwealth national conference. I have been to a few conferences here and there, but I must admit to being impressed. A conference for brokers and advisors who are affiliated with them, it was exceptionally well done. And a very smart crowd. These guys have attracted some exceptional talent.

Tomorrow morning I fly back to Dallas, where I get to see my new grandson, Hayden, for the first time. Born this week a little early while I am on the road, I get a call at 3 am on Monday telling me the news and sending me a picture. Wow. The heck with deficits and deflation. How can you not be an optimist?

Then later in the afternoon I am off for Argentina, Brazil, and Uruguay, speaking in four cities and meeting with clients (and future clients) of my Latin American partner, Enrique Flynn. And then back to Philadelphia, again in Orlando, Scottsdale, and one trip to New York in early December. Then not much else is scheduled - but past performance says that will change.

There is a steak and a bottle of wine waiting for me down the hall, so it is time to hit the send button. Have a great week. I know I am. I love South America, and look forward to coming back to you with my impressions.

Your wondering who made up this schedule analyst,

John Mauldin

Sell in May and Go Away

John Mauldin — Sat, 02 May 2009 04:18:00 GMT

Sell in May and Go Away?
The End of the Recession?
Is the US Consumer Back?
A Dangerous End Game
A Few Thoughts on Swine Flu

The old adage that one should "sell in May and walk away" has been around for years. I mentioned that bromide about this time last year, urging readers to head for the sidelines if they had not already done so. I was also suggesting a strategic retreat in August of 2006 (after which the markets went up 20% before plummeting). In this week's letter we look at the actual data and offer up a fresh viewpoint. Then we turn our eyes to the recent GDP numbers, which were awful, though many took comfort in the apparent rise in consumer spending. Are Americans back to their old ways? It will make for an interesting letter.

Sell in May and Go Away?

My friend and South African business partner Prieur du Plessis recently updated a chart on monthly stock market returns since 1950. It clearly shows that the November through April periods have on average been superior to the May through October half of the year. (To read his very interesting blog you can go to http://www.investmentpostcards.com/)

And the difference is quite significant. As Prieur notes, the "good" six-month period shows an average return of 7.9%, while the "bad" six-month period only shows a return of 2.5%. Of course, selling creates taxable events, which can hurt your returns.

Plus, you never know when the markets are going to go down and when they will be up. There can be a lot of variance from year to year. For instance, in 2007 the markets were up during the summer by 4.52% and down during the "good" period by -9.62%, which is opposite the average pattern. Of course, the markets did go down by 30% after May 1 last year and down another 5% since then. That is what bears markets can do.

Which caused me to wonder. The last 59 years have seen two significant secular bull markets (roughly 1950-1966 and 1982-1999) and two secular bear markets (1966-1982 and 2000-??? -- the one we are in now). I wondered if the pattern changed during the bear cycles, so I shot a late-night note off to Prieur and came in the next morning and had my answer.

It made a significant difference. May through October in secular bear cycles has been ugly. Look at this graph:

And just for fun, let's look at the monthly numbers since the present secular bear market began in 2000. So far, this has been a lot worse than the 1966-82 cycle, although we have not yet had the recovery phase from the current doldrums, which will likely make the overall numbers look better in 4-5 years.

As noted above, these graphs simply give us past trends and not an absolute forecast. But they do provide food for thought. There are times when you should be cautious and times when you should throw caution to the wind. I think this is the former. While some pundits are talking about green shoots and the second derivative of growth, this economy may be worse than their rosy forecasts of the end of the recession, as we will see in a few paragraphs.

The End of the Recession?

Let's revisit 2000 and 2006. The yield curve was inverted in the late summer and early fall of both years. By that I mean that short-term yields were higher than long-term yields. When that happens for longer than 90 days, a recession has always followed within 12 months. (I wrote numerous e-letters on the topic. You can go to the website and search for "Mishkin," one of the authors of a Fed paper on the yield curve.) I wrote in this letter on both occasions that it was time to get out of the market, as the stock market drops an average of 43% during a recession.

There is a YouTube of me on CNBC in August of 2006 on Larry Kudlow's show. I was forecasting a recession in 2007 based on the inverted yield curve. And if there was going to be a recession, I reasoned, then a bear market would follow. Larry and John Rutledge basically noted that "this time it's different," because the reasons for the inverted yield curve were different. And the market did rise another 20%+ for over 12 months.

There was a recession, but it did not come until 15 months later, in late 2007. The yield curve was right in forecasting a recession, but the timing was different this cycle. If you had gotten out in August of 2006, you were not terribly happy 12 months later; but today you are still way ahead, plus the gains on your bonds and alternatives.

On October 5 of 2007 I wrote about what I saw coming as a "Slow Motion Recession." I was more convinced than ever we were either in a recession or soon would be. As it turned out, we were. But at the time there was a lot of criticism from a lot of analysts. Christopher Amberger did a particularly scathing piece (which was at least witty) on YouTube on October 10, suggesting that the concept of a recession was nonsensical and there were still plenty of opportunities in the market. (Oh, and buy his newsletter to find out what they are). http://www.youtube.com/watch?v=UjAK0s9I8vA The market topped two days later.

The point is that it is more important to get the general direction right than to be right on the specifics. In August of 2006 I was seeing a modest recession in the future. As time went on, I became increasingly bearish. But whether it was to be a mild recession or a major one, the advice would have been the same. You do not want to get caught long the market before a recession.

Today, there are those who say the stock market will start rising six months before the economy does. And maybe it will. I don't know. The predisposition of this market is down. Valuations are not at a level that has spawned major bull markets in the past. At the beginning of real bull markets, volume is strong and rising. Now it is weak (modest at best) and shows no real sign of becoming strong, especially going into summer.

Further, this rally has all the earmarks of a major short squeeze. Regulators have recently (and correctly) been enforcing short selling rules that require stock to be delivered and settled on short trades. This may be a one-time event. When the short squeeze is over, the buying will stop and the market will drop. Remember, it takes buying and lot of it to move a market up but only a lack of buying to create a bear market.

Corporate earnings are likely to go even lower, as consumer spending is likely to get weaker in the coming months. Capacity utilization is at its lowest point since they began tracking it. The National Federation of Business says a recent survey shows none of the responders plans to raise prices, which is not a sign of business strength.

Banks are not yet lending, and the past quarter's positive performance was mostly accounting gimmicks. Citigroup, for instance, said they made $1.6 billion. They did this by booking a one-time gain of $2.7 billion, because the value of Citigroup bonds have fallen (!), giving them the theoretical possibility of buying back their debt at a discount. And with consumer and credit card loans showing more weakness, Citi decided to REDUCE its loan loss reserves, allowing it to show another $1.3 billion in profit. And then there was the profit of $400 million from the new mark-to-market rules, which allowed them to produce a profit on "impaired assets." Without all these games, there would have been a loss of $2.8 billion.

Maybe this time it's different. But when I survey the economic landscape, I see lots of opportunity for disappointments and missed targets. And bear market rallies are killed by disappointments and missed expectations.

To be long this market going into summer you need to be brave or have very serious stops on your portfolio. I think the possibility of missed expectations at the end of the second quarter is high. It could be ugly.

Is the US Consumer Back?

The headlines told us that even as the economy fell an annualized 6% in the first quarter, consumer spending rose by 2%. Given that consumer savings climbed to 4.2%, unemployment rose, and income was down, how did consumer spending rise? To get the real picture, you have to dig into the numbers. (Thanks to 82-year-old, long-time reader Paul Miller for doing the slicing and dicing of the data at his excellent blog http://musingsbymiller.wordpress.com/.)

First, the headline numbers are inflation-adjusted. Consumer spending in actual dollars rose $28 billion. But since prices went down (deflation), the "real" or after-inflation/deflation number shows up in the headlines as $44 billion.

But where prices went down makes the real difference. Gasoline and other energy costs were down $50 billion, allowing consumers to spend on other items. Over the last two quarters energy costs are down almost $200 billion from the second and third quarters, making a huge difference. But now the "tax cut" from energy is largely gone, as prices have stabilized.

Paul notes, "But ... now ... the gasoline tax cut has dissipated, and coming to the rescue are the Obama administration's tax cuts. In fact, the cuts began to be felt in the first quarter. Personal income declined modestly in the first quarter, by $60 billion, or a 2% annual rate. But personal taxes were down by $193.5 billion, some part of which was the result of the tax cuts, so that disposable income rose at a 5% annual rate. Putting taxes and lower gasoline prices together gave consumers $143.5 billion more to spend or save than they would otherwise have had, which accounted for the rather amazing performance of consumption in the face of immense job losses."

And going further into the GDP numbers, there is an interesting statistic. Imports fell more than exports, mainly due to oil. The net trade deficit was only about $26 billion last month. Falling prices in imports, and especially oil, actually added about 3% annualized to the GDP number. Without that boost, the number would have been far more ugly.

That being said, we are very likely to see better numbers in the future, and maybe even a positive one in the 4^th quarter. But a large part of that will be statistical. For instance, housing construction is now down to 2.5% (or thereabouts) of GDP. Drops in housing construction have contributed almost a negative 1% a quarter for the last year. Even if housing construction goes down another 10-20%, it is becoming a very small piece of the puzzle and is not likely to be a big drag on future GDP.

Inventories, though, have been a large drag on the economy for the last two quarters. While we could see inventories drop somewhat this quarter, as the ISM manufacturing number is still significantly negative, they will probably not drop a lot more in the third and fourth quarters.

There are more stimuli and tax cuts on the way, and they will start to have an effect, as individuals will have more disposable income, whether to pay down debt, save, or spend.

But that positive will be balanced by rising unemployment, likely to hit 10% or more by the end of the year. If you count those who are part-time workers wanting full-time work or who are discouraged workers, unemployment is over 15% today.

A Dangerous End Game

The Fed and the Obama administration are playing a dangerous game. The Fed is going to print trillions of dollars to forestall deflation and try to re-ignite the economy. But for a variety of reasons we will go into next week, a real, sustainable recovery may be a few years away. What happens when the market start balking at high and unsustainable national deficits? What happens when inflation (finally) does return? Can the Fed remain independent and take back the money it is printing in the face of what will likely be a tepid recovery? And if they don't, what happens to the dollar?

Next year, we will be entering what will certainly be the most dangerous era in my lifetime for the US economy. It is not clear what will happen. There are a lot of paths that can be taken, though some are more likely than others. For those who are convinced that high inflation and a falling dollar are absolutely, unequivocally in the future I have just one word: Japan.

Yes, there are differences, but there are a lot of similarities. While I think the most likely outcome is a long Muddle Through recovery, the likelihood of a lost decade of deflation a la Japan is a very real potential outcome. And the possibility of stagflation and a seriously impaired dollar is also quite real.

Investors, businessmen, and entrepreneurs need to be as nimble as possible. A free market will figure out what paths to take, and I am still optimistic about the long term. But we have some very dangerous times in front of us, and we need to be realistic.

And before I close, let me make a few comments about the Chrysler and GM issues. I tell my kids all the time that actions have consequences. If I hold senior secured debt of a company and the government tells me I have to take less than unsecured junior debtors, I am not going to be happy. I may have been dumb to make the loans in the first place, but I did it under a very specific contract and the rule of law.

If the Obama administration arbitrarily changes those rules to favor a political class (unions), then that is going to have a chilling effect on future lending to all corporations. As an aside, they are spending $12 billion to save 54,000 Chrysler jobs (at $22,000 per job). With 600,000 jobs a month being lost, why are these 54,000 jobs more special than those of the rest of the unemployed, who get a fraction of that amount in unemployment benefits?

Actions have consequences. The lenders who are forcing the Chrysler deal into bankruptcy court are not all "predatory hedge funds." They are mutual funds, pension funds, and other financial firms with small stakeholders as their investors.

Cerberus, the hedge fund that originally bought Chrysler, deserves to lose their money. They made a bad investment. But those who lent money deserve to be treated in accordance with the contracts they signed.

Demonizing investors and businessmen is hardly helpful. They are precisely the people we need to help get this economy moving. Governments don't create true job growth, businesspeople do, and mostly small businesses. I am not certain why small business owners, the job creation engine of the country, should see their taxes raised in order to protect bond holders of automobile companies or banks, or for union jobs to be preserved in companies that are clearly not competitive. But that is just my final thought late at night, before I hit the send button.

OK, one more thought. If Chrysler couldn't figure out how to make efficient cars from their partnership with Daimler-Benz, are they now going to become viable through a partnership with Fiat, which has been on the verge of bankruptcy for the last decade? Really? GM paid $2 billion in penalties to Fiat in 2005 so as to not be forced to buy them. And Fiat gets 20% for no cash?

Finally, a very quick three-paragraph commercial. In the current market environment, there are managers who have not done well and then there are money managers who have done very well. My partners would be happy to show you some of the managers they have on their platforms that we think are appropriate for the current environment. If you are an accredited investor (basically a net worth over $1.5 million) and would like to look at hedge-fund and other alternative-fund managers (such as commodity traders) I suggest you go to www.accreditedinvestor.ws and sign up; and someone from Altegris Investments in La Jolla will call you if you are a US citizen. Or you'll get a call from Absolute Return Partners in London if you are in Europe. If you are in South Africa, then someone from Plexus Asset Management will ring. And for my long-suffering readers who are patiently waiting for another accredited investor letter, there is one in the works. If you sign up today, you will get it. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.)

If you are not an accredited investor, I work with CMG in Philadelphia. We have created a platform of money managers who specialize in the alternative management space. By this I mean they do not need a bull or bear market in order to have the potential for profits. (Past performance is not indicative of future results.) You can go to http://www.cmgfunds.net/public/mauldin_questionnaire.asp and quickly read about the recent past performance of a manager we recently added to the platform, and then sign up to get more information.

If you are an investment advisor, all of my partners will work with you in providing your clients exposure to alternative-style investments and managers. Obviously, if your clients are high-net-worth individuals, then you will want to work with Altegris or ARP; and if your clients need lower minimums, then you should work with CMG. And if you have any feedback or comments, feel free to write me.

A Few Thoughts on Swine Flu

Intellectually, I know that flu is something that we live with every year. According to the Centers for Disease Control, seasonal flu infects between 15 and 60 million Americans each year (5% to 20%), hospitalizes about 200,000, and kills about 36,000. That comes out to over 800 hospitalizations and over 250 deaths each day during flu season.

Worldwide deaths from "regular" flu are between 250,000 to 500,000 a year. In the last SARS virus "epidemic" in 2003, there were around 8,000 deaths worldwide but none in the US.

Swine flu has been diagnosed 160 times in ten countries, plus several hundred more in Mexico. The toll is almost sure to rise a great deal, but will it reach the level of normal, everyday flu? I hope not, and I rather doubt it, at least based on the recent SARS scare.

But that is all an intellectual, distanced, nuanced concept. The real world is a little different. This morning I went to wake up my son to get ready to take him to school. For a real change, he was already up. He had been throwing up, he had a sore throat, and his head was warm. We finally found the thermometer and took his temperature. It was 100, and 20 minutes later had risen a degree.

We got into the car and went to the local "Doc-in-the Box." (For non-US readers, that is a local private-care clinic that will take walk-up patients without an appointment.) After a few tests, which they can now do in a few minutes, they determined it was not flu or strep throat. It was just some bug he had come down with that needed a course of antibiotics. We got the medicine and went home.

On the way back I asked him if he was worried about whether he had swine flu. The day before, his school had cancelled a field trip, and a local large school district (Fort Worth) had simply closed for a week after one diagnosed case.

"Yeah, Dad, I was worried a little. Glad it's not the flu." And Dad was, too. Statistics, whether financial or medical, become meaningless when it's personal.

Have a great week, and stay healthy!

Your planning to enjoy his May through October analyst,

John Mauldin

Back to the Future Recession

John Mauldin — Sat, 25 Apr 2009 02:24:58 GMT

MV=PQ
Financial Innovation: The Round Trip
2010-11: Back to the Future Recession
The Fed at the Crossroads
How Did We Get It So Wrong?
The Trend Is Not Your Friend When It Ends
Orlando, Naples, Cleveland, and Grandkids

This week we look at the second half of my speech from a few weeks ago at my annual Strategic Investment Conference in La Jolla. If you have not read the first part, you can review it here. The first few paragraphs are a repeat from last week, to give us some context. Please note that this is somewhat edited from the original, and I have added a few ideas. You can also go there to sign up to get this letter sent to you free each week.

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 genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can't have it.

MV=PQ. This is an important equation, 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 (roughly standing for the Quantity of production, or GDP)

So what happens is, if we increase the supply of money and velocity stays the same, and if GDP does not grow, that means we'll have inflation, because this equation always balances. 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. 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 the animal spirits that Keynes talked about are not quite there.

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

When they just print the money and buy Treasuries, as with 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.

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 here, another $500 billion there. Pretty soon it will be a really large total number.

When we first started out with TALF and everything, it was a couple hundred billion, and now we just 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 backups 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 maybe as much as $2 trillion. I've seen various studies. Ray Dalio of Bridgewater thinks it's about $1.5 trillion. It's some very big 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? It does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. The Fed has somehow got to 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?

Financial Innovation: The Round Trip

Financial innovation is one of the drivers of the velocity of money. We started in approximately 1991 creating the first securitizations and CDOs. It was done at Merrill Lynch, if I remember right. But they started getting copied, and then we went into warp speed, creating all kinds of new CDOs and SIVs that invested in loans, securitized mortgage debt -- most of which was rated AAA -- banks loans, credit card debt, etc. Without thinking about it, we created a shadow banking system that funded a huge chunk of our total credit markets. It was outside the bailiwick of the normal regulatory authorities.

Then in 2007 we began to destroy the shadow banking system. If it was working so well, why did we do that? Because they mismatched their liabilities and assets. They were borrowing short-term and lending long-term, and doing it highly leveraged. They were buying up long-term assets at 4-5-6%, some (or most) of them rated AAA. Then they were selling commercial paper at 1% or 2% -- so you get a 2-3% profit spread.

A 2-3% spread doesn't really make you anything, you're not really excited about that; so since we're dealing with AAA investments that everyone believes to be absolutely safe, let's leverage it up 6-7-8 times. Now you're talking a 20% return. Now you're talking about making money, real money. And I should note that we were also talking real commissions and monster bonuses.

I think one other side note needs to be made here. In hindsight, we can now look back and wonder what the investment banks were thinking. They "must" have known they were pushing bad paper into the system.

But their behavior tells us they didn't know. If they really believed they were, there would not have been so much of the toxic debt left on their books. Bear Stearns launched very large funds to buy this debt at obscene leverages and sold it to their best customers. At least some people in management thought there was real value in these securities, which just goes to show how lax or ignored the risk managers were in all parts of the financial industry.

Then it all began to implode, because people started paying attention to some of the assets on the balance sheets of the various SIVs and CDOs and suspected they might not be worth what they had originally thought. You have subprime mortgages in your Special Investment Vehicle? Hey, I'm not going to buy your commercial paper. Suddenly, the commercial paper market simply imploded. This was the start of the banking crisis.

So we started taking the innovation of securitizations off the table. The innovation that had driven the velocity to new highs was now slowly being pulled off. So, velocity slows down, and it's continuing to slow down with each passing month.

Let's survey the economic landscape. We have an unstable economy. Housing doesn't bottom until 2011 or 2012, unless, as I wrote the other day, we give immigrants a green card to come here. We need the immigrants anyway. We need smart immigrants. By the way, I've never had as much response to my letter, both positive and negative. It ran about 60/40 for. Many of the "against" were people outside of the US, saying why are you trying to take our best, we need them. I suppose there is a certain logic to that, but if we could pull a million homes off the market, it would solve a big part of the US credit crisis right now, not to mention, we would have people putting money into our system and it wouldn't cost taxpayers anything.

But back to the current scene. Consumer spending is slowing, and it's going to slow for years as savings increase. At one time we were savings 7-8-10% of our incomes, back in the early '80s. We grew from 63% of the economy being consumer spending, to 71% in 2006. We are going back to the mid --to low 60s in terms of the percentage of consumer spending in GDP. We are not doing it all at once, it's going to take years; but, gentle reader, it's the blue screen of death! We are hitting the reset button.

Economists have a term for this process. It's called rationalization. We have too many stores to sell "stuff," all sorts of stuff. Too many malls. We have too many factories to build too many cars, too many plants to build too many widgets for an economy where 65% of GDP is consumer spending. When we built all that capacity it was for an economy in which consumer spending was 71%; and because we were enthusiastic and believed we would grow at 3% forever, we probably built it for 73% or 74%.

We are watching capacity utilization fall off the table. It is down to 67%, fully 15% below normal. What happens when you see that? You start closing factories. It's just what you have to do. We are going to have fewer restaurants, fewer clothing stores. The survivors will get bigger market shares; that's just what happens. Schumpeter called it creative destruction.

And this being a different type of recession -- because we are hitting the full credit-cycle reset, it's going to take longer. I think the recession -- the actual, honest, mark-to-market numbers --will be negative through 2009. Then we'll start to improve. This current first quarter is going to be ugly again, then it will be a little better in the third quarter. The second quarter -- I don't know how bad it's going to be, but it's not looking good.

But in 2010 we could start seeing slow growth again, maybe Muddle Through. There might be a sluggish recovery in 2010, but we have to put an asterisk on that possibility because the Democrats are going to push through the largest tax increase in history.

First of all, the tax increase is the Republicans' fault. They didn't make the tax cuts permanent when they had the chance, so consequently they go away in 2010. US taxes are going to go way up, whether there is no compromise, so that we go back to the pre-Bush years, or there is some compromise because the Obama Administration realizes that putting in that type of a tax increase will throw us back into recession. Remember Roosevelt? What did he try to do? He raised taxes in the middle of a recession (1937), when unemployment was 14%, driving it back up to 20%. Unemployment will be 10% or 11% by this time next year, and maybe by the fourth quarter.

If you count those who are working part-time but want full-time employment, the unemployment number is closer to 15%. Yesterday, my taxi driver was a mechanical engineer who lost his job, but had kids and had to do whatever he could to put food on the table. He said there are a lot of people like him here in California.

The deficit is going to explode way past $2 trillion unless somebody can show some sense. Let's look at the carbon credit problem. Obama wants to impose this new carbon credits program, which sounds benign. We call it a credit and not a tax. Here's the issue. It gives us two bad possibilities, one of which is going to happen. Number one, he is assuming there is something like $800 billion coming in over the next decade from these carbon credits, and he's put that as income in his proposed budget, like it's going to get passed into the system. He is assuming that revenue. If he doesn't get it, deficits are much higher in the near term.

But if he gets it, it's even worse, as US industry becomes uncompetitive with Third World industries that don't have the same carbon credits and energy costs. Do you think China or India will pass the same legislation? They are building more coal-fired plants every month than we build in a year.

We are going to be seeing factory after factory shut down and moved off-shore, because they simply won't be able to compete. Either way, we go back to that economics technical term I used earlier: we're screwed. The carbon credits program is just a massively bad idea. There are things that we should do to cut down energy usage, but this is not the way to go about it. We can talk about other ways to do it if you want to.

2010-11: Back to the Future Recession

I think the country could re-enter a recession in 2010 and 2011; we would go right back into it when those tax hikes start to hit. What do tax increases do? They take money out of consumers' pockets -- and the consumers that actually spend. Plus, 75% of those who will see their taxes rise are small businesses that employ people, so we deflate ourselves.

Liberal economists are going to argue, "Wait a minute, John. We are taking it from these [rich] guys, but we are giving it to lower-income families, so it will get spent." But it's going through the government -- we don't get the same bang for our buck. We don't get new employment. We're simply transferring and creating a new welfare state; plus, we have a number of recent studies which show that the propensity now is not to spend the new money but to use it to pay down debt. This is not a pro-growth policy, and growth is what we need. Not wealth transfers and a new welfare state.

At some point inflation starts to show up again, because when you start running two-trillion-dollar deficits and you start trying to borrow it, at the same time the Fed is printing money, at some point in this process the bond markets (and the currency markets) are going to rebel. An unsustainable trend will keep going until it stops. I don't know when that day is, but the current policies mandate that we will hit the proverbial wall. One day it will be just like August 2007. Someone is going to ring a bell and the Treasury bond market is going to look the deficits and wonder how they will fund them, and they are going to let out a huge gasp and then throw up. Because you can't run two- to three-trillion-dollar deficits as far as the eye can see.

As Woody Brock so capably points out, the key to watch is the debt-to-GDP ratio. You can grow debt fast; but at some point you start to have to grow the economy faster than you are growing debt, or you become an economic basket case, where the dollar is devalued and interest rates go up fast. At that point, the Fed will have lost control. The key item to watch now is the budget debates. Are we going to build in $2 trillion deficits, or we will show some fiscal restraint?

The Fed at the Crossroads

And, are we going to try and do this when unemployment is at 10% or more? The Fed at some point is going to come to a crossroads. They can allow inflation, like the '70s. (And some of us are old enough to have lived through the '70s, though I really didn't notice much -- I actually made money on inflation during the '70s. I was in the printing business before I went into the investment publishing business. I would buy traincar loads of paper on credit and put it on warehouse floors; and because I was the only guy who could get paper and I had it at a good price, I got a lot of business. So I made money off of that inflation cycle.

We figure out how to Muddle Through, even during periods like the '70s. So the Fed can bring that back -- which they all swear they won't do -- or they can withdraw liquidity. What happens if they withdraw liquidity? It slows the economy down, because we are pulling money out of the system. Just as higher interest rates begin to take a toll on the economy, they will have to start pulling money out of the system to avoid higher inflation. By the way, if rates are rising that means the interest payments on the federal debt are rising, because we have a lot of short-term federal debt. Frankly, as a government, we should be buying all the 30-year bonds we can possibly buy. But we are not, because that would increase the pressure on the current debt. We have the long-term forecasting ability of a mongoose.

We are in the middle of a Great Experiment, the one truly great experiment of this time; so the economists are fascinated. We have Keynes versus von Mises versus Irving Fisher versus Friedman, and they all have theories about what you should do after depressions and what works. Someone commenting on Keynes said, "In a world organized in accordance with Keynesian specifications there would be a constant race between the printing press and the business agents of the trade unions. With the problem of unemployment largely solved, the printing press could maintain a constant lead."

Printing money. That's what the current Fed is doing. Just as aside, here is a great quote I came across. It really doesn't have anything to do with anything, but it's fun. John Ehrlichman told us about a conversation between Richard Nixon and Arthur Burns, who was Nixon's nomination to be Chairman. Nixon said, "I know there is the myth of the autonomous Fed [short laugh]. When you go up for confirmation some Senator may ask you about your friendship with the President. Appearances are going to be important, so you can call Ehrlichman to get messages to me, and he'll call you." I'm sure that's not done today.

Seriously, the independence of the Fed is critical, Nixon notwithstanding. Given the recent revelations about Bernanke and Paulson supposedly telling Ken Lewis at Bank of America not to tell the public about how bad the Merrill situation was -- do you think there might possibly be some pressure on Bernanke? His term is up early next year. It is quite possible we get a Fed chairman who would be more accommodative of a left-wing agenda than Bernanke, who I believe really will pull back from allowing inflation to get too high.

This would force budgetary discipline on Congress, which the left will not like. I can see some real issues in the upcoming nominating process if Bernanke is not left at the helm. Do we really want Larry Summers?

Let's get back to our discussion of the Great Experiment. Von Mises said there is nothing you can do about a deleveraging cycle, you basically just let it all go to hell and then pick up the pieces. The hair-shirt economists, I call the Austrians: just let it drop, take your medicine, take your 15-20% unemployment, and just deal with it, because you'll be able to come back faster from the lower base. By the way, to von Mises, the velocity of money was a meaningless concept. Gold was where you should have had your money to begin with.

Then there is Friedman, who produced his great work that says inflation is always and everywhere a monetary phenomenon. He had his studies to prove it. But when he did his studies, in the 30 years that he analyzed, the velocity of money was remarkably stable. So of course, inflation had a 1-to-1 correlation with money supply.

Fisher says, "The velocity of money is important." For Fisher, debt deflation controlled all other economic variables. It was the driving economic force. You're going to have to rationalize all your debts. There's nothing you can do about it; but what you do is, do as much as you can to provide a soft landing for the people who lose their jobs. Do whatever you can to get them along and to keep the system working, but you are still going to have to go through a credit reorganization. We are going to find out in 5-6 years who was right. That is the experiment we are living through. My bet's on Fisher, just for the record.

How Did We Get It So Wrong?

So how did we get it so wrong? How did we get here? Let's go back to first principles: Ideas have consequences. And bad ideas tend to have bad consequences. We've taught two generations of financial managers theories that were patently absurd. Rob Arnott is going to be here later with us for the panel discussion. Rob recalls standing in front of 200 academics, professors in schools that teach economics. He asked them, "How many of you believe in the efficient market hypothesis?" Something like two or three raised their hands. "How many of you teach it?" All of them raised their hands.

We have been teaching generations of MBA students economic garbage. Gaussian curves and things you could model. The classic line is from Ibbitson, is a brilliant professor and a brilliant mind, who said economics is a science. No it's not. It's barely an art form. It's voodoo. That's what we practice. We look at the entrails of the Wall Street Journal and try to predict the future. Sometimes it's about as bloody as sheep entrails. CAPM... poor Harry Markowitz's Modern Portfolio Theory got so twisted beyond recognition. I remember being with Harry Markowitz. I gave a speech at a big hedge fund conference about five years ago, talking about why Modern Portfolio Theory was not going to work. The next year it was the 50^th anniversary of Modern Portfolio Theory, and they brought Harry out to speak. He of course talked about why it was. I remember meeting him in the hall of this big hotel. And I asked him a couple of questions; I forget what they were because he so staggered me with, "Oh, you missed the whole concept of correlation and assets. Correlations change."

And he started drawing quadratic equations in the air. But because I was standing in front of him, he was drawing them backwards so I could see them. I mean, this guy is absolutely brilliant. But he's right, you should have a diversified portfolio of noncorrelated assets; but as John was showing yesterday, correlations in a crisis all go to one.

What money managers did was to create models that said, "If you do this, diversify your portfolio like this, and here are all your noncorrelated asset classes -- see what happens? You get long-term positive results."

And they would project that into the future. But they didn't project crises, when correlations go to one. Modern financial theory only works in models if you assume a few things that are patently not true in the real world. So we trained a generation of managers and investors that they should buy 60% stocks and 40% bonds. Yet for the last 40 years, bonds have outperformed stocks. Where was that in the model?

Well, we can go back to the 19^th century and see it. But we created a trend from 1944 to 2000 that said we were going up, and we trained a generation to believe they could model, and they did it. They modeled garbage, and now we've wiped out a generation of retirement income. I could go on and on, but it's nonsense.

We let the rating agencies become way too important. They were supposed to be the adults supervising the sandbox, and they weren't. They started out perfectly acceptably, but then they decided they wanted to rate multiple-obligor securities like real estate mortgage bonds using the same ratings they used for corporate bonds. They sold their business souls and didn't even realize it.

Remember, we trained a generation of people to think they could model this stuff. So they modeled what potential defaults would be, based on past performance, and not even past performance that looked like the assets in the investments they were rating. But it was scientific and looked like the models they learned in school.

Every time you get a letter from me, there is a page and a half down there at the bottom, full of disclosures. At least twice in those disclosures I say past performance is not indicative of future results. It's like, "coffee is too hot, don't spill it." We don't pay attention to it, but it's the most important thing, because past performance has nothing to do with future history.

The future is going to look different, yet we think we can model it. The models are bullshit. (That's a technical economics term that requires advanced degrees to use.) They just are. Now you can take some comfort from them, and you have to try and figure stuff out, and you look for correlations. That's what I do, and we all do that. I confess I use models every day.

But you have to recognize that the model has a huge asterisk beside it. You just can't bet the farm on it. And God, have I learned that the hard way. I've got bruises on my back from making assumptions. That's why I don't go around half-naked, because it would just look ugly.

We let the rating agencies use a corporate bond-rating system -- AAA, AAB -- for multi-obligor bonds that had nothing to do with reality, and they rated them up on the way up and now they are rating them down on the way down, and they are screwing us both ways. Because if you lose 1% on a triple-A bond, it immediately goes to junk. That means the banks have to write it off their capital and sell it for 50 cents on the dollar.

When did this problem start? July of 2007, when we introduced mark-to-market accounting. When did AIG have a problem? When they had to start writing their AAA's down. Now we should never have let it get to that place to begin with, but now we have to deal with reality. You can't just sit there and say, "Tsk, tsk, we need to let these guys go bankrupt."

No, you can't, not unless you want 25% unemployment again. We have "X" amount of pain to go through to get back to whatever the "new normal" will be. Think of this as a big tube of pain, OK? We can do it in one year or in seven or eight years. I vote for seven or eight. I don't want 20-25% unemployment. I would rather have 10% unemployment for seven years. Now, that's just me, because I know when my neighbor is unemployed, when my kid is unemployed, that it hurts.

The Trend Is Not Your Friend When It Ends

So, the establishment is now saying, "Let's keep the system going." Now, are we going to have problems when the Fed starts trying to pull the extra cash they are printing out of the economy? Yes. Is that going to create a different form of future history than we have experienced in the past? Yes. Therefore, trying to model the future based upon that past, will not work.

We believed the trend. The trend is not your friend when it ends. OK? It just isn't. Now, I'm the guiltiest person in the world. I live on what one of my friends calls "psychic income." That is the income you get when you take a current business model, the current business you are in, and you say, if I could grow these assets to "Y" I would make "Z". That "Z" charges me up. I haven't earned it yet and the train probably won't go there, but it gets me up in the morning. That's my psychic income. We all do that. But we rarely realize that it's just psychic income; it's not real income until the cash is there.

Given all that I have said, I still contend I am not a pessimist, at least not in the long term. Stocks go from high valuations to low valuations to high valuations. They've done it in US markets and world markets, and we are halfway through the trip in a secular bear market. We haven't gotten to low valuations yet, I don't care what they say. The P to E at the end of July was something like 289 on the S&P. You can go to the S&P website and you can see that. Now you smooth it with five-year curves and performance, and it goes to 20. 20 is not cheap. But it's going to get cheap -- at least that's what history tells us.

Now maybe history is wrong, because past performance is not indicative of future results; and I could be wrong, but sometimes you just have to set an anchor and say this is what I'm believing. I think we are going to lower valuations, and when that happens we will have compressed price to earnings ratios just like we did in 1982. The world will be coming to an end and we'll be moaning and groaning. We haven't gotten as bad as we were in '82 -- whoever pointed that out is correct.

But what will happen? The stock market will be a coiled spring and we'll have a bull market and we'll get to have fun in the stock market again. Until then, be careful.

Orlando, Naples, Cleveland, and Grandkids

I am writing today's letter at the St. Regis Hotel in Laguna Beach, California. I am going to hit the send button a little early so I can get out and walk around, as it looks to be too beautiful a place to be in my room writing. This weekend I join Rob Arnott and his friends (Mohammed El-Erian, Harry Markowitz, Jack Treynor, and Peter Bernstein, among others) at his annual conference. It is one of the few conferences I attend where I just go just to absorb as much as I can, and don't speak. This one looks to be special.

On Monday I fly out to Orlando to speak at the Chartered Financial Analyst's national conference on the "state of the union" of the alternative investment industry. I think my talk will garner mixed reviews, and is certain to be controversial in a few circles. I hope I get invited back some time.

Then I am back home for most of the next two months. I will make a quick trip to Naples to be with my friends at Jyske Global Asset Management for their conference the 29-31 of May (www.jgam.com). And I am going to schedule a quick trip to Cleveland to get a full physical at the Cleveland Clinic with my good friend and best-selling author Dr. Mike Roizen. I have put it off too long. I will tell you more about the really interesting program they have, where you can get a three-day, thorough physical in one long day. I think it is a real value.

And then there was a call from Tiffani last Saturday. She was in Kentucky visiting friends. One of my standing rules is that when I get back from Europe I am not to be disturbed before 10 at the earliest the next morning. But I got a call from her, and I groggily took it, worried that something was wrong.

"Dad, I'm pregnant. It's going to be a Christmas baby. What do you think?" Didn't she just tell me January 23 or so that they were going to try? That didn't take long. Not long at all.

Henry and Angel are due in June. Chad and his SO Dominique are due in October. I will go from no grandkids to three in the space of a few months. And Amanda is getting married in August. Lots of things happening in the Mauldin clan. And it's all good.

I need to wrap it up. Tiffani will be here in a few hours, and then the meetings start. Have yourself a great week; and if you are at the CFA conference, be sure and look me up.

Your almost ready to be a grandfather analyst,

John Mauldin

Further Thoughts on the Continuing Crisis

John Mauldin — Sat, 07 Feb 2009 05:56:53 GMT

Thoughts on the Continuing Crisis
The Right Direction, At Least
The Jobs Will Come
Can We Have a Little Inflation, Please?
Those Wild and Crazy Analysts
La Jolla, Conversations, and Richard Russell

When confronted about an apparent change of his opinions, John Maynard Keynes is reported to have said, "When the facts change, I change my mind. What do you do, sir?" The earnings season for the 4^th quarter is almost 80% complete, and the facts are dismal. It is worse than the current data shows, and could get uglier. Unemployment is increasing, and consumers are both saving more and spending less as incomes are not keeping pace with what little inflation there is. All in all, a very different set of facts than a few quarters ago. This week we examine some of the new facts, and start out by analyzing how Thoughts from the Frontline has done over the past two years with some of the more important predictions. It should make for an interesting letter.

At the end of the letter, I have a few notes on my upcoming Strategic Investment Conference in La Jolla, April 2-4 (which looks like it will sell out), information on the Richard Russell Tribute Dinner, a mention of my new Conversations service (which is getting very good reviews), and the need for one or two part-time editors.

The Right Direction, At Least

Over the last year, I have become increasingly more bearish on the economy than I was in January of 2007. In my 2007 annual forecast issue, I said that we would be in a recession by the end of the year (we were), and that it would be a long but not too deep recession, with a multi-year below-trend Muddle Through period to follow. I was thinking GDP would maybe be down 2-3%. As I have repeatedly written in this letter and said in speeches, the US stock market drops by an average of 43% in recessions. I saw no reason to be in the stock market, as there was just too much risk of a serious bear market. Further, since international markets now have close to a full correlation with the US markets, foreign stock indexes would be in trouble as well. I also said interest rates would be coming down and deflation would be a problem before we got through this recession.

(As an aside, there are a lot of very well-known perma-bearish analysts who called the recession, but were very bearish on the US dollar and positioned their clients in emerging-market stocks or other markets. Their clients have been mauled. Just because you get the economy call right doesn't necessarily mean you can call the right investment shots. Before you invest with a manager because he seems to have been right about something, look to see what his actual investment strategy has done. And that includes me or my partners.)

I also predicted the bursting of the housing bubble and the subprime credit crisis in late 2006 and 2007. While I was completely wrong about the severity of the current recession, at least I got the direction right. My advice would have been the same, which was avoid long-only stock portfolios and mutual funds, be long bonds, and access active, absolute-return managers and funds.

But the facts have changed. The reality is that we are in a much worse recession than I thought it would be two years ago. And as I wrote last month, we will probably be in recession for the full calendar year 2009, with the same lengthy multi-year Muddle Through Economy I originally envisioned, albeit from a lower base. So, what does that look like? Let's look at a likely set of facts, in no particular order.

1. Consumers are going to save more and spend less. It is likely that US consumers are going to push the savings rate back up to 6% (or more). Total US net worth decreased by $7.1 trillion through the third quarter of 2008, from housing and stock market losses. The trend suggests that could easily be up another $6-7 trillion by the end of this quarter. Greg Weldon speculates that is could easily be $15 trillion by the end of the cycle. That is a massive amount of wealth destruction. And while the absolute numbers are not as large in the rest of the world, the relative magnitudes are. This is a truly global recession. Economists say that anything below 2.5% in world growth is a global recession. We are down to 0.5% and falling.

2. The stimulus package is simply a pork-laden, misguided piece of legislation. The nonpartisan Congressional Budget Office released a report (I think yesterday) that says "CBO estimates that this Senate legislation would raise output and lower unemployment for several yearsÉ In the longer run, the legislation would result in a slight decrease in gross domestic product (GDP)." There is way too much spending on items that have very little current effect on the economy.

I am in principle in favor of a deep and large stimulus package. We need one, but what is on tap is not what will stimulate real job growth. All it does is create more debt that will have to be paid later by our kids. What else could we do? For instance, US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act. (Sent to me by Louis Gave of GaveKal, whose work will be highlighted in next Monday's Outside the Box)

Why not set a 10% tax rate to simply bring the money home, and a 5% rate if they use it for capital spending or to create jobs? Now that is stimulus that would actually result in more taxable income! And that money did help to create a boom in 2004. On an aside, this just goes to show how out of balance the US corporate tax system is.

What little real stimulus is in the bill will not hit all that much in the first half of this year. The fourth quarter of 2009 is likely to look better than the first quarter, but it is also likely to have a negative sign in front of it. I hope I am forced by the facts to change that prediction.

3. I am somewhat more hopeful about the Federal Reserve and Treasury programs, although all they really do is buy time for financial corporations to heal themselves. That is not all a bad thing, though. Volker did it in the early 1980s by allowing banks to carry debt from Latin American countries that was in default at full loan value. Otherwise every major bank in America would have been bankrupt.

And I agree that a lot of the process will be wasteful and unproductive. But such is the nature of crisis planning. Hopefully, they will not put into service the notion of a large "bad bank," but rather go ahead and put the zombie banks to sleep and help the healthy ones survive. But if US taxpayer money is involved, then shareholders should be wiped out first. If the rest of us have to lose on our stock investments, then bank investors should not be in a special protected class.

The downgrades by Moody's today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow.

"Moody's warned in a report last week that loss assumptions would be increased for RMBS and that downgrades could be expected. Moody's is projecting that alt-A deals originated in the second half of 2007 will experience 25.5% losses of original balance, compared to 23.9% of 1H07 deals, 22.1% for H206 deals and 17.1% for 1H06 deals. The rating agency in May expected average losses for 2006 and 2007 vintage deals to reach 11.2% and 14.7%, respectively." (The Big Picture)

These losses are just going to keep coming. Commercial mortgage paper will soon be written down as well. Banks will likely need at least $1.5 trillion in private investment and government funding.

4. As I have noted for almost two years, it will take until at least 2011 for the housing market in the US (and bubbles elsewhere, as in England and Spain, etc.) to stabilize. It will take several years for the creation of a new credit system to rationally replace the old "shadow banking system." This is why the recovery will take so long.

For an economy to grow over time, you need some combination of increasing population, productivity increases, and credit creation. We have destroyed a large part of our credit creation model (which was deeply flawed, even though for awhile it seemingly worked well) here in the developed world, and simply have to build a new one. That is why I believe we are going to see the creation of a massive new Private Credit Market that will compete with banks. You can see this developing here and there, but it is going to take time. The Fed is stepping in now and buying mortgages, credit card debt, student loans, etc., which is useful in the interim, but they need to make sure they do it at rates that will attract private capital and capital formation. We do not want to turn the Fed or Treasury into a national mortgage bank subject to political whim. That would be worse than what we have now. As an example, the government is now nearly the only source for student loans, as they set prices which just did not allow private companies to compete. We must not do that with mortgages.

5. The US government will run multi-trillion-dollar deficits for at least two years. As noted above, I think the current stimulus package will not be deemed sufficient by the third quarter, and the compelling need politicians will feel to do more will be almost uncontrollable.

Interestingly, the increase in federal spending is going to be accompanied by a substantial decrease in state and local spending, as almost all nonfederal entities must balance their budgets, and tax receipts are way down. If consumers are spending 5% less, it stands to reason sales taxes are down by 5%. Property taxes will be down, as will the state portion of income taxes. Increasing taxes will bring about local voter rebellion, so spending cuts will be the order of the day. As an example, state employees in California have every other Friday off, which cuts their pay by 10%. Expect more such cuts everywhere and on everything.

And while I am on the subject, state, county, and municipal pension plans are woefully underfunded. As in by trillions of dollars -- much as I wrote in Bull's Eye Investing in 2003. The signs were so there, and in a few years governments are going to have to figure out how to deal with major shortfalls in funding, as many municipal pension plans will be technically bankrupt.

Accompanying the increase in federal spending will be a real decrease in federal tax receipts, which will make the deficits worse.

6. The main driver in the economic world is deflation, as I have been writing for a long time. Yes, we had a brief whiff of inflation last year, but that was primarily commodity-driven, and that force is now spent. Commodities are likely to rise in price again, but not in the near future.

This is going to give the Fed the room to print money to monetize the federal deficit, and indications are that Bernanke will do it with a vengeance. He will do everything in his power to keep the US economy from catching "Japanese Disease," that is, descending into a deflationary spiral. I fully expect them to "move out the yield curve" and set longer rates at some lower number as well.

All of the above leads me to the following conclusions.

We are going to some new lower level of GDP and consumer spending, maybe as much as 5% lower, which is a serious recession. And the "recovery" is going to be slow. We don't get back to 3% GDP growth in 2010. Let me once again print a graph I have used several times, but it is just so important. You need to think about this one. This shows what the US economy would have been without mortgage equity withdrawals from 2001 to 2006.

Notice that the US economy would have grown less than 1% a year for five years, and barely that by 2006. And that is with consumers saving less than 1-2%! Now, let's imagine a world with savings going to 6% (or more), because shell-shocked US consumers now realize they may actually have to save to be able to retire. And what is it going to feel like when housing drops another 10-15%? Or more?!?!? And what if we have a repeat of a major summer bear market – which I make the case for in a few pages?

The Jobs Will Come

We could see well-below-trend growth for several years. I spoke this week to a small group of entrepreneurs that my daughter is involved with. (It is a business development/mentoring program called Vistage. I know several people who have seen their businesses really take off because of what they learned. If you are running your own business, I highly recommend it. I can see the differences it is making in my business because of Tiffani and other people I know who are involved. Their web site is www.vistage.com)

What I told them is that for those businesses which are dependent on the US consumer, their world is going to be smaller for a long time. We are in a period where the economy is going through what economists call rationalization. We are going to have to reduce the number of retail stores, coffee shops, automobile plants, fast food restaurants, car dealerships, etc., until we get to a level that makes rational sense for the size of the economy. We just built too much stuff, launched too many stores, and created too much capacity for almost everything.

The idea for the business person today is to still be standing when we get through this, as we will. That is what free market economies do. The day will come when we get back to 3-4% GDP growth. But it will be a rational growth based in real fundamentals, one that will last a long time. So hope is not a business strategy. You need to be planning for a lengthy recession and a slow recovery.

And if your business is one that helps producers cut costs? Or improve production? Then this is your time to shine. It is not clear what the stimulus plan will be, but look at it to see if there is something you can do to get in the flow of that money. There are opportunities out there.

We were in a similar period of malaise in the late 1970s. Everyone wondered where the new jobs would come from. The correct answer was, "I don't know, but they will." As it turned out, we saw the creation of whole new industries, which the government had little to do with. It is still the right answer. The new industries that we will see next decade? Biotech? Energy? A new wireless telecom build-out? Something out of left field? The correct stance is to be cautiously optimistic.

I am seeing some amazing private equity deals and new ventures. It is really a great time if you have capital, as you can pick among some very nice opportunities.

Can We Have a Little Inflation, Please?

Getting back to the Fed and deflation, there will come a point (I hope) when the Fed will actually bring about some inflation. That means they will have to tap on the brakes to keep from letting that get out of hand. That of course will slow any recovery, which is another reason I think the recovery from the current recession will be a lengthy one. It is asking too much for them to get it "just right." There is no formula here. They really do have to make it up as they go.

And while I don't think it is the likely case, it is quite possible that we could see a repeat of '70s-style stagflation. We could also slip into Japanese-style deflation, as the Fed may be pushing on a string. There is just no way of truly knowing. You have to stay nimble and go with the facts as they come down the road.

As investors, your goal is also to be standing when we get through this. There is another bull market in our future, as hard as that may be to imagine now. But it is several years off. Now is still a time for absolute returns and active management. You want to arrive at the dawn of the next bull with as much of your assets as possible. How will we know when we are there? Because valuations will be low. Which is a perfect time to segue into an analysis of current market valuations, as we close the letter.

Those Wild and Crazy Analysts

I have been writing about analyst earnings forecasts for some time. Earnings forecasts just keep dropping. I talked with the very interesting and gentlemanly Howard Silverblat from Standard & Poors, who is in charge of assembling the data for the S&P earnings. When I went to the web site, I noticed that "core" earnings were not on the spreadsheet. Core earnings take into account pension fund commitments and other items that sometimes do not make it into reported or operating earnings. During the last bear market, core earnings were a lot lower than reported earnings, as companies adjusted their pension commitments to make things look better than they were. I was wondering if we would see the same thing happening now.

I asked Howard about that, and he said they were having some issues in calculating them but expected the core earnings numbers to be back up in a month or so. And he quoted sources that suggested S&P companies were underfunded by $250 billion in their defined-benefit pension plans. Late last year, the Bush administration waived the requirement that companies fund their pensions to at least 92% of needed capital. It is now down to 80%. That leaves companies some room to play with on their balance sheets.

I commented on how bad earnings were last quarter. The web site shows earnings were a negative $3.14 a share, the first time they have ever been negative for a quarter. Ever! That was with 65% of companies reporting. He commented that it was worse than that. They don't have it up yet, but with 78% of companies reporting, losses are now a staggering -$8.56 a share. And it could get worse. The write-offs this quarter are just huge.

As he wrote, companies are not only throwing in the kitchen sink, but the refrigerator, washer, and anything else they can find as they seek to write off everything they can, to get it over with and start the new year fresh. They need to do a kitchen remodel, but there is no financing available.

So, how does that affect total earnings for 2008? The table above shows analyst projections from March of 2007 through today. Notice how they kept falling over time. They are now down 70% from what was expected two years ago. Earnings for 2008 are a paltry $29.57 and dropping. The S&P 500 closed at 868.60. That makes the P/E (price to earnings) ratio 29.4. (I use a decimal to show I have a sense of humor.)

So, what are they projecting for 2009? Let's take a look. Notice that they too have been falling over time.

If the S&P 500 were to close where it is today, and using the estimates for the first two quarters of 2009, the P/E ratio would be 36.4 on July 1.

But what if earnings merely fall to where they were in the last recession, or about 55-60% of where the projections are today? That would drop the 12-month trailing earnings for the four quarters ending June 30 to $15.90 and result in a nose-bleed P/E of 54.7 by the middle of the year.

If earnings don't come in dramatically better for the first quarter as opposed to last quarter, we could be setting up for a nasty summer bear market. Even in the bear market of 2001-2, the P/E did not get above 47. Which, by the way, at a 47 multiple would correspond to a range for the S&P of either 1111 if the earnings come in as projected or 731 if they come in at the lower range.

I see nothing on the horizon which suggests the economy is going to get manifestly stronger in the next two quarters. The real risk is that earnings come in weak for both quarters and investors simply despair this summer, throwing in the towel and bringing about a vicious bear market. I would seriously consider hedging any long positions you have before earnings season this next April. If they come in stronger, then we will see.

La Jolla, Conversations, and Richard Russell

As I mentioned at the beginning of this letter, along with my partners Altegris Investments, I will be co-hosting our 6th annual Strategic Investment Conference in La Jolla, California, April 2-4. I have invited some of the top economic minds in the country to come and address us, giving us their views on what seems to be a continuing crisis. It will be a mix of economic theory and practical investment advice. WE WILL SELL OUT, so do not procrastinate if you intend to register.

Already committed to speak are Martin Barnes, Woody Brock, Dennis Gartman, Louis Gave, George Friedman (of Stratfor), and Paul McCulley. I anticipate adding another stellar name or two, as a lot of very famous people are coming for the Richard Russell Tribute Dinner (see below). This is as strong a lineup as we have ever had, and on par with any conference I know of anywhere. And as a special bonus, we have invited Fredrik Haren from Sweden. I heard him speak at a conference in Stockholm last year and was blown away. You can click on the link below to learn more about the speakers.

Due to securities regulations, attendance is limited to qualified high-net-worth investors and/or institutional investors, because we will be showcasing a select number of commodity fund managers and other alternative strategies. Early registrants will get a discount. Last year we had to close registration, and I anticipate we will run out of room again, so I would not procrastinate. Click this link to find out more and register: https://hedge-fund-conference.com/register.aspx. And if you cut and paste this link, make sure you copy the "https:" so you go to the secure site.

And the first of the "Conversations with John Mauldin" is up! We recorded it last week, with Ed Easterling and Dr. Lacy Hunt. I thought it went very well for an inaugural talk. The complete audio and transcript are in the Membership Library already. For those who have subscribed, you should have received an email and be able to log in and listen or read the transcript. We are getting very favorable reviews. Multiple readers have let us know that the first Conversation was worth their entire year membership. I am quite pleased with the first transcript and the response to it. My next Conversation is in two weeks, with Nouriel Roubini; and then 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 that 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 JM77, which will give you the discounted price. https://www.johnmauldin.com/newsletters2.html

Now, about the Richard Russell Tribute Dinner on Saturday, April 4. It will be at the Hyatt in San Diego. We are going to be sending out invitations early next week to everyone who has responded so far, which is well over 500 people. If you have already responded, you will get a chance to register first, before we open it up again. Next week we will have a page where you can sign up; but when you get the invitation, I suggest you act quickly, as it really could sell out. This is going to be a very special night. If you are one of Richard's many thousands of fans you will not want to miss this. As I said, there are going to be a lot of well-known names there. We are still planning the program, but it will be special. (Note: to those who are attending my conference, noted above, this is a separate event, with separate tickets, in a different Hyatt.)

If you would like to attend, just contact us and we will get you an invitation. The cost will be $195.

And finally, Tiffani and I need an editor or two to help us in the process of editing our taped interviews with millionaires. Drop us a note.

It is time to hit the send button. Have a great week!

Your really optimistic for the long run analyst,

John Mauldin

Forecast 2009: Deflation and Recession

John Mauldin — Sat, 10 Jan 2009 14:38:00 GMT

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect
Muddle Through on Hold
Lies, Damned Lies, and Government Unemployment Numbers
Central Bankers of the World, Unite!
Predictions 2009
La Jolla, Bermuda, and Europe

Where are we headed in 2009? We will explore that in detail over the next few issues of Thoughts from the Frontline, but today we will start with some of the larger forces which will have a major impact on the economies of the world, and I will end with my usual attempt to forecast the various markets. We will look at deflation, deleveraging, the fallout from the stimulus plans (note plural), housing, consumer spending, unemployment, and a lot more. There is a lot to cover. But first two quick announcements.

Along with my partners Altegris Investments I will be co-hosting our 6^th annual Strategic Investment Conference in La Jolla, California, April 2-4. I have invited some of the top economic minds in the country to come and address us, giving us their views on what seem to be a continuing crisis. It will be a mix of economic theory and practical investment advice. Already committed to speak are Martin Barnes, Woody Brock, Dennis Gartman, Louis Gave, George Friedman (of Stratfor), and Paul McCulley. I anticipate adding another stellar name or two. This is as strong a lineup as we have ever had, and on par with any conference I know of anywhere.

Due to securities regulations, attendance is limited to qualified high-net-worth investors and/or institutional investors. Early registrants will get a discount. Last year we had to close registration, and I anticipate we will run out of room again, so I would not procrastinate. Simply click on the link below, give us your name and email, and you will be sent a form next week to register.

https://hedge-fund-conference.com/2009/interest.aspx?m=t

I should note that most attendees say this conference is the best investment conference they have ever been to. One of the benefits is being with several hundred very nice people in a relaxed setting. We do it up right.

Second, I and some of my fellow newsletter writers (Bill Bonner and Dennis Gartman, among others, are slated to be there) are going to be hosting a special tribute dinner to honor Richard Russell for his outstanding contribution of over 50 years to not only the craft of investment writing but also to the lives and investment portfolios of his readers. He is one of my personal heroes as well as a good friend. At 84, his writing today is better than ever, and now he writes every day, not just once a month! Richard is an institution in the investment writing world, and after talking with his wife Faye he has said he will let us plan the dinner.

Richard has some of the most loyal readers anywhere. I have personally talked to people who have been reading Dow Theory Letters almost since the beginning (1956), and their enthusiasm for all things Richard has not waned. We have a long list of people who want to attend.

Based on the response so far, we believe we can get a large roomful of Richard's friends, writing colleagues, and fans who have benefitted from his wisdom over the years, to honor him for a life well-lived and a true servant's spirit, as well as being a guide not just in the markets but in life. The dinner will be Saturday evening, April 4, 2009 in San Diego. In order to know how many people we should plan for, please send an email to russelltribute@2000wave.com indicating how many tickets you would like. If you have already responded, you will get an email with a link next week for you to register. If you have not and want to come, I suggest you do so quickly, as again we anticipate a packed room. The tickets will be $195, with any money left over going to Richard's favorite charity.

(Note: If you register for my conference, you must register separately for the Russell Tribute Dinner, which will be held at a different venue, after the close of my conference on Saturday. Thanks!)

And for new readers and those who get this letter forwarded to them, you can get a free subscription of your own just by going to www.frontlinethoughts.com. And now to our regular letter.

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Muddle Through on Hold

First, a quick look back at how I did in my 2008 forecast issue. In general, it was not a bad year in terms of getting the direction right on many of the markets, including gold, oil, the dollar (especially against the pound sterling), and stocks. Some predictions were on target, like a second-half rebound in the dollar.

But I missed the economy. I noted then that I believed we were already in recession (which we have now found out that we were), and I wrote that a recovery would begin by the end of the year, but that it would be a very weak one for a long time -- my basic Muddle Through scenario. Obviously, the recession is a lot worse than I thought it would be at the time. Looking to the end of this letter, I now think we will be in recession through at least 2009 before we begin a recovery, which will again be a rather anemic Muddle Through period of maybe two years, for a variety of reasons, some of which I cover today and others over the next few weeks.

And I should note that it was not long into the year before I began to get decidedly more gloomy, as many of you noted. And I expect that this year will bring a few surprises that will cause me to change my opinions yet again. When the facts change, I will try and change with them.

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect

For a very long time, I have been adamant that deflation is in our future. In the next few pages I outline how inflation might come back, but I doubt it will be this year. For now, deflation is the economic factor that the Fed and central banks will be battling. And believe me, it will be a very large and controversial battle.

We had a brief period last summer where inflation (as measured by the Consumer Price Index or CPI) was over 5%, and the trend was clearly up. The increase was almost entirely due to food and energy costs. Core inflation (less food and energy) was around 2%. Many commentators noted that real people actually bought gas and food and we should look at overall CPI and not just core. Now, with the drop in food and energy costs, their impact has vanished.

For the three months ending last November, the compound annual rate for the CPI was a negative(!) -10.2%, reflecting the almost 70% drop in energy. Annualized core CPI for the last three months ending November was a very low 0.4%. November CPI was a flat 0.0%. It has been falling steadily for the last five months.

December is likely to be negative. There is a trend here, and if you are a central banker it is not one you like. And that trend is being manifested in every part of the developed and much of the developing world. It is a global problem.

Given how high inflation was last summer, how could I credibly maintain that deflation was in our future? For reasons that I wrote about extensively then. Briefly, we were in a recession. Recessions are almost by definition deflationary. We had two massive bubbles bursting: the very visible housing bubble which was massively destroying wealth, and the less visible but even more powerful bursting of the credit bubble, which was accompanied by profound deleveraging and the destruction of what Paul McCulley termed the Shadow Banking System.

It would be a strange, strange world indeed if inflation could get any real traction in such an environment, and it didn't.

But now we have a structural problem in that deflation has the potential to get some very real traction going forward. Why? Because not just in the US, but all over the world, we built too much of almost everything. Too many houses, too many manufacturing plants, too many retail stores -- and just too much stuff.

In the US, capacity utilization is falling rapidly. Typically, if we produce "stuff" (cars, food, lumber, etc.) in the range of 80% of potential capacity, that is considered to be a good economy. Capacity utilization has been dropping for some time and is down below 75% for all industries, but in many industries is close to 70%. And the clear trend when looking at ISM manufacturing statistics is that it has a lot further to fall.

That means industries have no pricing power, as they can make a lot more "stuff" than they can sell. And when demand due to the recession drops as well, prices fall as producers try to stay in business.

As a very visible example, global output capacity for automobiles is 92 million cars, but sales will probably be around 60 million. Output in the US will be around 12 million, but right now sales are only about ten million. The average American household has 2.2 cars. Evidently, consumers are reducing the number of cars they own, buying used cars, and making their current vehicles last an average of 6 months longer -- all in just the last year.

Many auto plants, both in the US and abroad, are simply going to have to be closed. "Super-efficient Toyota expects its first operating loss in 70 years in the fiscal year ending March 31. Weak sales in China will probably force many of her 80 automakers to merge. Russian sales dropped 15% in November and 25% in Brazil from a year earlier." (Gary Shilling)

Just as there are too many auto dealers and too much auto manufacturing capacity, there are too many stores for a country whose consumers are in retreat. Consumer spending could easily drop 7% as the saving rate heads back up to 5% (or even more). It is estimated that over 70,000 retail stores will go out of business in the next six months. That would be in line with the 140,000 that closed doors last year. The economy and its businesses have to adjust to a new level of spending that will be the first serious consumer recession in 26 years.

Looking at Federal Reserve data, both total household debt and mortgage debt outstanding dropped in the third quarter, for the largest drop in 40 years. As I wrote almost two years ago, the disappearance of Mortgage Equity Withdrawals is having a negative impact of about 3% on US GDP. Evidence shows that this is also happening in Great Britain and other parts of Europe where there was a housing bubble.

Lies, Damned Lies, and Government Unemployment Numbers

There are some who see a ray of hope in the recent jobless claims reports, which have dropped back to "only" 467,000 in initial unemployment claims, down from 491,000 for the last week, after being over 500,000 for several weeks. Those numbers are seasonally adjusted. That hope disappears if you look at the actual numbers. For the current reporting week ending January 3, 2009, the advance number of initial claims came in at 726,420. Last week's advance number was 717,000. We have been above 600,000 new initial claims every week since the third week of November. Continuing claims jumped massively, by 744,000 to 5,316,124.

No conspiracy here. This is what happens when you try to smooth a volatile trend by using seasonal adjustments. If you use past performance as the tool by which you smooth the trend, when the trend changes, the seasonally adjusted numbers will be either too large or too small. Thus, the data understated the growth of jobs in 2003 because recent past performance had been bad, and it is now understating the number of unemployment claims and actual unemployment.

In December, the number of unemployed persons increased by a seasonally adjusted 632,000 to 11.1 million and the unemployment rate rose to 7.2%. Since the start of the recession in December 2007, the number of unemployed persons has grown by 3.6 million, and the unemployment rate has risen by 2.3% and is now at 7.2%.

I happened to be watching CNBC at the time of the release of the data, and several commentators remarked how much better the number was than they thought it would be. I wish they were right, but again, the actual numbers showed a loss of 954,000 jobs, over 50% more than the headline number reported in the press release. And that assumes that new businesses created 72,000 jobs from the birth/death model that I so frequently write about. It is possible that almost 1 million jobs were lost in December. I doubt the market would have liked that number.

I should note that the Bureau of Labor Statistics does not hide that number. You can find it if you dig for it. But most analysts seem to prefer just to take the press release and go with it. And most of the time that is fine. But in times like this, when trends are changing, you miss the bigger picture and get misleading data.

Unemployment could rise to 9-10% or more this year and on into 2010. That means we could easily see another 3 million lost jobs over the next year. That is going to put a lot of negative pressure on consumer spending. It also means that wages are not likely to rise, and we have already hard evidence of wages falling in many industries as companies try to find ways to remain solvent.

And that 9% will be the headline number. If you add people who have part-time jobs but would like a full-time job, and what are called marginally attached workers, the current rate is already 13.5%.

Average hours worked dropped to the lowest level since they began collecting data in 1964, as did hourly income. Given the increasing difficulty for consumers to borrow money and with income dropping, plus increased savings on the part of consumers, it is difficult to see how pricing power is going to come back any time soon.

This problem is multiplied throughout the developed world. The developing world, which sells products and goods to the US and European consumers, is starting to feel the pinch. Chinese and other Asian exports are dropping (more on that in future letters, but the data is ugly).

Overcapacity, rising unemployment, imploding leverage, lack of borrowing and/or lending, a serious retreat by consumers, and increased savings are all the conditions needed to bring about deflation. Left unchecked, we could soon see something like what Japan has experienced, and even potentially worse, as they started with a savings rate of 13%.

But deflation is not going to be left unchecked. It will be fought by central banks everywhere with low rates and the printing press, as well as government spending. And so, let's turn our attention to that process.

Central Bankers of the World, Unite!

There are many people who believe that the Fed and the Treasury increasing the money supply will bring about uncomfortably high inflation. And it is indeed their intention to "reflate" the economy. They are well aware of the problems that would develop if the US (and Europe!) caught "Japanese disease" or a prolonged bout of deflation. Bernanke has made it clear that "it" (as he called deflation in his 2002 speech) would not be allowe to happen on his watch.

And we have already seen a rather large growth in the monetary base. But as I wrote a few weeks ago, the velocity factor of money is slowing rapidly, creating the ability -- or dare I say it? -- the actual need to expand the money supply (you can read that in my December 5, 2008 post). But is it having an effect?

Good friend Gary Shilling raises some doubts (emphasis mine):

"Central banks around the world continue to cut their target rates, although in today's frozen credit market, that won't ever get the horse up on his feet, let alone to the water and drinking. The distrust of banks for even loans to other banks is shown by the still wide spread between LIBOR and the Treasury bills they covet.

"The M2 money supply is 60 times bank reserves, so normally when the Fed gives the bank another dollar in reserves, M2 rises by $60. But between August and November of last year, the $577 billion rise in reserves resulted in a mere $264 billion growth in M2, less than one half!"

See the chart below (the red, smooth line is M2, the dotted line is the adjusted reserves).

The Fed is aggressively expanding its balance sheet. They have made clear that they intend to purchase mortgage securities, consumer loans, and credit card securities. Corporate loans are on the table, as well as other forms of debt. (Finland is getting ready to purchase corporate debt. The list of countries that do so will rise very quickly.) This will be direct infusion of money into the system. As Bernanke said in 2002, he knows where the keys are to the room that has the printing press. And they are going to use it.

Obama and his advisors have signaled they intend to run a deficit of at least a trillion dollars. Right now, as I add it up, it is more like $1.3 trillion (the stimulus number keeps moving), and given that tax receipts are going to drop and unemployment benefits will rise (care to bet that unemployment benefits won't be extended to 52 weeks instead of the current 26?), it could be closer to $1.7-2 trillion. That would be almost 15% of GDP!

Let's get this straight. The only difference between the Treasury and the Fed under an Obama administration and the Bush administration is that Obama will be even more willing to spend (although Bush certainly showed little restraint). Incoming Treasury Secretary Tim Geithner has worked at Treasury and is now president of the New York Fed. There will be little difference between his policies (and those of Larry Summers, Obama's economic advisor) and those of Bernanke and Paulson. And like Paulson, he is going to have to make up the play book as he goes.

The Fed and the new administration are "all in," as they say in Texas hold 'em poker, in the fight to defeat deflation and get the economy growing. And eventually England and Europe will get it and join the fight (both the European Central Bank [especially!] and the Bank of England are behind the curve).

But there is a problem.

Lowering rates isn't enough to get consumers to spend when they have seen their wealth erode from losses in the value of their houses and investment portfolios and retirement accounts. The stimulus last summer was largely saved or used to pay down debt. What was an annualized stimulus of 3% of GDP in the second quarter, which is quite large, only kept GDP growth positive for one quarter.

Obama talks about creating 3 million jobs. If he can do it, that would only partially offset the job losses that will happen in his first year in office. But it will take a long time for much of the stimulus he is talking about to make its way into the economy. You can't turn on infrastructure projects in one quarter. It takes a lot of time to plan. New green power plants? Wonderful. I'm all for it. But they take years to authorize and build. Tax cuts? Again, much of it will be saved or used for debt.

The reality is that the US and much of the world are going to see their economies shrink for at least another year. And when that new, lower level is reached, the economy will slowly start to grow again. Remember those 71,000 retail stores closing? That means that those left standing will get more business and will be able to expand and grow and hire people. That is how recessions work. Excess capacity is worked through. Businesses cut back until they can get positive cash flow.

In 1978, in the midst of high inflation, bear markets, and malaise about all our jobs going overseas, the correct answer to the question "Where will all the needed new jobs come from?" was "I don't know, but they will." That is the correct answer today. That is what free markets and capitalism do. They find a way to make new paths and new businesses where none existed before. And it will happen again. Just with a little lag this time.

In the meantime, there is a lot of pain. An Obama administration is going to do what it can to help relieve that pain, even at the cost of trillion-dollar deficits for several years.

This you can take to the bank: If the Fed buys $500 billion in assets of various kinds and if the US government spends an extra trillion dollars and deflation is still a concern, they are going to double down and do it again. And yet again if they think it is necessary. They are not going to stop until the nominal economy is growing and inflation is above at least 1%.

How much will that number finally be? No one really knows. This has never been attempted. Maybe the initial stimulus package and Fed debt purchases will be enough. My bet is that it won't be, but that is just a guess. We are in uncharted waters. But the captains of the boats are all Keynesians. They are going to fight a recession and deflation with old-fashioned stimulus. And that means we had better adjust our portfolios and businesses for that reality.

Just to give you a picture of what economists think about the effect of the stimulus, let's turn to the Levy Economics Institute of Bard College, which is one of my favorite sources for original economic insight (http://www.levy.org/). They are a rather conservative lot. The graph below shows what two different levels of government stimulus will mean to the economy. They graph unemployment at no stimulus (top black line) and at two levels of "shock" or stimulus. Shock 1 is about $380 billion and shock 2 is about $760 billion. The dotted lines are what is known as "output gap," or the measure of the difference between the actual output (actual GDP) of an economy and what it could produce at its most efficient (potential GDP).

"The implication of these projections is that, even with the application of almost unbelievably large fiscal stimuli, output will not increase enough to prevent unemployment from continuing to rise through the next two years.

"It seems to us unlikely that U.S. budget deficits on the order of 8--10 percent through the next two years could be tolerated for purely political reasons, given the strong and widespread belief that the budget should normally be balanced. But looking at the matter more rationally, we are bound to accept that nothing like the configuration of balances and other variables displayed in Figures 3 and 4 could possibly be sustained over any long period of time. The budget deficits imply that the public debt relative to GDP would rise permanently to about 80 percent, while GDP would remain below trend, with unemployment above 6 percent.

"Fiscal policy alone cannot, therefore, resolve the current crisis. A large enough stimulus will help counter the drop in private expenditure, reducing unemployment, but it will bring back a large and growing external imbalance, which will keep world growth on an unsustainable path.

"É At the moment, the recovery plans under consideration by the United States and many other countries seem to be concentrated on the possibility of using expansionary fiscal and monetary policies.

"But, however well coordinated, this approach will not be sufficient.

"What must come to pass, perhaps obviously, is a worldwide recovery of output, combined with sustainable balances in international trade."

Let me wrap up with a quick note about housing. The economy is going to have a rough time getting back to trend growth with the housing market in the tank. New home sales fell 2.9% in November, while the median price declined 11.5%. Unsold inventories stood at a rate of 11.5-month supply. Housing starts fell nearly 19% in November, while the number of building permits was down 15.6%. Sales of existing homes in November fell more than 8%. The S&P/Case-Shiller 20-city housing index showed an 18% drop in prices in October from a year earlier, while the 10-city index declined 19.1%. Prices in the 20-city index have fallen more than 23% since their July 2006 peak, while the 10-city index is down 25% since its top in June 2006.

It will be 2011 before we work through the excess supply of homes, especially as we are seeing more and more come onto the market because of foreclosures. Prices are likely to drop another 10%. There will be more wealth destruction and more pressure on consumers. 10% of all mortgages are either delinquent or in foreclosure.

Predictions 2009

Let's close with some predictions. Ten out of ten analysts in the recent Barron's forecast saw stock prices rising 10-20% this year. For reasons I outlined last week, I think we could see a tradable rally in the next few months, but at the very least test the lows this summer, if not set new lows. Earnings are going to be far worse than any analyst's projections I have seen. And earnings drive stock prices.

Further, this recession is going to be the longest in anyone's memory. It is going to seem like it is never going to end (it will, I promise), and more and more investors are just going to give up on stocks. The buy and hold for the long run mantra is wearing thin. In inflation-adjusted terms, the stock market is about where it was in 1973! If you reinvested dividends, that gets you to 1991 (again, inflation-adjusted). It takes a lot of buying to make a bull market. It only takes an absence of buying to make a bear market.

Could we get a rally after the summer or fall lows? Sure. And it could be a good one. A lot depends on how fast the stimulus kicks in and whether it really has an effect. Will the Fed really buy large-cap corporate debt? I hope we can see something like a 1974 bottom in stocks develop.

I think the correlation between the US stock market, other developed markets, and emerging markets is close to one. I prefer to stand aside until the US economy has a clear direction and we can see whether the stimulus actually works. And then we can look at the world economy. I won't embarrass them by naming names, but those who argued for "decoupling" between the US and the rest of the world are not looking good. Someday, but not this decade.

I would be a buyer of quality bonds, both corporate and municipal. The key is to have a bond analyst who knows what they are doing and not just looking at ratings. There are some real values in the bond market today.

I would not be a buyer of US government debt. Treasuries, if not in a mini-bubble, have little upside potential and just don't yield enough. Why would I hold a ten-year treasury for 2.39%? I like TIPS at these prices. TIPS are pricing in deflation for ten years and, as I outlined above, I don't think the Fed will allow deflation to take hold.

With all the massive printing of money, you would think I expect the dollar to crash. I don't. The question is, what will it fall against? The euro? Really? The pound is better valued, but England and Europe are going to have to cut rates and apply massive stimulus as well. Every developed country will have problems. I can see holding Canadian, Australian, and other commodity-country currencies, but the leverage needed to make it a reasonable investment potential is too risky for individuals.

I can't see the Japanese letting the yen get too much stronger. China seems to want to halt the rise of the yuan, and the rest of Asia will devalue their currencies to maintain whatever they think of as a competitive advantage. Longer term, I like Asian currencies.

After a year of bouncing around, gold may be poised to rise against all major currencies. We could easily see new highs in the next year.

I think oil is going lower (and maybe much lower -- can you say $1-a-gallon gas?) in the near term. As I have written about before, oil is now in the steepest contango on record. That means oil is cheap today and more expensive in a few months. That is not normal. Oil is bidding for storage. You can make 20-25% on your money in a few months if you can buy oil and find somewhere to store it. At least 25 supertankers have been leased to store oil, and sources say another ten are being bid for. It remains to be seen if OPEC can really cut enough to make a difference in the near term.

As for the other metals, I think it is quite likely copper and its industrial allies will fall in price at least for the near term, until production can be cut and demand in Asia begin to rise again. I would not be a buyer of long-only commodity funds for the near term. Someday the bull market in commodities will return, but not until Asian demand picks up.

The risks to my forecasts are quite clear. The stimulus could happen quicker and be more effective than I think, and the economy and the markets could surprise to the upside. On the other hand, and more scarily, the Fed could be pushing on a string in a liquidity trap and the economy and markets could get hit harder, along with most assets.

Briefly, if you would like to look at a range of money managers I think have the potential to navigate the current market successfully, let me suggest you contact some of my partners around the world. If you are an accredited investor (net worth $1.5 million) and would like to look at a group of hedge funds and especially commodity funds in the US, go to www.accreditedinvestor.ws and fill out the form, and my partners at Altegris Investments will get in touch with you. If you are in Europe, use the same link and I will get you in touch with Absolute Return Partners in London. In South Africa, my partner is Plexus Asset Management. We will soon be announcing new partners in Canada and in Latin America.

If your net worth is less than $1.5 million, my US partners at CMG have a platform of managers and traders that take direct-managed accounts with minimums of $100,000. These are liquid and fully transparent accounts with managers with long-term track records. You really should check it out. The link is http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

And if you are an advisor or broker and would like to see the managers on the Altegris or CMG platforms and how you can access them for your clients, sign up and note on the form you are in the business. It might actually be fun to make a client call with a recommendation for a fund or manager that was up in 2008.

La Jolla, Bermuda, and Europe

Tiffani and I head out to La Jolla Monday to meet with Jon Sundt and his partners at Altegris Investments. There have been a lot of positive developments of late, including new managers, and of course we will be talking about the upcoming conference. And I will get to have a quick happy hour with Richard Russell and his son. The Tribute dinner is going to be so much fun.

On Wednesday, I am hosting a dinner at my new home for a small group of family office heads, hedge fund managers, and local businessmen. We are calling it an "Idea Dinner" and will throw out thoughts on how to invest in the coming year. I will report anything interesting.

I will be in Bermuda January 28-31 for a speech and some time away from the office to write on the book Tiffani and I are doing on millionaires. It is a fun project. And I have to have it finished by the end of February so I can get to London and Europe and New York in March.

I am always optimistic at the beginning of the year. Even though I see a serious recession, I am working, like every businessman in the world, on making my business grow in spite of problems in the economy. Free markets with motivated entrepreneurs will be what really creates a growing economy.

It is time to hit the send button. There is a fire in the family room, and it is time to relax. Enjoy your week. I know I will.

Your more optimistic than this letter implies 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

The Problem With Deleveraging

John Mauldin — Sat, 08 Nov 2008 04:21:00 GMT

The Problems of Deleveraging
1.2 Million Jobs and Counting
Be Careful of Geeks Bearing Recovery Data
Back to 1982
New York, Birthdays, and Moving

In general, we consider it a good thing to save money and to "owe no man anything save love." But what happens when a debt-happy society wakes up and decides that saving is a good thing for everybody? What happens when banks and hedge funds decide (or are forced) to reduce their debt? What happens when businesses of all sizes find it harder to get loans to operate?

In this week's letter we discuss "The Great Unwind," that process of deleveraging that we are now in the midst of. We also explore some recent economic data on the economy. It's a lot of ground to cover, so let's jump right in.

1.2 Million Jobs and Counting

The unemployment numbers came out today and they were ugly. October showed a loss of 240,000 jobs. But the really bad part was the negative revision to August and September, by a further loss of 179,000. As I have written in the letter numerous times, downward revisions in a slowing economy are the rule. Unemployment estimates are largely based on recent past performance. There is no way the models can catch a change in the overall trend. All the statisticians can do is go back and modify the data as hard information becomes available.

What the data shows is that the economy has lost 1.2 million jobs since December, with over half of those losses in the last three months as the problems from the recession accelerate. While two-thirds of the losses are in manufacturing and goods production, the service economy is also starting to show signs of strain. One in five lost jobs are from the retail sector.

Philippa Dunne of The Liscio Report writes: "A stunning fact: yearly job losses in private services, 0.4%, now match the worst of the 1982 recession and exceed the worst of 1975; once upon a time, the service sector wasn't very cyclical. Now it is."

Just as disturbing is the jump in the unemployment rate. It leaped to 6.5%, far above even the most dismal of expectations. For reasons we will go into below, it is likely we will see another 1 million jobs lost over the next year, with the unemployment rate headed up as high as 8%. There are now ten million unemployed Americans. You have to go back to 1982 and a double-dip recession to find an 8% unemployment rate. Very few people under 50 remember what that is like.

Look at the chart below. Notice how swiftly unemployment rises during a recession and continues to rise even after the recession is over. Since I do not think the current recession will be over until the third quarter of next year, we could see unemployment continue to rise for the next 8-10 months. At least, I hope it doesn't last longer.

Be Careful of Geeks Bearing Recovery Data

Before we look at how weak the economic numbers were from both the manufacturing and service sector surveys, let me cover an important point about recessions. You are going to hear all sorts of analysts (including sometimes even this humble analyst!) quote statistics that in general sound like: "Since the end of WWII average recessions have lasted X months, and thus we are almost through the current one, so buy what I am selling." Or the ever popular "Stocks tend to find the bottom in the middle of a recession, so now is the time to buy."

There will be lots of variations that all assume that past performance is somehow indicative of future results. And such an assumption is a prescription for investment pain.

First, there are not enough data points about recessions between the end of WWII and now to have any statistical meaning. I count 11 recessions since WWII. In what other human endeavor would we use just 11 data points and then decide to bet our hard-earned money? While average data can have meaning and give some grounds for comparison, it should be treated with heavy levels of skepticism when used as an argument for investing with conviction.

Let me tell you what we do know. Each and every recession is different from all the others and in different ways. That stands to reason, as the background economic environment was different for each one. The '70s and '80s were subject to serious levels of inflation. The recession at the beginning of this decade saw fears of deflation. Some happen with a strong dollar and some with a weaker dollar.

This recession is the result of serious bubbles in the housing and credit markets imploding. It is not the result of excess inventory or overinvestment in manufacturing capacity. As I have written numerous times, these excesses took years to build up and will take at least 2.5-3 years to correct. We are 15 months into the correction process. That is unlike any other recession we have experienced. So be careful in your use of comparisons based on historical averages.

One more point: since we do not know how long this recession will last, nor do what the results will be from further stimulus packages and hidden surprises, it is a mug's game to try and pick a bottom in the stock market based on some theoretical halfway point of this recession. You are going to hear over and over that markets anticipate the recovery about six months in advance. Given that this may be a very long and slow recovery that could be quarters away, be very cautious when you hear some bullish commentator using that "anticipation" rhetoric.

And with that said, let me now turn and look at some comparisons with past recessions that do offer some insight. By looking at how severe this recession is compared to previous ones, we can glean some idea of the level of problems we face now.

Back to 1982

The Institute for Supply Management released their October survey this week, and it was a shocker, helping send the Dow down by 10% in two days. It showed much more weakness than expected. This survey is collected from a large number of manufacturing firms. The ISM then makes an index of the data. For instance, if 60% of the reporting companies see new orders rising, then that would yield an index number of 60 for new orders. Anything below 50 shows negative growth. Below 40 shows a serious recession

The overall manufacturing number came in at a very weak 38.9. We are now down to levels not seen since September 1982. (Chart courtesy of Paul Kasriel and Northern Trust)

The internal data was even worse. New orders fells to 32, suggesting further weakness in the manufacturing world. Backlog of orders was 29. New export orders, a source of growth in recent months, fell from 52 to 41, a rather large drop for a single month. This shows the rest of the world is beginning to slow down as well. Boding poorly for employment, only 43% of companies reported that they were planning to add additional employees.

Nowhere was that illustrated more than in the auto sector. Last year sales were running at about 17 million new cars a year. Last month's annualized rate was 10.5 million, the lowest level since 1983. And a recovery might not be in sight for several years.

There is now about one car in the US for every person of driving age. An article in the Financial Times estimates that an extra 1.5 million cars a year have been purchased due to cheap financing, rebates, etc. If consumers decided they did not need more than one car, which would imply a flat growth rate, sales could drop by 3.5 million cars a year from the pre-crisis levels, which means Detroit would have a lot of spare capacity even after an economic recovery.

Further, I remember buying a car as a young man and not expecting it to last more than 80,000 miles before it needed major work or replacing. I now drive a 4-year-old Cadillac Escalade (I am a Texan, after all!) and it has 65,000 miles. I have a friend with an identical car that has 270,000 miles on it, and it is still running fine. My car could easily last me another four years, as could the cars of many people who bought new ones in recent years.

Basically, automobile manufacturers, in their drive to sell as much as possible, "brought forward" future sales of cars and, as a side effect, put lots of still quite good used cars on the road. New car sales are likely to be depressed for some time. It is somewhat like the housing problem. There is just too much inventory on the road that will have to be worked through. When Detroit gives me a real reason to buy another car, like an electric-powered vehicle, I will. And a lot of Americans, with a need to save money for retirement, are going to feel the same way.

As noted above, it seems that the service sector is now cyclical. The ISM Non-Manufacturing Survey results show broad-based weakness. The headline composite index dropped to 44.4 in October from 50.2 in September. This is the lowest in the 11-year history of this index. Indexes tracking new orders and employment also fell sharply, to 45 and 42 respectfully.

The data shows that we are sadly not yet close to the end of this recession. It is going to be a long slow Muddle Through Recovery. Do not expect a typical V-shaped recovery.

The Problems of Deleveraging

There is a quite humorous series of quote about the demise of the American consumer, starting with a Fed chairman in 1954 and going through one after another major financial figure in the ensuing decades. They have all been wrong. Predicting that the American consumer will change his profligate ways has not been a recipe for forecasting accuracy. This time, it may be different. Not because US consumers really wants to change, but that they may be forced to.

Look at the explosion of consumer debt (credit cards, auto loans, bank loans) over the last 20 years, rising to $2.6 trillion. Household debt, including mortgages, skyrocketed from 47% of personal income in 1959 to 117% in the fourth quarter of 2007. And from 25% of GDP in the first quarter of 1952 to 98%. (Gary Shilling)

Let's look at some numbers. Since 1 January, 2008, owners of stocks of US corporations have suffered about $8 trillion in losses, as their holdings declined in value from $20 trillion to $12 trillion. (Losses in other countries have averaged about 40%.) Homeowners will soon see their equity down by as much as $8 trillion, and those losses are likely to increase.

As highlighted here repeatedly, mortgage equity withdrawals counted for a full 3% of annual GDP growth in the period from 2002-2007. MEWs have fallen by 95%, and are falling again this quarter. Credit card debt is being reigned in. In fact, as the chart below shows, bankers are not surprisingly tightening lending standards to consumers, and raising their rates. (Again, from Haver Analytics, courtesy of Northern Trust)

Much of US GDP growth has been fueled by debt. And that debt is now going to be much harder to get, as equity in both houses and stocks has fallen precipitously.

Further, as detailed last week, US consumers are clearly cutting back. The retail sales figures that came out this week are dismal. J.C. Penney stores are down 13% year over year! At Nordstrom's, one of my favorite stores, sales are down almost 16% (six months ago they were growing at 10%!). Sales at major discounter Costco were down 1%. The Gap, The Limited, Target - store after store is down. Limited Brand sales are down by 70% from October of last year. All this does not bode well for Christmas sales. (Thanks to Greg Weldon of www.weldononline.com for that data.)

Remember how I talked about how auto manufacturers had cannibalized future sales? Credit cards have allowed many retailers to do the same. Money that goes to cut down credit card debt is money not spent today.

Consumers leveraged their way to higher levels of consumption, and now are going to be forced to reduce that leverage. Many others are going to see the need to increase savings to shore up retirement funds. People (and not just in the US, but throughout Europe) have learned that a home is not an investment.

Hedge funds are also being forced to de-lever. While for most styles of hedge funds, leverage was not all that high (an average of about 1.4 times equity), large redemptions, especially by funds of funds, are forcing sales of all types of assets, but in particular stocks. As an aside, this selling is not over. Mutual funds are seeing large withdrawals, and are also selling.

Large banks are being forced to reduce credit lines in order to shore up capital, as they must deal with subprime debt and other mortgage-related problems. Smaller banks are just now starting to deal with losses on commercial loans due to the economic downturn. That means that they will have to reduce their loan portfolios to meet capital requirements.

This is happening all over the world. Whole countries are imploding. Iceland? What were they thinking? Italian sovereign debt is now suspect, calling into question their ability to meet their deficits.

Just as consumers used debt to buy "stuff" they wanted now, so did businesses, banks, and governments. It powered a huge global growth boom. The Great Unwind will have the opposite affect, softening demand and weakening spending and growth. What leveraging did for growth, deleveraging will take back. It is likely to be a long, Muddle Through trip.

The IMF now projects that the developed world will slow by a collective 1% next year, dragging world growth close to zero. The export growth that has been powered by a cheap US dollar is destined to slow as world demand falls.

The good news? Oil prices are likely to fall even more, which will free up some money to be used in other ways. The ISM data showed that prices paid are falling, making inflation less likely. The US government deficit, under Democratic control, is likely to be $2 trillion in 2009, a staggering number to be sure. Without the pressure of inflation, and with the threat of outright deflation, it may even be that such a deficit can be managed. In the short term, this massive debt will provide a stimulus, lessening the effects of a deep recession.

The sad thing is that our children will be saddled with the debt for a very long time. Hopefully we spend it on things like infrastructure, which will be of some use to them, rather than on an endless stream of consumer stimulus packages that simply add to current debt.

As investors, businesses, and employers/employees, we will have to deal with the outcome of a major resetting of consumer spending. Unemployment will rise. Whatever stimulus package is enacted will mostly be used to draw down debt, and not actually spent. Businesses all over the world are going to have to rethink their growth plans to the extent that they were based on ever-rising US consumer spending. Earnings are going to be under real challenge in most industries. This is going to become more obvious as time goes by, and is going to challenge whatever bear market rally can be mounted.

All is not gloom and doom. The last major recession and problem period, in the '70s, saw a number of new businesses start and prosper (Microsoft, Apple, Intel, etc.). Businesses that have access to capital are going to be able to take market share and come out of this recession in much better shape. It is just a recession, after all, and will end. But I would suggest keeping your powder dry and being nimble. There are opportunities which will arise, as they do in every downturn. Just don't expect this recession to be like any past recession. Make your plans accordingly.

Make a note. I showed a chart a few months ago which illustrated that imports were falling, even as the trade deficit was not. This was because of the high price of oil. Oil at that time accounted for two-thirds of the trade deficit. When they tally the trade deficit for November in a few months, I think everyone will be surprised at how much the trade deficit has fallen.

This is something we will discuss in a future letter, as a lower trade deficit means there will be fewer dollars to buy US debt, just at a time when US debt will explode. That means that US citizens must save and buy that debt, or the Fed will have to monetize it, or rates will have to rise to attract capital. These are somewhat counterintuitive concepts and need explaining. But not this week. It is time to hit the send button.

New York, Birthdays, and Moving

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.

My #2 daughter, Melissa, turns 28 today. How do they grow up so fast? She is my wild child, though in recent years she has started to turn almost conventional in a few ways. We are going to celebrate her birthday next Monday evening with family and her friends, which will make for a very fun evening.

Moving both home and office in the space of two weeks is starting to look like rather a serious logistical challenge. While the home I will be leasing is large enough, so we can have room for my office (along with my small staff), it seems that I have way too much furniture between home and office. Not exactly a good market to try and get rid of used office furniture. And all those files? And an extra washer and dryer? Oh, well. Good problems to have.

Have a great week.

Your trying to figure out how to grow his business in this recession analyst,

John Mauldin

How Shall We Then Invest?

John Mauldin — Mon, 27 Oct 2008 23:36:06 GMT

How Should We Then Invest?
Those Wild And Crazy Analysts
The Evidence for Investor Overreaction
Stock Prices Are In Our Heads
Or, Maybe Investors Are Just Head Cases
Can We Actually Predict Earnings?
Buffett versus Grantham
Back to 1974?
Home Again and a New Home

Warren Buffett says buy. Jeremy Grantham says it will get worse. Both are celebrated value investors. Who is right? It all depends upon your view of the third derivative of investing. Today we look at valuations in the stock market. This is the second part of a speech I have given in the past few weeks in California and Stockholm. I am updating the numbers, as the target keeps moving. While from one perspective things look rather difficult, from another there is a ray of hope. What can you expect to earn from stocks over the next five years? It should make for an interesting letter. Note: this will be a little longer than usual, but part of it is there are a LOT of charts.

I should note that I am rewriting this on Monday. For the first time in over 8 years, I missed my Friday night deadline (see below). Last week's title for the letter was "The Economic Blue Screen of Death." By that I referred to the old "blue screen of death" that we used to get on early versions of Microsoft MS-DOS and Windows. You could be working away and suddenly, for no apparent reason, the computer would freeze up and you would get a blue screen. The only thing you could do was unplug the computer and hit the reset button - losing everything that was not saved when the computer crashed.

I likened this to the economic situation we are in now. With consumer spending "resetting" to a new lower level, we are going to have to hit the reset button on many business plans, and thus investments, as consumers are going to spend less and save more. Is that level 3% less? 5%? More? No one knows, but since we have not had a consumer-led recession since 1982, too many businesses assumed that the US consumer, like Superman, was bulletproof.

What will be the eventual savings rate? Will we get back to 7-9% from less than 1%? Maybe, because people are going to realize that savings today are the key to a happy retirement. That would put the new level of consumer spending a good deal lower than it has been. Thankfully, that climb in savings will not happen all at once but will play out over more than a few years. I think we will look back in the middle of the next decade and be quite amazed at how much US personal savings have increased. However, this is the Paradox of Thrift: what is good for the individual is hard on the economy, as by definition increased savings reduces consumer spending.

A quick point. This decrease in consumer spending that we are seeing now will not be a permanent condition. After we find that new lower level, consumer spending will start to grow again, albeit more slowly due to increased savings. That is because the US economy and population are growing, and increases in consumer spending are the norm in such conditions.

Now, and I have 100 Swedish witnesses for this, after I finished my speech Thursday morning in Stockholm for the institutional investors of Kaupthing Bank, I sat down and turned on my laptop, which is an Apple MacBook Air. There was a strange noise and then, I swear, I was staring at a blue screen. My Apple notebook, supposedly immune from the Blue Screen of Death, had frozen in a pale shade of blue. Later that night, over drinks, we speculated as to how Bill Gates could manage to do such things, remotely, in revenge. However, since the next day Apple in Malta could not fix it, I missed my deadline. I apologize. Now, let's jump right into the letter.

Those Wild And Crazy Analysts

Quick review: Last week we showed how consumer spending is falling, as we are in a recession. We then highlighted how analysts are dropping earnings estimates as time goes on. From projecting 15% earnings increases for 2008, they have dropped projections over 40% from March 2007 until today. Actual numbers will be much lower, as analyst projections for the fourth quarter are too high.

The same holds true for 2009. Since March of this year, just six months ago, earnings projections for 2009 have dropped 40% and are almost 10% lower than they were projected for 2008. However, estimates for operating earnings are still roughly double those for as-reported (or what's on the tax return) earnings. Analysts are still wildly overoptimistic. You can read last week's (October 17) letter here.

Now, let's look at the rest of the presentation. I argue in Bull's Eye Investing and this letter that we should look at long-term secular bull and bear markets not in terms of price but in terms of valuation. On September 26, 2003 I wrote about why we see long-term secular bear markets. I summarized the letter in the speech, but I think it will be useful to review a portion of it today. Remember, this was written in 2003, as a "new bull market" was already nearly a year old. The S&P 500 was at 1,000. So, for the last five years, you are down over 10%.

Investing is more than about price. It is about timing and valuations. Let's review. I put in bold some important points.

The Evidence for Investor Overreaction

Long-time readers know that it is my contention that we are in a decade-long secular bear market. It typically takes years for valuations to fall to levels from where a new bull market can begin. Why does it take so long? Why don't we see an almost immediate return to low valuations once the process has begun?

Because investors overreact to good news and underreact to bad news on stocks they like, and do just the opposite to stocks that are out of favor. Past perception seems to dictate future performance. And it takes time to change those perceptions.

This is forcefully borne out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled "Investor Overreaction: Evidence That Its Basis Is Psychological" is a well-written analysis of investor behavior which illustrates that perceptions are more important than the fundamentals. Let's look at that study in detail. Stay with me. This is important.

In any given year, there are stocks which are in favor, as evidenced by high valuations and rising prices. There are also stocks which are just the opposite. Dreman and Lufkin (or DL for the rest of this letter) look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based on perceived market valuations. They separately study Price to Book Value (P/BV), Price to Cash Flow (P/CF), and the traditional Price to Earnings (P/E). This creates three separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.

The top and bottom quintiles become stock investment "portfolios" for all three valuation measures. You might think of them as a mutual fund created to buy just these stocks. They then look ten years back and five years forward for these portfolios. There is enough data to create 85 such portfolios or funds. They first analyze these portfolios as to how they do relative to the market or the average of all stocks. They then analyze the portfolios in terms of five basic investment fundamentals: Cash Flow Growth, Sales Growth, Earnings Growth, Return on Equity, and Profit Margin. They do this latter test to see if you can discern a fundamental reason for the price action of the stock.

First, both the "out-performance" and "under-performance" of these stocks happens in the ten years leading up to the formation of the portfolio. Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The "in-favor" stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.

I should point out that other studies, which Dreman does not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors jump in. The Dalbar study, among many others, shows us that investors do not actually make what the mutual funds make because they chase the hottest funds, buying high and selling low when the funds do not live up to their expectations. The key word, as we will see later, is expectations. Other studies document that investors tend to chase the latest hot stock and shun those which are lagging in price performance. Thus, forming a portfolio of the highest-performing quintiles is an uncanny mirror to what happens in the real world.

Why does this "chasing the hot stock" happen? DL tells us it is because investors become overconfident that the trends of the fundamentals in the first ten years will repeat forever, "... thereby carrying the prices of stocks that appear to have the 'best' and 'worst' prospects. Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues. Such forecasts result in favorites being overpriced, while out-of-favor issues are priced at a substantial discount to the real worth. The extrapolation of past results well into the future and the high confidence in the precise forecast is one of the most common errors made in finance."

The more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.

Since you are not looking at the graphs, let me describe them for you. Predictably, the fundamentals improve quite steadily for the first ten years for the favorite stocks in comparison to the entire universe of stocks. But the price performance rises at very high rates, far faster than the fundamentals, particularly in the latter years. It clearly accelerates. It seems the longer a stock does well the more confident investors are that it will continue to do well and thereby award it with higher and higher multiples. The exact opposite is true of the out-of-favor stocks. Even though many of the fundamentals were actually slowly improving in relationship to the market as a whole, the stocks were lagging and the market punished them with ever-lower relative prices.

At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends. This re-strengthened the perceptions about these stocks and increased the level of confidence about the future. Again, past (and accumulated and reinforced over time) perception creates future price action.

Never mind that it is impossible for Dell to grow 50% a year or GE to compound earnings at 15% forever. As many times as we say it, investors continue to ignore the old saw "Past performance is not indicative of future results."

How much better did the good-performing stocks do than the bad-performing stocks in the ten years prior to creating the portfolios? The highest P/BV (Price to Book Value) stocks outperformed the market by 187%. The lowest stocks underperformed the market by -79%, for a differential of 266%! If you look at the P/CF (Price to Cash Flow) the differential between the two is 172%.

Yet in the next five years, the hot stocks underperformed the market by a negative -26% on a P/BV basis, and -30% on a P/CF basis. The out-of-favor stocks did 33% and 22% better than the market, respectively. This is a HUGE reversal of trend.

So, what happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the all-stars? The answer is a very curious "no."

"... there is no reversal in fundamentals to match the reversal in returns. That is, as favored stocks go from outperforming the market, their fundamentals do not deteriorate significantly, in some cases they actually improve.... The fundamentals of the 'worst' stocks are weaker than both those of the market and of the 'best' stocks in both periods."

In some cases, the trends of the worst stocks actually got worse. Even as the out-of-favor stocks improved in relative performance in the last five years, their cash-flow growth actually fell from 14.6% to 6.6%. While cash-flow growth for the best-performing stocks did drop by 6%, it was still almost 2.5 times that of the lower group. Read the following carefully:

"Thus, while there is a marked transition in the return profiles [share price], with value stocks underperforming growth in the prior period and outperforming growth stocks in the measurement period, this is not true for fundamentals. In nearly every panel [areas in which they made measurements], fundamentals for growth stocks are better than those for value stocks both before and after portfolio formation."

"Although there is a major reversal in the returns [prices] to the best and worst stocks, there is no corresponding reversal in the fundamentals." In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks. The data and the graphs clearly show that the fundamentals for the growth stocks clearly beat those of the value stocks, even for the five years after portfolio formation.

And yet, there was a very stark reversal in price. Why, if not based upon the fundamentals?

DL goes to another research paper, which shows "... that even a small earnings surprise can initiate a reversal in returns that lasts many years." They demonstrate that negative surprises on favorite stocks result in significant underperformance of this group not only in the year of the surprise but for at least four years following the initial event. They also show that positive surprises on out-of-favor stocks result in significant outperformance in the year of the surprise, and again for at least the four years following the initial event. DL attributes these results to major changes in investor expectations following the surprise.

So where was the overreaction? Was it in the years leading up to the surprise, which resulted in a very high- or low-priced stock (relative to the fundamentals), or was it in the immediate reaction to the surprise?

Other studies show analysts (as opposed to investors) are too slow to react to earnings surprises by being too slow to adjust earnings. Even nine months later, analysts' expectations are too high. (We will see this as we look at analyst performances today!)

Stock Prices Are In Our Heads
Or, Maybe Investors Are Just Head Cases

Dreman and Lufkin then come to the meat of their analysis. For them, underreaction and overreaction are part and parcel of the same process. The overreaction begins in the years prior to the stock reaching lofty heights. As Nobel laureate Hyman Minsky points out, stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction.

The cause of the price reversal is not fundamentals. It is not risk, as numerous studies show value stocks to be less risky.

"We conclude," they write "that the cause of the major price reversals is psychological, or more specifically, investor overreaction."

But DL go on to point out that when the correction comes, we tend to (initially) underreact. While we do not like the surprise, we tend to think of it as maybe a one-time thing. Things, we believe, will soon get back to normal. We do not scale back our expectations sufficiently for our growth stocks (or vice-versa), so the stage is set for another surprise and more reaction. It apparently takes years for this to work itself out.

As they note in their conclusion, "The [initial] corrections are sharp and, we suspect, violent. But they do not fully adjust prices to more realistic levels. After this period, we return to a gradual but persistent move to more realistic levels as the underreaction process continues through [the next five years]."

The studies clearly show it takes time for these overvalued portfolios to "come back to earth" or back to trend. Would this not, I muse, apply to overvalued markets as a whole? Might this not explain why bear market cycles take so long? Is it not just an earnings surprise for one stock which moves the whole market, but a series of events and recessions which slowly change the perceptions of the majority of investors?

Thus my contention that we are in just the beginning stages of the current secular bear market. These cycles take lots of time, anywhere from 8 to 17 years. We are just in year three, and at nosebleed valuation levels. The next "surprise" or disappointment will surely come from out of nowhere. That is why it is called a surprise. When it is followed by the next recession, stocks will drop one more leg on their path to the low valuations that are the hallmark of the bottom of secular bear markets. [Note: I wrote that in 2003.]

Given the level of investor overconfidence in the market place, and given the length of the last secular bull, it might take more than one recession and a few more years to find a true bottom to this cycle. It will come, of course.

But in the meantime, investors would do well do examine their own perceptions about the future, both positive and negative, and see if they might possibly be clouding their investment strategies. Remember, just because stocks are in a secular bear cycle does not mean there are not plenty of investment opportunities in other markets and strategies.

Just as there is more to life than work and money, there is more to investments than the stock market.

Can We Actually Predict Earnings?

Ed Easterling of Crestmont Reseach offers us the following very important chart. It is reported earnings compared to the historical trend line. As I have repeatedly written, earnings, especially when seen from a valuation standpoint, are mean reverting. They will fluctuate around the long-term trend line. And interestingly, that long-term trend line is nominal GDP. (Nominal GDP includes the effects of inflation.)

Total corporate earnings for any particular large country and stock market by definition cannot grow faster than nominal GDP (though individual stocks can do so). And since the S&P 500 is largely reflective of the US corporate world, earnings for the S&P 500 index will fluctuate around nominal GDP.

Notice how smooth that growth line for nominal GDP is? That will be important in a few paragraphs. But first, let's look at how well Easterling's historical trend line (which is nominal GDP) compares with Robert Shiller's ten-year smoothed earnings. Rather than use the earnings from any one year, which as we know can fluctuate wildly, he smoothes them by using a ten-year average.

Important: Notice how closely correlated the earnings for Crestmont's nominal GDP and Shiller's smoothed earnings are.

Now, this is where it gets interesting. Shiller's data is not predictive. But remember how smooth the earnings trend line from Crestmont was? Ed contends, and I agree, that there is a predictive element when we use nominal GDP. In other words, at some point in the future, earnings will grow back to and then exceed the long-term trend in nominal GDP.

So, while we are in the process of dropping below the mean or below the long-term trend line of earnings in terms of nominal GDP, we can be confident that at some point in the future those earnings will again revert above the mean. It seems to have been part of the economic laws since the time of the Medes and Persians.

This has important implications for future values. Let's look at the next graph, from Vitaliy Katsenelson. Vitaliy uses a 6% growth of earnings as his baseline (which is, not coincidentally, very close to the long-term rise in nominal GDP). Again, notice how earnings fluctuate around the mean.

Notice also the small box on the right, which show where earnings could actually fall to if earnings drop by the same percentage as they did in the 2000-02 recession. That would suggest that earnings will drop below $40, from the currently projected $48. Remember, last year projections for 2008 were $82.

We will come back to this; but if we can project that at some point in the future earnings will once again revert to nominal GDP trendline, then we can make some projections about what earnings will be in the future, or at least what "trend" earnings should be!

Buffett versus Grantham

On October 16 Warren Buffett wrote an op-ed in the New York Times called "Buy American. I am." Quoting from the beginning of the piece:

"THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

"So ... I've been buying American stocks. This is my personal account I'm talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

"Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation's many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now."

Jeremy Grantham, head of GMO, which manages $150 billion, has another opinion. Note that Grantham lost a great portion of his management business in the late '90s when he decided that the tech market was a bubble and did not participate. His huge pension fund clients decided he did not "get it" and left him in large numbers. He was right, they were wrong, and now his business is vastly larger. And again, he is putting his opinion and client money on the line. This from a recent Money Magazine article (courtesy of my friend Richard Russell):

"Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn't hit the lows it should have. Before it could, the housing bubble and tax cut that followed 9/11 kicked off the biggest sucker rally in history from 2002 to 2006. So I think the market isn't cheap yet. There is more pain coming. I don't think we'll hit the low until 2010.

"Previously in the interview, Grantham had this to say. 'All you have to do is open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk-taking People were just shoveling their money into risk on the pathetic idea that risk is always rewarded. You don't get rewarded for taking a risk. You get rewarded for buying cheap. Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1(for every $30 of assets they put up $1 of equity and borrowed the other $29). At leverage of 30 to 1 you have to lose only about 3% of your $30 worth of assets and your dollar of equity gets wiped out. You're bankrupt."

So, who is right? And the answer depends on your view of what I call the third derivative of value investing. The first two are price and earnings. The third derivative is time.

Long-time readers know I contend that markets go from high valuations to low valuations and back to high over very long secular bull and bear markets which last anywhere from 13-20 years, or about 17 years on average. These cycles do not stop in the middle and reverse. They tend to go the full course. That is why I could contend back in 2003 that were we not in some new long-term bull market. Valuations had not reached the levels from which bull markets are made. Stock market cheerleaders tried to spin it, but valuations are the fundamental ground of investing. You ignore them at your own peril.

Now, let's look at two more charts from Vitaliy. These show the long-term secular cycles in terms of valuation, both from one-year and ten-year smoothed P/E ratios. Note that we are not back to even below the mean, much less to some place we could call "low."

So, let's be a bit of an optimist. Let's look at yet another chart from Crestmont Research. What happens if stock market earnings revert to the mean in either 3 or 5 years? Ed also assumes that P/E ratios once again rise back to 22.5. From last Friday's close, such a reversion would yield very handsome returns: 23.5% compounded for 3 years and 15.9 % for five years. If you believe like Buffett that US earnings will revert back to (and above) the mean, then that suggests this is a time to buy, if you are buying for the long term. The full report is at http://www.crestmontresearch.com/pdfs/Stock%20PE%20Report.pdf

Back to 1974?

Go back and look at the valuation charts above. Note that in late 1974 valuations were still at about their long-term average. Buying then was not compelling from a valuation standpoint. But Richard Russell called the bottom in one of his more famous calls late in the year. And it was a "price" bottom.

There was a great deal of volatility in the next eight years, and another recession at the end of the period, before valuations finally got down to extremely undervalued single-digit levels. Thus, those years saw a rising stock market and ever-lower P/E ratios. That happened as earnings grew faster than the prices of the stocks! Why did prices not rise along with the earnings growth?

Now, gentle reader, we come full circle, back to the Dreman and Lufkin study. Investors, twice burned in the late '60s and early '70s, were reluctant to get back into the market in a large, overtly bullish way. They were cautious.

I think we may be in a reflection of that same period. While it is possible we have put in the lows for this cycle, I think that as the recession will be deeper and longer than most of us have experienced (think 1982), we will see more rounds of earnings disappointments. I think the market has more downside in its future. But sometime, whether it was last week, or a few quarters in the future, we are going to see a cycle low in terms of price.

But it will most likely be a repeat of 1974-1982. Lots of volatility. Very large run-ups followed by quick and vicious sell-offs on the way back up to new highs. This is NOT going to be a recovery back to new highs in two years. This is going to take a long time. Further, I don't think nominal GDP will be 6% for the next three years, for reasons stated last week.

Investors are going to get their hearts broken by their favorite companies time and time again. The economic news will not be good for another year at a minimum. This is not the stuff that wild bull markets are made of. That time will come, but it is not yet.

That being said, I am a believer in American business. They will figure out how to maneuver and prosper in this new environment. In 12 years, earnings will have doubled from the trend of last year, which suggests earnings could be $140 in 2020. Put a multiple of 20 on that and we have an S&P 500 at 2,800, up over 3 times from today. That is the long view.

How Should We Then Invest?

Am I personally a buyer today, like Buffett? No, as I think that in a secular bear market you should see absolute returns rather than the relative returns of passive index investing. And, I think there is more pain to come in the market. But there are opportunities other than index funds or long-only mutual funds. So, where should we put money to work today?

While I don't want to be long an index fund, if you are a stock picker (as Buffett is), then there is value out there. And if I am right and there is some more downdraft in the markets, then there will be more value in the near future. This is not a time for hope, it is a time for conviction. I wrote several long chapters in Bull's Eye Investing on value investing. Vitaliy Katsenelson recently wrote a book called Active Value Investing. It is a good guide. http://www.amazon.com/Active-Value-Investing-Range-Bound-Markets/dp/0470053151/ref=sr_1_1?ie=UTF8&s=books&qid=1225134991&sr=1-1 Take your time. There is no hurry. But start your analysis and research now.
I like active absolute return managers and investing. In particular, I like actively managed commodity funds which have a bias for volatility. Note: this is NOT an endorsement of long-only commodity index funds. Also, there are a small number of active managers who have demonstrated an ability to navigate this market. As Buffett says, it is not until the tide goes out that we know who is swimming naked. We now have a MUCH better idea of what volatility can do to an investment manager and his systems, and who understands the meaning of the word hedge.
It is somewhat heretical to say it in this market, but there are specific styles of hedge funds I like. We are seeing the gut-wrenching demise of many black-box quantitative hedge funds. Hopefully, investors have learned their lesson. There is no free lunch. However, I think that long-short hedge funds (and the few mutual funds that use that style, like John Hussman's) will once again find an environment in which they can prosper. If you want to be in the market, this makes a lot more sense to me.
I think that sometime next year it will be time to really think seriously about emerging market investments. Those markets have in general been beaten down far more than the developed-world markets. And the developed world is going to be growth-challenged in respect to emerging markets. You can find some real value. As an example, the largest liquor distributor in Thailand now pays an 8% dividend. Why? Because it was a large part of Thai index funds, and foreigners unloaded those funds in the current sell-off. And while Sweden can hardly be called emerging, last Thursday institutional investors were talking about the value there as foreigners have fled their markets, pushing values down.

Now, here's a rule. Write this down. If you are going to invest in an emerging market, make sure it is with someone who knows that local market. I do not want to have a manager with the name of Smith sitting in New York looking at a computer screen investing in Thailand for me, and neither should you! You need someone who understands the local scene.
Income is going to be critical. If you are going to put some money into bonds and other fixed-income instruments (not funds!), you should be doing it now. As I have been writing, there are simply steals out there in the fixed-income markets, as the margin clerks are forcing funds and individuals to sell any- and everything. The prices we see today will not be there in six months, and I doubt they will be there in three. If you are a fixed-income investor, you should be buying with both fists. But only if you know what you are doing. This is not the time for on-the-job training. Sometimes those bonds are selling at low numbers for a reason other than liquidity and margin calls. If you are not a seasoned fixed-income investor, then get professionals to help you. For portfolios of over $250,000 I can help you find a manager.
As I wrote months ago, we are seeing the rise of a new asset class I call Private Credit. These income and asset-backed lending funds are going to take market share from banks and become a market force of their own.
While today may not be the time in all markets, it will not be too long until you will be able to find either residential or commercial real estate at distressed prices almost anywhere, which you can buy and then rent out. Buying real estate at the right price and letting someone else pay down the loan is a proven formula for wealth in many a millionaire household.

In general, your target is not to beat the market. It is to beat zero. As I have written for years, the investors who win in this market are the ones who take the least damage.

Home Again and a New Home

It is good to be home from all my travels. Other than a trip to the Minyanville Christmas party in New York, I have no plans for travel until mid-January and not much more after that, although I know that will change. But it will be good to stay here and focus on writing the next book with Tiffani.

And speaking of home, I lease my abode, having sold my home years ago. I can lease cheaper than I can buy. But we now find in this market we can lease at even much better rates. We can lease a very large home in Dallas and move my office and small staff into part of it, cutting my total office and home payments by about 30-40%. There are several homes we have viewed that have good set-ups for a small office. In a few minutes, Tiffani and I will leave to go and look at the final selections, and we will make our choice. I will miss my office at the Ballpark, but saving one month a year in commute time as well as a lot of dollars just makes sense and cents.

This letter is overly long already, so I will hit the send button. Have a great week and remember, we will get through this.

Your looking for value analyst,

John Mauldin

The Economic Blue Screen of Death

John Mauldin — Sat, 18 Oct 2008 03:34:31 GMT

The Psyche of the American Consumer
The Consumer Weakens
The Paradox of Thrift
An Economic Blue Screen Of Death
Those Wild And Crazy Analysts
London, Stockholm, Malta, and Becoming a Grandfather

This week I am in California giving two speeches to the Financial Planning Associations of San Diego and Orange County. This and next week's letters will be the broad outline of the speech. We will look at how the retreat of the American consumer will affect the stock market. Has the recent drop (can we say crash, gentle reader?) in stock market valuations given us an opportunity to find value? We look at some very powerful evidence that suggests that may be so. Then we look at the counter to that view. Are we at the bottom, or is there more pain? And given the current state of affairs, how should we then invest? Where do we put our money to work when the dust settles, as it surely will.

As I noted above, this will be a two-part letter, finishing up next week. It will also print out a lot longer than normal as I have a lot of PowerPoint slides that are really important for you to see. A note to the 25% of my one million-plus readers who are outside the US: I am using illustrations from the US stock market to discuss timing and valuations, but the principles will translate to markets worldwide. In fact, considering that most stock markets worldwide are down even more than the US markets, they may be even more applicable. The time to become bullish on a lot of markets may be closer than we think. Let's jump right in.

The Psyche of the American Consumer

You have to have a bit of humor, and I think this cartoon says a lot.

The psyche of the American consumer has been seared, and perhaps permanently, reminiscent of the manner in which our grandparents who lived during the Great Depression were permanently scarred with the memories of that time. How it works out will be different this time, of course, and we will explore that later on. But one thing that is very likely is a major impact on consumer spending going forward. Let's look at a few facts on the state of the consumer.

The Consumer Weakens

Retail sales have fallen for the last three months. This is the first time sales have fallen in such a manner since the record keeping began. They are falling at an annual rate of 2%, which is unprecedented.

Auto sales are down, virtually in freefall, with many auto company sales down more than 30% (Volvo is down 50%!). And it may get worse. GMAC, the financing arm of GM, has announced it will not lend to anyone whose credit score is not 700 or more! Only 58% of Americans qualify. That means, for a large swath of the consumer marketplace, cheap auto financing is a thing of the past, unless auto companies underwrite loans with guarantees.

However, what we are seeing is auto companies abandoning leasing programs and other traditional marketing avenues in order to search for elusive profits. Where you could buy a car two years ago for little or no money down, many dealers are now requiring an average of 12% down. While this makes sense, it is definitely a change.

And it is not just in the US. Auto sales throughout Europe are off significantly, especially in countries that had their own equivalent of the US housing bubble.

How bad is it? We are becoming a morose nation, staying at home to drown our sorrows - even bar sales are down, almost 1%. While I am sure this audience is doing its part to help out the bartenders of the world, our clients are not.

Falling consumer and retail sales are not surprising, given the fact that almost one million jobs have been lost in the last 12 months, bringing unemployment to 6.1%. California, which is a bellwether state, has seen its unemployment rise to 7.7%. That is a (sadly) reasonable target for nationwide unemployment. Back-of-the-napkin analysis suggests that means at least another million jobs will be lost this cycle.

Falling consumer sales are showing up in the share prices of retailers and shopping mall REITs. Many are down to prices last seen 12-16 years ago, with price drops far below the market averages. Think Vegas is immune? MGM and Trump, to name just two, are down 90%!

But we lost a lot of jobs in the last (2001-2002) recession, and consumer spending did not go down. Won't the present trend reverse soon? Might it not just be from the shock of the credit crisis? And with gasoline prices down, giving us a $100 billion plus "tax break," is the worst not over?

It is reasonable therefore to ask why it should be different this time. Predicting the demise of the American consumer has been a favorite pastime of bearish analysts for over 50 years. And they have always been wrong. The American consumer has proven resilient through feast and famine, war and peace. But, the data and circumstances suggest this time may be different.

Let's look at the data that came out this week on the delinquency rates of various types of consumer debt. The delinquency rate on auto loans is 3.8%, up from 2.9% two years ago. Consumer finance? Up to a very high 8.3%. Credit card delinquencies are 4.8%, rising from 4%. Is it any wonder credit card companies are cutting credit lines and raising interest rates to try and stem the bleeding? Mortgage delinquencies have doubled from 2.5% to a current 5%. Consumer credit in general is up to 5% delinquent, more than two-thirds higher than two years ago. This is all illustrative of a consumer in trouble.

Look at this next chart from John Burn Real Estate Consulting. He surveys hundreds of homebuilders nationwide. The long and short of it is that new home sales forecasts are at all-time lows. Traffic (potential buyers) looking at new homes is dismal. In my own area in Dallas, there are brand new homes which builders are willing to lease at very attractive rates in order to generate some cash flow, at much less than the cost of buying. And given the level of prospective buyers looking for a new home, that is a trend likely to continue.

I should note that this morning housing permits fell to a 26-year low, around 786,000. But that statistic can be misleading. Back in 1982, the population of the US was 230 million. Today it is 305 million. We are roughly one-third larger. If you adjust for population, the number would be in the 600,000 range, which is far worse than a mere 26-year low. Those permits mean jobs, and permits need to rise with the population to maintain the job base.

And since we're looking at today's data, the Michigan consumer sentiment number simply fell off a cliff, plunging to 57 from over 70 last month and an average of 85 last year. It was only a few years ago that the number was over 100. The last time it was this low? We were in the midst of a very serious recession in 1982.

Let's get back to housing. This next chart is from www.dismal.com, showing the fall-off in mortgage applications. Mortgage applications for purchase are down by over 30% since the end of 2007, and down much more than that from the peak of 2006, as the subprime lending market has disappeared.

Let's pay particular attention to the fall-off in applications for re-financing, down by almost 60%. This was the source of mortgage equity withdrawals, which fueled consumer-spending growth even in the face of the last recession. Let's look at a graph I used two years ago, from work done by James Kennedy and Alan Greenspan, on the effect of mortgage equity withdrawals (MEWs) on the growth of the US economy.

Notice that in both 2001 and 2002, the US economy continued to grow on an annual basis (the "technical" recession was just a few quarters). Their work suggests that this growth was entirely due to MEWs. In fact, MEWs contributed over 3% to GDP growth in 2004 and 2005, and 2% in 2006. Without US homeowners using their homes as an ATM, the economy would have been very sluggish indeed, averaging much less than 1% for the six years of the Bush presidency. Indeed, as a side observation, without home equity withdrawals the economy would have been so bad it would have been almost impossible for Bush to have won a second term.

Now let's look at the update that James Kennedy posted last week to his numbers. While he does not have an update to the chart above, we do have the actual numbers for new mortgage equity withdrawals through the second quarter of this year. And what they show is MEWs simply withering on the vine. The engine of our GDP growth has essentially been turned off. Look at the fall in the numbers for yourself:

In 2005 there was almost $595 billion in mortgage extractions that went into some kind of consumer spending. Remember, according to the graph above, that translated into a 3% rise in GDP. In 2007, MEWs were down to $470 billion, for a boost of 2% to GDP.

The second quarter of 2008 saw an anemic $9.5 billion. At that run rate, we could see a drop-off of over 90% from 2005! Now, think what the second quarter would have been without the federal stimulus program of $150 billion. It might have looked and felt like this quarter!

While credit card growth has indeed risen to take up some of the "slack," it is nowhere near the previous levels of MEWs. With almost 20% of American mortgages either now or soon to be "under water," and because lending standards are tightening, it will be a long time before we see a significant upsurge in home equity withdrawals. Whatever growth we see in the next few years will have to come from old-fashioned sources, like real productivity and reality-based lending. Homeowner hallucinations are a thing of the past.

And for those of you who like to digest your numbers visually, here is the chart of the decrease in MEWs.

It is likely that whatever recovery we see will be slow in coming. Without MEWs, the period from 2001-2007 would have seen GDP growth of less than 1%! What has changed for the better? It is going to be a rather serious recession and a slow Muddle Through recovery of several years. Unless Obama, Pelosi, and Reid push through their tax increase. Then it will be a lot longer. Maybe even a repeat of 1980 and 1982, where we had back-to-back recessions in two years. Increasing taxes in a recession is the worst possible economic policy. You increase taxes, from an economic perspective, in good times.

Last year, I predicted we would see three things as a result of the bursting of the housing and credit crisis bubbles:

1. We are in a period where earnings disappointments are going to be the rule, not the exception.

2. Lower corporate profits puts pressure on the stock market,

3. Resulting in lower than expected long-term returns.

Let me add a fourth. The psyche of the American consumer has been seared, and perhaps permanently.

The Paradox of Thrift

We are (finally!) going to see US consumers start to increase their savings. Increasing home prices and increasing stock prices made many consumers feel comfortable that their retirement future was assured. Now that feeling has been crushed. Home values are not likely to bounce back for a very long time. And as I have written for a long time, we are facing a low-return environment for stocks.

Now, while it is a good thing for an individual to save money, it is not good for the economy as a whole, at least in terms of consumer spending and GDP growth. This is the Paradox of Thrift.

An Economic Blue Screen Of Death

The lack of the ability to borrow on homes, coupled with the need to save more money, is going to put a large dent in the US and world economy. My older readers will remember the Microsoft "blue screen of death" that would pop up from time to time when your computer froze. All you could do was hit the reset button. It is as if we have hit a giant economic blue screen of death. All we can do is hit the reset button. We are going to a new, lower level of consumer spending on an absolute basis, and perhaps as a percentage of GDP. Once that new level has been reached, we will start slowly growing from there; but until that point, the growth of the US economy is going to be severely challenged. We got ahead of ourselves through borrowing and confidence in the bull market, and now we have to deal with the new reality.

That means corporate earnings for many US companies are going to come under increased pressure. And as we will see below, the drop in corporate earnings is in line with the drop in the stock market.

Those Wild And Crazy Analysts

Look at how the projections for earnings per share for the S&P 500 have dropped over the past year. Every few months, estimates have dropped. It will get worse (teaser for next week: we look at graphs which show where earnings may go if they drop as much as in the last recession. And remember, that recession had growing consumer spending!).

Given the malaise and mood of the US consumer, the already low numbers for this year are likely to be revised down again. Let's go to the chart:

Now let's look at 2009 projections.

Notice that in February of 2008, earnings for 2008 had been revised downward to $71.20. But analysts were still bullish. They projected the next month an almost 10% increase in earnings for 2009. They are now down to $48. Remember the old Limbo song, "How Low Can You Go?" 2009 earnings can go a lot lower.

One last graph for this week and then we will call it a day. This is the actual data from S&P, which I copied from their web site. Notice the huge disparity between the as-reported earnings and operating earnings estimate for 2009. The operating earnings are literally double the reported earnings. Reported earnings are what companies use for tax purposes. They are also the basis for any historical comparisons you see. Operating earnings are what I call EBBS or Earnings Before Bad Stuff, or whatever term you use for BS.

The operating earnings estimates are "bottom up" (no pun here). That means that S&P gets the estimates from each of the analysts that follow the individual companies, and add them up for the estimate. The top-down estimates take into account economic conditions. It makes a HUGE difference as to who is more accurate. If the optimists are right, we are at single-digit price to earnings ratios (around 8). If the as-reported team is right, we are at relatively high levels, even after the recent large drop. How high? As of 11 AM Pacific, the 2009 P/E projected ratio is 20.2. That is not a level from which major bull markets are launched.

But is that the level we should be looking at? As we will see next week, if you take a longer-term view of a few years, you can make a case that we are getting closer to a secular bear price-cycle low. Next week, we look at how secular bear markets work and where we could go, and then I offer a few areas where you can look to place your portfolio. I am getting closer to the time when I can be cautiously optimistic.

We will get through this current crisis, and the falls in prices of assets of all types are beginning to create some real opportunities. We will explore those thoughts and a lot more next week.

London, Stockholm, Malta, and Becoming a Grandfather

As noted at the beginning of the letter, I am in California, but will fly home this afternoon. Tomorrow I explore some of the local Dallas housing values (leasing) and then fly on to London in the late afternoon, meeting with my London partners, Absolute Return Partners for a fast few days, and then on to Stockholm where I speak and will chair the day's events for Kaupthing Bank, which was a branch of the Icelandic bank a few weeks ago but now has been taken over by the Swedish government. I expect to learn a lot. And I get to spend some time with old friend Marc Faber. The original focus for the day, many months ago, was "Investing in an Age of Scarcity," but we will expand the topics covered with a nod to current affairs.

Then an ungodly early wake-up call, and on to Malta on Friday, where I will be involved in a series of board meetings of various hedge funds. Even more interesting. Saturday I start to work my way back to Dallas, and then I am mostly home for the next three months, where I will be researching and writing with Tiffani our new book, called Eavesdropping on Millionaires. We have been interviewing millionaires from all levels and from all over the world, but their stories have some common threads. This has had a huge impact on both Tiffani and me. I hope we can convey in the book what we are learning. It is changing my outlook and habits, I can tell you.

I got a text message late last night from my oldest son Henry. He assumed I was already asleep, but I was still up working. He wrote: "I know you wanted us to wait a little longer, but you are going to be a grandpa." He wrote a few more nice thoughts, along the line of wanting my advice and wisdom, etc. Like I have a clue. I feel supremely lucky that my (7!) kids have turned out so well. And we all enjoy and love one another, and I get to spend time with them as young adults. And I guess almost 60 is not be that bad to be a first-time grandfather. Should be an interesting and fun new chapter in my life, if my many friends who have traveled that road are any indication.

It is time to hit the send button. I have this speech to do in an hour, and my really good friend Rob Arnott is coming to have lunch. Life is a lot of fun. Enjoy your week and remember that friends, family, and health are where our true wealth is.

Your thinking more about the Big Stuff analyst,

John Mauldin

The Rise of A New Asset Class

John Mauldin — Fri, 01 Aug 2008 15:44:36 GMT

This week I am in Maine on vacation with my son, and next week is my daughter Tiffani's wedding, so for the next two weeks I am going to send an updated version of a speech I have been giving the past few months on what I think is the likely potential for the rise of a brand new asset class. It is too long to be sent as one letter, so we will start with the first part today and finish with the second part next week. This first part can be read as a standalone letter.

The Rise of A New Asset Class

I think we're at a watershed moment, what Peter Bernstein defines as an "epochal event," with the very order of the investment world changing as it did in 1929, in '50, in 1981, where a number of things came together - it wasn't just one thing but a number of events happening that conspired to change the nature of what worked in the investment world for the next period of time. It took most people a decade after 1981-2 to recognize that we were in a different period, because we make our future expectations out of past experience. It's very hard for us to recognize a watershed moment in the process. We're going to look back in five or ten years and go, "Wow, things changed." As we will see, it's going to be a change that's going to cost people in their portfolios and in their retirement habits.

We're going to look at a number of different concepts and separate ideas that in and of themselves don't make that much difference. But I think their confluence in the present moment is going to change things.

Now, some of this is new, some of it is old. The old stuff we're going to fly through. Most of you have been reading me for a while now, and you've got the concepts down. So let's start.

The first thing to note is that we're in a Muddle Through Economy. We're in a recession that's fueled by the bursting of two bubbles: the housing bubble and the credit crisis. The real question is: when do we come out of the recession? At what time do we come back to trend growth, which is 3 to 3.5 percent a year?

I believe that over the next 20 years the US economy will grow at roughly a rate of 3 percent compounded, in real terms. But I believe that we have some headwinds for the next year or two. So I think the real bottom of this economic cycle will be later this year, during the fourth quarter and possibly into the first quarter of next year. But it will take two years, for some reasons we are going to get into, to get back to long-term trend growth. It will take much longer than normal because the things that created the problem – the housing bubble and the credit crisis – aren't things that can respond to Fed policy, and they aren't things that can respond to the normal cycles. It's going to take a long time to work through these.

First, we had an investor-driven transaction bubble in housing. There were 48% more houses built since 2005 than should have been built, if you were simply looking at trends.

What that means is there are 3.5 million homes we have to work through. Now, that means that the 8 or 9 hundred thousand homes that we're now down to building a year, is going to end up going down to 400,000. It's going to take some time to work through those excess homes – for the prices to drop enough that people can go in and buy them or rent them. We are probably talking 2011 before we finally work through this housing crisis and get back to a normal market where housing contributes significantly to GDP growth.

Sales activity is probably going to correct another 30 percent. That's not fun. By the middle to the end of this year, sales are going to be really low. As a side issue, those of you who like to invest in real estate and actually want to own a home to rent are going to have some good opportunities.

Let's look at the credit crisis very quickly. We vaporized 60 percent to the shadow banking system, the SIVs and CDOs, the people who actually bought US mortgages, who bought student loans, who bought credit cards, who bought car loans. That's gone and it's never coming back. As we'll see, it's going to take well into the next decade for us to create a completely new infrastructure to replace the broken one. It took decades to get to where we were last year. I don't think it will take decades to recover, but it's going to take five, six, seven years. That means things are going to be difficult if you want to borrow money. Credit spreads are going to be wider; it's going to affect you more. By the way, if you're in business, if you're paying more, it's going to put pressure on your profits.

Let's look at GDP growth for the last ten years, with and without mortgage equity withdrawal.

Without MEW, we would have had two years, in 2001 and 2002, with negative GDP growth. We're not going to go get those levels of mortgage equity withdrawals today, not in this environment. We're still seeing some cash-out borrowing, but it's getting more and more difficult; and as home values drop, there are going to be fewer and fewer people pulling less and less money out of the "home ATMs." As Paul McCulley says, your home ATM is starting to spit out negative twenty-dollar bills.

That means consumer spending is going to continue to slow. We haven't had a consumer recession since 1990-91. There are a lot of people today who have kind of forgotten that consumer spending can actually slow down. That's going to happen from lower mortgage equity withdrawals, and it's going to happen because of higher gas and energy costs that are displacing normal spending. You've got to fill up your Ford F-150 to be able to get to work. I saw $4 a gallon gasoline when we arrived in La Jolla. I mean, I guess around here people don't really pay attention, but that means it would cost a hundred bucks to fill up my big SUV. That's just a lot of money. That's a hundred bucks I can't spend on something else – on clothes or kids or education. It means I'm going to be consuming less.

We're in a recession. Recessions by definition mean that we're going to be seeing rising unemployment. We're already up past 5.5 percent. We'll probably see 6 percent and maybe higher. We're not going to see the 9 and 10 percents like we did in the '70s or '80s, because we're not as subject to the manufacturing cycle as we were back then. That's both good and bad. We don't have that boom-bust in the manufacturing world. We're seeing a bust in the construction world and we're starting to see commercial lending and commercial building go down. But I don't think we're going to see the large 8 and 9 percent unemployment rates that we typically see in a recession. But still, if you see rising unemployment – and unemployment rises by 20 percent, from 5 to 6 — that means those people are going to have less money and they're not going to be spending it.

We're seeing inflation in an environment of low real-income growth. Inflation is running over 4 percent now. And real-income growth is running a little bit less. While we may see some nominal growth in consumer spending, real spending is going to be dropping over the next year. That has some consequences that we'll talk about later. Also, consumer spending is going to drop because we have less availability of easy credit. Now, it probably hasn't hit this room. But there is a wave of letters going out from credit card companies, cutting people's credit lines, cutting people's home mortgage lines. There are a lot of people actually hitting their home equity credit lines and putting it in a savings account because they're afraid that it's going away. They're afraid that they may not be able to get the cash when they need it. "What happens if I lose my job? I better get the cash, and I'll pay the difference in interest costs just to make sure that I'm OK." That's happening a lot.

In summary, lower mortgage equity withdrawals, higher gas and energy costs, rising unemployment, inflation in an environment of low real-income growth, and less availability of cheap and easy credit are all contributing factors to slowing consumer spending.

This has three major effects. First, lower corporate earnings. We're in a period where earnings disappointments are going to be the rule and not the exception. We're going to go into this in detail in just a little bit. But GE wasn't a one-off announcement. Yes, it was their financial system. But we're going to see a lot of earnings disappointments from all sorts of retailers, from all sorts of companies, for a variety of reasons. We're going to look at the documentation for a minute to demonstrate that. Second, lower corporate profits put pressure on the stock market. There's a relationship between earnings, valuations, and stock prices. And third, that also means we're going to see lower than expected long-term returns. That's going to be a problem for people who are looking for traditional assets to be the bulk of the growth for their retirement portfolios.

Now, I think we're still in a bear market. Remember that in 2000 and 2001, we had three corrections of over plus 20% percent and one in the plus 30% range. It's not unusual to see large corrections inside an overall bear market.

Why do I think we're in a bear market? Long-term markets – and we're going to talk long term for a second and then come to the shorter term – long-term markets in bear cycles have several characteristics. Number one, they all start with high P/E ratios. Now, Vitaliy Katsenelson, who wrote my e-letter this week so that I could be here, lays out what he calls "cowardly lion markets," as distinct from bear markets, because stocks tend to go sideways for a long period of time. We'll talk about why that is in a minute, but I think he's right on that.

You are told that you should invest for the long run. Twenty years for a lot of people is the long run. However, what they do not tell you is that you can see negative real stock market returns over 20 years. It's happened four or five times. So when you're reading in somebody's book that says, "Hey stocks are going to compound at 11 percent a year" or whatever la-la number can be seduced from the data, think twice.

In secular bear markets, you can have returns for long periods of time from zero to 3 percent, every 15 to 30 years. We're kind of starting one here again. If you went to Standard and Poor's website in March of 2007 and you asked what the earnings were going to be for 2008, their analysts said that earnings would be $92 for 2008. Two months later, at the end of the year in December 2007 – this is four months ago – they were projecting $84. In February, it was $71.20. Today Merrill Lynch estimates that earnings could drop to as low as $45 next year. Notice a trend here?

When you go into a recession, analysts begin to project lower earnings. They keep ratcheting them down. What do they use to project future earnings? Past performance. There are very few analysts who actually go out and say, "OK, how is this company going to perform in a recession?" They all say, "The company that I cover is an exception." This is how they're going to cover it, because they're talking to management.

And when's the last time management said, "Oh man, we're really going to get clobbered; there's a recession coming." Not if they want to keep their jobs. John Chambers will be telling us that Cisco's going to be doing wonderfully, just like he did all of '99, all of 2000 and all of 2001.

Now, what does this mean for P/E ratios? About 30 days ago, it was estimated, based on prices, that the P/E ratio for the end of the last quarter would be 20.5. Today, as companies mark their earnings down, the P/E ratio is 22.5. For the end of September, third quarter, a month ago, they were saying the P/E ratio would be 21. Today they're projecting that if the market stayed at the same price, it would be 28. Now, does anyone think we're going to see a P/E ratio of 28 at the end of the third quarter? People are going to be projecting positive earnings forward – and we're going to see one earnings surprise after another.

Remember, it takes three to four really good earnings disappointments to reach a point where investors really begin to understand that things are different, because we project future performance from past performance. When past performance disappoints us three or four times, then we begin to project negative performance, and that's when the stock market drops. It's not that the stock market is telling us that things are going to be better. It's that we have expectations of things getting better because that's what our past experience has been – so we need those disappointments.

This is from Vitaliy Katsenelson's book: If you take 10-year trailing P/Es – you average them together so you don't have the effect of just one year – you find that valuations go from high to low from where bull markets start, in what he calls a range-bound market or what I would call a secular bear.

They go from high valuations to low valuations and back. Around 2000 we were at 48. It's down to 30 today on those long, ten-year runs, and it always corrects below the mean. Valuations are mean-reverting machines.

If you just look at one year, you get the same effect. You have a P/E average of 15 – remember they're projecting 28. You don't have a projection of 28 in a recession and not have the stock market feel that.

Maine, Maryland, and Weddings

It takes a full day to get from Texas to Leen's Lodge (http://www.leenslodge.com/) in Grand Lake Stream, Maine. Trey and I make the last part of the trip by float plane. This is the third time I've gone with Trey, and I really look forward to the trip. It's just a great bunch of guys. As I have noted, we do make predictions about the markets. Last year a number of readers sent in their predictions, and we have tabulated those. I will report back on how well we all did, and some of you will win a book for being the best predictors.

It looks like I am going to Maryland for a day in a few weeks, and New York is looming on the horizon again, as well as another trip to Baltimore to be with my really good friend Bill Bonner (of Daily Reckoning fame) for his 60^th birthday party. Now that should be a blast.

It is amazing how many details have to be worked out for a wedding. And it is just a few days away. Tiffani will be gone on her honeymoon for almost an entire month, so a lot of business details have to be worked out for the interim. She and Ryan will be in South Africa and Ireland, and I really do want to leave her alone. She deserves some time away. When she comes back, we will really start to work on our book.

Have a great week. Enjoy the summer with friends and family.

Your ready for some fishing analyst,

John Mauldin

Muddle Through and Your Long Term Returns

John Mauldin — Fri, 14 Mar 2008 19:28:39 GMT

Muddle Through Gets A Boost Honey, I Vaporized My Customers Consumer Spending is Going, Going...South The Boomers Break the Deal Today we drop back to take a look at the economy and its long term effect on our portfolio returns. I am in Orlando this week...(read more)

How do You Spell Stagflation?

John Mauldin — Sat, 17 Nov 2007 04:16:26 GMT

In This Issue: How do You Spell Stagflation? Cooking the Inflation Books Gaming the Producer Price Index Consumer Spending is Up, but then Again, It May Be Down A Two Dimensional Problem Saudi Justice New York, Toronto, Europe and Thanksgiving This week...(read more)

Credit Crisis to Credit Crunch

John Mauldin — Sat, 10 Nov 2007 04:03:00 GMT

In this issue: A Confidence Credit Crunch Credit Crisis How Much is That Dog in Your Net Capitalization? King Dollar Faces the Guillotine The Euro-Yen Cross The Consumer is Getting Tired New York, Philadelphia, Switzerland and Phoenix Just when it felt...(read more)

A Little Discretionary Spending, Please

John Mauldin — Fri, 01 Jun 2007 07:54:00 GMT

Introduction Are we on a slippery slope of a recession, or was last quarter's weak GDP a turning point? This week's travel shortened e-letter looks at recent data and re-visits some thoughts on consumer spending from friend Joe Ellis' superb...(read more)

Real Estate and the Post-Crash Economy

John Mauldin — Fri, 29 Dec 2006 08:15:00 GMT

Introduction I am taking some time off from writing over the holidays, but good friend Barry Ritholtz offered to write this week's letter. It is a very thought-provoking piece on the importance of what he calls the "real estate industrial complex"...(read more)

Thoughts From The Frontline : Consumer Spending

The Best of Times

The Elements of Deflation

It Is the Best of Times

It's More Than Half Full

Argentina, Brazil, and Uruguay

Sell in May and Go Away

Sell in May and Go Away?

The End of the Recession?

Is the US Consumer Back?

A Dangerous End Game

A Few Thoughts on Swine Flu

Back to the Future Recession

MV=PQ

Financial Innovation: The Round Trip

2010-11: Back to the Future Recession

The Fed at the Crossroads

How Did We Get It So Wrong?

The Trend Is Not Your Friend When It Ends

Orlando, Naples, Cleveland, and Grandkids

Further Thoughts on the Continuing Crisis

The Right Direction, At Least

The Jobs Will Come

Can We Have a Little Inflation, Please?

Those Wild and Crazy Analysts

La Jolla, Conversations, and Richard Russell

Forecast 2009: Deflation and Recession

Muddle Through on Hold

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect

Lies, Damned Lies, and Government Unemployment Numbers

Central Bankers of the World, Unite!

Predictions 2009

La Jolla, Bermuda, and Europe

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

The Problem With Deleveraging

1.2 Million Jobs and Counting

Be Careful of Geeks Bearing Recovery Data

Back to 1982

The Problems of Deleveraging

New York, Birthdays, and Moving

How Shall We Then Invest?

Those Wild And Crazy Analysts

The Evidence for Investor Overreaction

Stock Prices Are In Our HeadsOr, Maybe Investors Are Just Head Cases

Can We Actually Predict Earnings?

Buffett versus Grantham

Back to 1974?

How Should We Then Invest?

Home Again and a New Home

The Economic Blue Screen of Death

The Psyche of the American Consumer

The Consumer Weakens

The Paradox of Thrift

An Economic Blue Screen Of Death

Those Wild And Crazy Analysts

London, Stockholm, Malta, and Becoming a Grandfather

The Rise of A New Asset Class

The Rise of A New Asset Class

Maine, Maryland, and Weddings

Muddle Through and Your Long Term Returns

How do You Spell Stagflation?

Credit Crisis to Credit Crunch

A Little Discretionary Spending, Please

Real Estate and the Post-Crash Economy

Stock Prices Are In Our Heads
Or, Maybe Investors Are Just Head Cases