Thoughts From The Frontline : Economic Crisis

Time for a Reality Check

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

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

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

World Trade Is Falling Off a Cliff

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

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

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

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

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

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

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

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

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

European Bank Losses Dwarf Those in the US

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

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

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

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

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

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

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

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

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

Geithner: "You Can't Handle the Truth"

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

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

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

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

Time for a Reality Check

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

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

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

Earnings Will Get Even Worse

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

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

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

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

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

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

Orlando, Colorado Springs, New York, and Las Vegas

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

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

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

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

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

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

Your on the lookout for more opportunities analyst,

John Mauldin

The Endgame

John Mauldin — Sat, 17 Jan 2009 21:29:29 GMT

The Endgame
Employment Numbers Are Worse Than Posted
Aye, Captain, I'm Giving Her All I've Got!
Problem #1: Deflation
Problem #2: Pushing on a String
The Muddle Through Middle
Conversations With John

Deflation? Stimulus? Deleveraging? Recession? A soft depression? A return to a bull market? With all that is going on, how does it all end up? When we get to where we are going, where will we be? In chess, the endgame refers to the stage of the game when there are few pieces left on the board. The line between middlegame and endgame is often not clear, and may occur gradually or with the quick exchange of a few pairs of pieces. The endgame, however, tends to have different characteristics from the middlegame, and the players have correspondingly different strategic concerns. And in the current economic endgame, your strategy needs to consist of more than hope for a renewed bull market.

Rather than looking at just one year, in this week's letter we take the really long view and ask what the end result or endgame will look like. There are three possible scenarios (and multiple combinations) that I can think of, we will explore each. Any of them could happen, so we will need to look at some signposts to get an idea of what is actually going to occur. I can make the following prediction that will be absolutely correct: Whatever scenario I lay out here, events and time will change what actually happens. But this will give you an insight into my longer-term biases, and that should be useful. As I tell my kids, put on your thinking caps.

There are a few housekeeping topics I need to cover, but I will do it at the end of the letter. I just did two interviews with Aaron Task and Henry Blodget at Yahoo Tech Ticker, and will provide the links. I also want to talk about the upcoming Strategic Investment Conference, April 2-4 in La Jolla, which is going to sell out. And make sure you get around to subscribing to my new information service, called Conversations with John Mauldin. I will be posting the first conversation very soon, and you don't want to miss it! So, stay with me and let's jump right into this week's letter.

Employment Numbers Are Worse Than Posted

First, I have to address some more government data that can be misleading. We were told Thursday that initial unemployment claims were "only" 524,000. The talking heads immediately said that was proof the economy is simply bad, not falling off a cliff. Again, like last week, that seasonally adjusted number masks the real number, which was 952,151. That is not a typo. There were almost 1 million newly unemployed last week! That is up over 400,000 from the same week in 2008, while the seasonally adjusted number was up only 200,000. Last week the real number was 726,000, so this is a material rise of over 225,000, yet the seasonally adjusted number suggests a rise of only 57,000 from last week.

The continuing claims data leaped over 500,000 to (again, not a typo!) 5,832,746. The length of time people are staying unemployed is also rising rapidly. We are up almost 1.5 million new continuing claims in just the last five weeks. That is a stunning rise of over 30% in unemployment claims in just over a month. The data is truly ugly, but it is what it is.

When you are in periods where there are deep outliers to the data because of very real turning points in the economy (such as we are going through now), the seasonally adjusted numbers can mask the real underlying trends, both up and down.

Aye, Captain, I'm Giving Her All I've Got!

Let me repeat a point I made last week, which is important and necessary for us to grasp if we are to understand where we are headed.

We are in completely uncharted territory in terms of the economic landscape. Like the USS Enterprise in Star Trek, we are boldly going where no man has gone before. But the captains of our fleet are Keynesians to their core (and they don't have any Vulcan advisors). They don't have any historical maps to guide us back to a functioning economy; they only have theory. The North Star they are guiding us by, for good or ill, is John Maynard Keynes, with a slight nod to Milton Friedman.

It is not a question of whether or not there will be massive stimulus. The question is simply how much and for how long. And my wager, as outlined below, is that it will be far larger than anyone would want to admit today. Think of Scotty, aboard the Enterprise, when Captain Kirk demands more power, "But Captain, I'm giving her all she can take. She's ready to explode!" (But he always finds a little bit more.)

Let's set the scene for where we are today. The US likely just experienced a 4^th quarter with GDP down over 4%. Some estimates suggest 5%. For all of 2009 we are likely going to be down at least 1-2%, which will make this the longest recession since the Great Depression. Unemployment is headed to at least 9%. Consumer spending will be off by at least 3% this year and again in 2010, as consumers start to find virtue in savings, which should rise in the US to 6% within a few years. Housing prices are going to drop another 10-15%, taking homes back to a level where they may be more affordable.

Corporate earnings are going to be dismal for at least the first two quarters, with forward estimates being lowered again and again. (For a thorough analysis of earnings, look at the January 2, 2009 issue in the archives.) Global trade is falling rapidly, and it is likely that we will see a global recession this year, which will result in further negative feedback on US, European, and Japanese exports.

On a more positive note, oil is below $40, which is more of a stimulus to consumers than anything anticipated by the incoming Obama administration (at least as far as consumers go). With short-term rates at zero, adjustable-rate mortgages are actually not the problem anticipated a year ago, and many homeowners are rushing to refinance their homes at lower rates. Large banks have indicated a willingness to actually cut the principle and interest on troubled mortgages, which might lower the number of defaults.

Conversely, the number of defaults is high and rising -- throughout the developed world. It is likely to be 2011 before the housing market finds a real bottom and housing construction can begin to rise.

The credit markets are still in disarray. While there are some signs that the frozen markets are thawing, the Fed and the US Treasury are having to provide more bailout capital to large US banks. Citigroup is breaking up. Bank of America needs massive amounts of capital to digest Merrill. The hole that is AIG just keeps getting deeper. It is going to take several years for the credit markets to function at anything close to normal, as we simply vaporized a whole credit industry worldwide. To think it will take anything less is simply naive. And in the meantime, the various central banks of the world, along with their governments, are going to step in to fill the need for credit.

Obama has signaled that he needs the remaining $350 billion of Troubled Asset Relief Program money as soon as possible, although his delegated Treasury Secretary, who will run the program, may be in some trouble, as he failed to pay taxes on his income from his stint at the IMF.

(This is not an "Oops, I forgot!" The IMF does not withhold income taxes from its employees. However, he was given a memo about the taxes he owed. And he did pay them for two years when he was audited and caught. He clearly knew the nature of the taxes due the two prior years, yet did not come clean on those years. Dumb move for someone on a fast-track career and who clearly has an impressive intellect. He has got to be kicking himself. Since the Treasury Secretary is in charge of the IRS, this is not good for Obama. Someone on his team should have vetted this more thoroughly. I do think Geithner is otherwise as qualified as anyone else on the short list, but this is a very large cloud hanging over him.)

The auto industry is reeling. Without a lot more government funds, it is unlikely that GM or Chrysler will survive without going through bankruptcy. The industry needs to shed about 20% of capacity. No amount of government funding will change that reality. Beyond autos, industry after industry is on the ropes.

I could go on and on, but you get the picture that is facing the Obama administration and the entire rest of the developed world.

So, how do we get out of this mess? As noted above, the captains of our collective ships are Keynesians. They are going to provide as much stimulus as needed.

Problem #1: Deflation

We got the Consumer Price Index numbers today, and they tell a tale of deflation. On an annualized basis, the CPI for the last three months was a negative -12.7%! Even core CPI, which is without food and energy, was a minus 0.3%. The CPI for 2008 was just 0.1% for the whole year. This was the smallest calendar-year increase since 1954, and it's down from 4.1% for 2007. (To see the whole release and data, you can go to www.bls.gov.)

I outlined the problem of deflation last week in my 2009 Forecast so I will not go into detail, except to note that central bankers are going to fight tooth and nail any tendency for deflation to catch hold in the economic mind of the country. It is simply part of their DNA.

Obama wants an extra $825 billion in his stimulus package, in addition to the $350 billion in TARP monies. The Fed has started to buy mortgage assets, and that could be $500 billion or more. That is in addition to some $300 billion plus and growing in commercial paper, in addition to bank assets, etc.

Let me predict right here that this is merely the first installment. The problems described above are very large. It is one thing to make credit cheap and yet another to make consumers either want to borrow more, or be able to convince a lender that borrowers can repay their debts. On the one hand, the government is providing capital to banks and hoping they will lend it, and on the other hand the regulators are telling them to reduce lending and increase their capital. Their commercial mortgages on a mark-to-market basis are imploding. Consumer credit risk is high and rising. What's a bank to do?

Let's add it up. In the US, we have seen massive wealth destruction on personal balance sheets. At the end of the third quarter the losses totalled $5.6 trillion, between housing and stocks. They could be over $10 trillion at the end of the fourth quarter. (Source: Hoisington) The losses will almost certainly top $12 trillion by the middle of the year as housing continues to deteriorate. Pick any country in the developed world or much of the developing world, and it's the same picture: wealth destruction.

We have seen at least a trillion dollars of capital on financial companies' balance sheets disappear; and given the recent spate of bailouts, it is likely to get worse.

As I have been pounding the table about, a credit crisis and imploding balance sheets, a housing crisis, and a massive earnings shortfall that yields a relentless stock market drop are all independently deflationary. The combined forces are massively so. To think that a mere trillion or so dollars in stimulus will be enough to reflate the US and the world economies is simply not realistic.

Let me offer a simplistic definition of what I mean by reflation: it's when the velocity of money stops falling for at least two quarters and the economy emerges from outright recession.

And much of the proposed stimulus is not really stimulus. Temporary tax cuts, as much as I like them, that are not targeted at getting small businesses recharged (which is where the real growth in jobs will come from) will likely be saved, much in the way that the last stimulus package did little real good for the economy, and simply put us another $177 billion in debt that our kids will have to pay. Helping keep people in their homes when they are already over their heads in debt is not really stimulus, however noble it sounds. Over 50% of mortgages that are reduced and rewritten are delinquent again within 6 months. That does not bode well for future efforts. Better to let the home go at some price to someone who can afford it. Tough love, but realistic.

Giving money to states to allow them to continue to spend beyond their budgets is not stimulus. And why should Texas pay for a profligate California? We have our own problems. The Robin Hood approach to stimulus programs is nonproductive and only encourages bad budgeting habits.

What will work? Infrastructure development, although that takes time, and some real thought should be given as to which projects are undertaken, rather than allocating according to which Senator has the most seniority. Spending on defense equipment, which must all have US content (which will be distasteful to the left), is real stimulus. Upgrading technology in a number of areas qualifies, although past experience suggests governments are not good at spending new tech money wisely.

Spending on green technologies? Creating a million new jobs in clean tech? Get real. How do we go from less than a 100,000 real clean-tech jobs to 1,000,000 in five years, let alone one? And three million new jobs? Really? From where? What government program could do this? In what universe? It makes for nice feel-good talk, but has no bearing on reality.

Don't get me wrong. In the midst of the late 1970s malaise, when the gloom was as thick as it is today, the correct answer to the question, "Where will all the new jobs come from?" was "I don't know, but they will." And it is still the correct answer. The US free market system is still the most dynamic economy in the world, and I truly believe that we will see new industries spring up, which will be a jobs dynamo. But that will take time. It is not a short-term solution, and by short-term I mean 1-2 years.

My bet is that in the third quarter, when earnings reports come out and are terrible, unemployment is over 8% and pushing 9%, and there is no evidence of a recovery, that we will see more stimulus from both the Fed and Congress. Count on it.

The Fed and the Keynesian captains of our economic ship are "all in." If the current plans do not reflate the economy, they are not going to say, "Well, that is too bad. We did what we could. Now we just have to go ahead and let the US economy catch Japanese disease." Not a chance. They will up the ante.

And they will keep trying to "jump start" the economy until it works. Obama told us to expect trillion-dollar deficits for years to come. Give him this: he is being candid and honest.

The Fed, and I think other central banks, are going to step in and be the buyers of last resort for a whole host of debts, both corporate and consumer. There are those who worry about creating inflation, because they actually do have to print money to buy these debts. While I would prefer a world where a central bank does not intervene in the markets, the time to fix the problem of excess leverage was a decade ago. Allowing banks to go to 30:1 leverage based on "value at risk" models and other financial wizardry that clearly neither the banks nor the regulators understood, was simply bad policy, and we are paying for it. As Woody Brock so wisely notes, 30:1 leverage is not three times more risky than 10:1 leverage, it is 25 times more risky. (Trust me, or at least Woody, on the math.) As an aside, many European banks were even more highly leveraged.

The End Game

The US (and indeed soon the whole world) is in a deep recession. The US is going to try and combat that recession with stimulus on a scale never before tried. It is a grand experiment. On the one hand is the theory that you can allocate stimulus and keep the velocity of money from falling. On the other hand is the theory that once the deleveraging process starts, there is not much you can do about it: it is going to work its way through the economy. We are about to find out which theory is correct.

So, let's look at three possible outcomes, with the best outcome first. The basic optimistic assumption is that, while this recession is deep and the worst in the post-WWII era, it is still just a recession. Free-market economies eventually recover. Recessions do their work of reducing excess capacity, and the businesses which survive enjoy increased market share and potential for profits to rise. And corporations do indeed have on balance stronger than usual balance sheets going into this recession, except for most financial corporations. Another exception is businesses that were bought by private equity firms with large leverage. Many of those will have to be restructured. And those that have too much leverage or were too aggressive with expansion programs? They will go the way of all overleveraged flesh.

Besides, the optimistic scenario holds, the massive amount of stimulus being applied to the US economy is on a scale never seen. It will work, just as an easy monetary policy has always worked. (Except in the '70s, but we won't make that mistake again! We learned our lesson, yes we did! Volker can stay in retirement.)

This scenario assumes that the psyche of US consumers has not actually been seared all that much, and that they will return to their spending habits as soon as they are able. It also assumes this is a normal business-cycle recession. There really is no endgame. It is business as usual. There has been no fundamental altering of the US dynamic. Banks will start lending again, businesses and consumers will start borrowing, and things get back to normal. Deflation is just some bugaboo that a weird coterie of economists and investment writers harp on to scare the children into behaving more rationally. It can't really happen here. And besides, the Fed can print enough money to make deflation go away. The real worry will be if they overshoot and inflation comes roaring back.

Problem # 2: Pushing on a String

The economy clearly let leverage run to an irrational level. You've seen the graphs. US debt to GDP is now over 300% and has risen precipitously in the last ten and especially the last five years. Leverage and debt fueled the growth of the economy, but debt growth hit a wall and now the deleveraging process is the painful result. This brings us to the worst-case scenario: that all the efforts of the Fed will go for naught and that we are in a liquidity trap.

A liquidity trap is a situation in monetary economics in which a country's nominal interest rate has been lowered nearly or equal to zero to avoid a recession, but the liquidity in the market created by these low interest rates does not stimulate the economy. In these situations, borrowers prefer to keep assets in short-term cash bank accounts rather than making long-term investments. This makes a recession even more severe, and can contribute to deflation. (Wikipedia)

And there is no question, at least in my mind, that the economy, if left to its own devices, would fall into a soft deflationary depression, which would take years to climb out of. The contention of those who believe that we are headed for such a state of affairs is that no matter what the Fed does, excesses on the part of consumers and unrestrained government deficit spending is going to create a Perfect Storm. First of deflation and then, because the Fed is going to try to re-inflate the economy by printing money, we will see a resurgence in inflation and a collapse or, at the very least, a serious drop in the value of the dollar. Further, to expect foreign governments to continue to buy depreciating dollars and allow the dollar to continue to be the world's reserve currency is not realistic. And of course, there are those who think we will eventually see hyperinflation as the Fed is forced to monetize the national deficits, with gold going to $3,000 (or higher!). And Obama, with his talk of trillion-dollar deficits for an extended period, certainly adds fuel to that fire.

If, and it is a big but possible if, the Fed is indeed pushing on a string, then we are likely to see 15% unemployment, yet another lost decade for the stock market, and a real calamity in the pension, endowment, and insurance worlds, which are planning on 8% long-term portfolio returns to meet their obligations. And while I think it is a possibility we must be mindful of, it is not the most likely scenario.

The Muddle Through Middle

Now, we come to the third scenario and -- no surprise to long-time readers -- the one I think is most likely. I think that after we climb out of recession, we Muddle Through for an extended period of time. Follow my reasoning, and remember that I am often wrong but seldom in doubt! And please allow me some room to speculate. I can guarantee that I have some (or most) of the particulars wrong. But I think I have the general direction we are heading in.

We are in a serious recession. We have to allow time for both the housing market and the credit markets to heal. This will take at least two years. I think we have permanently seared the psyche of the American consumer. Consumer spending is likely to drop at least 6-7% over the next two years, and maybe more. The combination of all three bubbles (consumer spending, credit, and housing), which were made possible by increasing leverage and poor lending standards, is by definition deflationary. (I know, I keep repeating, but most readers do not really get the rather disturbing implications.)

The US government in general and the Fed in particular will react to the problem. Most of the government stimulus, other than that used to reliquefy the banking system, build useful infrastructure, and encourage small business to expand, will be wasted or have little short-term effect. The Fed (and central banks around the world), on the other hand, do have the potential to succeed with a "shock and awe" type of stimulus program.

The problem is the Velocity of Money. (You can see this explained in my December 5, 2008 letter.) There is just no way of knowing when the Fed programs will really create some traction. Anyone who shows you a model that says such and such an amount of stimulus is needed is from the government, trying to tell you that this time we really do know what we're doing. Any such models are based on assumptions about things we have no way of knowing.

The Fed (and the US government) are going to continue to run deficits and print money until the economy begins to reflate. That is one thing I truly believe. Will it be a total of $2 trillion? Three? Four? More? I don't know. How large will the Fed balance sheet be in a few years? I don't know. And neither does anyone else. There are just too many damn variables.

But I do believe that at some point there will be some inflationary traction. And combined with an economy resetting itself at some new level of consumer spending, and with a basically resilient US free-market system, a recovery will begin.

But here's the problem. Let's assume, and we can, that we find this new set point for the US economy (see the "Economic Blue Screen of Death"). And that the economy begins to grow, but the Fed has injected a lot of liquidity. Now some of that liquidity is "self-liquidating." By that I mean, commercial paper is typically 90 days. The Fed simply has to begin to wind down its commercial paper investments, and it takes away some of the liquidity it created. Those mortgages they bought? Each month, as payments are made, a little liquidity is taken back from the economy.

And if inflation is an issue, they can begin to withdraw that liquidity or raise rates. Of course, that will serve to slow the economy down, but better a slower Muddle Through Economy than a return to the high stagflation of the '70s.

That gets us to 2011-12. The economy is growing, albeit slower than anyone would like, but government deficits are still in the trillion-dollar range, as Obama and the Democratic Congress have increased the entitlement programs, locking in big deficits for a long time. High deficits put the dollar under pressure. The demand from voters is to get the deficit under control. However, the Social Security surpluses are beginning to dwindle. And just like in the early '80s, we have a Social Security crisis. Some combination of higher taxes, reduced benefits for wealthier Americans, later retirement ages, and a different methodology of indexing for inflation will be the order of the day.

But Social Security is the relatively easy problem. Medicare benefits will be at nose-bleed levels and will swamp the ability of the government to fund it and other government programs. Democrats will never allow the programs to be cut back. And getting the 60-plus Republican senators needed for such cuts is just not likely to happen by 2012-2014.

The problem will be dealt with by cuts in some government programs, but mostly by tax hikes on the "rich" and increased contributions by participants. Since many of the rich are the very small business people who we need to create jobs, this is going to be very anti-growth, extending the Muddle Through Economy for yet another few years. And if taxes are raised too much in 2010 when the Bush tax cuts go away, then we could see a relapse back into a recession.

Such an environment of higher taxes and slow growth is not good for corporate earnings. Earnings in the recent years have been at all-time high levels as a percentage of GDP. Earnings as such are mean reverting, and thus are unlikely to rise back to previous levels in terms of percentage of GDP. (Of course, in nominal terms they should rise.) This is going to put a constraint on stock market growth.

Pension plans, endowments, insurance companies, and individual investors who are counting on 8% long-term compound returns from their stock portfolios are as likely to be disappointed in the next five years as they were in the last ten. The environment I am describing is one of compressing price to earnings ratios, much like the period from 1974 to 1982.

This environment is going to force the creation of new investment programs and products based on income generation. And that is one of the forces that will bring about a real recovery in the middle of the next decade. Investment capital will be made available to businesses that can generate low double-digit or high single-digit returns, as well as new technologies with the promise to deliver new paths to profits.

The second major force will be the arrival of new waves of technological change. We will see a biotech revolution beyond our current comprehension. It has the real potential for solving a great deal of the Medicare entitlement program problems. For instance, it is likely we will have a real cure for Alzheimer's within five years. Since that is as much as 7% of US medical costs, that can create a real cost reduction. The same for heart disease, obesity, cancer, and a host of other medical conditions that will start to be dealt with by a new generation of therapies. That is going to create a new, very real bull market in biotech.

I expect to see a new generation of wireless broadband that powers whole new industries. And it will not just be green tech, but entirely new forms of energy generation that drive the cost of energy down and, combined with other new technologies, make electric cars practical. And along about the end of the decade, the nanotech world begins to really get into gear.

And just as the tightly wound, low P/E ratios of the early '80s gave way to a spring-loaded major bull market as new technologies became the driver for a whole new set of public companies, we could (and should!) see a repeat of that performance. There is a new bull market in our future.

The problem is getting from where we are today to that next dawn. The definition of insanity is to keep repeating what you have done in the past and expect a different result. We are in a long-term secular bear market. P/E ratios are going to decline over time to low double digits. Hoping that stocks somehow rebound to new highs and that the economy is going to go back to what we saw in 1982-1999 or 2003-2006 is not a strategy. You need to be proactive and take charge of your portfolio, looking for absolute-return types of investments for the next 4-5 years. Simply using a traditional 60-40 split of stocks and bonds is not going to get you to retirement nirvana. It will lead to retirement hell.

Conversations With John

As we announced a few weeks ago, I am starting a new subscription-only service. While this letter will always be free, we are going to create a way for you to "listen in" on my conversations with some of my friends, many of whom you will recognize and some who you will want to know after you hear our conversations. Basically, I will call one or two friends each month, and just as we do at dinner or at meetings, we will talk about the issues of the day, with back and forth, give and take, and friendly debate. I think you will find it very enlightening and thought-provoking and a real contribution to your education as an investor. You can still subscribe now, before the actual launch of the service (in a week or so), at the holiday rate of 50% off. I will be having the first conversation next week, and it will include a spirited debate about the topics in this letter. Then, at some point in February, when Nouriel Roubini and I can match our schedules and continents, we will have a conversation you can listen in on as well. This is going to be a very fun project, and you won't want to miss one chat.

You will be able to listen online, download to your iPod, or read a transcript. To learn more, just click on http://www.johnmauldin.com/newsletters2.html, click the Subscribe button, and type in the code "JM44" to get your 50% discount. And read about the bonuses we will offer as well!

To see my interviews on Yahoo with Aaron Task and Henry Blodget, go to:

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. 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.

For whatever reason, this letter has kept me up very late. At 4 AM (!), it is time to hit the send button. For those of you who can actually take a three-day weekend, enjoy it! Alas, Tiffani has me working on a tight schedule as our book deadline looms, although I will slip away tomorrow evening to watch the Mavericks. And hit the gym of course.

Have a great week! And seriously, there are lots of opportunities in the world today. Just open your mind to some "out of the box" possibilities.

Your enjoying the ride 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

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

Where Do We Go From Here?

John Mauldin — Sat, 11 Oct 2008 03:20:20 GMT

Construction Lending: The Next Shoe to Drop
Lehman at the Center
Iceland Guarantees What?
Letters of Credit: Going, Going Gone?
What to Do and Where Do We Go from Here?
London, Stockholm, and California

I have been writing for almost a year that the next shoe to drop on US banks would be commercial construction lending. Today we look at some hard numbers. We look across the pond to sort out the problems in Europe. We look at the consequences of the losses stemming from Lehman. Then we look at one of the more serious consequences of the banking crisis, one that will bring the crisis home to you. Finally, we look at what the various governments of the world must do in response. It may not be fun, but it should be interesting. And it is important. Feel free to forward this letter to anyone who asks why we not only need the bailout but will need even more coordinated government action.

But first, let me offer a note of optimism before I serve up the not so good news. This is not the end of the world. There are a lot of very positive things happening in the US and the world. Companies are creating new inventions. Much of the economy, including health care, is moving along fine. I have lived through two serious recessions (1973-74 and 1980-82), and the point is that a free-market economy will find a way to eventually get back to solid growth. Recessions are simply part of the business cycle. Congress cannot repeal the business cycle. This will not be the last recession of my life. I hope to live long enough to go through 4 or 5 more.

Depressions are caused by governments making major policy mistakes. And we have made some in the areas of not regulating mortgage lending, allowing the five large investment banks to increase their leverage to 30 or 40 to one in 2004 (what was the SEC thinking?), and failing to oversee the rating agencies. That is behind us. It will make a normal recession deeper and the recovery longer, as I have been forecasting for some time.

But as I argue below, immediate actions must be taken by the government to avoid a much deeper problem. To not take actions to stem the credit crisis would be that major policy mistake which would compound all the other mistakes. I think everyone knows the seriousness of the problem and will act. Let's pray they do.

But whatever happens, there will be plenty of opportunity for investors and entrepreneurs to exploit. The world is on the cusp of a remarkable explosion of new technology of all sorts that will transform our lives. This march of progress went on unchecked last century, through two world wars, major depressions, numerous smaller wars, recessions, financial crises all over the world, famines and natural disasters, not to mention a lot of man-made ones.

The current crisis will pass. None of us will want to go back to the "good old days" in 20 years, for we will be living in the best of times. Just make sure you keep your powder dry so that you can enjoy it. And now, let's look at some less than uplifting news.

Construction Lending: The Next Shoe to Drop

The Bank Credit Analyst is one of the more reliable sources I know for information. They estimate that total losses from the current debt crisis could be anywhere from $1.1 trillion to $1.7 trillion. They estimate roughly half to be in the banking sector, or around $750 billion, and almost $590 billion of that has already been written off. That means that the $700 billion from the TARP (government bailout) program may actually be enough to handle the losses and inject some actual capital into the banks. Maybe.

The losses from subprime and other mortgage-related loans are well known. Most of those losses are in the larger banks, as smaller banks simply could not participate to any great extent. What is less well understood are the potential losses which smaller banks are in fact exposed to in the area of construction lending. Lisa Marquis Jackson, now writing for John Burns Real Estate Consulting (one of the best sources for hard real estate data), gives us some answers to the question of "how much?"

Outside of the large home builders and developers, most of the lending for construction of homes and commercial property comes from regional and local banks. A local home builder may finance 5-10 homes, or a developer a small strip mall or apartment complex, from their local bank. Look at the graph below. Since 2001, delinquencies had been rather small and well-contained. Then starting 18 months ago, the delinquency rates started rising.

Again, note that these are delinquency rates for business loans from banks and not for individual mortgages.

Over 16% of loans made for condominium construction are now delinquent. Loans made for single-family home construction are only slightly more than 12% overdue. But that masks a much bigger problem. Single-family loans account for 86% of all for-sale residential construction loans outstanding.

The good news is that for the top 100 banks by size, single-family loans make up only 2% of the total. But that small portion totals $245 billion. And condos add another $41 billion. That puts almost $40 billion at risk of default at today's delinquency levels.

It will be worse for many smaller banks, as they have larger commercial construction loan portfolios. As noted below, this may require some proactive action on the part of regulators.

Lehman at the Center

Now we know the consequences of allowing Lehman to fail. The severity of the credit crisis was deeply, severely worsened by the failure of Lehman. Based on the results of the credit auction today, sellers of protection will need to make cash payments of more than $270 billion, BNP Paribas SA strategist Andrea Cicione said in London. Some funds may be forced to dump assets to meet the payment demands if they haven't hedged.

How much of that debt will eventually have to be absorbed by various government programs or direct capital infusions? It is too soon to say, but you can bet it will be a lot.

If there is any good news to this, it is that much of the write-downs have already been made. It now looks like the Lehman CDS market sorted itself out with no failures, according to the International Swaps and Derivatives Association.

We have dodged a huge bullet. But the anguish this has put the credit markets through the past month was avoidable. The CDS markets MUST be made to migrate to a regulated clearing entity like the Chicago Mercantile Exchange. Next week would be a good time. While there have been serious losses by various players in other exchange-traded markets, there was no systemic risk, as everyone knew the value of their various securities, whether futures or options or other derivatives, and knew they would get their full value when sold.

With Lehman, no one really knew until late today. Thus banks and hedge funds had to sell anything they could in order to meet possible payments or losses, which caused wildly swinging prices in every market.

It is my bet that future memoirs of the various main actors and books on the credit crisis will look back at the failure of Lehman as the proverbial "last straw" for the unregulated CDS markets.

Iceland Guarantees What?

Let's get this straight. Iceland is a country of 300,000 people. I've never met an Icelander I didn't like. They are an extraordinary people. A few decades ago, they made their money on fishing, farming, and trading. Then they discovered banking and started to take deposits from anywhere and everywhere and make loans outside the country. Soon, the various banks' assets were over $140 billion, about 10 times the total GDP of the country, and they had far more foreign depositors than citizens. With foreign reserves of just 2 billion euros, what could the government do if there was a crisis?

Now Iceland has had to take over the banks and guarantee deposits. They also had to turn to Russia for a loan. Does anyone think Putin would hand out a no-strings-attached loan? Russia needs a refueling station for its Navy and will likely get it.

Note that Iceland gave its citizens the ability to withdraw money but did not extend that same privilege to the citizens of other countries. England and the Netherlands have already gone to court.

As noted by good friend Dennis Gartman this morning, "Since then, things have only gotten worse, with the UK government moving to freeze the assets of Icelandic companies in the UK, and Her Majesty's government has said that it will take whatever further actions it deems necessary to protect the assets of British companies and citizens currently held in Iceland, doing 'whatever is necessary to recover [our] money.'

"Thus, not only are banks fearful of lending money to banks; and not only are banks fearful of lending money to individuals and/or companies; and not only are individuals and/or companies fearful of lending money to the banks, but now nations are fearful of lending to other nations. This is Smoot-Hawley writ large, and of all of the circumstances that have prevailed in the course of the past several days, this is the worst; this is the most difficult to deal with. This is madness."

As noted last week, Ireland set off a feeding frenzy when it guaranteed all deposits in its banking institutions. Five billion euros poured in over the last week. One by one, European governments are having to guarantee their loans to keep money from leaving their institutions.

Let's look at the Irish guarantee on the face of it. There are six Irish banks, holding assets of $576 billion. That works out to three times Ireland's gross domestic product, or about $200,000 for every working person in the country. (Bedlam Asset Management) Yet depositors flooded them with money in just a few days.

This is a sign of panic. One goes where one can, trying to protect what one has. On the face of it, how could Ireland really guarantee all the deposits? Yes, there are real assets against the loans, but at what price? Could Ireland borrow enough to make good on even a portion of those assets, should they decide to walk? This is sheer panic.

Letters of Credit: Going, Going Gone?

Just as the business world is dependent upon commercial paper as its life blood, the world of global trade depends on letters of credit (LOC). Without LOCs, the world of trade quickly freezes up.

If you are a manufacturer of a product and want to sell to someone outside your borders, you typically require a letter of credit from the buyer before you load any cargo at a port. A letter of credit from a prime bank is considered to be proof of your ability to pay. It not only can be a source of ultimate payment, it can be a source of inventory financing while goods are in transit.

And if you are a business which is buying a product, you do not want to release money until you know the product is on the way. There are buyer's and seller's agents who make sure these things happen seamlessly, and world commerce had grown because of it.

Now we are starting to get anecdotal evidence that this extremely vital market is also freezing up. If you think the problems stemming from a meltdown with the commercial paper markets are threatening to the world economy, they are small potatoes when compared to a seizure in the letter of credit markets.

I had been thinking about this for a few weeks. Then an article posted on Naked Capitalist caught my eye. Quoting:

"At the end of the day, if every counterparty is bad then you don't have a market and you don't have an economy. I spoke to another friend of mine this afternoon, whose father has been in the shipping business forever. Pristine credit rating, rock solid balance sheet. He says if he takes his BNP Paribas letter of credit to Citi today for short term funding for his vessels, they won't give it to him. That means he can't ship goods, which means that within the next 2 weeks, physical shortages of commodities begin to show up. THE CENTRAL BANKS CAN'T LET THAT HAPPEN OR WE HAVE NO ECONOMY, LET ALONE A CREDIT SYSTEM."

And they quote the following story from The Financial Post of Canada:

"The credit crisis is spilling over into the grain industry as international buyers find themselves unable to come up with payment, forcing sellers to shoulder often substantial losses.

"Before cargoes can be loaded at port, buyers typically must produce proof they are good for the money. But more deals are falling through as sellers decide they don't trust the financial institution named in the buyer's letter of credit, analysts said.

"'There are all kinds of stuff stacked up on docks right now that can't be shipped because people can't get letters of credit,' said Bill Gary, president of Commodity Information Systems in Oklahoma City. 'The problem is not demand, and it's not supply because we have plenty of supply. It's finding anyone who can come up with the credit to buy.'

"So far the problem is mostly being felt in U.S. and South American ports, but observers say it is only a matter of time before it hits Canada. 'We've got a nightmare in front of us and a lot of people are concerned it's going to get a lot worse,' said Anthony Temple, a grain marketing expert based in Vancouver.

"Access to credit is key to the survival of maritime trade and insiders now say the supply is being severely restricted. More than 90% of the world's trade by volume goes by ship. 'The credit crisis has made banks nervous and the last thing on their minds is making fresh loans,' Omar Nokta, an analyst at investment bank Dahlman Rose, said in an interview with Reuters.

"While shipping has always been a cyclical industry whose fortunes rise and fall with the global economy, analysts said the current crisis over the drying up of credit is something they have never seen before."

If banks are refusing to go into the LIBOR market and lend to each other, then why would they want to take a letter of credit either? At first, it will be a small trickle, which is how the commercial paper meltdown started. Then it will be a flood.

The one good sector in the US is its export sector. Start slowing that down due to a lack of ability to ship or receive payments and see what happens to an already shrinking economy. If anyone wants to see how the credit crisis can affect Main Street, look no further.

It is hard to overstate the problem and the potential for it to create a true economic meltdown. It must be dealt with, and soon. See more below.

What to Do and Where Do We Go from Here?

The credit markets are frozen. Period. The chart below shows one week LIBOR going back for four years. Notice the gradual rise into 2005? It was a lock-step move with the Fed funds rate. And the less smooth drop was also in concert with the Fed funds rate. The recent spike is not responding to this week's Fed funds cut. The spreads are wider than ever. The problem is not just the price of LIBOR. There is no trading at any price. The LIBOR market is a fiction today. And left unchecked, this lack of dealing with other banks will spread to letters of credit and the international trade markets.

The G-7 group of nations is holding an emergency meeting this weekend. As I write this, reports are coming in that there are serious disagreements as to what to do. They cannot even agree on a press release.

Former Federal Reserve Chairman Paul Volcker urged that "all of them [the G-7 nations] now admit or all of them own up to the fact their own banks are going to need support," in an interview on PBS Television's Charlie Rose Show yesterday.

The real leadership and innovation in the banking crisis seems to be coming from London. UK Chancellor of the Exchequer Alistair Darling told Bloomberg Television that "It is absolutely essential that the world's largest economies act together, and act together now." Darling wants countries to guarantee lending between banks, either by turning central banks into clearing houses for the loans or having governments back them. (Bloomberg)

Sadly, he is right. It has come to that. We are close to the point of no return. Now, we are not talking about bailing out financial institutions. We are literally talking about saving the world economic system. Failed bank lending and a large decrease in letters of credit would guarantee a deep world recession. The last depression produced severe political backlash and a world war.

Frankly, it is simply not worth the risk to say that we should sit back and let the markets work. They are not working, and there are no signs they will. As with a patient whose heart has stopped, it is time to apply the shock treatment.

What should we do? We must simply guarantee LIBOR (interbank) lending worldwide for some period of time (say 3-6 months) or until banks can trust each other's balance sheets. With the Lehman crisis going on, with more mortgage credit problems being revealed, no one knows what their own exposure is, let alone what the exposures of other banks are. Until that dust settles, the LIBOR market will remain frozen. The longer this is allowed to continue, the worse the problems will be. And it needs to be handled on a coordinated basis.

Banking is truly global. The system cannot just be guaranteed by England or the US. It must be done in concert with all major nations contributing their share. Businesses must be able to trade across borders through banks that will accept one another's letters of credit.

Second, we must consider direct investment in some banks. This should be done as preferred shares, with the view to eventually selling the paper back into the market. To make sure that money is not invested poorly or on bad terms, the various governments should invest alongside private investors, on the same terms. If a bank cannot find private investors willing to invest alongside the government, then they should be quietly assisted into the arms of stronger banks. Banks that are too big to fail must be taken over.

Businesses must have access to credit as well. They cannot get it from banks with impaired balance sheets. This is critical to world trade as well as local commerce.

Third, for a short period of time, all bank deposits in the US must be guaranteed. Weak banks must be absorbed into stronger banks as soon as possible. There are banks with large construction loan books in the hardest-hit parts of the US housing crisis, and they need to be put down as quickly as possible. We are already seeing deposits leave banks, many of them small, due to depositor concerns that small banks will not be seen as too big to fail. This must stop. A blanket guarantee will help.

Fourth, mark-to-market rules must be reconsidered. A blanket one-size-fits-all rule clearly does not work and is part of the problem. As I have documented for the last month, there are numerous assets that have a market price far below their intrinsic value. That is because there are simply no buyers. If everyone is selling in order to raise capital, then that will drive down prices to bargain levels below intrinsic value. That does not mean the asset in question would not have a higher value in a market not in crisis.

These are extraordinary times. I know there will be those who believe the markets should be allowed to work or simply want those who created the crisis to pay. I do understand the anger. I too am angry, and have been for a long time. Those of us who saw this crisis coming are frustrated that no one bothered to pay attention.

But now that we are in it the midst of the crisis, there is no going back. We must look forward and do what we can to avoid an even worse crisis and potential depression. I believe we can do so if governments act promptly.

We are already in what will prove to be one of the longer recessions on record. If we look at the Leading Economic Indicators, which have about a 9-month forward-looking view, it will be late next year before we start to grow once again. Given that everything peaked last October through January (sales, employment, etc.), it is likely that the recession will be dated from the beginning of this year.

Long-time readers know I have been wary of the stock market for several years, suggesting that investors either avoid stocks or have close stop losses. No one taking my advice is long-only this market. Not that I have been perfect, but as it turns out, I was right on this one.

I have been fielding calls all week asking me if I think we are close to a bottom in the stock market. And my answer is, we are close to a short-term bottom, but I think we will trade lower over time due to what I think are going to be poor earnings for the next few quarters. If you are a trader (and that means you have been doing it for some time - not the time to get on the job training!), then maybe you can catch a rebound, which is overdue. But (and here is the big caveat) if there is no global coordination on some or all of the recommendations I made above, this is not going to be pretty. It will end in tears. Let's hope the authorities can get their collective act together.

The next two weeks I'll send a two-part letter on the longer-term investment view and how you should position your portfolios. Stay tuned.

London, Stockholm, and California

Next Thursday and Friday I am in Southern California, speaking at two financial planning conferences. Saturday I leave for London to meet with my London partners, Absolute Return Partners, and clients. Then on to Stockholm, where I will speak for the now-Swedish-government-backed bank Kaupthing. The government took the bank over last Monday (it was affiliated with the Icelandic bank of the same name). That conference will be on investing in an age of scarcity. I will be speaking and chairing the panels, and good friend Marc Faber will be there as well. It will be an interesting time to be in London and Europe. A quick trip to Malta, and then I will make my way back to Dallas.

Tomorrow night all seven of my kids and family will gather to celebrate my son Chad's birthday and mine as well (it was last week). It will be nice to have them all under the roof, if only for a day or two. And a pleasant reminder of what is really important.

It is time to hit the send button. My friend Jack Harrod has front-row seats on the glass for the Dallas Stars. I don't understand hockey, but it is exciting sitting that close. All the best, and have a great week - and here's hoping for a bounce in the markets.

Your hoping we see some positive news this weekend analyst,

John Mauldin

Who's Afraid of a Big, Bad Bailout?

John Mauldin — Sat, 27 Sep 2008 05:52:04 GMT

Who's Afraid of a Big, Bad Bailout?
It's the End of the World As We Know It
The TED Spread Flashes Trouble
The Transmission Mechanism
Let's Make a Deal
Colorado, California, London, and Sweden

"A tournament, a tournament, a tournament of lies.
Offer me solutions, offer me alternatives and I decline.
It's the end of the world as we know it and I feel fine.
(It's time I had some time alone.)"

- Lyrics from R.E.M., 1987

Flying last Tuesday, overnight from Cape Town in South Africa to London, I read in the Financial Times that Republican Congressman Joe Barton of Texas was quoted as saying (this is from memory, so it is not exact) that he had difficulty voting for a bailout plan when none of his constituents could understand the need to bail out Wall Street, didn't understand the problem, and were against spending $700 billion of taxpayer money to solve a crisis for a bunch of (rich) people who took a lot of risk and created the crisis. That is a sentiment that many of the Republican members of the House share.

As it happens, I know Joe. My office is in his congressional district. I sat on the Executive Committee for the Texas Republican Party representing much of the same district for eight years. This week, Thoughts from the Frontline will be an open letter to Joe, and through him to Congress, telling him what the real financial problem is and how it affects his district, helping explain the problem to his constituents , and explaining why he has to hold his nose with one hand and vote for a bailout with the other.

Just for the record, Joe has been in Congress for 24 years. He is the ranking Republican on the Energy and Commerce Committee, which is one of the three most important committees and is usually considered in the top five of Republican House leadership. He is quite conservative and has been a very good and effective congressman. I have known Joe for a long time and consider him a friend. He has been my Congressman at times, depending on where they draw the line. I called his senior aide and asked him how the phone calls were going. It is at least ten to one against supporting this bill, and that is probably typical of the phones all across this country. People are angry, and with real justification. And watching the debates, it reminds us that one should never look at how sausages and laws are made. It is a very messy process.

I think what follows is as good a way as any to explain the crisis we are facing this weekend. This letter will print out a little longer, because there are a lot of charts, but the word length is about the same. Let's jump right in.

It's the End of the World As We Know It

Dear Joe,

I understand your reluctance to vote for a bill that 90% of the people who voted for you are against. That is generally not good politics. They don't understand why taxpayers should spend $700 billion to bail out rich guys on Wall Street who are now in trouble. And if I only got my information from local papers and news sources, I would probably agree. But the media (apart from CNBC) has simply not gotten this story right. It is not just a crisis on Wall Street. Left unchecked, this will morph within a few weeks to a crisis on Main Street. What I want to do is describe the nature of the crisis, how this problem will come home to your district, and what has to be done to avert a true, full-blown depression, where the ultimate cost will be far higher to the taxpayers than $700 billion. And let me say that my mail is not running at 10 to 1 against, but it is really high. I am probably going to make a lot of my regular readers mad, but they need to hear what is really happening on the front lines of the financial world.

First, let's stop calling this a bailout plan. It is not. It is an economic stabilization plan. Run properly, it might even make the taxpayers some money. If it is not enacted very soon (Monday would be fine), the losses to businesses and investors and homeowners all over the US (and the world) will be enormous. Unemployment will jump to rates approaching 10%, at a minimum. How did all this come to pass? Why is it so dire? Let's rewind the tape a bit.

We all know about the subprime crisis. That's part of the problem, as banks and institutions are now having to write off a lot of bad loans. The second part of the problem is a little more complex. Because we were running a huge trade deficit, countries all over the world were selling us goods and taking our dollars. They in turn invested those excess dollars in US bonds, helping to drive down interest rates. It became easy to borrow money at low rates. Banks, and what Paul McCulley properly called the Shadow Banking System, used that ability to borrow and dramatically leverage up those bad loans (when everyone thought they were good), as it seemed like easy money. They created off-balance-sheet vehicles called Structured Investment Vehicles (SIVs) and put loans and other debt into them. They then borrowed money on the short-term commercial paper market to fund the SIVs and made as profit the difference between the low short-term rates of commercial paper and the higher long-term rates on the loans in the SIV. And if a little leverage was good, why not use a lot of leverage and make even more money? Everyone knew these were AAA-rated securities.

And then the music stopped. It became evident that some of these SIVs contained subprime debt and other risky loans. Investors stopped buying the commercial paper of these SIVs. Large banks were basically forced to take the loans and other debt in the SIVs back onto their balance sheets last summer as the credit crisis started. Because of a new accounting rule (called FASB 157), banks had to mark their illiquid investments to the most recent market price of a similar security that actually had a trade. Over $500 billion has been written off so far, with credible estimates that there might be another $500 billion to go. That means these large banks have to get more capital, and it also means they have less to lend. (More on the nature of these investments in a few paragraphs.)

Banks can lend to consumers and investors about 12 times their capital base. If they have to write off 20% of their capital because of losses, that means they either have to sell more equity or reduce their loan portfolios. As an example, for every $1,000 of capital, a bank can loan $12,000 (more or less). If they have to write off 20% ($200), they either have to sell stock to raise their capital back to $1,000 or reduce their loan portfolio by $2,400. Add some zeroes to that number and it gets to be huge.

And that is what is happening. At first, banks were able to raise new capital. But now, many banks are finding it very difficult to raise money, and that means they have to reduce their loan portfolios. We'll come back to this later. But now, let's look at what is happening today. Basically, the credit markets have stopped functioning. Because banks and investors and institutions are having to deleverage, that means they need to sell assets at whatever prices they can get in order to create capital to keep their loan-to-capital ratios within the regulatory limits.

Remember, part of this started when banks and investors and funds used leverage (borrowed money) to buy more assets. Now, the opposite is happening. They are having to sell assets into a market that does not have the ability to borrow money to buy them. And because the regulators require them to sell whatever they can, the prices for some of these assets are ridiculously low. Let me offer a few examples.

Today, there are many municipal bonds that were originally sold to expire 10-15 years from now. But projects finished early and the issuers wanted to pay them off. However, the bonds often have a minimum time before they can be called. So, issuers simply buy US Treasuries and put them into the bond, to be used when the bond can be called. Now, for all intents and purposes this is a US government bond which has the added value of being tax-free. I had a friend, John Woolway, send me some of the bid and ask prices for these type of bonds. One is paying two times what a normal US Treasury would pay. Another is paying 291% of a normal US Treasury. And it is tax-free! Why would anyone sell what is essentially a US treasury bond for a discount? Because they are being forced to sell, and no one is buying! The credit markets are frozen.

Last week, I wrote about a formerly AAA-rated residential mortgage-backed security (RMBS) composed of Alt-A loans, better than subprime but less than prime. About 5% of the loans were delinquent, and there are no high-risk option ARMs in the security. It is offered at 70 cents on the dollar. If you bought that security, you would be making well over 12% on your money, and 76% of the loans in the portfolio of that security would have to default and lose over 50% of their value before you would risk even one penny. Yet the bank which is being forced to sell that loan has had to write down its value. As I wrote then, that is pricing in financial Armageddon. (You can read the full details here.)

Let's look at the following graph. It is an index of AAA-rated mortgage bonds, created by www.markit.com. It is composed of RMBSs similar to the one I described above. Institutions buy and sell this index as a way to hedge their portfolios. It is also a convenient way for an accounting firm to get a price for a mortgage-backed security in a client bank's portfolio. With the introduction of the new FASB 157 accounting rule, accountants are very aggressive about making banks mark their debt down, as they do not want to be sued if there is a problem. Notice this index shows that bonds that were initially AAA are now trading at 53 cents on the dollar, which is up from 42.5 cents two months ago.

Accountants might look at the bond I described above, look at this index, and decide to tell their clients to mark the bonds down to $.53 on the dollar. The bank is offering the bond at $.70 because it knows there is quality in the security. They are being forced to sell. And guess what? There are no buyers. An almost slam-dunk 12% total-return security with loss-coverage provisions that suggest 40% of the loans could default and lose 50% before your interest rate yields even suffered, let alone risk to your principal – and it can't find a buyer.

One of the real reasons these and thousands of other good bonds are not selling now is that there is real panic in the markets. The oldest money market fund "broke the buck" last week, because they had exposure to Lehman Brothers bonds. We are seeing massive flights of capital from money market funds, including by large institutions concerned about their capital. What are they buying? Short-term Treasury bills. Three-month Treasury bills are down to 0.84%.

It gets worse. Last week one-month Treasury bills were paying a negative 1%!!! That means some buyers were so panicked that they were willing to buy a bond for $1 that promised to pay them back only $.99 in just one month. The rate is at 0.16% today. If something is not done this weekend, it could go a lot lower over the next few days. That is panic, Joe.

I don't want to name names, as this letter goes to about 1.5 million people and I don't want to make problems for some fine banking names; but there is a silent bank run going on. There are no lines in the street, but it is a run nevertheless. It is large investment funds and corporations quietly pulling their money from some of the best banks in the country. They can do this simply by pushing a button. We are watching deposit bases fall. It does not take long. Lehman saw $400 billion go in just a few months this summer. Think about that number. Any whiff of a problem and an institution that is otherwise sound could be brought low in a matter of weeks. And the FDIC could end up with a large loss that seemed to have come from out of nowhere.

The TED Spread Flashes Trouble

There is something called the TED spread, which is the difference between three-month LIBOR (the London Inter Bank Offered Rate which is in euro dollars, also called The Euro Dollar Spread, thus TED) and three-month US Treasury bills. Three-month LIBOR is basically what banks charge each other to borrow money. Many mortgages and investments are based on various periods of LIBOR. Look at the chart below. Typically the TED spread is 50 basis points (0.50%) or less. When it spikes up, it is evidence of distress in the financial markets. The last time the TED spread was as high as it is now was right before the market crash of 1987. This is a weekly chart, which does not capture tonight's (Friday) change, which would make it look even worse. Quite literally, the TED spread is screaming panic.

The Fed has lowered rates to 2%. Typically, three-month LIBOR tracks pretty close to whatever the Fed funds rate is. Starting with the credit crisis last year, that began to change. Look at the chart below.

Remember, LIBOR is what banks charge to each other to make loans. Lower rates are supposed to help banks improve their capital and their ability to make loans at lower interest rates to businesses and consumers. Look at what has happened in the past few weeks, in the chart above. The spread between three-month LIBOR and the Fed funds rate is almost 200 basis points, or 2%! That is something that defies imagination to market observers. On the chart above, it looks like it has not moved that much, but in the trading desks of banks all over the world it is a heart-pounding, scare-you-to-death move. The chart below reflects what traders have seen in the past two weeks, and it moved up more today.

Now let's look at the next chart. This is the amount of Tier 1 commercial paper issued. This is the life blood of the business world. This is how many large and medium-sized businesses finance their day-to-day operations. The total amount of commercial paper issued is down about 15% from a year ago, with half of that drop coming in the last few weeks. Quite literally, the economic body is hemorrhaging. Unless something is done, businesses all over the US are going to wake up in a few weeks and find they simply cannot transact business as usual. This is going to put a real crimp in all sorts of business we think of as being very far from Wall Street.

I could go on. Credit spreads on high-yield bonds that many of our best high-growth businesses use to finance their growth are blowing out to levels which make it impossible for the companies to come to the market for new funds. And that is even if they could find investors in this market! There are lots of other examples (solid corporate loans selling at big discounts, asset-backed securities at discounts, etc.), but you get the idea. Suffice it to say that the current climate in the financial market is the worst since the 1930s. But how does a crisis in the financial markets affect businesses and families in Arlington, Texas, where my office and half of your district is?

The Transmission Mechanism

The transmission in a car takes energy from the engine and transfers it to the wheels. Let's talk about how the transmission mechanism of the economy works.

Let's start with our friend Dave Moritz down the street. He needs financing to be able to sell an automobile. To get those loans at good prices, an auto maker has to be able to borrow money and make the loans to Dave's customers. But if something does not stop the bleeding, it is going to get very expensive for GM to get money to make loans. That will make his cars more expensive to consumers. Cheap loans with small down payments are the life blood of the auto selling business. That is going to change dramatically unless something is done to stabilize the markets.

Credit card debt is typically packaged and sold to investors like pension funds and insurance companies. But in today's environment, that credit card debt is going to have to pay a much higher price in order to find a buyer. That means higher interest rates. Further, because most of the large issuers of credit cards are struggling with their leverage, they are reducing the amount of credit card debt they will give their card holders. If they continue to have to write down mortgages on their books because of mark-to-market rules which price assets at the last fire-sale price, it will mean even more shrinkage in available credit.

Try and sell a home above the loan limits of Fannie and Freddie today with a nonconforming jumbo loan. Try and find one that does not have very high rates, because many lenders who normally do them simply cannot afford to keep them on their balance sheets. And a subprime mortgage? Forget about it. This is going to get even worse if the financial markets melt down.

We are in a recession. Unemployment is going to rise to well over 6%. Consumer spending is going to slow. This is an environment which normally means it is tougher for small businesses and consumers to get financing in any event. Congress or the Fed cannot repeal the business cycle. There are always going to be recessions. And we always get through them, because we have a dynamic economy that figures out how to get things moving again.

Recessions are part of the normal business cycle. But it takes a major policy mistake by Congress or the Fed to create a depression. Allowing the credit markets to freeze would count as a major policy mistake.

I have been on record for some time that the economy will go through a normal recession and a slow recovery, what I call a Muddle Through Economy. This week I met with executives of one of the larger hedge funds in the world. They challenged me on my Muddle Through stance. And I had to admit that my Muddle Through scenario is at risk if Congress does not act to stabilize the credit markets.

Let's Make a Deal

Why do we need this Stabilization Plan? Why can't the regular capital markets handle it? The reason is that the problem is simply too big for the market to deal with. It requires massive amounts of patient, long-term money to solve the problem. And the only source for that would be the US government.

There is no reason for the taxpayer to lose money. Warren Buffett, Bill Gross of PIMCO, and my friend Andy Kessler have all said this could be done without the taxpayer losing money, and perhaps could even make a profit. As noted above, these bonds could be bought at market prices that would actually make a long-term buyer a profit. Put someone like Bill Gross in charge and let him make sure the taxpayers are buying value. This would re-liquefy the banks and help get their capital ratios back in line.

Why are banks not lending to each other? Because they don't know what kind of assets are on each other's books. There is simply no trust. The Fed has had to step in and loan out hundreds of billions of dollars in order to keep the financial markets from collapsing. If you allow the banks to sell their impaired assets at a market-clearing fair price (not at the original price), then once the landscape is cleared, banks will decide they can start trusting each other. The commercial paper market will come back. Credit spreads will come down. Banks will be able to stabilize their loan portfolios and start lending again.

Again, the US government is the only entity with enough size and patience to act. We do not have to bail out Wall Street. They will still take large losses on their securities, just not as large a loss as they are now facing in a credit market that is frozen. As noted above, there are many securities that are being marked down and sold far below a rational price.

If we act now, we will start to see securitization of mortgages, credit cards, auto loans, and business loans so that the economy can begin to function properly.

What happens if we walk away? Within a few weeks at most, financial markets will freeze even more. We will see electronic runs on major banks, and the FDIC will have more problems than you can possibly imagine. The TED spread and LIBOR will get much worse. Businesses which use the short-term commercial paper markets will start having problems rolling over their paper, forcing them to make difficult cuts in spending and employment. Larger businesses will find it more difficult to get loans and credit. That will have effects on down the economic food chain. Jim Cramer estimated today that without a plan of some type, we could see the Dow drop to 8300. That is as good a guess as any. It could be worse. Home valuations and sales will drop even further.

The average voter? They will see stock market investments off another 25% at the least. Home prices will go down even more. Consumer spending will drop. What should be a run-of-the-mill recession becomes a deep recession or soft depression. Yes, that may be worst-case scenario. But that is the risk I think we take with inaction.

A properly constructed Stabilization Plan hopefully avoids the worst-case scenario. It should ultimately not cost the taxpayer much, and maybe even return a profit. The AIG rescue that Paulson arranged is an example of how to do it right. My bet is that the taxpayer is going to make a real profit on this deal. We got 80% of AIG, with what is now a loan paying the taxpayer over 12%, plus almost $2 billion in upfront fees for doing the loan. That is not a bailout. That is a business deal that sounds like it was done by Mack the Knife.

This deal needs to be done by Monday. Every day we wait will see more and more money fly out the doors of the banks, putting the FDIC at ever greater risk. Panic will start to set in, moving to ever smaller banks. Frankly, we are at the point where we need to consider raising the FDIC limits for all deposits for a period of time, until the Stabilization Plan quells the panic.

I understand that this is a really, really bad idea according classical free-market economic theory. You know me; I am as free market as it comes. But I also know that without immediate action a lot of people are really going to be hurt. Unemployment is not a good thing. Losses on your home and investments hurt. It is all nice and well to talk about theories and contend the market should be allowed to sort itself out; and if we have a deep recession, then that is what is needed. But the risk we take is not a deep recession but a soft depression. The consequences of inaction are simply unthinkable.

Joe, I am telling you that the markets are screaming panic. Yes, Senator Richard Shelby has his 200 economists saying this is a bad deal. But they are ivory tower kibitzers who have never sat at a trading desk. They have never tried to put a loan deal together or had to worry about commercial paper markets collapsing. I am talking daily with the people on the desks who are seeing what is really happening. Shelby's economists are armchair generals far from the front lines. I am talking to the foot soldiers who are on the front lines.

Every sign of potential disaster is there. You and the rest of the House have to act. It has to be bipartisan. This should not be about politics (even though Barney Frank keeps talking bipartisan and then taking partisan shots, but I guess he just can't help himself). It should be about doing the right thing for our country and the world. I know it will not be fun coming back to the district. Talking about TED spreads and LIBOR will not do much to assuage voters who are angry. But it is the right thing to do. And I will be glad to come to the town hall meeting with you and help if you like.

With your help, we will get through this. In a few years, things will be back to normal and we can all have stories to tell to our grandkids about how we lived through interesting times. But right now we have to act.

Colorado, California, London, and Sweden

It is time to hit the send button. This was personally a great week. For whatever reason, I did not suffer jet lag flying to South Africa for just two days, then overnight to London, and back the next day. It was a good trip. I will report more about South Africa in a later letter, but this e-letter is already a little long.

I leave Sunday for a quick trip to Longmont, Colorado (near Boulder) to look at a very interesting technology company (InPhase) that makes holographic memory disks, with good friend Dr. Bart Stuck of Signal Lake Partners.

I will be in San Diego and Orange County the 16^th and 17^th of October for back-to-back speeches, then I leave Sunday for London for two days and then on to Sweden for a conference and speeches there, a quick trip to Malta, and then back home, where I will be chained to my desk by daughter Tiffani as we do interviews and write a book.

I do enjoy traveling from time to time, seeing the rest of the world. One of my secret pleasures is reading International Living and thinking about what it would be like to have another home somewhere. Cheap thrills. You can subscribe if you like by following this link.

Have a great week. I fully believe (OK, deeply hope) that Congress will act. We can all breathe a collective sigh when they do.

Your still believing in Muddle Through analyst,

John Mauldin

It's more than Fannie and Freddie

John Mauldin — Sat, 23 Aug 2008 01:12:02 GMT

It's More Than Freddie and Fannie
The US Banking System Is in Trouble
$500 Billion and Counting
Fannie, Freddie, and the Credit Crisis
Baltimore, La Jolla, and South Africa

Yet another crisis confronts us, as we will have to deal with the aftermath of a rather large number of bank failures over the next year, which is likely to overwhelm the ability of the FDIC to insure your bank deposits. Today we look at the banking system, the FDIC, and Freddie and Fannie. It's not pretty, but as realists we must know what we are facing.

But first, I just want to say I am glad that Richard Russell is doing fine. For those who do not know, he suffered a mild stroke last Friday. I talked to him yesterday, and he was a little tired but doing better. He has decided to cut back his writing schedule and relax a bit more, which is a good thing. At 84, he has written a daily (and sometimes lengthy) commentary and has been writing the monthly Dow Theory Letter since 1958. He is the dean of newsletter writers. He has forgotten more than most of us will ever know about the markets.

His doctor told him he needed to seek some balance in his life and cut down on the stress. I know how much it takes to write my one letter each week; I can't imagine what it takes to write five. Basically, his plan is now to post his stats and only write about the markets when something important is happening, about every two weeks. I hope he sticks with that plan, as I want to be sharing dinner and drinks with him for many years to come. I am sure you join me in wishing him and his lovely wife Faye all the best and a healthy and quick recovery.

The US Banking System Is in Trouble

A few weeks ago when I was in Maine, I met Chris Whalen. Chris is the managing director of a service called Institutional Risk Analytics, whose primary business is analyzing the health of banks and financial institutions. If you are one of their clients, you can go to their web site and drill quite deep into all aspects of every bank in America. And what they have done is come up with various metrics which compare how well-capitalized a bank is, how much risk it is taking, and what kind of losses (or profits) it can expect. It is a one of a kind firm, and the data gives Chris a very special perspective on the US banking system.

And what he sees is not pretty. There is a crisis brewing. He expects 100 banks to fail between now and July of 2009. Most of them will be small, but there will be a few large banks. The total assets of those banks he estimates to be $850 billion (not a typo!). Those are the assets the FDIC is going to have to cover when they take over the banks.

Take Washington Mutual as an example. There are problems there. Their debt now trades at 20%, which is worse than junk. There is no way they could issue preferred stock to recapitalize their business. And they are going to need more capital, as they have writedowns in their future due to the slowing of the economy. Any common issue would have to seriously dilute existing shareholders almost to the point of nothing. There are circumstances in which they can survive, but it would take a remarkable recovery for the US economy, which is not likely. Maybe management can pull a rabbit out of the hat, but it will need some strong magic to get the capital they need at a cost they can live with.

The FDIC has about $50 billion. These reserves have been built up over the years from deposit insurance paid by banks that are part of the program. They are going to need an estimated $20 billion just to cover the failure of Indy Mac. The FDIC will have to cover only a small percentage of the $850 billion, as some of those assets will surely be good. But if they have to cover 10%, then the FDIC would need another $50 billion. Does that sound like a lot? Chris thinks a more conservative number for planning purposes would be 20-25% potential losses, and you hope it does not get there.

Sometime in the next few quarters, Congress and the President, either the current group or early in the term of the next President, are going to have to address that potential shortfall, before we see bank runs as people fear that FDIC insurance reserves may not be enough. The very sad fact is that taxpayers are going to be on the hook for some time. What is likely to happen is that a loan facility will be made to the FDIC so they can borrow as much as they need, and pay it back from future bank insurance payments.

You can't make up the shortfall just by raising fees. Chris points out that raising fees right now is not really a winning option, as that just makes the financial books of marginal banks even worse. You can raise rates as the banking system returns to health.

If Congress and the President wait too long, there could be a very serious problem, as depositors could start moving their funds under $100,000 (the insured amount) to what they perceive may be a safer bank than their current bank. Rumors could run rampant. This is something that needs to be addressed now. Frankly, this should be addressed right after the elections AT THE LATEST, in consultation with Congress and the new President.

If you are worried about your bank, you can go to Chris's web site and pay $50 for a brief analysis of your bank and an update for the next four quarters. If you have less than $100,000 in your accounts, you should not worry. But for businesses with large deposits and cash flows, it might be worth checking on the health of your bank. The link is http://us1.institutionalriskanalytics.com/Cart/Request.asp?affiliate=bmg123.

You can click on the link that says "Click here for the free samples" in the lower right corner of the page to see if the format of what they offer is something you would find useful.

$500 Billion and Counting

We have seen some $505 billion in bank write-offs so far in this credit crisis. It is serious naiveté to assume that this will be the extent of it. Most of the write-offs have been mortgage-related. We have not yet seen the write-offs that will come as consumers start defaulting on credit cards, auto loans, and other consumer debt. Neither have we seen the losses that will come from commercial real estate or corporate loan as the recession progresses. You can't write off something until it goes bad, although you can increase your loan loss provisions. This of course hits earnings and your stock price and thus your ability to raise new equity. It presents a very difficult dilemma for bank managers and investors deciding whether to invest or go away.

Sober-minded analysis from the IMF suggests that the total write-offs by all banks may be $1 trillion. Dr. Nouriel Roubini is much more alarmed and puts the potential losses at closer to $2 trillion. That means that banks over time are going to have to increase their loan loss provisions, hitting both earnings and capital. And that means they will have to raise more investment capital and equity at a time when their stock prices are low.

It is a vicious spiral. Banks have less capital, so they are able to lend less to the very businesses that need the money; and without said money the businesses will be less capable of paying their current loans, which means that banks have less capital. Rinse and repeat.

That only prolongs the recession and Muddle Through Economy, which hurts consumers and corporate profits, which in turn puts more pressure on banks. Ultimately it means that banks are going to have to raise a lot more capital than anyone who is buying financial stocks today imagines. And it is largely going to be expensive capital. Look at this note from Bennet Sedacca of Atlantic Advisors:

"Financial entities like banks, broker/dealers, regional banks, finance companies, and insurance companies need credit at reasonable rates in order to finance themselves. I have been concerned for many years that the door would finally shut on banks, brokers and others to raise new capital in the debt markets.

"For many regional banks like KeyCorp, Zions, Regions, and National City, the door has already shut on them--if they wanted to raise capital in the debt market at levels where their outstanding issues regularly trade, they would have to pay 12-15%, hardly economic levels. GM bonds trade near 27% yields. Washington Mutual trades north of 15%.

"Then there are the 'good banks', like J.P. Morgan and Wells Fargo. J.P. Morgan recently sold $600 million of preferred stock at 8 3/4 % and Wells Fargo sold $1.3 billion at 8 5/8%, plus underwriting fees.

"Below I offer up a few guesses of what other issuers would have to pay to issue preferred stock.

Lehman Brothers--11-13%.
Merrill Lynch--11-12%.
Morgan Stanley--9-10%.
Citigroup--9 1/2-10 1/2%.
CIT Group--12-15%.
Fannie Mae/Freddie Mac---15%
Keycorp--11-13%.
National City--13-15%.
Wachovia--10-12%.
Zions Bancorp--13-15%.
GM/GMAC--not possible.
Washington Mutual--not possible.
Ford--not possible."

Bennet does note a good point. Banks that conserved capital and managed their risks well will be in good shape to take over weaker brethren. They will have access to the capital markets for the money they need for expansion. My own bank was acquired recently by another small regional bank. Deals are getting done.

In another note, and to illustrate this point, Sedacca points out that it is not just Freddie and Fannie. Besides Washington Mutual, mentioned above, "RF (Regions Financial) needs to raise $2 billion says Sanford Bernstein. Let's see, what are their options? They can sell debt. The problem here is that you couldn't sell debt if you wanted. The last reported trade in RF paper was 2 weeks ago nearly +700 to the 30 year or close to 12%. Their preferreds trade at 10% and the stock is now a 'single digit midget' near $8 a share. So if you could even get a deal done, shareholders would get a 50% haircut."

Fannie, Freddie, and the Credit Crisis

Let's turn to Freddie and Fannie. There must be some people who think there is some way that the shareholders of Fannie and Freddie will not lose everything, as their shares actually trade. This just simply goes to show that you can fool some of the people some of the time. And as we will see, some of those people are very serious institutions.

It is almost a forgone conclusion that the US Treasury will have to step in and for all intents and purposes nationalize the two government-sponsored enterprises. The estimated losses in these two firms are far beyond what they could raise in a traditional market. And the longer the government waits, the worse the situation is likely to get.

Moody's downgraded the preferred stock in these firms to almost junk level because of the increased likelihood of "direct support" from the US Treasury, which, depending on the nature of the support, could wipe out both the holders of the common and the preferred. The preferred shares have already lost half their value since June 30 on speculation that an intervention would mean a stop in dividend payments (highly likely) and issuance of new preferred that would take preference over current preferred.

Interestingly, this would put more pressure on the banking system, as many banks hold the GSE preferred shares as assets, choosing to get a little extra return over traditional and more conservative assets. But then of course, Fannie and Freddie preferred were considered safe just a few months ago, with the best ratings from Moody's.

"Regional banks including Midwest Bank Holdings Inc., Sovereign Bancorp and Frontier Financial Corp., may have the most to lose. Melrose Park, Illinois-based Midwest has $67.5 million, or as much as 23 percent of its risk-weighted assets, in the preferred stock, while Philadelphia-based Sovereign owns about $623 million and Everett, Washington-based Frontier about $5 million." (Bloomberg)

It is doubtful that banks which hold these assets have written them down yet, but with a downgrade they will almost certainly be forced to do so in the near future. For the record, Fannie Mae has 17 classes of preferred stock, with more than 600 million shares outstanding. Freddie Mac has 24 classes of preferred stock, with about 460 million shares outstanding. The existing shares are trading worse than junk bonds, paying 17-19%.

And it may be a total write-off. It is hard to imagine how Treasury Secretary Paulson, or a new Treasury Secretary next year, could put US taxpayer money into the companies at risk without wiping out the current common and preferred shareholders. The justified outrage would be huge.

The basic problem is that without Freddie and Fannie the US mortgage market would go from crippled to moribund, if not dead. We have created a system that could not function in the short term without them, and the pain of allowing them to collapse would be another 1930s-style Depression, the era in which these firms were first created. They were never designed to take on the huge leverage they did, or to use hundreds of millions in lobbyist money and campaign contributions to create a massive payment scheme for management and shareholders. Congressional estimates are that this could cost US taxpayers $25 billion, a significant multiple of their current market caps.

Fannie and Freddie will not be able to raise capital on their own. At this point, why would any rational investor put that much money into a company with such a convoluted preferred share scheme, without government guarantees? That estimated loss assumes that the housing market does not get worse from this point. Losses could be much worse, or things could get better. Who knows? Why invest in something with so much uncertainty?

But there are more problems. You can't just take someone else's property, and that is what stock is, without some serious reasons. You almost are forced to wait for a crisis, otherwise shareholders would sue, saying that they suffered unnecessary losses. You can certainly expect the preferred shareholders to sue. That is why Paulson hired JP Morgan to figure out how to recapitalize the banks. I don't envy the people who are working on that one. Maybe there is some magic somewhere, but as we saw with Bear Stearns, at the end of the day it is all about adequate capital.

The GSE companies should be adequately capitalized and broken up into much smaller firms that would not be too big too fail in the future, and put under a regulator that would enforce reasonable leverage limits, with the profits going to pay back the US taxpayer before any profits or dividends are paid to any other future owners.

That is, if the government takes the two GSEs and puts capital (probably in the form of loans and guarantees) into them, which puts taxpayers at risk, then allows a public offering of the smaller entities to raise capital to repay the loans, any shortfall should be made up by the issuance of preferred shares, and the common shareowners would wait until the government loan was repaid before they would be eligible for a dividend.

And the people responsible for creating the leveraged systems, the board, et al., should be forced to resign. New top management all around.

The ultimate goal should be for taxpayers to get their money back and any guarantee, implicit or explicit, to be removed. No mortgage bank should ever again be allowed to be too big too fail.

Now, taken as a part of the total credit crisis, which will run to over $1 trillion (at least), $25 billion may not seem like a lot. But I hope this is a wake-up call for better regulations and safeguards.

And before I go, let me reiterate my call for regulators to force banks to move their credit default swaps to an exchange. The potential for a blow-up is serious, and it could dwarf the current credit crisis. I am not saying it will happen, just that it could. Even a low-risk event should be protected against. Credit default swaps are legitimate business transactions. They are very useful. They should just be put on an exchange, like futures or options, where there is 100% transparency as to counterparty risk.

Baltimore, La Jolla, and South Africa

I am home for a few weeks, enjoying the tail end of summer. On September 6, Tiffani and I will head to Baltimore to be with Bill Bonner, founder of Agora Publishing, and a host of friends, to celebrate his 60^th birthday. It is hard to believe that we have known each other for 26 years. What an incredible business model he has created. He has adapted with the times, letting his business evolve into a multi-hundred-million-dollar enterprise. I remember first going to his offices in Baltimore, which were definitely in a very bad part of town. I was nervous just walking two blocks in broad daylight; but the offices were inexpensive, I suppose.

He is the one of the best pure writers I know. You can read some of his essays and subscribe to the free Daily Reckoning (be warned: Bill is quite bearish) by clicking on this link: http://www.dailyreckoning.com/rpt/mauldin.html.

Tiffani and I will then be going to La Jolla September 15 to meet with my partners at Altegris, and meet some new potential associates. Right now, drinks with Richard and Faye Russell is on the calendar, and I really look forward to it.

Then a few weeks later I will head off on a quick trip to South Africa, where I will be speaking for an investment group in Cape Town, then maybe stop off in London for a day and then hurry home in time to do my regular letter.

That is enough to make me tired, so I think I will hit the send button and go home and see who is there. Have a great week.

Your needing to seek my own balance analyst,

John Mauldin

The Problem with the Euro

John Mauldin — Fri, 30 May 2008 20:34:42 GMT

The Problem with the Euro
Swapping out Commodities
The Euro at Par with the Dollar
Laguna Beach, Montreal and Las Vegas

By John Mauldin

Last week I wrote that we could see a drop in the price of oil as speculators seemed to be storing oil in very large tankers and "slow steaming" them to port in a bet that prices would rise. When everyone is on the same side of the trade, the time is right for a reversal. This is especially true when there is a large potential supply sitting on the sidelines.

This week we briefly look at this prediction, and perhaps even more ominous problems for commodities in general, at least in the short run. The new turn our attention to the euro. It will make for an interesting letter.

First off, oil dropped about 4% yesterday and is down almost $10 from its high only a week ago. Yet supplies of crude oil surprisingly dropped by 8.8 million barrels yesterday. Oil shot up on the news as both those who were short covered their bets and even more people piled into the long side of the trade.

But then the EIA report gave the rest of the story. It seems the shortfall "was due to temporary delays in crude oil tanker off-loadings on the Gulf Coast." And as Dennis Gartman noted this morning, "officials at the Louisiana Offshore Oil Port (LOOP) said

that some crude oil tankers cancelled scheduled deliveries last week." The owners of the oil in those tankers are now down about 6-7%, whether it is speculators in the pits or the actual trading companies.

I talked with George Friedman of Stratfor this morning, and he says that the supply of tankers is even tighter, which suggests there is even more oil on the seas looking for a home. Crude oil prices could be under pressure in the next few weeks and months as whoever holds that oil is going to want to get it onshore somewhere and out of very expensive tankers.

Swapping out Commodities

The Commodity Futures Trading Commission announced yesterday that they are looking very hard at possibly closing a regulatory loophole that allowed some extremely large commodity index funds to get around position limits. For those not familiar with the concept of limits, it basically works like this. No trader or fund is allowed to own more than a specific amount of a commodity traded on the futures exchange. This limit varies from commodity to commodity and exchange to exchange. The point is to keep one group from manipulating the price of a commodity, as the Hunts did with silver in the early 80s.

The loophole is one where large investment banks can sell a "swap" for a specific commodity like corn and then hedge their position in the futures markets. There is no limit on the amount of the commodity that can be hedged. So, a fund can accumulate sizeable positions far in excess of what they could do directly by working with an investment bank. In essence, the swap is a derivative issued by a bank which acts just like a futures trade, but it is with the bank as guarantor and not an exchange. Swaps are not regulated as such. And up until now, the banks were seen as legitimate hedgers so there were no limits on what they could buy in the futures markets.

This works for very large commodity index funds which try to mirror a particular commodity index and need to be able to buy very large positions in excess of the normal limits (and there are scores of them), and for the banks that make the commissions and profits on the swaps. Remember, the fund gets a management fee, so growing the size of the fund grows their fees.

These indexes typically have about 26 commodities, with the largest allocation to oil, but almost anything that is traded has some small portion of the allocation. As I noted last week, there are some who believe this is working to drive up the price of commodities beyond the simply supply and demand principles. Whether or not you believe this to be the case, the CFTC is looking at the loophole.

The key word in the announcement yesterday was the word "classification." Right now the banks are classified as hedgers and as such have no limits. But they are not really hedging the actual physical commodity as a farmer or General Mills might do, but the hedge is their financial position.

If the CFTC decides to look through them to the funds, and they did use the word transparency in their announcement, they could decide to change the classification of the banks from hedgers to speculators. While I do no think that might make a difference in the long run, in the short run it could make commodities volatile in the extreme, and exert downward pressure up and down the price curve, depending on how they would decide to unwind the commodity index funds.

For what its worth, I advised my daughter to get out of the commodity fund she was in for the time being. When the regulators are in the room, anything could happen. And they are getting intense pressure from Congress to change the rules. My bet is that the train has left the station and it is but a matter of time until position limits are put in place for commodity funds, including commodity ETFs. Is that a good thing? I think not, but that matters not one whit. The hand writing is on he wall.

Does this mean I am not a long term commodity bull? No, I remain bullish on a host of commodities over the long term from a supply and demand perspective. It is just that you might want to consider whether to stand aside for a time while the congressional elephant is stampeding around the room. Maybe it is a non-event and someone figures out a way to unwind the positions slowly and over time. Maybe the grandfather the current funds at the size they are today. Who knows? As I said, when the regulators are under pressure to do something, I want to know what the new rules will be before I play in the game.

The Euro at Par with the Dollar

About five years ago, I said that the euro, which was trading at about $.88 at the time would rise to $1.50 and then fall back to $1 over the course of a decade or more. It would be one huge round trip. By the way, giving credit where credit is due, that opinion was crystallized over a long dinner with bond expert Lord Alex Bridport and several companions in Geneva. The logic was compelling then and it still is now. We are halfway through that decade long trip and it remains to be seen if we get back to parity. I think we will.

Why would the euro fall? Because the currency is still an experiment in cooperation. At some point, one or more of the weaker European countries is going to need more monetary stimulation than the majority of the countries in the union, for a variety of reasons. Will they pull out to be able to issue their own fiat currency? Will the EU as a whole slow down as the US recovers?

About 4 times a year, I give myself permission to not write a letter, taking a little mental vacation. This week, Louis Gave is graciously allowing me to use a chapter from his latest book, "A Roadmap for Troubled Times" which highlights some of the problems the euro is going to face, as well as analysis on a host of topics.

Gentle reader, this is an important topic and Louis says it better than I can. I highly recommend you get the book and read it. It is only about 200 pages and is a very easy read. The chapters on China are worth the price of admission, as well as his suggested investment themes. You can order the book at Amazon.com.

So, without further ado, let's jump into the problem with the Euro.

The Change In Policy

The Divergence in European Spreads - Why Now?

Back in May 2007, we wrote a piece entitled "Part 2-So What Should We Worry About". In that ad hoc comment, we wrote: "The crux of the thesis of our latest book, The End is Not Nigh, is simple and goes something like this: a) Asian central banks continue to manipulate their currencies and prevent them from finding a fair value against either the US$ or the Euro; b) this manipulation triggers an accumulation in central bank reserves which, in turn, leads to low real rates around the world; c) the combination of low global real rates and low Asian exchange rates amounts to a subsidy for Asian production and Western consumption; d) in the US, the subsidy has by and large been captured by individual consumers; e) meanwhile, in Europe, the subsidy has been cashed in by governments whose debt has skyrocketed; f) we see little reason why, in the near future, the subsidy should be removed; but g) if it were removed, the US would most likely encounter a consumer recession (not the end of the world); while h) Europe could go through a debt crisis (far more problematic)."

We went on and wrote: "Last week, and against most observers' expectations, the Indian central bank did not raise rates at its meeting. Instead, it seems that the authorities are allowing the currency to rise and hopefully thereby absorb some of the country's inflationary pressures (linked to energy and higher food prices). In recent weeks, the rupee has shot higher and now stands at a post-Asian crisis high. And interestingly, the local market is loving it. While Indian stocks had been sucking wind year to date, the central bank's apparent policy shift (from higher interest rates to higher exchange rates) has triggered a very sharp rally.

This of course is an interesting turn of events and we would not be surprised if Asian central banks were to study developments in India carefully over the coming quarters. After all, India is blazing a path that a number of Asian countries may yet decide to follow.

One could argue that a change in monetary policy in Asia could end up being a "triple whammy" for Western economies. It would mean that:

Asian central banks would export less capital into our bond markets and this would likely lead to a drift higher in real rates around the world.
Asian exchange rates would move sharply higher, which in turn would likely mean higher import prices in the US and Europe.
As Asian exchange rates start to move higher, Asia's private savers would likely start repatriating capital, further amplifying exchange rate and interest rate movements. This would also likely lead to collapses in monetary aggregates in the Europe and the US.

Finally, we concluded the paper by saying: As we highlighted in Part 1: Why We Remain Bullish, we are not worried about valuations. And we are also not worried about "excess leverage" in the system, or the threat of a "private equity bubble". We also do not fear an "economic meltdown" or a brutal end to the "Yen carry-trade" (which we did fear in the Spring of 2006). Instead, if we had to have one concern, it would have to be a possible change of monetary policy across Asia and the impact that this would have on real rates around the world. As we view things, the only reason Asian central banks would change their policies is if food prices continued to increase (in that respect, owning some soft commodities—a hedge against rising real rates—makes sense to us; as does owning Asian currencies). Interestingly, such a turn of events seems to be unfolding in India, yet no one seems to care. Monitoring changes in Asian inflation, monetary policies and exchange rates could prove more important than ever.

Nine months after that paper, we have indeed just gone through a period of a) rapidly rising food prices which have led to b) faster inflation rates across Asia, which have triggered c) a change in Asian monetary policy, notably a willingness to let the currencies appreciate faster than they have in the past. And if Asian central banks are now finally allowing their currencies to rise, then one thing is sure: Asian central banks will no longer need to print large amounts of their own currencies and accumulate US$ and Euros. They will thus also no longer need to buy US Treasuries and European bonds to the extent that they have.

Is it a co-incidence that, as Asia starts to allow its currencies to rise, US mortgages have been hitting the wall and spreads amongst European sovereigns have started to widen? The subsidy that Asian central banks have been giving to consumption in the US and governments in Europe (see The End is Not Nigh) is now disappearing.

Indeed, for the past five years, spreads of Italian ten-year government bonds to German bonds have hovered between 15bp and 25bp. But recently, spreads have started to break out on the upside.

And, of course, Italy is not alone. All across Europe, we have seen a widening of spreads between the "stronger" signatures (Germany, Holland, Austria, Finland, Ireland) and the "weaker" signatures (Portugal, Italy, Greece, Spain, Belgium, France) including those of Eastern Europe (Latvia, Romania, Hungary, Poland...).

Now as our more seasoned GaveKal reader will undeniably remember (see Divorce, Italian Style, or The End is Not Nigh), we have argued that spreads between Europe's sovereigns were set to widen for the past few years. And yet, nothing happened. Until, that is, we started to see Asian central banks allowing their currencies to start appreciating faster.

But what happens if Asian central banks now stop buying up European government debt to the tune of recent years? For a start, European money supply growth should decelerate rapidly and with it, economic activity. A bigger problem will then be the ability of European governments to raise further financing. Indeed, as economic activity tanks in Europe, and the Euro starts to fall, it is likely that investors will all of a sudden realize that governments only go bust when they issue debt in a currency that they cannot print.

In the past fifteen years, France government debt to GDP has moved from 35% in French Franc (i.e.: a currency the government could print at will) to 70% in Euros (i.e.: a currency that only the ECB can print). No wonder that Francois Fillon, the current French Prime Minister recently declared: "I run a state which now stands in a situation of financial bankruptcy, which has known deteriorating deficits for fifteen straight years and which has not voted a balanced budget for twenty-five years. This cannot last."

More importantly, the tightening-up of Europe's financial situation, and the widening of spreads between the "good borrowers" such as Austria, Finland or Germany and the "poorer borrowers" such as Italy, Greece, or Portugal, could have a devastating impact on Europe's commercial banks. Consider this piece of news from January 2008: "Landesbank Baden-Wuerttemberg, Germany's biggest state-owned bank, said 2007 profit will be about 300 million euros ($438.9 million) because of a drop in prices of banking and government securities. LBBW said it doesn't expect any defaults since the securities concerned have good ratings."

Less profits because of a drop in government securities? The careful reader may be somewhat surprised by this statement; after all, everywhere one cares to look across the OECD, government bond yields are close to their 2003 lows. So how did Germany's biggest state-owned bank manage to lose money on government securities? The answer, we believe finds its source in the funky regulations of Basel II. According to Basel II, an OECD country bank can sell a credit default swap on an OECD sovereign and this CDS:

Does not have to be marked to market (since it is assumed that an OECD country will not default on its debt).
Does not require the selling bank to put aside any capital on its balance sheet (since, once again, it is assumed that the country on which the CDS is written will not default).

In other words, for the past few years, clerks all over Europe's banks and insurance companies have boosted the bottom line with the "free money" that the sale of CDS provided. Every now and then, a clerk at the Treasury department of ABC Landesbanken would call up Goldman Sachs or Deutsche Bank and say: "I want to sell US$ 1bn of protection on Italy at 15bp for five years". And for five years, ABC Landesbanken would receive US$1.5 million without having to set aside capital on its balance sheet or take a "mark to market" risk on its income statement. Or so it thought...

Indeed, as the spreads between Italy and Germany start to widen something unexpected happens (a CDS will tend to reflect the spread between the issuer's debt and risk free debt of the same maturity. Otherwise an arbitrage could be made. If Italy's debt traded at 100bp over Germany and a CDS on Italy only cost 20bp, one could buy the Italian bond and buy the CDS and capture a "free" 80bp): ABC Landesbanken receives a margin call from Goldman Sachs and Deutsche Bank and, all of a sudden, what was a "risk and capital free" trade turns out to impact liquidity. Needless to say, this is the situation we are now in and this probably contributes further to the widening of spreads. All of a sudden, Europe's commercial banks are no longer keen to sell the spread as they have been for the past decade... in fact, they are most likely trying to buy back some of the contracts they wrote before they move too far against them.

In other words, a widening of spreads represents the worst of both worlds for European banks. For a start, it puts their balance sheets under pressure. For seconds, it cuts down their income as the writing of CDS on Europe's weaker sovereigns slows to a crawl.

For Europe's policy-makers, the widening of spreads poses a serious challenge which, if left unchecked, could cut to the very credibility of the Euro and the European construction exercise. It could also trigger a negative spiral such as the one we saw in the US whereby as the cost of borrowing increases on the weakest signatures, rolling over debt becomes more problematic, hereby inviting higher spreads etc... So how will Europe's politicians respond to this new challenge?

The widening of credit spreads across Europe reflects an economic reality. It makes no sense that say, Belgium and Ireland should borrow at the same rate.

The Euro 100bn question for investors should thus now be whether a) the recent widening is a one-off event and spreads are set to soon tighten again or b) the recent widening is the beginning of a more fundamentally-based re-pricing of risk across Euroland. The quandary now is whether politics can get us out!

In the mid 1990s, Europe's leaders got together and, in essence, said: "wouldn't it be great if we all got to borrow at the same rate as Germany?" And everyone around the table agreed that this would be a good thing. The decision was thus taken to a) create a currency which would resemble the DM, b) that this currency would be managed by a central bank with a mandate very similar to the Bundesbank's and c) that countries around the Euroland would strive to harmonize their fiscal policies (Maastricht Treaty rules and Stability and Growth Pact) to ensure the long term survival of the Euro. At the time it was also envisaged that the collapse in interest rates in certain countries (Italy, Belgium, Spain...) would give a tailwind to growth which would allow governments around the more indebted EMU countries to tighten their belts and clean up their fiscal houses.

The collapse in interest rates happened, as yields converged to the German rate... but unfortunately, the clean-up in fiscal houses did not. In fact some countries like France cashed in the "growth dividend" and voted themselves greater benefits such as the 35-hour work week.

Which brings us to today and the recent widening of spreads across Europe. This widening is a sign that the market is starting to acknowledge that the promises have not been kept. Thus, the best thing for Europe's governments would be to start keeping the promises that were made ten years ago. But of course, the main problem with that solution is that it implies that Europe's governments will have to tighten their belts over the coming quarters, i.e.: at the worst possible time in the cycle. After all, it is always hard for a government to pull back and shrink its size of the GDP cake... but in an economic slowdown, it is close to impossible.

It is all the harder to do when there is little political will for far-reaching reforms. As a former German central banker once told us: "I use to think that France needed a Margaret Thatcher, I now realize she needs an Arthur Scargill" (Scargill was the Trotskyite leader of the Miner's Strike). In other words, to get a government to shrink its size, you first need a serious crisis (or a scarecrow a la Scargill); only then do people accept real sacrifices.

And we should make no mistake about it: reforming Europe's welfare states will take real sacrifices. Take pensions as an example: for years, most European countries have run a pay-as-you-go system whereby people of my generation will pay directly for the retirement benefits of my dad's generation (actually, this sounds like what I do at GaveKal every day). In other words, Europe's pension systems are usually massive pyramid schemes; they work as long as the base grows and ever more people contribute to the bottom of the pyramid. The problem, of course, is that in a growing number of European countries, the base is no longer growing.

As such, the off-balance sheet liabilities assumed by the government in matters of pensions which, until recently, had always been self-funding, are now set to come back on the governments' balance sheets. Now the last time Europe ran a comprehensive survey of pension liabilities was in 2003... and the data back then was scary. We guess the situation does not look any better today.

Europe's deteriorating demographic and pension situation alone means that Europe's governments do need to contemplate serious pension reform. Or, failing that, to open their borders to workers from all horizons in order to keep expanding the tax-paying, pension- contributing workforce. Needless to say, neither of these options is very enticing politically. As such, rather than convince millions of pensioners to cut their benefits, or work longer, Europe's politicians may be tempted to try and convince a small minority of central bankers sitting in Frankfurt to massively ease monetary policy and print a bunch of money to help the governments meet their liabilities.

In essence, the scenario we are painting is a simple one: the credit crunch which has thus far mostly only engulfed the US is starting to make its way into Europe. And soon enough, Europe's banks will likely be reporting losses and write-downs, and investors will flee to the safety of the highest government bond paper. Unfortunately for Italy, Greece, Belgium or Portugal, their paper does not qualify as "high quality".

Now as we highlighted earlier in this book, a credit crunch typically invites a "three-step" plan policy response. First, one collapses the currency (to make one's assets and goods more attractive to foreign capital and invite inward capital flows). Secondly, one needs to see the banks recapitalized (if the market can not do it, then the banks need to be nationalized). Thirdly, one puts in place a very steep yield curve in order to force the banks to start lending again and the private sector to take risk.

It is obvious today that this course of action is very much the preferred path of, for example, President Sarkozy. Hardly a day goes by without the French President taking the ECB to task for doing so little to help Europe's liquidity crunch. But each time he does, his comments are increasingly met by responses from Angela Merkel, the German Chancellor, for whom the independence of the ECB is sacrosanct.

The possibility of a massive easing from the ECB is nonetheless an interesting one and raises the question of how the market will respond to a more activist ECB. Would an ECB that did the bidding of politicians be seen as less of a Bundesbank and more of a Bank of Italy/Banque de France? And if so, would long bond yields across Europe be below 4% and the Euro at 1.55/US$? Would the foreign central banks that have been piling into European government paper remain keen to finance Europe's welfare states?

Another question, of course, is what would happen in the event of a bank bankruptcy in Europe? Would the ECB bail out the failing bank? Would the government of a failing bank be allowed to bend the EU's competition rules and nationalize the troubled financial institution? These are all questions with answers that remain unclear.

Of course, there is another way to go about dealing with a credit crunch: bitter infighting. This is what Japan did throughout the 1990s when the MoF would tell the BoJ that massive monetary easing was needed, only for the BoJ to turn around and say that the MoF needed to stop financing the construction of bridges that went from nowhere to nowhere. And as the infighting ensued, the Japanese banking system wrote off its entire capital base not once, but twice, over the course of the decade. Meanwhile investors shied away from all asset classes save the highest quality government bonds.

Could the same thing unfold in Europe? In Japan, there were only three sets of players (the BoJ, the MoF and the LDP) and over fifteen years, they could not seem to get the three-step plan (currency devaluation, bank recap, steep yield curve) right. In that regards, when considering the numbers of players involved in Europe, one may fear that the same policy paralysis could easily grip Europe. And, in this case, the recent break-out in the spreads that has now started will prove to have marked the start of a revolutionary trend for our financial markets: the end of the convergence trades and the start of the divergence trades.

A few years before his death, Professor Milton Friedman declared: "It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." Today, one should question whether the "real bump" is being hit and whether Milton Friedman will end up being proven right. But regardless of where one falls on the answers to these questions, one thing is sure: selling the bonds of Europe's weakest signatures and buying protection on Europe's weaker banks continues to make sense. It is some of the cheapest protection available against what remains a massive "fat- tail" risk to our financial systems. That's why we love this trade so much: the potential rewards are huge and the upfront costs still marginal. More importantly, it is a very good hedge against what would be a nightmare scenario for many financial institutions.

A Final Thought

In the next chapter of A Roadmap for Troubled Times, Louis goes into detail into how Italy might be the country to push the European Central Bank to take steps it might not otherwise want to take. Again, I strongly suggest you get the book. It is very thought-provoking and one of the better reads that I have had this year.

Laguna Beach, Montreal and Las Vegas

I leave with my daughter and partner Tiffani to fly to Laguna Beach in about an hour to be with Rob Arnott at his annual Research Affiliates Symposium and party. Rob arranges for some of the brighter economic minds in the country to give presentations. Harry Markowitz, Burton Malkiel, Peter Bernstein, Paul McCulley and Jack Treynor, among others. On Saturday evening, my good friends Vernor Vinge and David Brin, who have both won every award you can win in Science Fiction several times over, as well as being in the science Fiction Hall of Fame, will regale us with their views of what the future will look like. I get to moderate that event, and I am looking forward to it.

I fly to Montreal in a few weeks to speak for a conference put on by Canaccord and will get to have dinner with Martin Barnes and Pierre Casgrain. And then I will fly to Las Vegas July 10-12 for the annual Freedom Fest Conference where I will speak several times, but the line-up of speakers is as strong as any conference I have been to. Denish D'Souza will debate Christopher Hitchens, Steve Forbes, Ron Paul, Stephen Moore (Wall Street Journal) Charles Murray, George Gilder, John Goodman and about 100 other speakers, each impressive in their own right, will be there as will 1,000 freedom loving attendees. You can go to www.freedomfest.com and click on the list of speakers and register. Mark Skousen is the driving force behind the conference, and he does it right. I hope to see you there.

This will be a good weekend, as the food is always great and the intellectual stimulation is better. But the best part is being with friends and enjoying it together. Have a great week.

Your having more fun than ever analyst,

John Mauldin

The Fed at the Crossroads

John Mauldin — Sat, 17 May 2008 06:08:00 GMT

Retail Sales Take a Dive
Accounting for Inflation
The Fed at the Crossroads
Sell in May and Go Away
South Africa, Flowers, and On the Road

Is the economy poised for a recovery, as the stock market seems to expect? Or are we in for another few more quarters of recession and/or slow growth? In this week's letter we take a look at consumer spending, inflation, and other data to see if we can find a clue or two to give us an idea of the direction of the economy. There is a lot of data, so let's jump right in. (Media note: Right now I am slated to be on Kudlow and Company next Wednesday.)

Retail Sales Take a Dive

Many commentators, looking for a bullish lifeline, have pointed to the fact that retail sales grew in April by 1.8% over this time last year. But that is truly grasping at straws. Just last November they were growing at 6% year over year and have been dropping relentlessly for the last six months. And as good friend and data maven Greg Weldon points out, retail sales last November were 1.3% over inflation and now are a negative 2.1% below inflation. Retail sales are clearly headed down. (www.weldononline.com, a must-read for those who need in-depth analysis of all things and data economic)

But there was growth. Gasoline sales were up 16.3%. And food sales were up 6.1%. 77% of the increase in retail sales this year has been from increases in food and gas sales. If you take out food and gas, retail sales are down by about 2% in the last three months.

The consumer is getting squeezed. Reuters did a rather anecdotal, but revealing survey of Wal-Mart buyers at the beginning of the month. They found a significant increase in store traffic from the end of the month to the first of the month. Surveys showed that shoppers were stretched on their budgets due to rising gas and food costs and simply had to wait until their monthly checks came to go to the store for food. Many indicated they had changed their buying habits, now shopping at lower-cost stores like Wal-Mart.

At the Mauldin household I must admit to a kind of food shock upon my return. I eat a lot of smoked turkey from a local grocery deli. Arriving back from South Africa last night, I sent my oldest son to the store to put in a supply for the next few days. My "regular" turkey that was about $5.99 a pound a few months ago is now selling for $8.99. That is considerably higher than the 5.9% food-at-home inflation rate that the folks who give us the CPI tell us is the case. Next time I will find a less expensive brand, as the Reuters survey suggest shoppers all across the country are doing.

(I do recognize the inconsistency of saving a few dollars at home while I eat out at nice restaurants where the price increases are even greater. It is all about what is in your head. There are books and massive studies devoted to such behavior.)

"Leslie Dach, executive vice president of corporate affairs and government relations at Wal-Mart, said the cycle of shoppers running out of money in between paychecks and then flocking to its stores on payday is 'more pronounced, more visible.'

While many U.S. retailers are facing waning sales as shoppers cut back on purchases of clothes, jewelry or home furnishings, Wal-Mart's vast grocery business and its emphasis on low prices is spurring a resurgence at its U.S. stores and in its stock price." (Reuters)

But prices are actually up at Wal-Mart. And not just from food. Looking at the latest Commerce Department data, we find that US import prices are up 15% year over year. Even taking out gasoline, prices are up 6.2%. And it is somewhat surprising that it is only 6.2%. Why?

Because the dollar has fallen by more than 6%. The Chinese ambassador to the US, Mr. Zhou Wenzhong, recently pointed out that the Chinese renminbi has appreciated almost 19% since July of 2005. I have been writing for years that the Chinese would allow their currency to appreciate slowly and steadily for their own purposes and on their own schedule. They need to do so in order to contain their own rising inflation. Look for it to rise another 10% by the middle of next year.

Consider that because of the rise of the renminbi, the prices for oil and food imports in China have risen 20% less than for US consumers. And the prices they charge us for their goods are only about 4% higher. But that meager growth is up from only 1% last fall. Those (notably economics-challenged Senators Schumer and Graham) who have been pressing for China to allow its currency to rise are going to find that such a rise ultimately means higher prices for US consumers. Be careful what you wish for, Senators. You just might get it.

Lower consumer spending is not just due to gas and food. There is also a psychological component. Frederic Mishkin, one of Ben Bernanke's colleagues at the Fed, has done research that suggests the "typical American family will cut its spending by up to 7 cents for every dollar in housing wealth it loses. Given a 20% fall in prices, this adds up to a nationwide reduction in consumer spending of about $350 billion a year, or 2.5% of the U.S.'s gross domestic product. That's a big number - more than enough to tip the economy into recession." (Conde Nast)

And that's if the fall in prices is only 20%. I continue to put forth the proposition that we are going to see a slow Muddle Through Recovery, as the boost we got from Mortgage Equity Withdrawals during the last recession will not be available this time.

Accounting for Inflation

If beauty is in the eye of the beholder, inflation is in the eye of the statistician. Because the number you end up with is dependent on the models and assumptions you choose. As the chart below shows, there have been two major revisions to how inflation is figured, one in 1983 and another in 1998. (Thanks to Barry Ritholtz at The Big Picture for this source.)

Note that using the same methodology as was used in 1983, inflation would be around 11.6% today. Before 1983, the BLS used actual home prices to account for inflation. After that time, they used something called Owners Equivalent Rent or OER. This is the theoretical price a home would rent for. There are sound reasons to use OER and equally good reasons to use actual home prices (as is done in Europe). But both methods have flaws. You just have to pick a methodology and stick with it.

And there are reasons to think that OER may not rise as it would normally do in this part of the cycle, because so many homes which cannot sell are being rented out, and rent prices might not rise as much as in past cycles.

Using actual home prices is only useful in an average sense over long periods of time. If you own a home with a 30-year mortgage you bought ten years ago, then you have not experienced price inflation for ten years. You have seen the value of your home go up, but that is not (necessarily) inflation. Your mortgage is the same. And a first-time buyer today has the potential to see a 30-50% deflation in home prices from a year ago if he is in the right area, like Florida or California.

Further, the OER tries to measure what a house would rent for. If someone pays more than that rental price, then there is some other factor at work. The Bureau of Labor Statistics suggests that this other factor is investment. If someone pays more for a house than the equivalent rental price because it is perceived as a good investment, then you are measuring apples and oranges. The OER tries to take out the investment angle.

Because the government agencies use OER, inflation was understated in the recent housing bubble. As home prices drop, OER would normally overstate inflation somewhat. If we had used actual home prices then inflation would have been overstated in the last six years, and now the CPI would be turning negative, even as gas and food are rising dramatically.

As I said, neither method is perfect. Over very long periods of time, either will give you reasonably accurate data. But over a time period as short as a few years, let alone a few months, there can be considerable "noise."

Also, notice in the chart that in 1998 the Clinton administration adopted new methodologies, among them hedonic pricing. Hedonic pricing suggests that as a product or service improves, the price for the equivalent item in today's market will fall. As an example, if we buy a computer that is twice as powerful as it was a few years ago, the statisticians assume that prices have fallen even if we pay the same for the computer.

In the same way, if in one year you had to pay extra for features like power steering or power windows in a car, and a few years later they were considered standard, then once again the price would be deemed to have gone down, as you were getting more "value" for your dollar. This is considered to be the case even if in actual dollars you paid more for the car.

Again, you can make a rational and serious economic argument for hedonic pricing. And believe me, many economists do. But those changes, along with others, have lowered the official rate of inflation. And since many government benefits are also tied to the official rate of inflation, the current methodology has lowered government expenses as well, including inflation adjustments for Social Security and pensions.

At one time, you could make a good case that the inflation numbers overstated inflation. But I am not persuaded that is the case anymore, even though many economists still argue that point. The CPI is more or less accurate ON THE AVERAGE. But that may not be the case for you. Your actual rise (or fall) in the level of your expenses may be more or less than the average.

But we do notice the increases more. The Bank Credit Analyst has a very interesting chart in its recent May issue. It shows that the high-frequency spending items like gasoline, food, education, and medical care make up 50% of the Consumer Price Index. These are items which we buy on a regular basis. And they are going up at a weighted average rate of 6.8%, a lot higher than the 4% for the CPI as a whole.

The 20% of the CPI which are low-frequency items like furniture, appliances, vehicles, and so on are actually falling at a -0.7% rate. Since OER (equivalent rent) is roughly 30% of CPI and is rising at 2.8%, even as home prices fall the overall rate is about 4%.

Our tendency to notice the price increases in more frequently purchased items more than the drop in less frequent expenditures is known as salience. What we see every day is more visible to us and is on our minds. And because the reality is that those prices are rising much faster than headline inflation, we tend to think inflation is understated.

I can look at my credit card bills and know that my restaurant bill is rising at much more than 4% a year. I do not think I am eating all that much better, and am actually eating less food in an attempt to hold down my weight. My travel expenses are up by more than the 5-7% in the BLS numbers. Those prices, and the price of turkey, are in my face constantly.

The Fed at the Crossroads

"I went down to the crossroads, fell down on my knees.
"Asked the Lord above for mercy, 'Save me if you please.'"

- Robert Johnson

Legendary blues singer Robert Johnson was said to have sold his soul to the devil at the crossroads outside Rosedale, Mississippi, to be the best blues singer ever.

The Fed is also at a crossroads. What's the price for low inflation and a booming economy? Can you have both in today's environment without a deal with the devil? And can even Old Slewfoot deliver on such a dream?

Inflation is uncomfortably high at 4%. Even core inflation is well above the 1-2% comfort zone. But the economy is soft and getting softer. Even with the stimulus package kicking in this quarter, consumer spending is likely to be weak. There are some at the Fed who would like to raise rates as soon as possible to deal with inflation, but the economy is not cooperating. The housing crisis just keeps getting worse, and the credit crisis is causing banks to tighten lending standards on every manner of credit, even with Fed fund rates low. LIBOR and other credit costs and spreads are not dropping as one might have thought they would in response to low Fed fund rates. Tax receipts are slowing well below projections, especially sales tax receipts.

Let's look at some of the pressures on the economy. According to the National Small Business Association, more than 5,000 firms filed for bankruptcy in April 2008, the most in any month since new bankruptcy laws took effect in 2005. The data also show that in the first quarter of 2008 13,155 businesses filed for bankruptcy, an increase of nearly 45% from the 9,103 business bankruptcy filings during the same period in 2007.

Economists suggest that the leap in bankruptcy filings is a result of the troubles that started with subprime mortgages and other financial instruments of Wall Street, which are now trickling down to Main Street. The ensuing credit crunch, skyrocketing commodity prices, and dormant consumer sales are likely culprits for pushing many more businesses to the brink of bankruptcy throughout 2008.

The debt of 174 large US companies is trading at distressed levels, at well over 10% above comparable treasuries. Diane Vazza, S&P's credit chief, says defaults are rising at almost twice the rate of past downturns.

"US and European banks and financial institutions have 'enormous losses' from bad loans they haven't yet recognized and may have a harder time wooing sovereign-fund rescuers, Carlyle Group Chairman David Rubenstein said.

"'Based on information I see,' it will take at least a year before all losses are realized, and some financial institutions may fail, Rubenstein said... He didn't name any companies." (Bloomberg)

JPMorgan Chase & Co.'s chief executive said Monday that while the crisis in the credit markets appears to be three-quarters over, he believes a US recession is just beginning.

"'Even if the capital markets crisis resolves, it does not mean that this country will not go into a bad recession,' said CEO James Dimon, whose bank saw its first-quarter profit fall by half due to the recent collapse of the US mortgage market. 'The recession just started."

Raising interest rates in this type of environment would be very difficult. Seemingly everyone now reveres Paul Volker. But many forget, as Charles Gave points out, that he put the country through two severe recessions, bankrupting many Latin
American countries because of the high interest rates on the loans they had made in US dollars at much lower initial rates (shades of 'teaser rates'), which resulted in the technical bankruptcy of every major US bank. Those were not pleasant times, especially in Latin America. Be careful what you wish for.

If Ben Bernanke and the Fed governors decided to pull a Volker and raise rates in order to combat 4% inflation, there would be lynch mobs forming.

And it is not clear that inflation would respond to rising rates without a severe slowdown and an even worse recession. Oil prices would not respond to interest rates. Inflation, as Friedman tells us, is always and everywhere a function of money supply, and the money supply is not growing at anywhere near the rates of the 1970s. Oil is a function of supply and demand, spurred on by speculation. You can deliberately slow demand by tanking the economy, but are lower gas prices worth an 8% unemployment rate?

Likewise with food. Food price increases are due more to government policy (as in ethanol and subsidies) and increased demand for higher-quality foods, especially protein, from developing nations. I have yet to see a persuasive argument that food prices would respond to higher interest rates by courteously going lower. Unless, of course, you put the world economy into a severe recession. That would reduce demand for higher-quality foods. Again, not a wise policy.

Given that, the markets seem to be telling us that inflation in the future will not be the problem that the headlines suggest it is today. Let's look at this note and chart from Charles Gave of GaveKal (www.gavekal.com):

"The next question is the behavior of prices in the future. And to gage this, I will review two tools: one is the ECRI future inflation gauge of the University of Columbia,

and the other is the expected inflation for the next ten years as derived from the differences between a classical bond and an inflation indexed bond.

[Note: the red line is the ECRI gauge (left scale) and the grey is the expected inflation measure (right scale).]

"The least that can be said is that neither the forecasting tool of the Columbia University (which peaked at the beginning of 2006), nor the expected inflation are showing any signs of panic. We certainly do not see any significant rise in any of these two tools similar to the ones we saw from 1998 to 2000 or from 2002 to 2006. So maybe, just maybe, what we are seeing today is a change in relative prices (food and energy higher, housing lower) and not a general rise in the inflation rate."

I would not be surprised at all to find that inflation is not the problem it is today, by this time next year. In fact, given that we are seeing two bubbles burst and a recession and slow recovery, all of which are by definition deflationary, it would be odd if inflation got worse from here. Stranger things have happened, but the odds favor a view that inflation pressures will ease.

Bottom line? I think the Fed will be on hold for a rather long time. We are in a Muddle Through Economy. Even if the economy gets worse, as Jamie Dimon predicts, the problems in the economy would not be helped by lower rates. And until the economy starts growing at a rate above 2%, it will be difficult to justify raising rates in the face of such slow growth. And given the pressure on consumer spending and housing prices, I think the recovery that should begin later this year is going to be a rather tepid one.

Sell In May and Go Away

Numerous studies show that since World War II, as much as 99% of stock market returns have been generated between November 1 and May 1. Good friend and fishing buddy David Kotok of Cumberland Advisors sums it up nicely:

"According to the Ned Davis (NDR) database, starting in 1950, $10,000 invested in the S&P 500 Index every May 1st and then liquidated every October 31st would only be worth $10,026 today. That's right: had you stayed out of the stock market from November through April and only been in the market from May through October, you would have had no change during the last 57 years. 21 of those years would have been negative; 36 were positive. This happened during the same period that stock prices were rising about 75% of the time and markets made extended upward moves.

"Consider the results of the reverse strategy. Buy the S&P 500 Index on November 1st and sell all your stocks on May 1st. The outcome is dramatically different. Your original $10,000 would now be worth $372,890 as of April 30th closing prices in 2008. Out of the 58 periods you would have had positive results in 45 of them and negative results in only 13 years."

David goes on to show research at www.cumber.com as to why he thinks you should hold off on selling. I disagree, but then the stock market has been confirming David's position. My thought is that the Continuing Crisis will put pressure on corporate earnings throughout the summer, with more earnings disappointments at the end of this quarter.

Earnings disappointments are the stuff of bear markets. Richard Russell, one of the more astute market observers and in the past a serious bear, thinks we are now in a bull market. Dennis Gartman is now a bull. How do you argue with such astute traders?

I am sure Larry Kudlow will argue that the markets are telling us a recovery is imminent because the markets are rising. Nevertheless, I think this could be a very rocky summer for the markets in general. I look back to 2001-02 and find three bear market rallies of 20%. The market evidently did not know as much as it thought. But then, what do I know? If you have specific stocks you like, or are a trader, then that is fine. But for those whose only real equity choice in the retirement plan of investment in a long-only index, I would find one of the other options in bonds

South Africa, Flowers, and On the Road

South Africa was wonderful. I so enjoy the country and the people. The game runs were excellent at Sun City, as was the resort. I highly recommend it. And thanks to Prieur du Plessis and Paul Stewart at Plexus for being such great hosts.

And now I must tell a story about assumptions, and how they can rise up and bite you. It seems I left a bag on the American Airlines flight which I took to connect with South African Airways at Dulles in Washington, DC. It had my shoes, belt, and ties in it. So, I got to Johannesburg without the basics. On Monday morning I rushed to the local mall, walked into a well-known men's clothing store, and bought a belt and ties, paying for them with my personal Citibank credit card. I did not like the shoes in that store and went to another one and chose a nice Italian pair, as there were no other options and time was running short. I tried to use the same credit card, but it was turned down this time. I then used my Citibank business card, and promptly forgot to call Citibank to see what the problem was.

The next Sunday, at a gift shop at the Cape of Good Hope, my business credit card was turned down. I pulled out my emergency-use-only, don't-leave-home-without-it American Express card (I don't get miles from them I can use). I then called Citibank, and they said they just wanted to make sure I had the card in my possession and was using it. They then reactivated it. I asked them to do the same for my personal card.

They looked up the number and then said I needed to talk to the fraud department. I was then asked if I had charged a rather large sum of money for flowers. I informed Citibank that I had not. They said the store was trying to run the charge every day. We both assumed that someone at the first men's store had stolen my number and was using the card to run a scam, buying flowers that they could sell on the local street for cash. I was glad that Citibank was on top of things. When I got back in the office today, my new personal card was waiting.

As I was activating it, I told Tiffani to come in and began to tell her the story, with embellishments, of how I was almost the victim of fraud. Why would anyone think I would spend such a preposterous amount of money on flowers? And I am afraid I used that story in the last of my presentations in South Africa, talking about the need for credit research and liquidity (you would have needed to be there to see the real relevance).

Assumptions.

"Dad," said Tiffani with a Dad-has-done-it-again smile and a don't-tell-me shake of her head, "that was the florist for my wedding, and we have to make a deposit. We couldn't figure out why the card was not going through." I just dropped my head and gave the Dad sigh. I guess I do in fact spend mad sums of money on flowers. And I will enjoy every minute of them. August 8 is just around the corner.

I am off to La Jolla for a quick trip Monday and then back the next day, hoping to get some writing done next week. Look for a very interesting Outside the Box on Monday evening from my friends at Casey Research. They provide some very sobering data on the energy market.

We have not yet found the lost bag at Dulles. While the shoes and books can be replaced, the bag is actually a delegate bag from the 1996 Republican National Convention and has some personal sentimental value. I hope it can be found.

Have a great week. And avoid assumptions.

Your wiping the egg off his face analyst,

John Mauldin

"Nearly 56 percent of Americans believe their current economic standard of living is declining, according to a national poll this month by the Sacred Heart University Polling Institute in Connecticut. That number is up from 24 percent in 2006. Only 38 percent of respondents said their standard of living is improving, compared with 72 percent in 2006."

Thoughts From The Frontline : Economic Crisis

Time for a Reality Check

World Trade Is Falling Off a Cliff

European Bank Losses Dwarf Those in the US

Geithner: "You Can't Handle the Truth"

Time for a Reality Check

Earnings Will Get Even Worse

Orlando, Colorado Springs, New York, and Las Vegas

The Endgame

Employment Numbers Are Worse Than Posted

Aye, Captain, I'm Giving Her All I've Got!

Problem #1: Deflation

The End Game

Problem # 2: Pushing on a String

The Muddle Through Middle

Conversations With John

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

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

Where Do We Go From Here?

Construction Lending: The Next Shoe to Drop

Lehman at the Center

Iceland Guarantees What?

Letters of Credit: Going, Going Gone?

What to Do and Where Do We Go from Here?

London, Stockholm, and California

Who's Afraid of a Big, Bad Bailout?

It's the End of the World As We Know It

The TED Spread Flashes Trouble

The Transmission Mechanism

Let's Make a Deal

Colorado, California, London, and Sweden

It's more than Fannie and Freddie

The US Banking System Is in Trouble

$500 Billion and Counting

Fannie, Freddie, and the Credit Crisis

Baltimore, La Jolla, and South Africa

The Problem with the Euro

Swapping out Commodities

The Euro at Par with the Dollar

The Change In Policy

The Divergence in European Spreads - Why Now?

A Final Thought

Laguna Beach, Montreal and Las Vegas

The Fed at the Crossroads

Retail Sales Take a Dive

Accounting for Inflation

The Fed at the Crossroads

Sell In May and Go Away

South Africa, Flowers, and On the Road

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