Thoughts From The Frontline : Economic Forecast

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

Forecast 2009: Deflation and Recession

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

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

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

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

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

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

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

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

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

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

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Muddle Through on Hold

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

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

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

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect

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

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

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

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

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

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

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

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

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

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

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

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

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

Lies, Damned Lies, and Government Unemployment Numbers

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

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

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

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

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

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

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

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

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

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

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

Central Bankers of the World, Unite!

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

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

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

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

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

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

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

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

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

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

But there is a problem.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Predictions 2009

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

La Jolla, Bermuda, and Europe

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

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

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

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

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

Your more optimistic than this letter implies analyst,

John Mauldin

The Economy Gets a Margin Call

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

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

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

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

Where Have All the Consumers Gone?

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

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

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

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

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

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

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

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

Why Is the Dollar Rising?

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

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

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

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

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

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

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

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

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

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

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

Can We Actually Muddle Through?

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

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

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

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

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

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

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

The Potential for a Large Stock Market Rally

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

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

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

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

Is GM too Big to Let Fail?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

New York, Moving, and Another One Leaves the Nest

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

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

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

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

Your ready already for recovery analyst,

John Mauldin

General Motors

A New Asset Class, Part Two

John Mauldin — Sat, 09 Aug 2008 01:57:07 GMT

The Rise of A New Asset Class, Part 2
Unrealistic Expectations
The Boomers Break the Deal
A Nation of Wal-Mart Greeters
Weddings and 08-08-08

Last week's letter was the first part of a speech I have been giving on what I think will be the rise of a new asset class. This week will be the second and final part. Let me set up this section with a few paragraphs from last week's letter and then a quick summary. If you want to read the entire letter from last week, you can go to the website archives.

But first, a quick note. George Friedman from Stratfor was at my daughter's wedding rehearsal dinner last night. He had just found out about the invasion of South Ossetia by Georgia and was keeping track of the events over his Blackberry from his correspondents on the ground in Georgia.

The media is not particularly excited over the events in Ossetia and Georgia, and the markets seem indifferent. It's much more important than it looks. This the first time since the fall of Communism that the Russians have directly and openly intervened in the former Soviet Union under the claim, made by Dmitri Medvedev, that Russia is the guarantor of security in the Caucasus. That's what the Russian Prime Minister Putin also said. Russia has claimed a sphere of influence in the Caucasus. And that is of historical importance. (Think Monroe Doctrine.)

This is payback for Kosovo. Putin didn't want an independent Kosovo and was ignored with contempt. Payback is an independent Ossetia, with Russian military intervention guaranteeing it. If it's good enough for the Americans and Europeans, it's good for the Russians too. Why the Georgians invaded Ossettia is opaque. For some reason they felt they had to move. The Russians were clearly ready and by dawn had armored formations in South Ossettia and air strikes in Georgia. (The Russian army is about 40 times the size of Georgia, and far better equipped.)

The question on the table now is whether the Russians will stop there or are going into Georgia proper. US embassy personnel are being evacuated - at least some of them - so the US takes this seriously. The US has no military options at this point. We've been talking about the window of opportunity Iraq has created by diverting US forces. Well, the Russians just climbed through the window.

The important thing to watch isn't the US or Europe. It is what the states of the former Soviet Union do, from the Baltics to Ukraine to Kazakhstan. The Russians have announced that there is a new sheriff in town, and this does not apply only to Georgia. These countries hear the message - the foreign minister of Lithuania went to Georgia this morning. All of them are calculating what this means for them in the future. And you need to be thinking about world energy, grain, and other primary commodity markets if Russia dominates the FSU and starts to manage everyone's commodity production and sales. While Georgia has little oil or gas, the pipelines from Russia go through there.

Ossetia is a province (country?) of 70,000. Normally, one would think these events were of little importance. But if Russia is making a statement of a new policy and intends to rebuild the former empire in at least a de facto manner? The US has training troops and personnel in Georgia. They are quite pro-American. While the world focuses on the Olympics, the real show may be in the Caucasus. Let's hope cool heads prevail. It is interesting to note that Bush and Putin were meeting in Beijing over this topic. I wonder what Bush will see when he stares into Putin's soul this time.

I asked and George agreed to establish a free page on his web site for the next few weeks, which they will update periodically on the situation there. This is something we should monitor. The link is http://www.stratfor.com/analysis/intelligence_guidance_conflict_south_ossetia This is one of the reasons why I read Friedman and Stratfor. No major news media had eyes on the ground when the trouble broke out. George did. In an interesting twist, the Russian news media is quoting Stratfor as a source. The world is truly strange. And now on to my speech.

The Rise of A New Asset Class

I think we're at a watershed moment, what Peter Bernstein defines as an "epochal event," with the very order of the investment world changing as it did in 1929, in 1950, in 1981, where a number of things came together - it wasn't just one thing but a number of events happening that conspired to change the nature of what worked in the investment world for the next period of time. It took most people a decade after 1981-2 to recognize that we were in a different period, because we make our future expectations out of past experience. It's very hard for us to recognize a watershed moment in the process. We're going to look back in five or ten years and go, "Wow, things changed." As we will see, it's going to be a change that's going to cost people in their portfolios and in their retirement habits.

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

Last week I pointed out that we are in:

A Muddle Through Economy for at least another 18 months, caused by
the bursting of the housing bubble
and the concurrent onset of the credit crisis, neither of which will really respond to a lower Fed funds rate, but simply have to be worked through.
This situation will lead to reduced growth (or even contraction) in consumer spending, which we are seeing now, from lower mortgage equity withdrawals, higher energy costs, rising unemployment, inflation in an environment of lower real income growth, and less availability of cheap and easy credit.
I went into a detailed analysis of earnings, showing that corporate earnings are likely to continue to drop precipitously, which will eventually weigh upon the stock market. Price to earnings ratios are mean reverting over long cycles, and there is no reason to expect that not to be the case in the future. This will be a drag on long-term growth in US stock portfolios.

Let me offer one chart (courtesy of Vitaliy Katsenelson) from last week on this last topic, which illustrates the problem, and then we will jump into the final part of the speech. The current situation is worse than the chart depicts, because on Wednesday of this week the as-reported 12-month P/E ratio for the S&P 500 was 22.87 through the end of the second quarter. We have a LONG ways to go to revert to the mean. The only way for that to happen is for earnings to rise or for stock prices to fall, or some combination of both. Otherwise, you have to suggest we are in an era of permanently and significantly higher stock valuations. (Remember, these cycles last an average of 17 years. We are only 8 years into this one.)

Unrealistic Expectations

Valuations are important. They are the key to long-term returns. Your expected returns in any one 10-year period highly correlate with where you start investing. If you start when stocks are cheapest, you're going to compound at about 11 percent. But if you start when they're the most expensive, at an average PE of 22, you're going to compound at about 3.2 percent over the next 10 years. For the people and the pension funds that are expecting to get the 8 or 9 percent that they've got written into their returns in their equity portfolios, that's not good news. The following chart from my friends at Plexus illustrates the point. I should note that this calculation works not just on US stocks but in every market that I have seen studied. This is a fundamental principle of investing.

So, what we have is a situation where many aging Baby Boomers and the pension funds and insurance companies which are investing on their behalf are not likely to be able to get the returns they need in order to meet their obligations from traditional US equity holdings.

The Boomers Break the Deal

Now, let's jump to another subject. Boomers (and that would be me and most of the people in this room) are going to break the deal our fathers and grandfathers made with our kids: that we would die in an actuarially and statistically definable timeframe. Without being able to know how large populations will "shuffle off this mortal coil," things like planning for Social Security and Medicare, insurance, and pension plans become a very dicey business.

And the news we Boomers have for our kids and the actuaries who actually care about these things? We're not going to die on time. We're going to live longer, and this is going to have consequences for everyone's investment portfolios. We're not going to get into why we're going to live longer; the simple answer is that medicine is advancing. The boomers are going to live, on average, about 10 years longer than they statistically should; my kids and those under 40 are going to live, on average, a lot longer. But that is a topic for another speech.

Simple fact: the majority of Boomers don't have enough savings. Numerous studies show they haven't saved enough to be able to retire. They certainly haven't saved enough if they're going to want to live longer and take advantage of medicine to do that.

If we start living longer, there are going to be massive problems with pensions and annuities, because there are actuarial tables that say people are going to die along this timeline. If all of a sudden - and over a ten- or fifteen-year period would be all of a sudden from an actuarial or pension fund point of view-people start living longer, it's going to mean that those who pay will run out of money sooner rather than later. Since they will notice the problem long before they get to the end of the money, they will have to make adjustments. That means they are either going to have to lower pension payments, or they're going to have to get more money from somewhere (either increased contributions or increased returns).

Now, if they're in a period where they're projecting 8-percent returns from their equity funds, and they're not getting 8 percent - if they're only getting a long-term 4 to 6 percent from here over the next ten or fifteen years - that's a big problem in funding. Public pension funds have the same problem, but it is much worse. They're a couple of trillion dollars underfunded. This is why you're seeing California cities beginning to declare bankruptcy, because they're having to tell their firemen and policemen, "We can't pay you what we agreed to pay you; let's renegotiate something." It's going to get ugly in a lot of cities. For those of you who live here in San Diego, it's a huge problem. Politicians promised the police and fire and the city people all sorts of wonderful things, they got their votes, and they are not going to have to be there to deal with the problem when it becomes a crisis in a few years. Isn't politics wonderful? Promise anything for votes today and let our kids pay for it tomorrow.

The problems that we're projecting for Social Security and the underfunding today are massively understated. We're going to have to pay a lot more for Social Security than we expected, because we're going to live longer. And the younger generation isn't going to be real happy about having to pay a lot more money to older people who are living longer and don't want to (or can't) go back to work. When they started Social Security, retirement was at 65 and the average person died at 66. There wasn't a lot of expected payout. Now people who make it to 65 will on average live well into their 80s and are soon going to live well into their 90s. This is going to create generational issues.

It will also demand an increase in taxes. It's coming guys, and you are the target. You've got a big target right on your wallet. Like in California: "If you're making over a million, we want to take an extra one percent" - that's going to happen in so many states.

A Nation of Wal-Mart Greeters

Now, let's look at it from another angle. Let's say you're getting ready to retire, you're 65, and you put your money into the most aggressive portfolio you can that historically has given the best returns - that's the stock market - and you're going to take 5 percent out a year. That seems a reasonable number. A lot of people say, "We can take 5 percent of our money out every year." What would happen? Well, remember that graph I just showed you? Depending on the P/E ratio when you retired, if you started out when stocks were the 25 percent most expensive, over 50 percent of the time you'd run out of money in an average of about 21 years. Look at the table below from my good friend Ed Easterling of Crestmont Research.

Even if you started when stocks were the 25 percent least expensive, you would run out of money before the end of your remaining 30 years about 1 out of 20 times. If I came to you and said, "You know, you got a medical problem and we're going to have to have an operation tomorrow. And oh, by the way, you've got a 5 percent chance of dying," you would probably be quite nervous. What I'm telling you now is, if you get too aggressive with your retirement and investment assumptions in a Muddle Through World, especially at the beginning, you're going to end up with problems. We could end up with a nation of Wal-Mart greeters. (Not that there is anything wrong with those happy people who greet me! It is just not the retirement many people plan for.)

But many in the Boomer generation that is getting ready to retire have not made adequate plans and are assuming very optimistic future returns. So are their pension plans. You're going to be living with neighbors and friends who have this problem. And not just neighbors and friends but voters looking for someone to solve their financial problems with your tax dollars.

The Wealth of Nations

Now, let's look at the next topic: the wealth of nations. From 1981 to 2006, our national wealth in terms of the houses we own, stocks we own, real estate, bonds, businesses - everything - our national wealth (or maybe it's better to say, the prices we put on our assets) grew from $10 trillion to $57 trillion. Over very long periods of time national wealth is by definition a mean-reversion machine. Over 40 or 50 years national wealth has to revert to the growth in nominal GDP. That's just the way the economics and the math work out.

Basically, the principle is that trees cannot grow to the sky. Just as total corporate profits cannot grow faster than the overall economy over long periods of time, neither can national wealth. Think of Japan. At one point in 1989, relatively small areas of Tokyo were worth more than the total real estate of California. And then the bubble burst and Japanese national wealth decreased and grew much less than GDP and is now in line with the long-term nominal growth of GDP.

In the US, long-term growth of nominal GDP is about 5.5 percent. We've actually grown by 7.2 percent for the last 25 years. To revert to the mean means that over the next 15 years, maybe more if we're lucky, we're going to see nominal wealth grow between 2.5 and 3 percent. That's a major headwind and a major dislocation from the experience that we've had. Investors have been expecting to get the past 25 years to repeat themselves. The laws of economics suggest that cannot be the case.

We have seen a monster growth in equities in terms of total market cap, even given the flat growth of the last ten years. We all know about the housing market.

Remember the part above where we talked about stock market valuations being mean reverting? We are watching housing values come down. What we are going to see is a very difficult period for asset growth in precisely the two areas where investors tend to concentrate their portfolios: US stocks and housing. Using history as our guide, that period could last for another 5-7 years.

Let me hasten to add that I am not suggesting that the stock market will not go up over the next seven years. What I am suggesting is that we could be in a period like 1974 through 1982 where the stock market did indeed go up over those eight years (in fits and starts), but profits went up even faster. Thus, P/E ratios were in single digits by 1982.

Let's begin to put all this together. What are the requirements of retirement, whether for individuals or pension funds? I think I made the case that traditional investments are going to underperform - that's the stock markets of all the developed countries and to some degree the emerging markets.

But, you've got to have income and savings if you want to retire. You can't throw caution to the winds and invest in the most risky and volatile assets in hopes of getting the returns you need. Hope is not a strategy. You do not want to take much risk with retirement assets, which will be hard to replace.

You've got to figure out, "How do I get income in an era of low interest and low CD rates?" And, "How do I convert my savings, and what do I put them in that will give me that income?" If you're a pension fund, if you're expecting 8 percent from your equity portfolios and you're only getting 2 to 3, at some point you're going to get nervous. You're going to realize you've got to do something else. Same thing with insurance companies and annuities. That means there's going to be a drive for more absolute-return-type funds. The problem is, the place to go for reliable absolute returns is smaller funds. But most large pension funds are trying to put one or five or ten billion to work, not a few million. And if everybody tries to get in the water at the same time, the pond could get very crowded.

Now, full circle. This is where I think the credit crisis is going to come to the rescue. I think we're having a reverse-Minsky moment. Hyman Minksy said that stability breeds instability. The longer something is stable, the more instability there is when that moment of instability happens. The crisis period of instability is called a Minsky moment. So we had a long period of time of remarkable stability in the credit markets, then there were a few cracks here and there, and now we're having the crisis which started in July of 2007. The losses in both housing values and bonds will be in the trillions of dollars. Why? Because stability creates an environment for people to feel safer taking on more risk and leverage. It's just part of human nature. Note: This is not just an American disease. It has happened since the Medes were trading with the Persians and in every corner of the earth.

But now I think we will get kind of a reverse of this pattern, a reverse-Minsky moment, where instability will breed stability, because we as investors, we as human beings, don't like instability; and we'll do whatever it takes and whatever we need to do to demand a return to a stable investment environment.

So, two forces that I have touched on in this speech are going to come together. First, we have destroyed - we've vaporized - 60 percent of the buyers for the structured credit market and badly wounded the survivors. We've got to create something to substitute for that, as we need a smoothly functioning debt market to allow for growth and a healthy business environment. It is absolutely necessary for individuals to have access to credit for purchases. If we all had to go to cash, it would be a disaster of biblical proportions.

Second, there is a need for equity-like returns on the part of investors of all sizes, from the smallest to the largest pension funds. If you can't get 8-10% from equities over the next ten years, where do you turn?

I think what we're going to end up creating, and what we're already beginning to see happen, is going to grow into a huge wave: we're going to see the creation of a series of absolute-return funds that I think of as private credit funds. I don't really want to call them hedge funds, because they're not really hedging anything.

For all intents and purposes they're going to look like banks. They're going to put their green eyeshades on, and when they loan you money, they're actually going to expect it to come back. And they're going to expect it to come back with a level of risk return commensurate with the level of risk they're taking. Instead of going through the messy business of getting depositors to put money into accounts, depositors who can come in and out, and having to service them and let them write checks and all of that stuff, they're going to go to investors and say, "Give me $100 million or $200 million or $500 million, and I can attack this market and give out loans in this manner, and I can generate these returns - 8 percent, 9 percent, 12 percent."

Maybe some of these markets we can lever up two or three times. Two or three times leverage sometimes sounds like a lot. But our average commercial bank is leveraged 10 times. Our investment banks are leveraged 25 times or more. Two to three times in a properly structured debt portfolio isn't a lot of leverage, but it can give you high single-digit or low double-digit, relatively stable returns.

These private credit funds will look like private equity, in that they will have long lock-up periods, so that the duration of the investment somewhat matches the duration of the loans made. It is the mismatch of duration that has created much of the problem in the current market. All sorts of investment vehicles like SIVs, CDOs, etc. borrowed short-term money and made long-term investments.

So, we've got demand from two sources. We've got a demand from a retiring generation, from a pension generation, demanding equity-like return, when they can't get equity-like returns from the equity market. We've got a demand for credit funds - we've got to replace the people we've vaporized.

We're going to see the creation, I think, of a multi-trillion-dollar marketplace of people, pensions, and investors looking to be able to attack those credit markets. Initially it will be for large funds and investors, but it will eventually filter down to structures that the average person can get into.

For a lot of us, we're going to see the ability to find stable returns, equity-like returns, show up at our door. And one way to attack this initially may be funds-of-funds, where you can spread your risk over a number of these types of funds and managers. It's going to require somebody to go in and actually analyze the banker who's making the loans to see if he's, you know, a real banker. Because we know we don't want the guys from Wall Street who made the last set of loans running our funds, at least not until they've gone back to school to learn what a loan is.

I know I am leaving a lot to be said, but my time is coming to an end. Let me say in closing that while a broad asset class that I call private credit funds will share some characteristics, the individual funds themselves will be quite different as to what type of credit they provide (housing, commercial real estate, auto, corporate, credit card, student, and a score of other areas), what types of returns they target, who their customers are, and who their investors are.

Further, while private credit will initially compete with banks, I think that at some point banks will see this as an opportunity to return to their recent and very profitable model, which is to originate loans and then sell them off. Properly run, private credit will be good for the managers as well as the investors. And there is no reason that the management cannot be the banks. In some ways, they have an obvious advantage in this market, as it will be easier for them to attract large investors like pension funds and sovereign wealth funds.

This is a new era. We're going to have to shift from thinking that broad-based stock funds are for the long run. Over the last ten years, if you invested in the S&P 500, your net asset value is flat and dividends have badly underperformed inflation. With today's high inflation and lower earnings, that underperformance could last another lengthy period. If your time horizon is 30 years, then maybe you can talk about the long run. But if your time horizon is 5-10 years before retirement, you need to think about your definition of long run.

Now, you can buy individual stocks if you're a great stock picker or find a manager who is rather good at picking stocks. Donald Coxe was talking to us about agriculture, which I agree is in a bull market. There are other types of technologies - I think the biotech world is going to be huge, starting in the next decade. There are going to be places where we can go into specific target areas and make equity-like returns from equities. But I don't think we are going to be able to do it in a cavalier, "I'm going to put my 401(k) into the Vanguard 500" manner and walk away. It's going to be a challenge for your retirement portfolio if you do.

Retirement in today's world is going to take considerably more thought (and funds!) than was traditionally believed. I encourage you to look at your own situation and carefully analyze the assumptions you have made.

Weddings and 08-08-08

The wedding in a few hours has been the occasion for friends from far and near to gather. Most you will not know, but as noted above George and Meredith Friedman and Paul McCulley got to town in time to have a long leisurely lunch with us. Dr. Mike Roizen just called to say he's off the plane. My friend from first grade, Randy Scroggins, and my first business partner, Don Moore, have come in. It now seems there will be 150 people at the wedding. We first thought 75. Oh well, so much for my forecasting ability. It is great to have so many friends from both sides of the aisle here.

It is not just the Olympics that begin on 08-08-08. In about two hours, Tiffani will be saying her wedding vows to Ryan. They picked a most auspicious date, and I trust it will bode well for them.

It is an interesting set of emotions I am dealing with. I am happy for her and Ryan. It is a start of a new chapter in their lives, and in mine. They are talking about kids, and are committed to making me a grandfather, if Henry and Angel don't beat them to it. (With seven kids, I will ultimately have more than my share.) They all grow up so fast. Where did the time go?

My 91-year-old mother is in the hospital and can't come to the wedding. We almost lost her last week, from an infection she apparently caught in the hospital while there for minor surgery. She is fine now, but can't make the wedding. The contrast of old and new, looking back and looking forward, is food for some serious meditation.

The wedding is going to be something special. As anyone who knows Tiffani will attest, she cannot do anything without a serious dash of her own unique flair. Several national TV series have asked about getting options on the video.

I think I mentioned a few weeks ago that there are going to be some serious fireworks at the wedding when we do the formal toasts. Tiffani was most insistent about having fireworks, and they will be choreographed to music. And while we were going over the plans, I met with the man who is directing the fireworks. For a little extra on the side, he threw in some special effects. What Tiffani and Ryan do not know is that when the minister says, "I now pronounce you man and wife," there will be a round of fireworks going off, and when they kiss an even larger display will erupt over their heads. Every woman says they want to see fireworks when they kiss their new husband. Tiffani will. And Dad's eyes may just get a little moist.

It is time to hit the send button and put on my tux. I am not supposed to be late for this one. All the best, and have a great week.

Your getting a tad sentimental analyst,

John Mauldin

Earnings and Mr. Bear

John Mauldin — Sat, 26 Jul 2008 04:25:00 GMT

Earnings and Mr. Bear
Earnings Before Bad Stuff
How Ugly Can it Get?
A Lean Mean Reversion Machine
Some Thoughts on Energy
Oregon, Maine and a Wedding

"The stock market is a voting machine in the short run and a weighing machine in the long run." - Benjamin Graham

The voting part of the equation is tempered by fear and greed. It is largely emotional, although investors like to think of themselves as rational players. That emotion is driven by views of the future. If you can be confident of large and growing returns, you are less likely to be swayed by the erratic movements of a stock. But as confidence wanes? Well, that is the stuff that bear markets are made of.

Because at the end of the day, what the market weighs is earnings and the ability of a company to reliably produce them. This week we look at what earnings are likely to be over the next year and see if we can discern what that suggests for the markets. We also take a look at the energy markets, the possibility of a further drop in the price of oil, and muse on what a sane energy policy for the world would look like. There is a lot to cover, but it should make for an interesting letter.

But first, a quick announcement. I have recently agreed to do a regular interview each issue with the editors of EQUITIES Magazine, which will be in the magazine and on their web site. They are also going to feature me on their web-site home page with my latest writings, under the title "Guru Blog." I am excited to be associated with a magazine that has been around for 57 years.

In return, they have agreed to give any reader of mine a free subscription to EQUITIES Magazine. You can go to http://www.equitiesmagazine.com/mwi and simply register and get the magazine sent to your home. There is also a link to an interview I did in April with them. They have a lot of content and free resources like real-time stock quotes and portfolio managers. Check it out!

Earnings and Mr. Bear

A theme in this letter for many years has been that over time markets of all descriptions revert to the mean. The classic definition of mean reversion is "the behavior of a variable in which the values for that variable move towards the long-run average value for that variable." Prices, indexes, and all types of economic variables tend to fluctuate around their long-term averages.

Profits as a percentage of nominal GDP is one of the more significant mean reversion examples. Last year we saw pre-tax profits as a percentage of nominal GDP climb to a 55-year high of 14%, which is really rather astounding. Why? Because over time, profits track nominal GDP. In the post-World War II era, nominal GDP growth has averaged 7.1%, while profit growth has averaged 7.4%. Profits over the long term as a percentage of GDP have not changed significantly for generations. Or put another way, profit growth has matched GDP growth. We will examine later what might happen if profits reverted to their long-term average (think ugly).

Now, in the short term, the difference between corporate profits and nominal GDP can vary wildly. But in the fullness of time, economic pressures will work to bring corporate profits back to the mean. This can come in the form of higher or lower wages, changes in productivity, higher or lower taxes, recessions, or growth booms. All of these and more affect corporate profits.

Let me give you one more way to look at it. If the economy is growing at 7% (nominal), then corporate profits cannot continue to grow for more than a few years at 15%. If that growth trend continued, then at some point in the future the entire GDP would consist of corporate profits, as each year the percentage of corporate profits in the GDP would increase. Since trees cannot grow to the sky, nor can corporate profits become larger than the economy, and so logic dictates that there will be an adjustment in the future. And we are beginning to see that logic play out. Let's look at a few numbers.

Trailing as-reported 12-month corporate profits on the S&P 500 peaked in the second quarter of 2007 at $84.95. In March of 2007, S&P forecast 2008 earnings would be $92. Then the economy began to run into trouble and S&P began to drop their 2008 forecasts, as the table below shows. (By the way, this is not to pick on S&P. Nearly every major forecast had similarly optimistic views.)

What actually happened? 2007 earnings actually came in at $66.18, following a lot of ugly write-offs in the last quarter. The estimate for 2008 is $72.01, as you can see above. Interestingly, they project lower earnings for 2009, down to $67.66. At today's closing price of 1257, that projects to a lofty price to earnings (P/E) ratio of 18.55, well above long-term averages and well above trend for periods of poor or no growth. For the record, there is no record in history of a bull market starting at a P/E of 18.

Earnings Before Bad Stuff

One other interesting statistic that caught my eye: Reported earnings are what you pay taxes on. They are what you really made. S&P also estimates operating earnings, or as I characterize them, Earnings Before Bad Stuff, or Earnings Before BS. There has been a lot of Bad Stuff of late. Operating earnings for 2007 were almost 25% higher than reported (real) earnings, and about 15% (so far) for 2008.

But the analysts at S&P must expect a lot of Bad Stuff in 2009, because they project a difference of almost 45% in 2009. Remember that they project real earnings to be $67.66 in 2009? Well, they project operating earnings to be a whopping $108.60. That will be a growth in earnings of almost 25% in 2009.

Before we get into whether such earnings growth is likely, think about an environment where company after company keeps reporting large write-downs every quarter. Of course, they will tell you it is just this once, so don't sell us - now is a buying opportunity. Long-time readers know that I have written on several occasions about how continuing earnings disappointments are what create a bear market. Typically it takes at least three to really get the attention of analysts and investors, who begin to lower their projections for both profits and price targets.

How Ugly Can it Get?

David Rosenberg, the North American Economist at Merrill Lynch, is one of my favorite analysts. He is a mainstream economist who is most definitely not a cheerleader. He can be quite bullish as times, and when he thinks the times call for it, he can be rather bearish. As we will see below, he is quite bearish of late. I am going to quote from his opening remarks in a commentary dated July 25, where he is changing his forecast. Remove sharp objects from your nearby vicinity.

"Forecast addendum: Adjusting to the new reality

"Just like consumers, who are insulating their windows and making fewer trips to the malls, we are adjusting our economic forecast to the new high-oil price reality not to mention the latest round of trauma in the mortgage markets. Though fiscal stimulus [rebate checks] will provide a lingering boost to 3Q we expect GDP to plummet 2.5% in 4Q and see a similar decline in 1Q. In all, we have shaved our 2009 GDP forecast to -0.5%, a full percentage point lower that where it was previously, while 2008 is broadly unchanged at 1.5%.

"Less consumer, more unemployment, profit squeeze ahead

"The scenario we ran last May, when we shocked the model with higher oil prices, now appears to be playing out as predicted. With rebate check delivery winding down, there is now little shielding the consumer from the full force of $4+ gasoline, deflating real estate and equity markets and rising unemployment. The new reality means a deeper downturn for consumers, higher headline inflation, more belt-tightening from businesses and a mammoth profit squeeze. It also keeps the odds squarely in favor of more rate cuts from the Fed, in our view.

"Back to the 1970s

"Once the last of the rebate money is spent, in either July or August, consumer spending is expected to roll over, and hard. The oil shock we're experiencing is on par with the spike in the mid-1970s and consumer spending will see a similar downturn, in our view. The unemployment rate will probably crest at about 7.0% in mid-2009, a half percentage point higher than our previous outlook. We're expecting a 3.0% decline in PCE in 4Q 2008 and 1Q 2009 does not promise to be much better. We look for savings to rise, as consumers adjust to the tighter credit environment by building their savings rate up to 2-3/4% by the end of 2009.

"2008 stimulus - round two?

"The deeply disappointing retail sales report this week only serves to underscore how far behind the curve consumer is financially and a grim foreshadow of what lies ahead once the rebate checks are all spent. Flat spending was all consumers could muster in July with three quarters of the $106 billion total rebate checks in their bank accounts. We take consolation from the notion that the folks in the Beltway are doing the same math we are and thus the drumbeat of another round of stimulus is getting louder all the time.

"Housing still in the weeds

"The good news is that we're probably more than half way through the real estate correction. The bad news is that we've likely still got at least another 15% down on home prices to go before we reach bottom. Moreover, housing starts still need to breach the 700,000 mark to deal with the mountain of new and existing homes with for-sale signs on them. The supply situation will not be helped by the latest fractures in the mortgage securitization market, which will only slow the pace that homes can be sold and inventories can be cleared."

Below is a table with some of his forecasts. You can read the whole report at http://www.realclearmarkets.com/The%2520Market%2520Economist%252007%252018%252008.pdf .

Can you say Muddle Through?

A Lean Mean Reversion Machine

Remember a few pages up when we were talking about the mean-reverting qualities of corporate earnings? If corporate earnings fell to their long-term average, that would mean a drop of about 50% from the peak, which would mean $45 in operating earnings, and even lower for reported earnings. You could easily see a P/E ratio north of 25 or 30 if the market did not move down. Quoting from another Rosenberg commentary:

"To put this into perspective, the four-quarter trailing EPS figure in the 2001 recession hit a trough of around $38; in the 1991 recession, the trough was just over $18. That means that we are not talking about Armageddon [projecting $45 earnings], but rather offering up some analysis highlighting the risks to the outlook. We will bottom at levels much higher than the troughs in the past; that is the good news. The not-so-good news is that the level of the S&P 500 in the past that tended to coincide with $45 earnings was right around the 1,000 mark; and if we were to slap on a typical trough multiple of 10-12x on that earnings stream, then ... well, you do the calculation."

I highlight this analysis because it illustrates the point I have been making for a long time. Recessions do ugly things to corporate bottom lines. They savage earnings, and that is what ultimately drives the stock market lower. For you to be bullish today, you have to believe that the recession is over and that earnings are going to rise, not fall.

A 15% drop from where we are today would not be out of historical character. It would be a merely average bear market in an average recession. Given the extremes to which profits rose in the last cycle, it would be strange indeed if they did not revert to the mean or go below. The Dow below 10,000 is not unrealistic, or the S&P below 1,000.

I clearly do not know the future, and the market does as much as possible to make me look bad. But I simply believe that the risk is to the downside. And if Rosenberg is anywhere near right, then it could get a lot worse. Continued earnings disappointments, combined with ever increasing write-offs implied by the S&P numbers, is not the environment for a renewal of the bull market. The current run-up is a bear market rally, in my opinion. It is a time to lighten up, if you have not already.

Some Thoughts on Energy Policy

The US Geological Survey said the Arctic may contain as much as 90 billion barrels of untapped crude oil and 1.67 quadrillion (with a "Q"!) cubic feet of natural gas. This is equal to approximately 13% of the world's undiscovered oil and 30% (!) of the undiscovered natural gas. There is yet more offshore oil and gas off the coasts of the US that is not being utilized. And that is assuming current technological methods. You have to know technology is going to improve recovery rates.

There are debates about energy policy, as to whether we should go to solar, wind, or bio-fuels, drill for more oil and gas, build 45 nuclear plants, etc. I don't get it. I would like to check a box that says all of the above.

The reality is that the world is going to demand more oil as the developing nations want more cars and energy. Oil production is declining in Mexico and Russia and other countries where we get our fuel. While proper drilling and better political climates could make up for declining production of older fields, it is not the long-term solution.

In the short term, we need to drill in the Arctic and offshore. Even though I am going to show why oil could go back to $100 in the near term, in the long term (3-5 years) it could easily go to $200 and $6 a gallon if we do not do something now, and maybe even if we do. It will take years for any oil or gas to come from offshore and Arctic sources. If we are going to have that energy in five years, we need to drill now.

And it can be done safely. A large portion of the oil and gas for the US comes from the offshore fields of Texas and Louisiana. There was a class 5 Hurricane Katrina which ripped through these offshore rigs a few years ago, and not one of them had even a minor environmental problem. These rigs are built solid and safe.

To drill in the Alaskan Natural Wildlife Arctic Reserve means drilling on a few square miles of land which is basically wasteland. No beautiful scenery. No tourists. Very few caribou. We have been drilling in Alaska for a long time without problems, and technology has improved.

Oil coming online in a few years will help hold down prices today. That is the way markets work. Every year we wait will mean higher prices and more money sent outside of the US. But drilling for oil is not the long-term solution.

T. Boone Pickens has been running TV ads talking about a plan to divert natural gas to automobiles and reduce our need for oil. A key point is that we are sending $700 billion out of the US each year for oil. Over ten years it could be over $7 trillion. It is the largest transfer of wealth in history. It is unsustainable. It will be a serious drag on the dollar, which will make things even worse.

Look at this graph from my friends at GaveKal. It shows the US trade deficit, but the black shows the percentage of the deficit that is related to oil. Note how it has risen in the last few years, even as we have imported less in non-oil items. We have an oil deficit that is close to 3% of GDP, when ten years ago it was less than 0.5%. And the gap is rising as oil prices increase.

Pickens is a big proponent of wind power (and is putting his own money into wind, so he is "talking his book"). But there is a strong logic to what he says. Slowly converting our power grid to 15-20% wind (or even 5%) would be useful. You can see a quick presentation at YouTube: http://www.youtube.com/watch?v=Avt8Yo2WE14&feature=user

The July 21 Fortune has a great article on the rush to build solar power plants in the deserts of California, Arizona, and Nevada. Applications have been filed to build plants that would generate a theoretical 60 gigawatts of electricity. To put that into perspective, California only uses 33 gigawatts. And the biggest and richest firms are lining up to get land to build solar. These are not small start-ups. And that energy projection is using current technology, not even assuming what we will have in 5-10 years.

Note that California has over 10% of the population of the US, so there are people who actually want to use their money to build solar plants to provide 20% of the US demand for electricity. That is not a trivial pursuit.

Ironically, there are radical environmentalists who are planning to sue to stop this solar production because some desert animal's habitat might possibly be disturbed. Seriously? These are the people who think humans should leave the planet so that animals can live in peace and harmony with nature. And they are dictating our energy policy. Yes, we are talking about covering a great deal of uninhabitable desert with solar and thermal panels. And the government is taking its sweet time processing the applications. But we need to change the laws so that we can start the process. Allowing a few radical environmentalists to abuse the laws to prevent one of the best chances for renewable energy is just crazy.

You can read the well-written article by Todd Woody at http://greenwombat.blogs.fortune.cnn.com/2008/07/15/the-solar-land-rush/.

Senator John McCain wants to build 45 nuclear plants. Yes, that will take some time, but that means we need to start now. Within 15 years, and probably 10, our cars will be electric. We need to start building the power systems to meet increased demand for electric transportation.

And let's not forget clean coal technologies. All of the above can be done and still reduce our carbon footprint. But the point is that whoever gets elected next November needs to have a plan and put someone in place to actually lead and stop the bickering. It should not be either/or. It should be all of the above, because some of the ideas will not work out as predicted.

Either we are going to see the economic life sucked out of this country, or we can respond by doing everything that is in our power. There is not a shortage of energy. There is a shortage of leadership to produce the energy we need. A real energy policy would also have the benefit of boosting the beleaguered dollar.

T. Boone Pickens may be able to make energy policy the #1 election issue. And with another major effort by Pete Petersen, who is going to spend $1 billion telling the US how bad our Social Security and Medicare problems are before the election, maybe we can get enough people upset enough to demand some action. Maybe. Hopefully.

And speaking of the price of oil. It is $123, down from almost $150. Supplies are building and demand is being destroyed by high prices. Which of course reminds us that the cure for high prices is high prices.

How low could oil go? Data maven, uber trader, and good friend Greg Weldon recently developed a number of charts showing how supplies of oil-related products are rising and spreads are tightening. If we are in a correction, how low could oil go?

I must confess, I do not understand the fundamental aspect of something called a Fibonacci retracement, but the pattern keeps repeating itself over and over, so you have to pay attention. These are numbers based on work done by Leonardo Fibonacci in the 1200s. Basically, when a market starts to correct, it tends to go to certain points for support. Traders use them so much that they become psychologically important, which may be why they are useful.

Look at the chart below. It shows that if oil goes to its Fibonacci retracement levels, it could drop to $110 or below $100. That would not, as Greg notes, violate the longer-term bull market trend, but it could be seen as a normal correction. Just food for thought.

Oregon, Maine, and a Wedding

Tomorrow I fly out for a meeting in Portland, Oregon and back on a ridiculously early flight Tuesday morning. (What was I thinking?) And then Thursday I fly to Maine for David Kotok's Annual Shadow Fed Fishing Event. My youngest son Trey (now 14) and I fly to Bangor and then take a float plane to Leen's Lodge to meet with 30+ people. There will be several Fed economists, and some well-known names like Paul McCulley of Pimco, Martin Barnes of Bank Credit Analyst, Barry Ritholtz, John Silvia of Wachovia, and some very sharp traders and analysts. Right now, Steve Leesman of CNBC and a crew are slotted to come in, or so I am told. Everyone basically ships in a case of their favorite wines, so it is a very fun event. I can tell you that some of the participants go all out in their choice of wine, and I look forward to tasting scores of different wines.

But the conversation and comradery are the best part. We get up every morning and go out on the lake with local guides to fish, then meet for lunch on an island, eat what we caught, talk shop, tell lies, and drink lots of wine. Then we go out again and come back for a gourmet dinner, and drink even more wine and maybe some of Martin's Scotch. Then get up and do it again. And repeat. And the best part for Trey is that he always seems to catch twice as many fish as I do, as well as the biggest.

On Saturday night, everyone gathers in the lodge to place small bets (typically $10) on where the markets will be one year hence. Last year I asked those of my readers who wanted to, to also make predictions. We will go back this week and see how you did, and the best will be sent a copy of some book that I like. (Besides one of mine. Though I assume you already have those.) And I already know I have won one bet, so I will be a winner again this year. It will be interesting to see how close I came in the other bets. I will write this up in a later letter.

And then I come back for Wedding Week. The wedding is August 8. I spent Thursday with Tiffani and Ryan, meeting with wedding planners, musicians, caterers, fireworks managers (sigh), and a legion of people coordinating an event that has grown beyond the original vision. But what fun. And to see your daughter so happy? Priceless.

The weeks seem to go by so fast this summer, and now it is late and time to hit the send button. Have a great week.

Your hoping he can catch more fish this year analyst,

John Mauldin

Is it a Bull, Bear or Cowardly Lion Market?

John Mauldin — Fri, 11 Apr 2008 21:09:51 GMT

Bull, Bear, and Cowardly Lion Markets Market Cycle Math Where Are We Today? Analyze and Strategize Switzerland and American Airlines Are we in a bull, a bear, or a cowardly lion market? As we will see, the answer can make a huge difference in your investment...(read more)

More Thoughts on the Continuing Crisis

John Mauldin — Sat, 05 Apr 2008 05:14:00 GMT

There is so much that is happening each and every day as the Continuing Crisis moves slowly into month 8, so much news to follow, so many details that need to be followed up that it can get a little overwhelming. Where to begin? Maybe with a "minor" change of the rules on how we value assets, then a look at the proposed changes in regulations...(read more)

Where is the Bottom in Housing?

John Mauldin — Fri, 28 Mar 2008 15:10:15 GMT

Housing - Finding the Elusive Bottom Where is the Value in Housing? Bottom Line? There is no Bottom in Sight The Real ARMs Race Cancun, La Jolla, London, and Switzerland Existing home sales rose by 2.9% in February, the first significant rise in home...(read more)

The Subprime Virus

John Mauldin — Fri, 27 Jul 2007 08:05:00 GMT

The Subprime Virus The Subprime Virus 2007 Mid-Year Forecast Compete With the Pros When the Facts Change Credit? What Credit? global Warming, Maine and San Antonio As predicted in this letter early this year, the credit markets have finally begun to tighten...(read more)

Fun in the Subprime Summer

John Mauldin — Fri, 20 Jul 2007 08:04:00 GMT

Fun in the Subprime Summer Hot Fun In The Summertime Collateralized Loan Obligations The Economic Outlook for Leveraged Credits The New Mickey Mouse Club Planes, Trains and Automobiles This week I am already in Maine and getting ready for a weekend of...(read more)

A Raging Bull

John Mauldin — Fri, 02 Feb 2007 08:25:00 GMT

Introduction This week I am in South Africa. At the moment I am literally flying from Johannesburg to Durban in a single-engine Pilates PC 12, a very upscale Swiss-manufactured plane. I am told pilots will know and appreciate the plane. It is supposedly...(read more)

Some Additional Firming?

John Mauldin — Fri, 13 Oct 2006 06:59:00 GMT

Introduction Are we in for a soft or a hard landing? Did retail sales slow, as the data suggest, or is the underlying data quite bullish? We will look at the arguments, and then look at the most reliable of all economic indicators to see if we can get...(read more)

2006 Mid-Year Forecast

John Mauldin — Fri, 23 Jun 2006 06:34:00 GMT

Introduction This week we will venture into the always hazardous area of making my semi-annual forecast. I make some non-consensus projections as to the economic climate for the next six months, and of course look at Fed policy. We will also quickly review...(read more)

Forecast 2006: On the Gripping Hand

John Mauldin — Fri, 06 Jan 2006 06:23:00 GMT

Introduction Once again it's time for me to demonstrate the foolhardy part of my nature by putting to electronic pen my forecast for 2006. I spend more research time on this one letter than on any four or five combined, simply reading hundreds of...(read more)

The More Things Change

John Mauldin — Sat, 23 Apr 2005 02:14:00 GMT

The More Things Change This is the text of a speech given at the Accelerating Change 2004 conference at Stanford University. The conference organizers asked me to look out over the next 3-4 decades and offer my thoughts as to what the future may look...(read more)