Thoughts From The Frontline : Employment

If This Is Recovery…

John Mauldin — Sat, 14 Nov 2009 05:31:00 GMT

If This is Recovery, Where Are the Taxes?
Last Business Standing
Stimulus, What Stimulus?
The Reality of Unemployment
Let the Good Times Roll
The Quick Double-Dip Scenario
Phoenix, New York, and Thoughts on the Internet

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let's look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we're in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter's creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won't know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen's Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we've lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let's see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish's very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let's look at his assumptions:

Job losses are likely to continue for a minimum of another year.
When job gains start, they will be very slow at first, then pick up.
An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
A falling participation rate (boomers retiring) will continue to mask reported unemployment.
Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let's start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike's blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let's look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let's be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn't look like that will be the case. So, let's quickly see what a double-dip scenario might look like. Let's be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it's getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I've noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Phoenix, New York, and Thoughts on the Internet

Next week I take a quick one-day trip to Phoenix, then back to do a satellite-remote speech to a South African hedge fund conference. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org). Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

The 7 kids, spouses, and grandkids are starting to gather. We will all have brunch Sunday and then a shower for Tiffani. She has another 6 weeks before she is due, and she is really uncomfortable. Walking is literally a pain.

Permit me to reminisce. A little over 9 years ago I started this letter on the internet with about 2,000 email addresses. It was a new version of what had been a print letter, as that was the business I knew. The internet was still a new thing to me, but it seemed like a good idea at the time. Little did I know.

I am still amazed at the growth and the direction my business and life have taken. My letters are sent out by various publishers and affiliates to over 1.5 million readers and posted on dozens of web sites, and the numbers have been growing rapidly of late. I am grateful. But I wonder what would happen if I started it today. Ten years ago there was little in the way of free economic letters. Not a lot of competition.

Today, there is so much free information that it's staggering. There have to be thousands of blogs and hundreds of free letters, some with very large circulations. It seems a new star is born every few months. While much of it does not add to the level of conversation, some of it is quite excellent. I think I am lucky to have started when I did.

And I am grateful for the kind attention you give me. As I turn 60, I note that this has been a rather overwhelming last ten years. A lot of changes for me, and almost all of them very good. But there are more to come. The last two flights I was on I was connected to the internet at 35,000 feet. I sense a lot more changes coming. I am thinking a lot about how to keep up and not get left behind, how to make sure that you, gentle reader, continue to get my best. That is what, at the end of the day, drives me.

Have a great week. I know I shall. Dad loves it when his kids (from 15 to 32) and spouses and grandkids are all under one roof.

Your amazed at it all analyst,

John Mauldin

The Glide Path Option

John Mauldin — Sat, 07 Nov 2009 04:54:00 GMT

The Present Contains All Possible Futures
The Ugly Unemployment Numbers
Argentinian Disease
The Austrian Solution
The Eastern European Solution
Japanese Disease
The Glide Path Option
Philadelphia, Orlando, and Phoenix

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we're headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.investorsinsight.com and search for terms I am writing about. And I will start out by briefly touching on today's ugly unemployment numbers, with data you did not get in the mainstream media.

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.investorsinsight.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don't know, I write a brief monthly column for them.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

"Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual 'change' in the underlying labor market situation ... in which case, October's figure of 817,000 represents the fourth LARGEST yet, behind last month's (September's) second largest figure of 1,021,000 ... for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer 'in' the Labor Force ...

"... the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

"Bottom line ... basis this measure AND the 'Total Unemployment Rate,' we could conclude that not only is there NO 'improvement' in the labor market, but moreover, that it continues to DETERIORATE, intently."

There are plenty more implications in the data, but let's turn to the topic of the day.

The Present Contains All Possible Futures

Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea.

Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets.

If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from? The answer is that it can't be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes.

We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let's review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.)

Argentinian Disease

One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower?

One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here?

Hyperinflation is not an economic event; it is a political choice. I think last Tuesday's election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything's possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen.

I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices.

The Austrian Solution

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

The Eastern European Solution

As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world's problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He's a very fun and knowledgeable guy.

As we were talking about possible paths, he brought one to mind that I hadn't thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day.

We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change.

Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can't even get the obvious changes needed in the financial regulatory world.

Sidebar: I am outraged at the paltry proposed financial "reforms." Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don't care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Japanese Disease

I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their "lost decades" with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago.

As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!)

And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don't make sense can go on longer than we think.

Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor's Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame.

So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets.

Japan elected to run large deficits and raise taxes. As I wrote in the October 16^th letter (http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/10/17/muddle-through-r-i-p.aspx), "Savings equal Investments:

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

I don't want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama's chairman of the Council of Economic Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect.

In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in "G" must be made up by savings from consumers and businesses and foreigners.

But "G" does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business.

And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth.

This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits for longer than most observers currently believe.

We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare.

Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take.

The Glide Path Option

A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term.

If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years.

The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce "G" (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do.

The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs.

That's pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a "V" ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time.

And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that's for another time.

Philadelphia, Orlando, and Phoenix

I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy.

Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4^th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/), Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds.

It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed.

Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy.

I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time.

Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year.

Your always optimistic at the beginning of the season analyst,

John Mauldin

The Best of Times

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

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

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

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

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

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

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

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

The Elements of Deflation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It Is the Best of Times

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It's More Than Half Full

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Argentina, Brazil, and Uruguay

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

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

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

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

Your wondering who made up this schedule analyst,

John Mauldin

Killing the Goose

John Mauldin — Sat, 10 Oct 2009 03:07:00 GMT

Killing the Goose
What Were We Thinking?
Let's Play Turn It Around
Detroit, the Red Sox and the Yankees, and Traveling Too Much

Peggy Noonan, maybe the most gifted essayist of our time, wrote a few weeks ago about the vague concern that many of us have that the monster looming up ahead of us has the potential (my interpretation) for not just plucking a few feathers from the goose that lays the golden egg (the US free-market economy), or stealing a few more of the valuable eggs, but of actually killing the goose. Today we look at the possibility that the fiscal path of the enormous US government deficits we are on could indeed kill the goose, or harm it so badly it will make the lost decades that Japan has suffered seem like a stroll in the park.

And while I do not think we will get to that point (though I can't deny the possibility), for reasons I will go into, there is the very real prospect that the upheavals created by not dealing proactively with the problems (or denying they exist) will be as bad as or worse than the credit crisis we have gone through. This is not going to be something that happens overnight, and the seeming return to normalcy that so many predict has the rather alarming aspect of creating a sense of complacency that will only serve to "kick the can" down the road.

This week we look at the problem, and then muse upon what the more likely scenarios are that may play out. This is a longer version of a speech I gave this morning to the New Orleans Conference, where I also offered a path out of the problems. This letter will be a little more controversial than normal, but I hope it makes us all think about the very serious plight we have put ourselves in.

Let's review a few paragraphs I wrote last month: "I have seven kids. As our family grew, we limited the choices our kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. How many times did Dad say, ‘What were you thinking?' and get a mute reply or a mumbled ‘I don't know.'

"Yet how else do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own choices. And a lot of them make a lot of bad choices. After having raised six, with one more teenage son at home, I have come to the conclusion that you just breathe a sigh of relief if they grow up and have avoided fatal, life-altering choices. I am lucky. So far. Knock on a lot of wood.

"I have watched good kids from good families make bad choices, and kids with no seeming chance make good choices. But one thing I have observed. Very few teenagers make the hard choice without some outside encouragement or help in understanding the known consequences, from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up. So quickly."

What Were We Thinking?

As a culture, the current mix of generations, especially in the US, has made some choices. Choices which, in hindsight, leave the adult in us asking, "What were we thinking?"

We made a series of bad choices and suffered the credit crisis because of it. Now, as a nation, we are in the middle of making an even worse choice, one that will leave us with no good choices - only choices of pretty bad to awful. Let's begin with a quote from a recent client letter by my friends at Hayman Advisors (in Dallas).

"Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

"There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

"According to the current Office of Management and Budget (OMB) projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010, with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. [Emphasis mine]

"One has to ask whether the US reached the critical tipping point. Beyond the quantitative measurements associated with government deficits and money creation, there exists a qualitative aspect to such a scenario that may be far more important. The qualitative perceptions of fiscal and monetary policies are impossible to control once confidence is lost. In fact, recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future."

Let me point out that the deficits for 2010 assume a rather robust recovery, and so they could turn out to be much worse, especially if unemployment continues to rise and Congress decides (rightly) to extend unemployment benefits.

The interest on the national debt in fiscal 2008 was $451 billion. Even though the debt has exploded, the interest for fiscal 2009 is down to "only" $383 billion. My back-of-the-napkin estimate says that is over 20% of total 2009 tax receipts. I guess when you take interest rates to zero and really load up on short-term debt, it helps lower interest costs. (More on that future problem later.) http://www.savingsbonds.gov/govt/reports/ir/ir_expense.htm

The fiscal deficits are projected to be about 11% of nominal GDP, which is now roughly $14.3 trillion. The Congressional Budget Office currently projects that deficits will still be $1 trillion in ten years.

Last spring I published as an Outside the Box a very important paper by Dr. Woody Brock on why you cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system. If you have not read it, or would like to read it again, click here.

I am going to reproduce just one table from that piece. Note that this was Woody's worst-case assumption, adding 8% of GDP to the debt each year, and not the 11% we are experiencing today. The Congressional Budget Office projections are now even worse, and that assumes a very rosy 3% or more growth in the economy for the next five years. Under Woody's scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP, depending on your growth assumptions. Take some time to study the tables, but I am going to focus on 2015 and not the outlier years.

$1.5 trillion dollars means that someone has to invest that much in Treasury bonds. Let's look at where the $1.5 trillion might come from. Let's assume that all of our trade deficit comes back to the US and is invested in US government bonds. Today we found out that the latest monthly trade deficit was just over $30 billion, or $370 billion annualized (which is half what it was a few years ago). That still leaves $1.13 trillion that needs to be found to be invested in US government debt (forget about business and consumer loans and mortgages).

Killing the Goose

$1.13 trillion is roughly 8% of total US GDP. That is a staggering amount. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about whether to create an alternative to the dollar as a reserve currency. (And if I was watching the US run $1.5 trillion deficits with no realistic plans to cut back, I would be having private talks too. They would be idiots not to do so.)

There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three.

Now the Fed is in fact monetizing a portion of the debt as part of its quantitative easing program, and US consumers are saving more. Tax receipts are way down. I can tell you there is a great deal of angst in New Orleans tonight about the Fed monetization. This is traditionally a "gold bug" conference, and many of the participants and speakers see only inflation in our future.

Long-time readers know that I think the Fed has been able to get away with its rather large monetization program because of the massive deflationary forces let loose in the world by the credit crisis, which is forcing a monster deleveraging regime all over the world. Where has all the money gone that the Fed has printed? Right back onto the Fed's balance sheet as bank reserves. The banks are not lending, so this money does not get into the system in the usual manner associated with fractional reserve banking. Until that happens, and is accompanied by increasing wages and employment, inflation is not in our immediate future.

And this brings us to our conundrum. You cannot continue to run deficits significantly larger than nominal GDP for too long without risking the demise of the economic system. Ask Argentina or any of the other nations where hyperinflation occurred, as detailed in the study mentioned above. But we are in a deflationary environment, so the Fed can monetize the debt far more than any of us suppose without risking immediate and spiraling inflation.

But there is a limit to the Fed's ability to do so without causing real inflation. First, as long as the Fed is independent, at some point they will simply have to tell Congress we can no longer monetize the debt. While I am sure that some of you doubt they would do so, the Fed officials and economists I have been around are pretty adamant about that. There is a line they will not be pushed past. It may be further than I like, but it is there.

The Fed cannot simply buy up all the debt needed to fund the government. Again, no one on the FOMC would either advocate or allow that. That would in fact start us down a very dangerous path rather quickly. Therefore, they must have a large number of willing bond buyers outside the Fed. The good news, gentle reader, is that we will find someone to buy that debt. That is also the bad news. Let's go back 30 years.

Legend now has it that Paul Volker single-handedly took the inflation bull by the horns and ripped them off. Now, it took fortitude to do that in the face of certain recession and high unemployment. Those were not fun days. But his partner in the deed was the bond market. Bond investors simply demanded higher returns, because they were really worried about inflation.

At some point, if we do not get the government deficit under control, the bond market is once again going to react. Seemingly overnight, real (inflation-adjusted) rates are going to rise, and will do so rapidly. And I am not talking about 1 or 2%. You just cannot have 8% of a $14-trillion GDP go into US government debt every year, forever, at today's low real rates.

Let's play a thought game. If you take 8% of US consumer spending and save it, and it finds its way into government bonds, you have reduced consumer spending and therefore the actual GDP. But how about those who want to invest in stocks? Foreign bonds and currencies? New businesses? Loans of all types? How much are we going to have to save to get the necessary capital? How high will the saving rate have to be to finance all those other activities in a world where debt securitization is still anemic?

Some will point to Japan and their government debt-to-GDP ratio, which will soon be over 200%, a far cry from where we are today. Why can't we grow our debt to 200%? Because the Japanese have long had a culture of saving and investing in government bonds. It's what you do to support the country. But even they will run into a wall as their savings rate continues to drop, because so many of their citizens are retired and are now selling bonds to finance retirement. They too are running massive fiscal deficits, on the order of the size of the US deficits. And does anyone really want to have two lost decades, like Japan?

How long can we go before there is an upheaval? I don't know. The markets can remain irrational or complacent for a lot longer than most of us think. It could be years. Or not. Suddenly, it will be July 2008 and the bond vigilantes stampede.

But now, we seemingly can borrow with no consequences. The deflation that is in the air, plus the lack of bank lending holds, down the normal inflation impulses. We as a nation are leveraging ourselves up. We're partying like it's still 2005. The music is playing and we are dancing. Our Congress is trying to figure out how to run even higher deficits.

At some point, the consequences will be significant. There are two paths, and it is not clear which one we will take. First, we might see inflation kick in and actual rates rise. Since so much of our national debt is short-term debt, that means yet another rise in the deficit as rates rise. Mortgage rates rise, putting pressure on the housing market. There will be even more pressure on commercial mortgages. Consumer debt will be harder to get and cost more. It will mean funding costs for businesses will rise, and that hurts employment. It would be a return to the 1970s of high interest rates and stagnant growth in a very slow-growth environment.

Second, we could see deflation kick in and, even though rates stay more or less where they are, real (after-deflation) rates could rise as they did in the '30s and in Japan.

Some of my most knowledgeable friends argue for the inflation side, and others take the deflation side. I tend to think the Fed will fight deflation until we get inflation, but the consequences will not be pleasant. There is no benign path.

How can we avoid such an upheaval? The only way is to make some very difficult choices. There have to be some adults making the choices, as the teenagers now in control clearly cannot make them.

As I have written in the past, we can run deficits of 2% of GDP for a very long time, which in a few years would be about $300 billion. It is my belief that if the bond market and world investors saw a credible plan to put us on a path to a deficit no larger than 2% of GDP, the dire upheaval that is in our future could be avoided.

But that will mean some painful choices. It is not a matter of pain or no pain, it is just deciding when and how bad it will be. The longer we wait, the worse the consequences.

Let's Play Turn It Around

There are businessmen who are called turnaround specialists. They come into companies that are sick but have a basic competency, and that with the right management can be made into viable concerns. Generally, the choices the new management makes are painful to those involved, but they are necessary if the enterprise is to remain a going concern.

So, for the next few pages, I am going to suggest some things we can do to turn the US around. They are not easy fixes, and I know a lot of readers will not like what they read or will disagree on points. But something like this is going to have to be done, or we risk killing the goose.

First, we must acknowledge the deficit is out of control, and spending must be cut. If we raise taxes by as much as the Obama administration now wants to, we will most assuredly put the country back into a deep recession in 2011. Think what raising taxes in 1937 did to a nascent recovery. A $3-trillion-dollar budget is 20% of the US economy. That is just simply too much.

Quick fact. The most credible studies show that government expenditures exert no multiplier effect on the economy. Actually, they show them to be very slightly negative. This is not just in the US. However, the tax effect has a multiplier of 3! If we raise taxes by $300 billion in 2011, that will slam the economy in the face. Further, we will collect less taxes than projected, as economic activity will fall.

You cannot cure a too much debt problem with more debt. We cannot borrow our way into prosperity. Every crisis of the past decades has been a result of too much debt and leverage and we seem to want to repeat the past mistakes, hoping that this time it will be different. It won't.

Ok, now let's play the Turnaround Hammer Game.

+ We should start with a 5% acrossthe-board cut in spending in all programs. Federal employees, except for military personnel, should see a 5% cut in pay as part of that program. The average federal worker makes $75,419 a year, while the average in the private sector is $39,751. The rest of us are taking pay cuts in the form of higher taxes. No cost of living increases, etc. We are on an austerity program and need to do what it takes. If a program is deemed too important to be cut, then another program has to be cut more.

Then the next year another 2.5% cut across the board. And then an absolute freeze on the overall budget size until the deficit is 2% or less of GDP.

+ Social Security must be fixed now. We all know that it is going to have to be done, so why not just do it? Means testing should be a part of the mix. As an idea, for every $10,000 in income a retiree has, he gets $1,000 less in SS payments. And increase the retirement age down the road. When SS was launched, retirement age was 65. But the average life span was 65. There are other things we can do, but whatever our poison of choice is, we need to take it.

+ Medicare must be revised, with real health-care reform. The national debt is $56 trillion if we count unfunded liabilities, much of which is Medicare. It will become a nightmare around the middle of the next decade. Adding more expenses now without cutting elsewhere makes no sense. If we kill the goose, no one will get anything excect very empty promises.

Side note: there actually is a lot of waste in the system. Software should be written that analyzes every patient and procedure and produces an outcomes-based analysis of what is reasonable, rather than throwing every test at every patient. And the government should make sure, even if it has to spend the money, that the updated system is in place in every hospital and clinic in the country. And doctors should be given access to it so they can decide what type of care is appropriate to prescribe. And health-care reform means tort reform.

Today, I got a note from a friend of mine who just had yet another heart attack. It seems his stent is now blocked by 50%. He is a vet, and his primary care is the Veterans Administration. The Veterans Hospital system will not do a procedure to unblock the stent until it is 70% blocked. He does not have any money, so he is simply waiting to have another heart attack. I am really looking forward to government-run health care.

+ Each year we allow almost 1 million immigrants into the US, mostly family of people already here. I suggest that for the next two years we stop that. Instead, let anyone who can buy a home, passes basic screening, and can demonstrate the ability to pay for health insurance immigrate to the US and get a temporary green card. If they behave, then the card becomes permanent after four years.

We almost immediately put a floor on the housing market, absorb the excess homes, and within a year the housing-construction market, along with the jobs that are now gone, will be back. That is stimulus that costs the taxpayers nothing.

+ While I can't believe I am writing this, taxes are going to have to rise, if for no other reason than this Congress is hell bent on raising taxes. But rescinding the entire Bush tax cuts, plus adding a 10% surcharge as Congress wants to do in one fell swoop, is an absolute guarantee of a recession. So do it gradually over (say) 4 years, and then reinstitute the cuts when the deficit is under 2% of GDP. Remember the negative tax-multiplier effect of raising taxes. And the definitive work on that was done by Obama's chairman of the Council of Economic Advisors, Christina Romer.

We should consider a VAT tax and a major cut/reorganization of the corporate tax. We need to encourage corporations to hire more, and you do that by taxing less. Let's make our corporations more competitive, not less. Our taxes are much higher than those of any of our major competitors. And please forget that insane carbon tax. If you want to cut emissions, do it straightforwardly by raising taxes significantly on gasoline. Don't back-door it on consumers. (And I am NOT advocating such a policy.)

+ An aggressive tax benefit for new venture-capital money that is invested in new technologies will result in new industries. The only way we can grow our way out of this mess is to create whole new industries, like we did in the late '70s and '80s. (Think computers and the internet and telecom.)

+ Unemployment is likely to continue to rise and last longer than ever before. We have to take care of the basic needs of those who want work but can't find it. Unemployment insurance should be extended to those who are still looking for work past the time for benefits to expire, and some program of local volunteer service should be instituted as the price for getting continued benefits after the primary benefits time period runs out. Not only will this help the community, but it will get the person out into the world where he is more likely to meet someone who can give him a job. But the costs of this program should be revenue-neutral. Something else has to be cut.

+ We have to re-hink our military costs (I can't believe I am writing this!). We now spend almost 50% of the world's total military budget. Maybe we need to understand that we can't fight two wars and support hundreds of bases around the world. If we kill the goose, our ability to fight even one medium-sized war will be diminished. The harsh reality is that everything has to be re-evaluated. As an example, do we really need to be in Korea? If so, why can't Korea pay for much of the cost? They are now a rich nation. There are budgetary fiscal limits to being the policeman for the world.

+ Glass-Steagall, or some form of it, should be brought back. Banks, which are subject to taxpayer bailouts, should not be in the investment banking and derivatives-creating business. Derivatives, especially credit default swaps, should be on an exchange, and too big to fail must go. Banks have enough risk just making loans. Leverage should be dialed down, and hedge funds selling what amounts to naked call options in any form, derivative or otherwise, should be regulated.

Let me see, is there any group I have not offended yet? But something like I am suggesting is going to have to be done at some point. There is no way we can continue forever on the current path. At some point, we will hit the wall. The fight between the bug and the windshield always ends in favor of the windshield. The bond market is going to have to see a credible effort to get back to a reasonable deficit, or we risk a very difficult economic environment. The longer we wait, the worse it will be.

It is not going to be easy to persuade a majority of Americans that we need to do something now. More realistically, we are going to probably have to begin to experience a crisis of some type to get politicians motivated to do something.

This last Tuesday, I spoke to the Financial Leadership Association at the University of Texas at Dallas. It was mostly undergraduates, and my assigned topic was how financial research impacts our investment decisions. In touched on the topic above, in less detail, but pointing out that at some point we are going to have to bring the deficit under reasonable control. I got some push-back, as some could not understand why we just couldn't keep running deficits, as we simply owe it to ourselves. I tried to explain, but for a few of them I was not getting through (though I think most got it). And these were the finance students! I shudder to think what the sociology department would be like.

We are not going back to normal, although it is likely we will see some form of Statistical Recovery. But we cannot get complacent. Somewhere out there is the real potential for another crisis, which will dwarf the last one. You will not want to be long much of anything when it happens, except hedged or liquid investments. Though admittedly, this could go on for a long time. I just don't know how long "long" is. Other than it will be too long and then not long enough.

Detroit, the Red Sox and the Yankees and Traveling Too Much

I leave for Detroit next Friday and speak at a private conference on Saturday, then rush to the airport to fly to New York. My friend Barry Habib has second-row behind-home-plate tickets to what we hope is a Yankees - Boston Red Sox playoff championship game. That would have to be one of the most exciting games to watch - the emotions will run as high as in any sporting event around. So I find myself in the strange position of cheering on both the Yankees and the Red Sox in the first round of playoffs, and hoping that there is not a four-game sweep in the second.

Dinner with the guys at Yahoo Tech Ticker on Monday, and then an early train to Philadelphia, where I will speak at a conference hosted by my friends and partners at CMG. Dinner that night, a very early flight to Dallas, change airports, fly to Houston to speak at Salient Partners, then a late-night flight back to Dallas, up early to fly to Orlando to be with Jon Sundt of Altegris at the Commonwealth conference, fly back early (sigh) Saturday morning to Dallas, drive home, pack, and take an overnight flight to Buenos Aires to start a speaking tour with new Latin American partner Enrique Fynn, then on to Montevideo, Uruguay, Sao Paulo. and Rio de Janeiro, and then back to Montevideo for a day of R&R. Then back home Monday. I am already tired.

Tomorrow I get to hear Karl Rove (wonder if he will remember me from our Texas days?), Howard Dean, Charles Krauthammer, and a lot of friends, then a series of parties tomorrow night. I always enjoy coming to The Big Easy for this conference. (Note to Chinese and Spanish translators: the Big Easy is a nickname for New Orleans. I can't expect them to know that one.)

It is time to hit the send button, as I have to speak at my next session. You have a great week, and remember that together we will get through all the coming problems. Just keep paying attention.

Your worried about all the unintended consequences analyst,

John Mauldin

The Elements of Deflation

John Mauldin — Sat, 05 Sep 2009 04:43:00 GMT

The Elements of Deflation
The Failure of Economics
The Super Trend Puzzle
Final Demand and Income
Unemployment Was NOT a Green Shoot
Washington, DC, San Diego, and Johannesburg

As every school child knows, water is formed by the two elements of hydrogen and oxygen in a very simple formula we all know as H2O. Today we start a series that starts with the question, What are the elements that comprise deflation? Far from being simple, the "equation" for deflation is as complex as that of DNA. And sadly, while the genome project has helped us with great insights into how DNA works, economic analysis is still back in the 1950s when it comes to decoding deflation. Notwithstanding the paucity of understanding we can glean from the dismal science, in this week's letter we will start thinking about the most fundamentally important question of the day: is inflation, or deflation, in our future?

But quickly, I want to thank the many people who wrote very kind words about last week's letter. Many thought it was one of the better letters I have done in a long time. If you did not read it, you can read it here. And of course, you can go there and sign up to get this letter sent to you each week for free. Why not become of my 1 million (plus and growing) closest friends?

The Failure of Economics

Among the economists and writers I regularly read, there are some who, if they agree with me, I go back and check my assumptions - I must have been wrong. Paul Krugman is one of those thinkers. I admit to his brilliance, but his left-leaning philosophy does not particularly square with mine, and I find that most of the time I disagree.

That being said, I strongly encourage you to read his essay in the New York Times Magazine, which comes out this weekend. It is worth the high price of the Times to read it, if you can't get it online. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn't even come close to predicting the current financial malaise. Indeed, as he points out, most schools of thought said the state we are in could not happen. You can read at the essay if you are a member, or register for free if you are not. http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1.

Krugman writes, as I have in repeated columns, that we have taught two generations of economists and financial practitioners faulty theories. Even now, believers in the Efficient Market Hypothesis and CAPM hold to their beliefs in the face of clearly contrary evidence. It is a very thought-provoking piece and worthy of a long weekend read. He names specific names and pulls no punches. This is as close to starting a barroom brawl as you get in economic circles.

He calls for a return to and fresh analysis of Keynesianism. Sigh. I would go further. A plague on all their houses. Whether Keynes or Friedman (monetarism) or von Mises (the Austrian school of economics) or the rather new school of behavioral economics, they all have deficiencies and (sometimes gaping) holes in their logic. At the same time, they all contribute to our general understanding of the world, and there are benefits to studying them.

Let me risk an analogy. It is like reading about some religious scheme for interpreting the world and then becoming a true believer, arguing for that point of view as received wisdom - it's your belief system. Five Nobel laureates say this and seven say that. My guru is smarter than your guru. Look at how the math proves this point. And so on...

Krugman concludes: "So here's what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit - and this will be very hard for the people who giggled and whispered over Keynes - that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.

"Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: 'There is always an easy solution to every human problem - neat, plausible and wrong.'"

I agree we need to examine our assumptions. I am not sure that makes me want to unreservedly embrace Keynes. Keynesians missed as badly as anyone else in this crisis. Yes, the Austrians generally called some of the problem, but their solutions call for 25% unemployment and an unworkable global economy and a serious depression. Not sure that I want to sign up for that, either. And, they totally discount the concept of the velocity of money, which we will look at next week.

We need a new and better economic understanding, not some semireligious adherence to dogma laid down by men who were in no way familiar with current world conditions. Keynes, von Mises, Fisher, Schumpeter, Minsky, Hayek, Smith, et al. were giants. They absolutely must be read and understood. But a real science builds on the work of the former generations and does not hold onto theories as if they were scripture.

As much as many economists would like to think so, economics is not a precise science. A global economy cannot yield to hard math in the way that one can model a protein, at least not with any model that has yet been offered. At best, the models let us see through a glass darkly, suggesting the potential for connections between a few variables, while assuming that all others are held constant. It is precisely the illusion that we can model the economy that got us into the current mess.

(By the way, good friend Paul McCulley has written a very interesting essay on why the Fed has to change their models on inflation targeting - the Taylor Rule is not up to the task - and whether or not to deal with bubbles before the fact, rather than mopping up after they burst. What was assumed has clearly not worked. You can read it at www.pimco.com.)

I am often asked what school of economic thought I adhere to, and the answer is, none. I would rather try to get it right. And rather than argue for one policy or another (which admittedly I sometimes do), it is more important to figure out what those who actually will effect policy will do, and then make sure we are not in the way of the train they are sending down the tracks. Agree with Krugman or not, he is one of the principal conductors on the train.

And that brings us back to the elements of deflation.

The Super-Trend Puzzle

I am a big fan of puzzles of all kinds, especially picture puzzles. I love to figure out how the pieces fit together and watch the picture emerge, and have spent many an enjoyable hour at the table struggling to find the missing piece that helps connect the patterns.

Perhaps that explains my fascination with economics and investing, as there are no greater puzzles (except possibly the great theological conundrums or the mind of a woman, about which I have only a few clues).

The great problem with the economic puzzles is that the shapes of the pieces can and will change as they rub against one another. One often finds that fitting two pieces together changes the way they meld with the other pieces you thought were already nailed down, which may of course change the pieces with which they are adjoined, and suddenly your neat economic picture no longer looks anything like the real world.

(Which is why all of the mathematical models make assumptions about variables that allow the models to work, except that what they end up showing is not related to the real world, which is not composed of static variables.)

There are two types of major economic puzzle pieces. The first are those pieces that represent trends that are inexorable: they will not themselves change, or if they do it will be slowly; but they will force every puzzle piece that touches them to shift, due to the force of their power. Demographic shifts or technology improvements over the long run would be examples of this type of puzzle piece.

The second type is what I think of as "balancing trends," or trends that are not inevitable but which, if they come about, will have significant implications. If you place that piece into the puzzle, it too changes the shape of all the pieces of the puzzle around it. And in the economic super-trend puzzle, it can change the shape of other pieces in ways that are not clear.

Deflation is in the latter category. I have often quipped that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA change that makes you viscerally and at all times opposed to deflation. Deflation is a major economic game changer. You can argue, as Gary Shilling does, that there is a good kind of deflation, where rising productivity and other such good things produces a general fall in prices, such as we had in the late 19^th century.

But that is not the kind of deflation we face today. We face the deflation of the Depression era, and central bankers of the world are united in opposition. As McCulley quipped to me this spring, when I asked him if he was concerned about inflation, with all the stimulus and printing of money we were facing, "John," he said, "you better hope they can cause some inflation." And he is right. If we don't have a problem with inflation in the future, we are going to have far worse problems to deal with.

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

Final Demand and Income

For instance, inflation always seems to be accompanied by higher wages. That makes sense, as workers want more to justify their labor if prices are rising. But today we have wages dropping over time. Yes, even though wages went up this month by 0.3%, it was all due to a one-time increase in the minimum wage. Without that government mandate wages would have been flat or falling. Look for wages to fall over the rest of the year.

There are no pricing pressures on wages. Look at this very eye-opening graph from my friends at one of my must-read letters, The Liscio Report. (www.theliscioreport.com).

Throughout the last decade, the number of strikes involving a thousand or more workers averaged about 22 (but averaged over 300 annually from the time they started tracking this item). We are on target this year for 2, an amazing 62-year low. Indeed, we have the opposite happening. Workers are seeing jobs lost, wages being slashed, hours being cut back, and a loss of benefits, as businesses react with cost cuts to the lack of demand.

While it is technically possible to have inflation with rising unemployment and falling wages, it would take a great deal of monetization to achieve, and that will bring us to a new idea in a few paragraphs.

Unemployment Was NOT a Green Shoot

But quickly, let's look at today's unemployment numbers. This was not the way one would want to celebrate Labor Day. Unemployment rose to 9.7%. Some take comfort in that unemployment in the Establishment Survey (where they call existing business and poll them) was only down by 216,000, which admittedly is better than 600,000 but is still a very bad number. Rising unemployment is not the stuff that inflation is typically made of. And there are reasons to think the picture may be worse than that. Here are a few thoughts from David Rosenberg:

"What was really key were the details of the Household Survey, which provide a rather alarming picture of what is happening in the labor market.

"First, employment in this survey showed a plunge of 392,000, but that number was flattered by a surge in self-employment (whether these newly minted consultants were making any money is another story) as wage & salary workers (the ones that work at companies, big and small) plunged 637,000 — the largest decline since March (when the stock market was testing its lows for the cycle). As an aside, the Bureau of Labor Statistics also publishes a number from the Household survey that is comparable to the nonfarm survey (dubbed the population and payroll-adjusted Household number), and on this basis, employment sank — brace yourself — by over 1 million, which is unprecedented. We shall see if the nattering nabobs of positivity discuss that particularly statistic in their post-payroll assessments; we are not exactly holding our breath."

The ISM numbers came out this week and, while manufacturing is up, the service industry (which is far larger) is still contracting, and the employment elements in the surveys show employers are still planning to cut jobs. Think about almost 11% unemployment next summer in the middle of the political season. Watch the competition among politicians to demonstrate they care and "get it." And watch as they spend your money to show how much they care.

And from the above mentioned Liscio Report: "As we outlined back in May, financial crises hammer employment, resulting in average losses of 6.3% followed by a long flat line. We hate to point it out, but we're currently down 4.8% from the December 2007 onset, and if US job losses in this recession stay in line with the major financial recessions in "advanced" countries studied by the IMF, we stand to lose another 1.8 million jobs. Some of those will likely be taken out in upcoming benchmarks, stimulus money has some clout, and no one has a reliable crystal ball, but we need to remember where we are in a painful cycle if we see some hopeful flickers."

That would take us to well over 11% unemployment.

Interesting statistic. Want to know where wages are rising? Think federal government workers. The gap between civilian and government workers was less than $13,000 nine years ago, but now is almost $30,000. Inflation has been 24%, but government wages are up 55%. According to a recent release from Rasmussen Reports, a government job remains "the top employment choice in today's economic environment." (chart from Clusterstock)

States, counties, and cities are having to make deep cuts, in both jobs and programs. Today's Wall Street Journal talks about the cuts in state after state. States cannot print money like the US can, so at some point they have to either raise taxes or cut spending to balance their budgets. Raising taxes just makes it less profitable for businesses to remain in your state. There is a very high correlation with high state taxes and unemployment.

The following chart shows how rapidly income taxes are falling. Sales tax receipts are down. At some point voters are going to demand that their federal government show some of the same restraint that households, cities, and counties are being forced into. My bet is that next year raises for government workers, even those in unions, will come under attack. They won't be cut, but watch as political backlash builds.

Without federal stimulus, the GDP of the US would have been over minus 6% in the second quarter, not the minus 1% it was. The third quarter would be flat to down and not the plus 3% it is likely to be. Housing and autos will turn down as the stimulus on those markets goes away.

I think it is very possible we will see a negative GDP by the first quarter of next year. Unemployment will still be rising. Deflation will be more of a problem, because the housing component (the largest portion of the consumer-inflation index), based roughly on rentals, is clearly under pressure. While we don't have enough space this week to go into detail, savings are up and consumer spending is down. Without the stimulus, things would be much worse.

Here's the kicker. Expect to see a big push for another large stimulus package next spring (and maybe sooner), as the effects of the current one wear off. The government wants to bring back demand by getting consumers to spend again. And you can count on unemployment benefits being extended. A tax holiday on Social Security taxes below a certain income? In the short run they can do it, but at a long-run cost.

It is going to be hard for a Democratic administration to not push for another large stimulus. That is what Krugman and his fellow travelers will be pushing. Classic Keynesian thinking wants both for the government to run large deficits and for the central bank to print more money. Remember, last year I said that the Fed would print a lot more money than they are talking about in the current plans. They are going to have the cover to do so, because deflation is going to be seen as the problem.

Next week, we will look at money supply and the velocity of money, savings, consumer demand, and more as we further explore the complex molecule that is deflation.

But one last thought, as I have had a lot of questions on gold recently. "Isn't gold telling us that inflation is coming back?" The answer is no. Since the early '80s the correlation between gold and inflation has dropped to zero. Gold has had very little to say in the last 30 years about inflation.

But what it may be saying is that paper currencies are a problem. Gold is going up not only in dollar terms, but in euros, pounds, yen, and more. My view is that gold should be seen as a neutral currency. The dollar is the worst currency in the world, except for all the others. Is it possible the Fed will not respond and print more money next year? Sure. And the dollar could rise as deflation kicks in. The only time we saw the purchasing power of the dollar rise in a sustained manner was during deflation, in the last century.

The race is not always to the swiftest or the fight to the strongest, but that's the way to bet. And right now, my bet is the Fed will print money to fight a double-dip recession and deflation. And gold would be one way to play that bet.

Washington, DC, San Diego, and Johannesburg

Quick inside industry note: Many RIA and brokers have left some of the large brokerage firms to go with smaller broker dealers or start up as independent investment advisors. Some of the larger firms had platforms that accessed the world's top hedge-fund managers. Now that the advisors are independent, they are looking for a similar platform.

Altegris Investments has a world-class lineup of top-tier hedge-fund managers that advisors can access for their clients at much lower minimums. Altegris employs 65 people and has over $2 billion under management. They focus solely on alternative investments. They have 10 staff members dedicated to research and due diligence on the hedge-fund universe. I know Jon Sundt (CEO of Altegris) personally and I know that he is driven to find the best investment talent in the world. If you are an advisor for high-net worth-clients, you should go to www.accreditedinvestor.ws and sign up and they will call you.

And if your clientele consists mostly of smaller clients, you should look at the platform of trading advisors at CMG. http://cmgfunds.net/public/mauldin_questionnaire.asp

Next week I have to go to Washington, DC for a quick trip and then the next night fly to San Diego for the Schwab conference. Coincidentally, both Altegris and CMG will be at the conference. I will be around those booths on Tuesday the 15th. Look me up.

And next Tuesday I will speak via satellite to a CFA conference in Johannesburg. I've done a lot of TV over satellite, but not a full, hour-long speech and Q and A. This should prove interesting.

It is getting late and time to hit the send button, so I will cut my remarks short and just wish you a happy Labor Day and a great week.

Your ready for a holiday analyst,

John Mauldin

The Statistical Recovery, Part 2

John Mauldin — Sat, 15 Aug 2009 00:49:00 GMT

The Statistical Recovery, Part Two
A Recovery Statisticians Can Love
A Few Thoughts on the Housing Market
Some Thoughts from Maine
Tulsa, Birthdays, Weddings, and Paul McCartney

A few weeks ago I first used the term "statistical recovery" to describe the nature of today's economic environment. Today we are going to further explore that concept, as it is important to have a real understanding of what is happening. This coming "recovery" is not going to feel like a typical one, and those expecting a "V"-shaped recovery are simply making projections from previous economic recoveries, which, based on the fundamentals, are not warranted. And of course, a few thoughts coming back from Maine are in order. There is a lot to cover, and this may take more than one letter.

But first, let me note to subscribers to Conversations with John Mauldin that we have posted my Conversation with George Friedman of Stratfor and will soon post a very interesting Conversation I had with John Burns (of John Burns Real Estate Consulting) and Rick Sharga of RealtyTrac. These may be the two most knowledgeable people on the housing market in the country. There is a lot of poorly informed speculation about the housing market, and I think this Conversation will help clear away a lot of the fog. PLUS, they both agreed to allow me to post their eye-opening PowerPoint stacks to Conversation subscribers (normally only available to their clients), so you get a very special bonus. And finally, David Galland of Casey Research is allowing me to post a most thought-provoking interview he did with Neil Howe. This is one of the best things I have run across in a long time. I do work on giving my Conversations subscribers good value.

George and I are going to be doing a regular quarterly Conversation called Geopolitical Conversations with John Mauldin and George Friedman. We believe that these new Conversations will help you better understand not only the global political landscape but also how it affects the financial umbrella that we are under. In this first Conversation, we talked about the "exogenous" risks to the markets (those from outside the markets themselves) posed by the geopolitical world.

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

The Statistical Recovery

The unemployment numbers came out last Friday, and Steve Liesman of CNBC did several interviews live from Leen's Lodge in Maine. I postponed an hour of fishing to be on air with Martin Barnes (of the Bank Credit Analyst) to comment on the numbers. Everyone seemed quite excited that the US lost "only" 247,000 jobs. However, it is still almost twice as large as a year ago, and at that time 128,000 lost jobs seemed pretty bleak. However, comparing it to the average of 692,000 lost jobs per month in the first quarter, those looking for good news immediately started talking about how a recovery is around the corner.

The unemployment numbers are some of the most seriously revised numbers in all of government data. The first monthly estimate is notoriously imprecise. Why people make investment decisions based on this release is beyond me. As I mention continuously, because of seasonal adjustment factors, the unemployment numbers understate job losses in a recession and also understate job gains in a recovery. About the most we can get from the current data is the broad trend. Admittedly, the trend is getting better, but we are still in a hole and no one has stopped digging.

What we can see is that we are down 6.7 million jobs since the beginning of 2008! We have roughly eliminated the job growth of the last five years. And that does not take into account the 150,000 new jobs that are needed each month just to maintain the employment rate because of the increase in population. It took 55 months once the 2001 recession was officially over to get back to the previous employment peak. That is 4.5 years, gentle reader, and we are further down now and faced with massive deleveraging. It is going to take a lot longer this time. Let's look at some of the reasons why.

I took a different tack in the CNBC interview. I pointed out that even though it is possible (likely?) we will see a positive number for GDP for the third quarter, it is not going to feel like a recovery for quite some time.

By the middle of next year (2010), when I think we will finally hit an unemployment bottom, we will be down close to 8 million jobs, wiping out all the jobs created since the middle of 2004. Unemployment is likely to be more than 10%, unless they keep playing games with the number.

A Recovery Statisticians Can Love

What I mean by that remark is that the unemployment number went down even though we lost 247,000 jobs. How can that be, you ask? Well, the government assumes that if you were not looking for a job within the last month, then you are not unemployed; therefore, on a statistical basis the number of people unemployed went down by 400,000. (There are 2.3 million such discouraged workers.) More in a minute on the problem that will cause down the road.

Assume that we will need 9 million jobs over the next five years (150, 000 jobs a month for 60 months) and add the 8 million lost jobs. That means we have to add 17 million jobs in the next five years to get back to the 4.5% unemployment of 2007, let alone the under-4% we saw in 2000.

That means we need to grow employment by about 12% over the next five years. But it's worse than that. What is known as U-6 unemployment is over 16%. There are another approximately 8.8 million people who are either working part-time but want full-time jobs or are among the 2.3 million discouraged workers as mentioned above.

(The definition of U-6 unemployment from the BLS web site: "Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule." http://www.bls.gov/news.release/empsit.t12.htm.)

Let's make the assumption that the part-time workers want to go to full-time (which they say they do). Typically employers will increase the hours of part-time employees before adding new workers. That will be a major drag on potential job growth. It is the equivalent of creating at least 4 million jobs, except that no new jobs are created. Plus, those who want jobs but are not looking will come back into the market if jobs are available. That adds another 2 million. Now we are seeing the need for 23 million new jobs in five years, to get back to the "Old Normal."

That is an increase of 15% total employment from today's levels over the next five years. That type of jobs growth will only happen with significant economic growth. Normally, you should expect the economy to rebound to at least 3% trend GDP growth. That is what has happened historically. But we are not in the Old Normal. We are entering the era of the New Normal, where looking back at historical trends will prove to be misleading at best.

On average, and VERY roughly, you would think you would need a minimum of 15% real GDP growth over five years to get us back to what we think of as acceptable levels of unemployment. Actually you would need more, as productivity growth lessens the need for more workers. Oh, and add in the Boomer-generation workers who are not going to retire because they now cannot afford to.

(I think we will be lucky to have 10% real GDP growth in the next five years, for a host of structural reasons that we will be going into below and over the next few weeks.)

Unemployment will be rising for at least another two quarters and probably through the middle of next year. That should not surprise us too much, as unemployment kept rising for almost two years after the last recession, which many dubbed "the jobless recovery." The recession ended in 2001, but as the graph below shows, the unemployment rate rose until the middle of 2003.

We may have a "statistical recovery." The numbers may be positive for a variety of reasons only a statistician could love, but it is not going to feel like a recovery to the rest of us. Maybe that is why consumer confidence took another hit today, dropping to its lowest level since March, helping to drive the market down.

The economists at economy.com, who normally have a bullish tinge to their writing, said it succinctly: "Confidence will struggle to gain ground in the months to come, as consumer budgets remain stretched. Little wage income, prospects for reduced bonus payments, reduced access to credit, and no capital gains are all constraining consumers' ability to meet their financial needs and recover from the sharp drops in wealth they have experienced. Many consumers are struggling to pay their debts. Supports are coming from reduced layoffs, equity market gains, and stimulus such as the cash for clunkers program, but that is proving inadequate to lift spirits so far. It will likely be some time before conditions turn enough for confidence to improve decisively. Key drivers of confidence include developments in the labor and housing markets and the path of energy and equity prices."

(My friend Bill Bonner described the Statistical Recovery as being just like a female impersonator. He is just like a real woman in every way, except for the essential ones.)

The consumer's sense of discomfort is shared in executive suites across the country. "Chief Executive Magazine's CEO Index, the nation's only monthly CEO Index, dropped to 63 in July, after showing gradual improvement. All components of the index are down, with Employment Confidence taking the largest hit...

"What's worse is that pessimism over employment is reaching new heights. The Employment Confidence Index declined 25 percent with 57 percent of CEOs expecting continued decrease in employment next quarter. Over 95 percent rate the current employment environment as bad—the highest level for 2009. Less than 5 percent think employment conditions are normal and virtually no one (0.4 percent) thinks they are good." (The Bill King Report)

A Few Thoughts on the Housing Market

Bill also sent me a link to a very interesting survey of the real estate market. Those in the real estate business will find this of value, although it makes for grim reading. (http://www.campbellsurveys.com/AgentSummaryReports/AgentSurveyReportSummary-June2009.pdf)

Three (of the sixteen) of their summary bullet points stood out:

The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in ready REO, 14% for short sales, and [only!] 36% for non-distressed properties. [REO means "real estate owned," typically by a bank as a result of a foreclosure.]
43% of homebuyers are first-time homebuyers, 29% are current homeowners (relocation or retirement homes), and another 29% are investors.
Only 31% of non-REO home sale listings are unforced or optional; other major reasons for listings include financial stress (including short sales), long distance relocation, and divorce or estate sales.

Think about that for a minute. Two-thirds of home sales are either foreclosures or banks taking a loss on the mortgage. Of the remaining 36%, only 10% are as a result of something we could call a normal selling process. And that is nationwide. There are lots of places where foreclosures are low. Reading this report anecdotally, there are large areas (California, Nevada, Arizona, Florida) where almost the only housing action is distressed or forced sales, that is, sales at a significant discount to original asking price.

Look at the chart below from Rick Sharga at RealtyTrac. Today we learned from them that foreclosures set a new monthly record of 360,149 properties that received a default or auction notice or were seized last month. One in 355 households got a filing, the highest monthly rate in RealtyTrac records. Many hard-hit areas have rates higher than 1 in 39 homes! Foreclosures are now running about six times higher than just four years ago.

And there is little relief in sight. There is typically about one foreclosure for every 6-10 jobs lost. It will be higher this cycle, as so many homebuyers are underwater on their mortgages and have little incentive to try and keep up payments while they are unemployed. Further, there are 500,000 REO-owned homes that are not on the market as of yet (what Sharga calls shadow inventory), and a wave of foreclosures will result from option ARMs and Alt-A loans resetting next year. Note: July's record numbers are not in the chart below.

John Burns gives us the next graph, which is an estimate of foreclosures for the coming years. (www.realestateconsulting.com)

Notice that he estimates more foreclosures next year than this year, with very little relief until 2014! This does not bode well for housing prices, which are a big factor in consumer sentiment, which is a big factor in consumer spending.

It does mean that renters can find some very good deals, as there are now areas (like Phoenix) where it is cheaper to buy smaller homes than to rent. Remember the statistic above that first-time home buyers are 43% of the market and investors another 29%? Lower prices make housing more affordable, and with the government incentive programs for first-time buyers really working (for once), the lower end of the housing market may actually stabilize sooner than the overall market.

As I wrote almost two years ago, the housing market will not bottom before 2011 and maybe into 2012. We just built way too many homes in our exuberance; and with tightening lending standards (as there should be) the number of people who can qualify for a mortgage is down, although (again) falling prices make homes more affordable. The median price in California is down by 60%. (Although I saw today where Bill Gross bought a tear-down on the water in Newport Beach for $23 million. That will help the average some.)

Homeowner vacancy rates are close to 3% of total homes, which is well over 2 million homes. Many of these are not yet on the market.

Retail sales were down in July. And that was with Cash for Clunkers in full force. The headlines said that economists were shocked. Really? Consumers are saving more, and actually paying down credit-card and bank debt. We will go into those details more next week, as it is getting close to time to hit the send button.

Some Thoughts from Maine

Last weekend I got to go to Leen's Lodge at Grand Lake Stream in Maine (www.leenslodge.com - highly recommended) to meet with 35 economics types and their friends. This is a very knowledgeable group, with a lot of well-known names. We fish in the morning, meet at a campsite for lunch (drink wine and eat what we caught), fish some more, go back to the lodge, eat a gourmet meal and drink some more wine, and then go on talking. This goes on for 2-3 days. I throw my diet to the wind, and pay for it over the next month, but it's worth it.

On Friday Steve Liesman and some local guides bring out their guitars and entertain, with a lot of loud, if somewhat off-key, singing from the crowd. (Liesman, by the way, really can play the guitar quite well.) On Saturday night we bet on the future of the markets and events - typically small amounts, and lots of side bets. This year I won five out of six side bets I made last year.

As usual, bets were all over the board. But a few interesting ones surfaced. David Kotok and George Friedman offered rather (for this crowd) large sums to take on all comers that Bernanke would not be reappointed. I took part of that offer, as did a number of others (for the record, the Fed economists at the meeting do not bet and were quite closed on the topic). I was surprised at the intensity of that debate. This is a well-informed crowd when it comes to Fed policy and actions, and if this question is (politely) contentious among friends in July of 2009, what will it be like in the latter part of the year, when Obama has to make the appointment (Bernanke's appointment is up in January of 2010)? And among those who do not get along? This could be a very noisy appointment process.

A few years ago (2006 and 2007), I was repeatedly told I was "too bearish." Now, my Muddle Through prediction was seen either as overly optimistic or the most likely scenario by a large number of attendees. The concerns about the credit markets are still quite strong, with many thinking we will be facing banking problems for years. There were more than a few who bet that Citibank will not be around in its current form by this time next year. (I did not take that bet.)

A number of participants saw a double-dip recession as a distinct possibility. I think it is a probability in 2011 as the Bush tax cuts expire. If Congress moves up the increase in taxes to 2010, which is what the House Democrats want, that recession could start in 2010.

Tulsa, Birthdays, Weddings, and Paul McCartney

Today is my mother's 92^nd birthday, so I need to leave soon, as she eats early. The order of the day is Luby's Cafeteria. Interestingly, she had me when she was 32, and Tiffani is 32 and will have her first around Christmas. Other than her hearing, mother is still going strong, if a little more slowly, and shows no real signs of letting up. She is now bionic, with two new knees and hips over the last decade.

Next week I leave for Tulsa on Thursday to prepare to give away my daughter Amanda on Saturday to a nice young gentleman, Allen Porter. They (along with her twin sister Abigail) say they intend to move to Dallas after the first of the year, which will make Dad happy, as all the kids will be in the local area. A little golf on Friday morning with the new in-laws, parties, and so on. It should be a large wedding and a fun weekend. They have lots of friends, it seems. I do intend to write my letter as usual.

I also intend to be in the bar on Thursday night at the Hilton at 9:30-45, assuming Southwest is on time. If anyone cares to meet, feel free to drop by.

Thinking about Mother's birthday reminds me that I turn 60 on October 4. For whatever reason, it is not bothering me like 50 did. Maybe 60 is the new 45? Paul McCartney is now 66, and is on the road with what I am told is a very good show. I will find out Wednesday when he plays Dallas and I get to go to the new Cowboy Stadium to see him play. With most of his set scheduled to be Beatles tunes, I am really looking forward to being there. I got to see Eric Clapton last month. He is on top of his game. Maybe blowing through 60 is not all that bad.

Have a great week. I shall.

Your hoping I can avoid paying for another wedding for a few years analyst,

John Mauldin

The Statistical Recovery

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

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

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

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

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

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

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

Can China Lead the Global Recovery?

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

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

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

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

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

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

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

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

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

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

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

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

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

Who Ends Up with the Old Maid?

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

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

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

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

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

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

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

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

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

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

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

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

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

A Statistical Recovery

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

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

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

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

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

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

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

The Last Bear Standing

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

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

The Muddle Through Economy*

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

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

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

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

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

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

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

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

New York, Maine, and Tulsa

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

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

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

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

Your doing better than Muddle Through analyst,

John Mauldin

The End of the Recession?

John Mauldin — Sat, 27 Jun 2009 02:55:59 GMT

The End of the Recession?
The New Normal Is Still In Our Future
The Hidden Problem Within Unemployment Data
Was Income Really Up?
Tulsa, London, and The Baltics

Last week we began a series on data abuse, about how various commentators twist and torture data to make it say what they want, or fail to look at the details underneath the headlines. Predictably, there is a lot of fodder this week as we forge ahead into this ripe territory. The headlines screamed that US income data went up unexpectedly. Green shoots were everywhere. But if you look at the actual data, you find something much different. And, I keep hearing the insistent refrain that the market is telling us that the recovery is around the corner. Well, the recovery may be, but can the market really tell us that? I have about 25 windows open in my computer, with tons of misleading data. Let's see how much we can cover in this week's letter.

But first, I want to focus your quick attention on a new "Conversation" I will have next Monday. (For those readers who are new, I have a subscription service where I hold conversations with friends on a variety of current topics. I am gratified that it's getting rave reviews.)

I have been writing about the New Normal of late, and for my next Conversation I have invited two of the sharpest analysts I know to talk about what the New Normal will look like.

What levels do we get to? What does the world economy look like? What will the path to recovery look like? And so on! David Rosenberg, former chief economist for Merrill Lynch, one of the few mainstream analysts who got it right (now with Gluskin Sheff in Toronto) and the brilliant Michael Lewitt of Harch Capital Management, someone who was writing about the credit crisis long before it happened, are both deep thinkers, and both have strong ideas about how our future will unfold. I can't wait to get them at the same table and see if we can flesh out a few concrete ideas.

And if you subscribe today, you also can get the recently released and widely praised Conversation I did with Donald Coxe and Gary Shilling on commodities and where those markets are going. That ended up as a very powerful debate, and one from which listeners said they really came away with meaty ideas.

You can subscribe now at $109 (using code JM75), before we raise the price when we add a new quarterly Conversation service with good friend and head of Stratfor, George Friedman. He gets back from Australia this week, and we will schedule a meeting soon!

And now to funny-looking data. Where to begin? There are so many targets of opportunity!

The End of the Recession?

I walked into the office yesterday evening and there was someone on CNBC talking about how the 50-day moving average of the S&P 500 rising above the 200-day moving average was telling us the market was getting ready to rise and the recovery had started. I listened to his babbling for another 2-3 minutes and couldn't take it anymore (and no, it was not my friend Larry Kudlow, who is a lot more balanced than whoever was on.)

We keep getting told that the market is telling us "something," usually that the recession is going to end. For some reason, people keep repeating the bromide that the market looks out about 6 months. To that I politely say, rubbish.

Riddle me this, Batman. Did the market see the recession in October of 2007? We were already in recession and the S&P 500 (see below) was making new highs! Where was the market prescience? Did it see the 25%+ drop in January of this year? And I could go back and cite scores of examples where the market "missed" the future turning points over the past ten decades.

What about the shibboleth that the market turns up 6 months before the end of a recession? Sometimes that is true. But does it mean anything? The same people who said it meant something last December and January are saying it means something now. But now it's June and the recovery is not here, so maybe the market wasn't telling us something in January after all.

Gentle reader, there will be a recovery. We will talk about what kind in a few pages, if we have the time. And it is (statistically speaking) likely that the markets will have turned up before the actual recovery. But does that mean anything today?

Go back to the chart above. Notice that in 2003, when the market finally turned up, we were already well out of recession. And the market had a very quick 12% or so drop while we were in recovery, while later we went on to a 90% run-up! Was the drop telling us anything, or do we explain it away?

"In the short run," St. Graham said, "the market is a voting machine. In the long run it is a weighing machine." The voting is based on current sentiment, but what the market weighs in the long run is earnings. The market tries to forecast future income streams. And it gets it wrong as often as it gets it right.

Let's look at this yet another way. This is an important concept, and it should be a component of your economic BS detector. The CNBC host talked in breathless terms about the importance of the 50-day average moving above the 200-day average. It means nothing until it means something, and we won't know what that something is for some time.

Earlier this week (Monday, I think) the 50-day average moved BELOW the 200-day average. The analysts at Bespoke Investment Group noted:

"Going back to 1928, this is the 25th time that the S&P 500 has declined through both of these levels on the same day. On page two we have provided a table showing each of these occurrences as well as the index's returns going forward. Based on those prior instances, the S&P 500's returns going forward have been notably negative. While the S&P 500 has averaged positive returns over the next week, average returns have been negative over the next month, three months, and six months." (emphasis mine)

But 33% of the time, the markets were up six months later, often by quite a bit. And sometimes down quite a bit, but on average only slightly. Which means that as a forward-looking indicator it is interesting but not anything I would put my money (or client money) on!

(I saw some reports that differed, selecting fewer such data points and suggesting that market returns were up after such an event. Logically, that can't be. Let's be generous and just assume sloppy research.)

Before major market moves down, the 50-day average will always move below the 200 average. And the reverse is also true. It is not a sign. It is just what statistically MUST happen. And sometimes they reverse themselves, and sometimes they don't. We have no way on God's green earth of knowing whether the two moves (both up and down) this week will be bullish or bearish six months from now, based simply on the moving averages crossing. You can make the data say anything you want, but you are still just guessing.

Sidebar note: Trend Following 101. I spend a lot of time analyzing trend-following money managers of one kind or another. Basically, they look at data and try to spot trends and then invest in them. A trader who is right 70% of the time is amazing and very rare. 50% is more like it for successful traders. But they have sharp risk controls that cut their losing trades and let their winning trades "ride." Being right 50% of the time can be profitable over time. (Being right 50% of the time is harder than it looks!)

But in the media you get these "analysts" who talk a good game, acting as if a 50-70% probability is something meaningful. "The market has turned. The recession is over." And they say that when we have the first balance-sheet recession in 70 years, yet they want to compare garden-variety recessions to what we have now. Again, we can only know which of the moves (above and below the 200-day moving average) will be the real "indicator" in six months. It is only an indicator today to the extent that we can drive our cars forward looking in the rear-view mirror.

The New Normal Is Still In Our Future

Now let's take that principle a little further. Last week I detailed how air, trucking, and rail shipping is down 20% year-over-year. Global trade is down about 30% in the major exporting countries (see below).

World trade shrinks : Chart 1: Year-over-year change in total exports from 15 major exporting
countries (1991-02/2009) / Chart 2: Year-over-year change in exports from 15 major exporters
between February 2008 and February 2009 (size of circles reflects volume of exports in 2008)

End of the world? Do we just keep falling? No. At some point, six months or a year from now, the year-over-year comparisons become easier. If you are at 100 and fall to 80, then a year later you are at 88 and voila! you have a 10% increase! And the perma-bulls will be talking it up. The fact that you are still down 12% from the peak is ignored.

The point is that we have fallen quite a bit in a lot of major categories. There is really only so much you can fall. And then when you reach that new lower level of the New Normal, you begin to rise. At some point, we will be on the path to "recovery." That does not mean that we will be back to the halcyon days of mid-2007 within a year. It just means that we have stopped falling and now have to adjust to the levels of the New Normal.

The Hidden Problem Within Unemployment Data

This is going to be most evident and painful in the unemployment numbers. Last month saw the number of unemployed rise by 345,000. What was not in the headline data was that 217,000 of those jobs were estimated from the "birth-death" ratio. The US economy creates new businesses that do not get counted in the data, so the BLS estimates what that number is, using previous data patterns. When the economy turns, it overestimates new jobs in recessions and underestimates them in recoveries. No conspiracy, it is just the best methodology we currently have.

But does anyone really think 200,000 jobs were created last month? The real number of lost jobs is worse than the headline. And next month the birth-death number will likely be over 200,000 again. Add another 100,000 or so to the headline number to get closer to reality,

Again, analysts talked about a turnaround because job losses were "just" 345,000. That is a higher number than any month in the 2001-02 recession, and larger than the month after 9/11. That is a green shoot? Yes, we will see the monthly unemployment numbers fall, but they are falling from historic highs. And based on some research by the San Francisco Federal Reserve, it is likely that we will see still higher unemployment that will persist for a while longer.

Let me quote and summarize through the research at http://www.frbsf.org/publications/economics/letter/2009/el2009-18.html. (It is not long, and worth reading.)

"Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market. Specifically, we suggest that the relatively low level of temporary layoffs and high level of involuntary part-time workers make a jobless recovery similar to the one experienced in 1992 a plausible scenario."

Essentially, there are always workers moving into and out of employment. What they note is that the patterns seem to be changing. In the '70s and '80s, job losses were quick and deep, but the recovery was also quick. In the last two recessions, job recovery was noticeably slower, giving rise to the term "jobless recovery." It was the lack of hiring, and not firing, that was responsible for the slow employment recovery. MY thought is that before 1990 many of the job losses in recessions were from manufacturing. Businesses were quick to lay off and quick to rehire. We now have fewer manufacturing jobs, so the rehiring process has been much slower in recent recessions.

"The long and gradual return to pre-recession unemployment levels implied by the Blue Chip consensus forecast is consistent with a labor market recovery that is slightly weaker than that experienced in 1983 and slightly stronger than that experienced in 1992. However, should labor market conditions instead proceed along the path taken in the 1992 recovery, the unemployment rate could peak close to 11% in mid-2010 and remain above 9% through the end of 2011."

That is not in any Congressional budget forecast. Want to run an election campaign at 10% unemployment levels?

"... What does all this mean for the course of the labor market? We combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization. We plot this measure in Figure 3, which shows that the labor market has considerably more slack than the official unemployment rate indicates. The figure extends this labor underutilization measure using the Blue Chip consensus forecast for the unemployment rate as a benchmark and then adding a share of involuntary part-time workers based on the proportion of workers in that category to the unemployed during the current recession. This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate. This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates." (emphasis mine)

Was Income Really Up?

Now, let's turn our attention to today's headline. Income is surprisingly up. That has to be a green shoot, right? Well, not if you look at the underlying data.

Personal income from wages and salaries was down $12 billion in May. So how did income go up? A large increase in "government social benefits" and a decline in personal taxes accounted for all the gain, and then some. The increase was the effect from the recent stimulus package, which is (for now) temporary, and not the result of a recovering economy. Hardly green shoots. It is just borrowed money from another (government) source. In principle, it is not much different than home equity withdrawal, except that taxpayers are on the hook.

And those government subsidies are going to increase. Look at the graph below. What it shows is that the average duration of unemployment is at a 60-year high, and rising. It is now at 22.5 weeks. Unemployment benefits stop at 39 weeks, temporarily up from 26 weeks. More and more people each week are thrown into very dire circumstances when they fail to find jobs and lose the benefits. Care to wager whether, when Congress comes back from vacation, the time people are allowed to be on unemployment will be increased?

And speaking of the increase in government payments to individuals, what did they do with them? In aggregate, what is happening to this stimulus? The data came out today, and I must admit I was surprised. I have been writing for years that American consumers would start to save in this recession, but I (and nearly every credible observer I read) thought that we would see a more gradual rate of increase in the savings rate. The increase in savings has been nothing short of remarkable. (See graph below.)

From a negative 3% in late 2005 (the result of massive borrowing, primarily mortgage equity withdrawal and credit cards), we have risen to a positive 6.9%. That is the highest rate since 1993. The savings rate was less than 1% last August. And totals savings (on an annualized basis) was $608 billion in April, rising to $768 billion in May. That is a 30% month-over-month increase! Maybe the American consumer has found a new religion!

But, there is more than just a new savings fervor at work. Spending rose more than disposable income, so without that increased level of government transfer payments, it is unlikely that savings would have risen as much. Before we get too giddy about savings going through the roof, we need to wait a few months to see if this was the result of new savings religion or government transfer payments (stimulus), which will soon wind down

That being said, given the sharp increase in savings, it's no wonder shipping is down 20% and global trade in the exporting economies by 30%. No wonder retail sales are down, except for Wal-Mart and other lower-price venues.

Final thought for today. The Congressional Budget Office released another report this week, saying that the current deficit levels are unsustainable. They suggest that either taxes must increase by $440 billion or spending must be cut by a like amount, or some combination. If you assume some of the new health-care and other programs are enacted, the number comes closer to $700 billion.

This is not a Congress that wants to cut other parts of the budget by $700 billion. Raising taxes by $700 billion (over 4% of GDP) will dip us back into recession. Not raising taxes will result in debt that cannot be funded at anywhere close to today's rates. A recent IMF study is very sobering about the worldwide problem of growing country debt. Finding a trillion dollars in the market every year, when every other country is also trying to raise debt is simply not going to happen. It will destroy the dollar. There are few good choices in front of us, and fewer still good choices that are likely.

OK. One final suggestion for your weekend reading. Atul Gawande, writing in The New Yorker, weaves a very sobering picture of the problem of reining in health-care costs. He contrasts two Texas border cities with similar demographics, yet one spends twice as much on health care. One town has doctors who order every possible test and the other doesn't. There is no real difference in outcomes. And then compare it to other areas, and the problem facing any health-care policy becomes all too evident. Reportedly, Obama has had everyone read this, and you should too. It provides a very different angle on the problem. http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?yrail

Tulsa, London, and The Baltics

Last Tuesday I went to an Eric Clapton and Steve Winwood concert. At 64, Clapton can still play the guitar as well as anyone on this planet. It is always fun to see a man at the top of his game.

I get up early tomorrow, flying with family to get to Tulsa to be at my daughter Amanda's wedding shower, and then celebrating the twins 24^th birthday tomorrow night. Amanda's wedding is August 22, right around the corner. If there is a recession going on, no one in the wedding industry seems to know. This is the second wedding in two years, and I still have two more unmarried daughters. It's a good thing the word retirement is not in my vocabulary. If we can't get the wedding budget under control, I am going to need about 600 new Conversations subscribers in July.

July 15^th I leave for London and will guest host CNBC Squawk Box from 7-9 on Friday the 17^th. Then on to Finland, St. Petersburg, and the Baltic capitals, and ending in Rome. (Why Rome? Because that is where we could get mileage tickets back to Dallas. But I might as well spend a few days.)

Then I (and my son Trey) will spend one evening and morning in New York August 5-6 before going on to Maine for the regular August fishing extravaganza with David Kotok and a rather fun crowd of economists and other ne'er-do-wells. It is a tough ticket to get, and I am glad to be invited.

There are lots of exciting things happening in my business, and we will be making announcements in the next few weeks. You have a great week.

Your going to listen to more hard blues analyst,

John Mauldin

This Time its Different*

John Mauldin — Sat, 20 Jun 2009 02:53:00 GMT

This Time It's Different*
Peter Bernstein, R.I.P.
Welcome to the New Normal
The Three Amigos
Credit Spreads - Bullish or Bearish?
ISM - Is Less Bad That Good?
Contain Your Enthusiasm
London, The Baltics, and Rome

I have often written that the four most dangerous words in the investment world are "This Time It's Different." If memory serves me, I have written several e-letters disparaging various personages who have uttered those very words, and gone one to confirm later that it wasn't different. It almost never is. And yet - and yet! - I am going to make the case over the next few weeks that it really is different this time, with only a lonely asterisk as a caveat. What prompts my probable foolishness to tempt the investing gods is the rather large amount of bad analysis based on unreasonable (dare I say lazy or surface?) readings of statistics that is coming from the mainstream investment media and investment types with their built-in bias for bullish analysis. Normally, gentle reader, your humble analyst is a paragon of moderate sensibilities, but I have been pushed over a mental edge and need to restore balance. I anticipate that this topic will take several weeks, as trying to cover it all in one sitting would exhaust us both. It should be fun. But first...

Peter Bernstein, R.I.P.

Sadly, Peter Bernstein passed away at 90 years young on June 5. One of the great honors and privileges of my life has been getting to know Peter and his lovely wife, Barbara. Introduced at a small dinner five years ago, I have been privileged to share many dinners and meetings with him in the years since, soaking up his wisdom. Only a month ago, he made a presentation (by satellite) to Rob Arnott's annual conference and was at the top of his intellectual game. His writing of late has been some of his best. Peter cofounded the Journal of Portfolio Management and truly was the dean of investment analysts.

He wrote 10 books (five after the age of 75!). I am often asked what books I would recommend for insight into the economic world. At the very top of my list has always been Against the Gods: the Remarkable Story of Risk. If you have not read it, then get it and put it on top of your summer list. Capital Ideas is also brilliant. The Power of Gold is a must-read. You can get all three in a set at Amazon.

Jason Zweig wrote a very moving obituary in the Journal and reminded me of a few quotes I've heard from Peter. "'What we like to consider as our wealth has a far more evanescent and transitory character than most of us are ready to admit.' He urged investors to regard their gains as a kind of loan that the lender - the financial market - could yank back at any time without any notice.

"Asked in 2004 to name the most important lesson he had to unlearn, he said, 'That I knew what the future held, that you can figure this thing out. I've become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the investment process.'"

Peter and I chatted several times during the last year, and he continued to tell me that those who thought we were in for a typical recovery were probably going to be wrong. In private conversations he was very worried about the world, and added much wisdom to those of us privileged to sit at his feet.

Isaac Newton once said, "If I have seen further it is only by standing on the shoulders of giants." In the world of investment wisdom, there is no shoulder higher than that of Peter Bernstein. Rest in gentle peace, my friend. You will be greatly missed.

This Time It's Different*

Ben Bernanke's career will be analyzed and written about for many years. But the one thing that has caused me the most pain is his bringing of the term "green shoots" into the investment lexicon. These may be the two most overused and annoying words of my investment career. Every possible sign of a recovery is anointed with the phrase.

Of late, there has been a tendency for analysts to see numbers or statistics that are "less bad" and interpret them as signs that we are in recovery or at least almost there. They glance back at previous recoveries and say, "Doesn't this look like the last time? When such and such happens it means that recovery is on the way. We should therefore buy stocks" (or whatever).

That we are condemned to read such musings is part of the investment landscape. But that does not mean we shouldn't take the time to look at what the writer of those words is actually looking at. All too often of late, I find these people grasping at straws or failing to understand the data.

My premise for uttering the heresy "This Time It's Different*" is that the fundamental nature of the economic landscape has so changed that comparisons with post-WWII recoveries is at best problematical and at worst misleading.

As we will see next week, we are on a track that looks far more like the Great Depression than the recessions of our lifetimes. To expect a normal recovery cycle, whether it is corporate profits or lending or consumer spending or capital investment or (pick a category) is just not reasonable. This is a period that is fundamentally, in so many ways, different. And the recovery (and there will be one!) will also be of a different warp and woof throughout the entire world economy.

Let me see if I can summarize my thinking before we get into the reasoning behind it.

First, we are at the end of a huge cycle of increasing private debt that ended in an overleveraged society. The process of reducing debt and unwinding leverage is going to take a rather long time. It will not be the typical one or two years and then things get back to an ever-higher normal. We are, using a phrase coined by my friend Mohammed El Erian at PIMCO, on our way to a new normal. We are hitting a massive reset button on our economic world, taking us to some new and lower level of consumer spending, leverage, etc. No one knows what the new level will be, although admittedly we are closer to it than we were a year ago.

At this new normal, we will not need as many malls or factories or stores or new-car plants or car dealerships or any number of other things to satisfy the new normal of consumer desires. As an example, and jumping ahead to a statistic for one minute, capacity utilization is now approaching 65%. Anything under 80% is anemic. Does anyone really think that businesses (in general) are going to invest more money in expanding capacity, in the face of the lowest level of production relative to potential since the 1930s?

The savings rate has shot up from zero to 6% in just a very short time. It used to be 12%. It would not be all that unusual historically for savings to go to 9% or more in a few years. That means that consumer spending will drop by 9%. Since consumer spending was 70% of GDP, that new lower level will become our new normal. And of course, due to population growth and hopefully increasing incomes, consumer spending will once again grow from whatever that new normal will be. But it is going to take some time for spending to reach the level of our productive capacity of a few years ago. We are going to have to shutter a few factories and businesses.

David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart ... the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

As we will see, the housing market is going to take at least two more years to truly recover. Looking at one month's data that shows housing starts up a few thousand as a sign of recovery in the housing market is, well, silly. Housing starts are anemic and the inventory of unsold homes is still at all-time highs (a ten-month supply) with more and more homes coming onto the market through foreclosure.

The multiple causes of the recession are not subject to a quick fix. Offering to pay someone $4,500 to trade in an old car for a new one is a rather pathetic way to try and jump-start consumer spending and the auto industry. Is it not enough that we will "invest" $50 billion in GM, while shrinking the company to a size where it will be difficult for profits to ever pay back that investment? We have to add insult to injury and borrow more money to buy cars. Care to wager whether GM will need more money within five years? (And by the way, I love my GM (Cadillac) car, and will likely buy another one at some point, so I wish them well.)

The "stimulus plan" was ill-conceived and not very stimulative. But the combination of the Fed and Treasury and massive monetary infusions has pulled us back from the brink of Armageddon. But we are not out of the woods yet. There is much heavy lifting to be done on the way to the land of the new normal.

Welcome to the New Normal

Secondly, my premise is that the recovery is going to take longer and be much less robust than any recovery since WWII. With unemployment likely to go over 10%, and with our new normal world not needing as much production of so many things, unemployment is going to stay stubbornly higher for longer than in any previous recovery. We are going to look next week at a very sobering report from the San Francisco Fed that suggests we may be for a longer than usual jobless recovery.

Thirdly, all this is going to affect corporate profits, especially for companies that depend on consumer spending. Those investors who expect corporate profits to rebound in 2010 are likely to be disappointed. (For the record, if you go to the S&P web site, analysts are projecting anywhere from a 40% to a 60% rebound in earnings for 2010 for the S&P 500. I would willingly take the "under" on that bet if I could find any takers.) I think whatever profit recovery that is built into the market at today's prices is generous. It is going to be tough to get much of a return from traditional buy-and-hold equity index investing for some time.

Fourthly, this is a global problem and primarily one in the "developed" world. I think we will find that much of Europe will be in a worse state of affairs than the US. If there are bright spots in the developed world, I tend to think they will be Canada and Australia/New Zealand. The opportunities are more likely to be in emerging markets, after they adjust to the new normal.

What this all means is that we as investors, entrepreneurs, managers, employees, and consumers need to adjust our expectations. For those of us in the US, this is complicated significantly in that we really have no idea what new level of government spending and taxation we will be faced with in 2010 and beyond. For one of the few times in my life, what the government does is likely to have a huge impact on the economy, as there is the potential for a significant shift in the very fundamental nature of government involvement in the economy. It is difficult to see what the new normal will be.

In Continental Europe, your new normal is going to be further complicated by an eroding banking crisis that is likely to put a real crimp in any recovery. China and Asia must adjust to lower US consumer spending. They have built too many factories to supply what seemed like an inexhaustible US consumer. They have to find new internal markets or face their own new normal.

All that being said, at some point, perhaps as early as the third quarter, we could see a positive number for GDP, although I think it will be later. Part of the reason that we will see some positive numbers is that year-over-year comparisons are going to get easier to make. Last summer, when inflation was close to 5% and I was writing that deflation was the real danger, oil was rising from $40 to $160 and food prices were going through the roof. Now oil is back to $70 and so we get lower year-over-year inflation numbers. Over the last two years the price of oil/energy is up, but we measure inflation on a yearly basis.

Housing construction was once about 5% of GDP. Obviously, the collapse of housing construction has had a rather negative impact on recent GDP numbers. But housing is probably close to, if not at, a bottom. Even if it dropped by another 20%, it would have far less of an impact on GDP at the much-reduced level where it is now.

It is similar with inventories. They can only drop so much, and eventually they get to the new normal and stop being a drag on the statistical GDP. We are not in an unrelenting death spiral. There is a bottom. It is like a person jumping out of an airplane. They fall rather rapidly until the parachute opens, and as they get closer to the ground they manipulate the chute to further slow the descent. But until they reach the ground, they are still falling. That is the case today. The economy is still falling, but the parachute has opened. We are going to reach the bottom at some point. We will find that new normal. We just need to adjust our activities and plans around that new destination.

I truly believe we get back to 3% GDP growth and 4% unemployment at some point in the future, but it is going to be more than a few years, especially if taxes are raised as much as is talked about in some circles. But just as in the late '70s, when the outlook was not very bright, things will change for the better. When asked back then where the new jobs would come from, the correct answer was "I don't know, but they will come."

It is the same today. There are whole new technologies and industries that are going to be created in the next decade. Entrepreneurs will respond with new innovations and businesses. Jobs that are not now on the horizon will spring up.

As a society, we are having to work through the excesses of a lifestyle that was propped up by ever-increasing debt and an out-of-control consumerism. That will happen in the fullness of time. But it WILL take time, and we need to adjust our expectations to account for that.

Over the next few weeks, I am going to drill down into the data to show why recovery will take longer and to help you withstand what will be an onslaught of out-of-control bullishness over data that is simply less bad. Let's start with a few easy targets.

The Three Amigos

In 2001, I wrote about what I called the Three Amigos that I watched to give us an indication of the direction of the economy. They were capacity utilization, high-yield bonds, and the (now-renamed) ISM numbers. Watching the direction they go gives us a good idea where the economy is headed. I have not written about them for years (as a trio), so let's revisit our old friends. We saw above that capacity utilization is still in a cliff dive. For there to be an actual recovery, we need to see capacity utilization start to climb back up. That is not currently a very positive indicator.

Credit Spreads - Bullish or Bearish?

A number of commentators have been effusive about how credit spreads have "come back in." And indeed, junk-bond yields have fallen. That is a good thing. Look at the graph below (courtesy of Tony Boehk).

Note that yields have simply come down to levels associated with recessions, and not with actual recovery. What happened last year is that junk-bond yields priced in Armageddon. Now they simply price in a recession and slow recovery. Could they improve more? Certainly. But the easy lifting is done. The direction is right. Let's see how they do the next few months. If those yields keep falling, that would be a very positive sign.

ISM - Is Less Bad That Good?

The Institute for Supply Management released their data for May, and again, commentators were enthusiastic about the increase in the manufacturing index. Green shoots and other signs and wonders were all over the media.

The ISM is a survey of manufacturers about how their businesses are doing. They are surveyed on ten criteria, like new orders, employment, inventories, backlog of orders, etc. (for the full report, you can go to http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942).

From these responses the ISM creates an index. An index number above 50 means that the manufacturing sector is growing, and below 50 means it is shrinking. At the web site above, you can get quite a bit of detail. It is quite true that we have come back from what was the lowest overall index number in 30 years. But we are simply back to the level that was the low in the previous two recessions. The ISM number is "less bad" and that is a good thing, but it is still a bad number. Yes, it is headed in the right direction. Let's look at the actual chart.

Of course, as businesses adjust to the new normal, whatever that level is, year-over-year comparisons will start to be positive. Simplistically, if a business makes 500 widgets a month and sales fall to 300, they will likely report falling production and rising inventories. Over time, inventories will finally settle out as management adjusts, and at some point inventories and production will (hopefully) start to rise. This gets reported as positive. The actual numbers may be down from the peak, but the direction of the company is once again on a positive slope.

When you look at the actual numbers comprising the release, the manufacturing part of the US economy is still contracting. Is it less bad than a few quarters ago? Yes, but it is still bad. The recent number is only slightly higher than the average for the last 12 months. We need this number to be above 50 to talk about an actual recovery in the here and now, as opposed to the future.

Contain Your Enthusiasm

Shipping containers moving into US ports rose by 2% in April, from March. That was cause for celebration in some circles. Buried way down, if mentioned at all, was the fact that compared to a year ago shipping is down 22%. And year-over-year comparisons have been worse for 22 months in a row. At some point, you get to a bottom. We find the new normal. But if the new normal is down 20%, that is a different-looking economy.

This quote came from good friend Dennis Gartman:

"'Stuff' moves by air when it is needed swiftly, but we can compare year-on-year data to get an idea of the relative weakness or strength of the economy. At the moment, the data is still very, very weak. According to the data reported out by the International Air Transport Association, after having touched just barely under $60 billion in '07 and '08, this year the IATA 'guesstimates' that only $40-$42 billion will move into the US.

"We are effectively back to the levels of '00-'04 and we are well below anything since '05. Having reached its worst year-on-year comparison back in December of last year when there was 23% air-transported cargo moving into the US from abroad, these yearly comparisons have remained about 20% lower since. Inventories of 'goods' on the nation's shelves remain high, and so long as that is true then we are going to see horrid, recessionary year-on-year comparisons in this very timely data."

Dennis also looked at rail shipments: "Since the start of this year this year, when the year-on year comparison was a relatively tepid -8%, the trend has been steadily 'from the upper left to the lower right' on the charts. By March, the year-on-year comparisons were averaging -15%. By April, -22%; by May -25%; and now, after a week or two of June, they are -26%. This is not a trend to be tampered with; this is a trend of some very real severity, and for now we fear that it is a trend rather firmly intact. Thankfully, it looks back, not forward; but if the past is prologue to the future, the future still looks rather bleak.

"Finally, there is a glimmering of hope on the rail horizon, and that is that the June figures, as they are compiled, are showing some signs of life. According to the AAR, 'freight traffic on US railroads during the week ended June 13 continued to show signs of gradual improvement ... [as] rail car loadings and intermodal were up from the previous week with carloads at their highest level in 10 weeks.'"

Welcome to the new normal. It is a quite distinctively different world than that of 2006. Global trade is off 10% and there is outright deflation in many places. We will have lots of data to look at over the next few weeks as we explore the new normal, but that is enough for today.

Oh, I almost forgot. The asterisk on "This Time It's Different*"? Human nature hasn't changed. We are still driven by fear and greed. The business cycle has not been repealed. Free-market capitalism will get us back (with a few new rules of engagement). What's different will be the nature of this recovery. All the other eternal truths will remain.

London, The Baltics, and Rome

I leave for London in mid-July and will co-host CNBC Squawkbox from 7-9 AM on Friday, July 17. Then the plan was to go to Eastern Europe. Things have changed, and now I am thinking of doing a tour through the Baltics, starting with Finland, then going down through the three Baltic nations, maybe a side trip to St. Petersburg, and then end up in Rome for a few days. That should be a fun vacation. We will see how much I can really pack in! But I do love to go to new places and meet new friends.

It is Father's Day weekend and all seven kids are in. The house is full. Tomorrow night we all go to see the new grandchild. Brunch on Sunday. The US Open at the Black. This weekend just can't hardly get any better. I may do my part to help the economy and go get the new Apple iPhone. My youngest son's phone broke, and my excuse is that I can give him mine and the new one then only "really" costs me $100. Consumer spending is not dead yet, to judge from the lines. But technology is a necessity, I keep telling myself.

Have a great weekend. I hope you enjoy yours as much as I am going to enjoy mine.

Your still missing his own dad analyst,

John Mauldin

Faith-Based Economics

John Mauldin — Sat, 16 May 2009 03:19:31 GMT

Can I Have Some More of that Data, Please?
The Fault, Dear Brutus, is Not in Our Stars
Faith-Based Economics
Is Unemployment a Lagging or a Leading Indicator?
An Unsustainable Trend in Debt
Some Thoughts on the Health Care Problem

Why does government data need to be revised so often? Is it conspiracy, as some claim, or is it methodology? And if it is methodology that leads to faulty data, then why not change the methodology? Is unemployment a lagging indicator, as conventional wisdom suggests? We look again at the underlying assumptions to suggest that things are not always the same. And finally, we look at unsustainable trends, fiscal deficits, and health care -- there is a connection.

But first, a quick note about the latest "Conversations with John Mauldin" that I just did with Don Coxe and Gary Shilling. These two esteemed analysts have different views on whether commodity prices will rise or fall, and are not afraid to make their views known. I edited the final transcript today, and I can tell you that even though I was "at the table" I learned a lot reading it the second time. If you want to understand the nature of what is a very central debate, this is a must-read. This was a VERY lively debate. Most of my friends know that I am not shy, but it was hard to get a word in edgewise as these guys went at it. It was great fun to watch.

And if you have not yet subscribed, you can go back and listen to my Conversation with Chris Whalen and Rick Lashley on the banking crisis, and see if you can figure out what motivated the Manhattan district attorney's office to call me asking for clarification. Plus the quintessential piece with Lacy Hunt and Ed Easterling on the fundamentals of the current economic crisis, which many subscribers said was worth the price of an annual subscription. And then there is the Conversation I did with Nouriel Roubini. It is all there for you.

The new Conversation will be posted early next week. Subscribers will get an email notifying you when it is up. Also, George Friedman of Stratfor and I are going to start doing a regular quarterly Conversation that will be a separate product, but if you subscribe today you will get it as part of the regular service for a year.

Right now, we are offering a subscription for $109, $90 off the regular $199 price. To learn more, you can click here and subscribe, if you haven't already. Insert code JM75 for this special offer. You can enter that code on the final screen of the subscription process.

Note: When George and I record that first piece sometime in the next few weeks, the price will rise to $129 a year, so you should act now. As we add more features like the one with George, current subscribers will simply get the new services, but the price for a new subscription will rise. New subscribers will however get access to the previous Conversations, at least for now.

Can I Have Some More of that Data, Please?

One of my regular reads is the blog The Big Picture. They featured a short piece by Michael Panzner this week. He put together some rather interesting data and then asked a question, which gives me an opportunity for discussing government data. Let's see what he had to say, and then I will make my comments.

"Many market-watchers claim that U.S. economic statistics are increasingly being revised downward in subsequent periods, suggesting that the figures initially being reported by Washington are "puffed up," so to speak, most likely for political purposes.

"Well, I went back and had a look at the differences between the reported and revised data for various series, including monthly retail sales, nonfarm payrolls, industrial production, and durable goods orders, to try and figure out if the cynics are right.

"Using data from Bloomberg, I calculated whether the revised data for each month was lower than the first-cut estimate. Then I tabulated 12-month running totals for each series to see if there has been some sort of systematic bias (in other words, whether the pattern of monthly downward revisions was trending higher instead of undulating up and down).

"To make the comparisons easier, I subtracted the 12-month tally as of May 2002 (an arbitrarily chosen date) from the monthly totals for all four economic series so that the starting point for each would be the same — zero.

"Based on a quick read of a graph of the data (see below), it does seem as though the pattern of negative revisions has been trending higher lately, especially during the past year or so, suggesting that the cynics may be on to something.

"That said, I am not a statistician, and the results may be nothing more than "noise." There is also the possibility that my methodology is lacking (because, for example, the margins-of-error for each month's data are relatively large, or because of certain quirks that crop up when an economy is in transition). Still, you gotta wonder..."

Actually, Mike (can I call you Mike?) your last thought is the correct one: "or because of certain quirks that crop up when an economy is in transition."

Go back to 2003-04. Notice that the numbers of downward revisions in non-farm payrolls are negative in your graph? Remember all the talk back then about the "jobless recovery"? We can now look back and see there were a lot of jobs being created. They just did not show up in the early statistics. And look at the opposite reaction in industrial production: here they revised strongly downward for a the better part of two years, yet it turned out there was a production boom going on.

Was all this a conspiracy on the part of the Bush administration to make things look worse than they actually were? Hardly seems like rational political behavior.

The "problem" comes from the methodology. There is no exact data for any of those statistics. They have to get as much data as they can and then make estimates. Part of the process of estimation uses previous trends. It is as if we were using past performance of a mutual fund or stock to project future returns. Even though we look at the past performance, we should know that past performance is not indicative of future results. Just look at some of the top-performing value-oriented mutual funds in the recent bear market, like superstar Bill Miller's Legg Mason Value Trust fund (LMVTX), the after-fee returns of which had beaten the S&P 500 index for 15 consecutive years, from 1991 through 2005. It did rather poorly last year, even in comparison with the S&P, which was horrid. Past performance is interesting, but it can disappoint. And sometimes rather viciously.

Now, just as saying that a fund on average will produce a 10% return does not mean that it will yield 10% every year, neither do government statistics work that way. While the methodology for each series of data is different, they all are more or less trend-following. They take past relationships in the data they can gather and use them to estimate current numbers. And -- this is important -- on average and over longer periods of time, they are pretty accurate.

They will revise the data many times over the coming years, getting closer and closer to the actual numbers. For instance, I can't remember exactly when, but it was several years later that we learned that we were already in a recession in the third quarter of 2000, at the very time most economists were calling for a robust economic future! (Except for your humble analyst, who was predicting a recession, and had been for some time because of the inverted yield curve, but that's another story.)

But in the short run, at economic transitions they are going to get it wrong, because the backward-looking data is mean-reverting. But how else would you do it? One of the keys to economic transitions is to look at the direction of the revisions. Recently, the revisions have all been negative. Things are actually getting worse than the initial data suggested. And during the last recovery the data kept getting revised upward, especially six months and one year later.

The Fault, Dear Brutus, is Not in Our Stars

Look again at the very useful chart above (great work, wish I had thought of it!). Non-farm payrolls, which for some odd reason everyone pays attention to, is especially wrong at the turns. Anyone trading on non-farm payroll data deserves the losses they will get.

One of the reasons that non-farm payrolls are so often revised is that the Bureau of Labor Statistics (BLS) is forced to estimate the number of new businesses being created each month that are simply under the radar screen of government statisticians. This number is called the birth/death ratio. You could not create a useful payroll number without this estimate, yet it is simply a wild-eyed guess based on past trends, which by definition we know will change at economic turning points.

Further, almost no one pays attention to the fine print in the data, which talks about margin of error. The statisticians clearly understand the limits of their data, even if the public does not. Often, the margin of error is larger than the number being given, so that a positive number may actually turn out to be negative, and vice versa, when viewed from a few years out.

As Cassius said in Julius Caesar, "The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings."

Faith-Based Economics

Should we cast aspersions on the data creators? I rather think not. The various government statistics creators are doing their best to give us information that, over time, will be useful. Some is more useful than others in real time. Some has large time lags before it is accurate. To expect the BLS or the Commerce Department to have accurate current data is expecting them to know the future. The very people who are the most critical would never presume to be accurate about the prices of stocks six months out (or even one month), on a consistent basis. Yet that is the kind of prescience they want from government statisticians.

Do you really want data from government sources that makes assumptions about economic recoveries and recessions? That is the job of independent economists, and they generally do it pretty badly. There is no need for the government to compound the errors.

Again, repeating myself, anyone who trades on government statistics as being anywhere close to accurate in real time deserves any losses they get. They are at best a foggy window through which we peer into the future. Taken together, and with some seasoning of time, they can be rather useful; but to pin hopes of a recovery or a bull-market run on one week's data is hazardous to one's wealth.

Reading and watching all the analysts and economists who "see" recovery in one set of data or another makes me wonder what sort of faith-based economics they actually practice. Just as it requires faith to believe in God, it also requires a lot of faith to believe in forecasts made on a single month's set of data, or based on past performance.

Are you interested in finding a real green shoot? Let's look for a quarter when the economic data keeps getting revised upward, two and three months out. That will signal a real recovery. As long as the data is being revised downward, the economy is "having issues," as my kids would say.

Quick sidebar to those who keep asking: Yes, I think we have seen the worst of the economic data, as far as GDP goes. But that does not mean we don't have further negative quarters in our future. I just don't think they will be a negative 6 like they have been the last two quarters. And we may even see a quarter this year with a positive number. But take it with a grain of salt when the usual suspects declare the end of the recession. Look into the data that produces the numbers. As Gary Shilling points out, eight of the last eleven recessions have had a positive quarter, only to see more negative quarters follow. GDP numbers are quirky. But here's to hoping for a real recovery when we do see the next positive number.

Is Unemployment a Lagging or a Leading Indicator?

There is a very interesting animated graphic done by Chris Wilson at Slate.com (http://www.slate.com/id/2216238/). It shows the progression of unemployment by US county over the last two years. I reproduce the beginning and ending stages of the graph for you below, and apologize to those of you who are reading this in black and white, as it will not be as dramatic. But if you watch the entire series, it shows how rapid the deterioration in unemployment has been. (It takes about ten seconds.) The first graph shows that there 2.6 million jobs had been created in 2006. The last one shows that job losses were 5 million through March and, if we add in April and estimates for May, it will be close to 6 million. Again, the actual animation is dramatic, and made my daughter go "Ouch!"

It's been 50 years since we have seen unemployment drop as rapidly as it has in the current recession. Given that we have a much smaller percentage of manufacturing jobs now, that volatility is breathtaking. Look at the data since 1930 from the St. Louis Fed:

The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month:

"Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions.

"... The bounce in the economy and the stabilization in markets reflect government actions that are big enough to impact near-term growth rates, but are not sufficiently directed at the root problem of excessive indebtedness to produce permanent healing. The deterioration in employment markets will continue because companies' profit margins are so deeply damaged that a little bounce in growth won't do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion."

This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. Using the past data in today's world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio.

An Unsustainable Trend in Debt

This week, the federal government published two important reports on long-term budgetary trends. They both show that we are on an unsustainable path that will almost certainly result in massively higher taxes. By 2016 we will have to fund Social Security out of general revenues, as the surplus we now have will be gone. And there are no trust funds. They are a myth. It as if I wrote myself a check for $2 trillion and then declared I was worth $2 trillion. The money is just not there. Social Security makes Bernie Madoff look like a small-time crook.

And Medicare is in far worse shape. For those with the stomach, you can read Bruce Bartlett's analysis at http://www.forbes.com/2009/05/14/taxes-social-security-opinions-columnists-medicare.html. He estimates that taxes will have to go up by 81% if we are to pay the obligations as they now stand.

Now that is unsustainable. It won't happen. And as the saying goes, if something is unsustainable, at some point it will stop. No getting around it. Long before we get there, change you will not like will be forced on the US.

The following headline caught my eye: "Obama Says US Long-Term Debt Load is 'Unsustainable.'" Yet they announced a $1.8 trillion deficit, which is really going to be at least $2 trillion, and are getting ready to pass health-care programs that will mean at least a trillion in deficits for as long as one can project.

How will they pay for it? Even getting rid of the Bush tax cuts will only produce a few hundred billion a year, which is nowhere near enough. They project much lower medical costs in the future, because they assume they are going to figure out ways to cut costs and make medical care more efficient. As if no one has ever tried that.

Yes, there are some savings on the margin; but the only way you really cut costs is to ration health care, especially health care in the last year of life, which is about 30% of health-care expenses. That is going to be very tough in the US. But when faced with a real budget crisis, the choices are going to be stark. And that crisis is coming if we do not control spending.

You cannot propose massive increases in spending without either creating crushing debt that the markets will simply not allow, pushing interest rates much higher and really slowing growth and hurting the economy. It is a simple fact that you cannot increase the debt-to-GDP ratio without limit.

We found the limit on personal and corporate debt this past year. We pushed the limits until the system crashed. And now the US government wants to basically do the same thing. They are planning to see where the limits on government debt-to-GDP will be. Unless cooler and more rational heads in the Democratic Party prevail, this is not going to be pretty. Sometime in the middle of the next decade we will hit the wall, and it will make the current crisis pale in comparison.

The only way to solve the problem is to grow GDP more rapidly than debt, and for that to happen you have to have policies which are shaped for the growth of the economy or massive savings by consumers. And right now we have neither. Cap and trade is hugely anti-growth. So are high corporate taxes, and Obama is proposing to effectively raise corporate taxes by closing loopholes for income earned outside the US. Much better would be to lower the overall corporate level to a competitive world rate and then require the offshore income to be taxed. A lower rate would actually increase tax revenues.

Looming protectionism worldwide is a problem. (See the article at http://www.msnbc.msn.com/id/30758018.) Towns in Ontario, Canada with a population totalling 500,000 have effectively barred US contractors from doing business with them, in retaliation for job losses stemming from US protectionism in the stimulus plan. That movement is spreading. A US steel mill with 600 union jobs will have to close down because its owners are not US-based, and thus it is not technically a US supplier. They are losing jobs to US-owned mills -- but those are US jobs. The insanity goes on and on. As I have written for many years, the one thing that really gets me worried is protectionism. That can make this very significant recession into a depression quicker than you can imagine. Bad ideas have bad consequences.

All in all, we face some very difficult decisions, not just in the US but all over the developed world. Ironically, the less developed nations will have fewer problems and on a relative basis will likely grow much faster than the developed world. But, multi-trillion-dollar deficits and massive new programs are not the right answer.

Obama is right: the debt load is unsustainable. Let's hope he will do more than talk, and show some budget restraint.

Woody Brock has given me permission to pass on to you his recent notes on this very topic of what we have to do to get out of this crisis. It will soon be an Outside the Box. Read it. It is a very sobering and thought-provoking piece.

Some Thoughts on the Health Care Problem

Now, some positive news. This week I visited the Cleveland Clinic and went through their Executive Health Program (more on that below). I got to visit for several hours with my doctor, Michael Roizen, of YOU: The Owner's Manual fame (not to mention all his subsequent books). They have now sold over 20 million copies, and I highly recommend them.

I have long been a student of medical trends, and long-time readers know that I think the next really big boom will be in the biotech world. I asked Mike what three things he thought would have the biggest impact in the next five years in medicine. What he said gave me hope, because he thinks there may be some advances in medicine that could help solve some of the basic health issues we all face, and at the same time give us some relief from the high and rising costs of medical care. I was aware of most of the research, but did not know that we were as close as it appears we actually are.

Briefly, he feels there are three developments in late-stage trials that could have major impacts. The first is the development of sirtuin, which so far seems to be delaying the effects of diabetes but also seems to work for a host of diseases that are inflammatory in nature (including many heart-related issues). It essentially delays the symptoms for 30-40 years. While the current trials are for very specific diseases, he thinks sirtuin will have a wide applicability and that it could be huge, as inflammation is the cause of a number of diseases. This could prolong useful life and forestall a number of debilitating conditions.

Second, there is a late-stage-three trial due out soon that promises to increase muscle mass. I have been reading about such developments, but was not aware that something might be available within a few years. This promises to help people stay active a lot longer than currently possible, which will be a good thing if we are going to live longer.

And finally, there is a study and trial which shows that DHA may delay the onset of Alzheimer's disease, which eats up a significant portion of US medical budgets.

I recently spent time with a research doctor at the University of California Irvine who believes that muscular dystrophy and other brain/nerve-related diseases may be conquered within five years.

We may just get lucky. Instead of high and rising medical expenses that we cannot pay for without bankrupting the country, we may be able to reduce our medical bill by staying healthier and living longer.

Everybody should be like my personal hero, Richard Russell. I hope to be writing as well as he does when I am 85. With some luck, I might just make it.

Let me quickly recommend to my readers that they get serious annual physicals. At the Cleveland Clinic this week I saw seven doctors in one and a half days, and went through some serious poking and prodding. The program was tailored to my needs, as it is different for every person. You see professionals who are geared to your physical challenges. They make all the arrangements, and a staff person walks you into see the doctors, who are on very tight schedules.

The advantage of the Cleveland Clinic is that they are very oriented toward helping you not get sick in the first place. I am turning 60 this year, and Iwant to be active for a very long time. You have to be proactive.

As an aside, I had a colonoscopy. I was really dreading it, but it is one of those things you need to do. As it turns out, it was nowhere near as bad as I thought, and they basically gave me a drug which allowed me to relax and only experience a little discomfort. ("You are going to feel really relaxed in about 30 seconds.")

You can learn more at www.clevelandclinic.org/executivehealth. Whether it is there or somewhere else, get a serious physical. I want you to be reading me in 25 years as much as I want to be writing.

It is time to hit the send button. I will close by wishing you a very healthy week.

Your really an optimist at heart analyst,

John Mauldin

Green Shoots or Dandelion Weeds?

John Mauldin — Sat, 09 May 2009 04:43:00 GMT

A Few Thoughts on Recessions
Are the Green Shoots Really Dandelion Weeds?
Is That a Leaky Bucket?
Frugality Is Back in Vogue
Where Will the Jobs Come From?
Cleveland, New York, and Mother's Day

Go to Google. Type in "green shoots." In about a 10^th of a second you will find 28,900,000 references. Scrolling through a few pages, you find a lot of references to the beginning of the end of the recession. Today we look at some data to see if we can indeed see the end. Most readers will be surprised to know that the number of people employed in the US went up (!) in April. Yet so did the unemployment rate. Is that green shoot just another dandelion weed in our economic garden?

We'll jump into that and more, but first let me quickly mention the new subscription service that we began offering this year, called "Conversations with John Mauldin." One of my "secrets" is that I have a very powerful rolodex (or, for the younger crowd, my contacts list). In this new project, each month I call up one or two of my special contacts in the investment and economic world and hold a conversation with them about the important topics of the day -- where the US and global economies are going, how we should be investing, what opportunities and pitfalls are out there, etc. Some will be names you recognize, and others will be names you will want to know. You get to listen in, download to your computer, or read a transcript -- whichever you prefer.

The reviews from subscribers have been more than excellent. Over the top, actually. You can read some of them at the website below.

I just recorded a Conversation with Donald Coxe and Gary Shilling. Both men are among my favorite analysts, and have been remarkably right with their calls for a long time. However, their views on how commodity prices will develop over the next few years differ considerably. Mischievously, I thought it would be fun to get them together. Neither are shy or retiring men, and both can articulate their views very well, thank you. The conversation turned into a lively debate, one in which I did not get to say as much as I do in a normal Conversation. I think subscribers will find it one of the best we have done. I certainly came away with a lot to think about.

The Conversation will be posted next week. Subscribers will get an email notifying you when it is up. Also, George Friedman of Stratfor and I are going to start doing a regular quarterly Conversation that will be a separate product, but if you subscribe today you will get it as part of the regular service for a year.

Right now, we are offering a subscription for $109, $90 off the regular $199 price. To learn more You can click here and subscribe, if you haven't already. Insert code JM75 for this special offer. You can enter that code on the final screen of the subscription process.

Note: When George and I record that first piece sometime in the next few weeks, the price will rise to $129 a year, so you should act now. As we add more features like the one with George, current subscribers will simply get the new service, but the price for a new subscription will rise. Also, new subscribers will get access to the previous Conversations, for now.

Thanks, and now let's jump into the letter.

Are the Green Shoots Really Dandelion Weeds?

When the employment numbers come out, my usual routine is to go the Bureau of Labor Statistics website and peruse the actual tables (www.bls.gov). I was rather surprised to see that the actual number of people employed in the US rose by 120,000. That has certainly not been the trend for a rather long time.

So, are things back on track? Is the recession just about over? Is that a green shoot? I don't think so.

First, there are actually two surveys done by the BLS. One is the household survey, where they call up a fixed number of homes each month and ask about the employment situation in the household and then take that data and extrapolate it for the economy as a whole. So, while the number of employed rose, the number of unemployed rose a lot faster, by 563,000 to 13.7 million. In addition, there are 2.1 million who are "marginally attached" to the workforce. These individuals wanted and were available for work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

According to the survey, headline unemployment rose 0.4% to 8.9%, the highest level since 1983. But if you count those who are working part-time but want full-time work, as well as the "marginally attached," the unemployment rate (called the U-6 rate) is an ugly 15.8%.

For whatever reason, the markets were happy that the headline number of the other BLS survey, the establishment survey of lost jobs, was "only" 539,000, down from a negatively revised 699,000 in March. At least, the thinking was, the numbers were not getting worse, though it is hard for me to be encouraged by half a million lost jobs. That may not be the worst of it, however, since 66,000 jobs were temporary workers hired for the 2010 census, and the BLS estimated that the birth-death ratio added 226,000 jobs as a result of new business creation. Really? This will mean that there will likely be a major revision downward at some future point. The number will likely be well over 600,000 in the final analysis.

Further, it is likely that we will see at least another 1.0-1.5 million lost jobs over the rest of the year, taking unemployment very close to 10%. As an aside, the Treasury used an unemployment rate of 9.5% in their stress test of the banks, which suggests the test was not all that stressful. And, showing further weakness, there were 66,000 fewer temporary jobs. If there was really a nascent recovery, you would see a rise in temporary workers.

Average wages rose by a mere 3.2% on an annual basis, and by just 0.1% for the month, and the average work week was at an all-time record low of 33.2 hours. In nearly any inflation scenario, rising wages play an important part. This suggests that inflation is not in our near future.

Is That a Leaky Bucket?

Let's play a thought game. Picture the economy as a leaky bucket, maybe not as bad as the one below, but leaking nevertheless.

We have put holes in the bucket of our economy, and the "water," or GDP, is leaking out. We are going to settle at some new lower level of GDP and consumer spending. At some point, we can fix the holes and begin the process of increasing the level of the water. Typically, this happens relatively quickly.

However, a recent study showed that recessions that come as a result of or in conjunction with a financial crisis take a lot longer to recover from. The study looked at 122 recessions, of which 15 were associated with financial crises.

The research, published as Chapter 3 in the April 2009 World Economic Outlook (WEO) of the International Monetary Fund, finds that recessions that are either associated with financial crises or that are highly synchronized worldwide have historically been longer and deeper, and featured weak recoveries (see chart). The combination of these two features -- a rare phenomenon in the postwar period -- resulted in even costlier recessions, which lasted almost two years.

"In addition to the current global recessionary cycle, there were three other episodes of highly synchronized recessions: 1975, 1980, and 1992. These recessions were on average longer and deeper. Distinct from other episodes, the recoveries from these recessions feature much weaker export growth, especially if the United States is also in recession.

"A perfect storm? Recessions that are associated with both financial crises and global downturns have been unusually severe and long lasting. Since 1960, there have been only six recessions out of the 122 in the sample that fit this description: Finland (1990), France (1992), Germany (1980), Greece (1992), Italy (1992), and Sweden (1990). On average, these recessions lasted some two years, were unusually severe, and featured weaker-than-average recoveries." (IMF)

In addition, I would suggest that the current recession is unlike any in the study, in that the habits of the American consumer are changing right before our eyes. Instead of spending and borrowing with little or no savings, people are now reducing their borrowing and increasing their savings. Savings are now 4% of income and are likely to rise to 7-8% or more in the next few years, as consumers see the need to repair their balance sheets and retirement funds.

Frugality Is Back in Vogue

While Wal-Mart and other low-cost retailer sales are up, Saks and other high-end retailers are down by as much as 30%. There is a new frugality in vogue. That new hole in the bucket? It is the damaged psyche of the American consumer. Consumer spending is going to fall, and when it does find that new level it is going to grow more slowly than in the past.

And that, gentle reader, is why the recovery is going to be a long slow Muddle Through. This recession will end, as all recessions eventually do. We will see a positive number, maybe as early as the 4^th quarter. Employment should turn back up, albeit slowly, after that.

Typically, in a recession jobs are lost because sales slow and production is not needed. When sales recover, so do jobs.

But we are permanently destroying jobs in this recession, all up and down the food chain and in numerous industries. There will be fewer cars made, for a long time. Less demand for financial service jobs. Housing construction will be a long time recovering, well into 2011 or 2012.

And commercial real estate? General Growth, the largest operator of malls, with 166, filed for bankruptcy protection and in a very controversial move took all 166 malls into bankruptcy as well. General Growth was the largest issuer of Commercial Mortgage-Backed Securities (CMBS), which is how the great majority of commercial mortgages are created. The lenders thought they had direct access to the cash flow of the malls. Some of those malls are quite profitable. Cue the lawyers.

If this rather aggressive move is allowed to stand up in court, it could do serious damage to the whole commercial real estate industry, which is already in upheaval, and throw new construction projects into serious difficulty. And less construction means fewer jobs.

Where Will the Jobs Come From?

As the water in our bucket seeks a new economic level, there are simply going to be fewer jobs to make "stuff," as we consume less. We can't rely on many of the old jobs and industries to come back in short order, as has been the case in the past. In order for new jobs to be created, we are going to have to create new businesses and expand current ones.

The vast majority of new job creation in the US is by small businesses and entrepreneurs. Yet today small business faces a tough environment. Banks have tighter lending policies. Venture capital is tough to find. Competition in a shrinking economy is brutal.

And the Obama administration wants to raise taxes on small businesses by raising taxes on the "rich." 75% of those rich he targets are small businesses who need capital in order to grow, but are having trouble getting it from banks.

Sure, entrepreneurs will do what they have to do, and higher marginal tax rates will typically not keep them from working as hard as possible to make their businesses successful. If the tax rates of the large majority of businessmen and women go back to the pre-Bush level, it will not make us close our businesses, but it will cut down on the capital we have available to expand. It will slow down economic growth and hinder job creation. There is just no getting around that fact.

There is a reason that high-tax states have higher unemployment rates and lower job growth. Taxes have consequences for economic growth.

The sad reality is that it is going to take a long time to get back to acceptable employment levels in the US. It now takes an average of over 21 weeks to find a new job, a new record. Stories from friends in the financial services business are particularly difficult, as there are many very highly qualified people for every job that comes available. And it is not going to get better any time soon.

How could we add 120,000 new jobs while unemployment is going up? Because the number of people looking for jobs is growing far faster, as more and more young people come into the market place and couples now find they both must look for a job. And that is a trend that is going to continue.

So many bullish analysts talk about the second derivative of growth, by which they mean that we are slowing our descent into recession. But it is not the second derivative that is important. What is important is that the first derivative, actual growth, return. Until that time, unemployment will continue to rise, which is going to put pressure on incomes and consumer spending, and thus corporate profits.

Profits in the first quarter, with nearly 90% of companies reporting, are down over 50% from last year and are 18% less than estimates. Yes, inventories are down, but so is final demand from consumers and businesses. There is a reason that GM and Chrysler are shutting down for two months this summer. That will percolate throughout the economy.

As the realization that the economy is not due for a robust recovery sinks in, I think the chances for another serious bear market test of the stock market lows will become increasingly high. As David Rosenberg said in his final memo from Merrill Lynch (and good luck to him in his new position, where I hope we all still get to read his very solid analysis!), if a few weeks ago someone had said you could sell all your stocks 40% higher, most of you would have hit that bid.

Now that price has in fact been bid. Do you want to gamble on a renewed bull run in the face of a continually shrinking economy? I suggest you give it some serious thought, or at least put in some very real stop-loss protection.

Cleveland, New York, and Mother's Day

I thought I was staying home in May. Well, plans change. I am going to the Cleveland Clinic on Monday for a full physical with Dr. Mike Roizen (YOU: The Owner's Manual, etc.) which I have postponed for too long. This is an excellent program. I will give you a report next week.

Then on June 3^rd I will be in New York for a very special conference hosted by my friends at The Big Picture. The conference is called "Capitalism after Crisis -- A look at Banking, Hedge Funds, and Media during the Recession ... and Beyond." It is an all-day affair on June 3, 2009 at the New York Athletic Club. There is a great line-up of speakers -- like Dylan Ratigan, Nassim Taleb, Doug Kass, Barry Ritholtz, Chris Whalen, and Josh Rosner -- and your humble analyst will do the closing keynote address. The conference is $895, but my readers get a special deal of $695 if they use this link: https://secure.pnmi.com/bigpicture/?source=mauldin

Much of the family will gather for Mother's Day. My mother will be 92 in August. She is bionic, with two new knees and two new hips. Mother was in the WACs in World War II and went to Germany, where she met my father. She did not have an easy life, as Dad was an alcoholic for most of his life, but she stayed with him. She has always had a positive attitude. We almost lost her this last year, when she went into the hospital for minor surgery and ended up getting a very deadly stomach virus. She was actually giving my brother her last requests one night, as they thought she might not make it through the night -- but she did. I come from hardy stock.

And speaking of mothers, Tiffani is coming along and is now two months pregnant. I get the blow-by-blow narrative each day in the office. It does bring back memories. Enjoy your weekend; I certainly intend to enjoy mine. The Mavericks are in the playoffs, although so far Denver is eating our lunch. And Star Trek is out. I am a huge Trekkie. It will be a fun next few days.

Your can't wait to see Star Trek analyst,

John Mauldin

Back to the Future Recession

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

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

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

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever genetically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: deflation, we can't have it.

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

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

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

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

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

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

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

Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the Libor market because they are worried about credit risks? It does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. The Fed has somehow got to get it into the financial system. They've got to figure out how to create some movement.

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

Financial Innovation: The Round Trip

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2010-11: Back to the Future Recession

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

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

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

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

The Fed at the Crossroads

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

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

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

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

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

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

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

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

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

How Did We Get It So Wrong?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Trend Is Not Your Friend When It Ends

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

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

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

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

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

Orlando, Naples, Cleveland, and Grandkids

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

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

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

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

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

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

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

Your almost ready to be a grandfather analyst,

John Mauldin

Solving the Housing Crisis

John Mauldin — Sat, 21 Mar 2009 21:05:00 GMT

Solving the Housing Crisis
Housing Could Drop Another 20% in Pricing
Buy A Home, Get a Green Card
A Real Stimulus Package
Las Vegas, La Jolla, and the OC

This last Tuesday the Wall Street Journal published an op-ed by my friend Gary Shilling and Richard LeFrak. They offer a simple solution for the housing crisis: give foreigners who will come to the US and buy a home resident status (green cards). This is a very important proposal and one that deserves national attention and action. Gary was kind enough to send me two lengthier white papers offering more facts. In this week's letter we are going to look at this proposal in more detail than the small space that an op-ed can offer. And while this letter will be somewhat controversial in some circles, I ask that you read it through, giving me the time to make the case. I will also add a few thoughts as to why this could not only help solve the housing crisis, but help put the nation back into growth mode.

Long-time readers know that I have been growing more and more bearish of late. I have been writing for a long time that we are in for a long period of slow Muddle Through growth as the twin crises of the housing bubble and credit bubbles require time to heal. Today we look at a serious proposal for cutting the time to healing for at least one of those bubbles (housing), and at least keep the other (credit) from getting worse. This is the most serious idea I have seen that could actually make a real positive contribution to the economy and help put us back on a growth path.

I will post Gary's papers and a link to the actual op-ed piece for those who want to do further research, but let me make one point at the beginning that he did not emphasize: the US is already allowing roughly 1 million immigrants a year into the country (which for a variety of reasons I and most serious economists of all stripes believe is a very good thing). We are suggesting that we simply change the nature of what constitutes the conditions for acceptance, so as to jump start the housing industry and the economy. We are not suggesting additional immigrants, although nothing would be wrong with that. I will also post a link for you to send this e-letter to your congressmen and senators.

Let me put up front a few benefits of a program that would allow legal status to immigrants buying a home. Housing values would stabilize and in many cases rise. The massive losses because of bad loans that are being subsidized by US taxpayers would be stemmed, saving many hundreds of billions, if not a trillion or more dollars. The excess inventory of homes would quickly disappear and the millions of jobs that were lost as home construction fell into a deep depression would come back. If housing values rise, many families would be able to refinance their homes at lower rates and have more income left over after paying their mortgages. $12 billion in commissions would end up in real estate agents' pockets, helping a very battered and bruised group. Hundreds of billions will flow into local businesses, as these new immigrants will need to furnish their homes. This could mean as much as a half trillion dollars in sorely needed stimulus in the next few years, without one penny of taxpayer money and actually adding taxes back to governments from local to national. And we are not bringing in 1 million foreigners, we are attracting 1 million mostly middle-class new Americans, which, if we are smart in how we do this, will result in more jobs for all Americans. So let's jump right in and look at the details.

Housing Could Drop Another 20% in Pricing

Let's review the situation as it will be if we do nothing. Shilling shows that we built 6.7 million more homes in this country between 1996-2005 than the normal trend would have projected, partially because we underbuilt the decade before that. New housing starts average about 1.5 million in normal times but have fallen to 500,000 recently, and could fall further as unemployment rises and demand declines. Even so, Shilling estimates that we still have about 2.4 million excess homes.

This compares rather well with estimates by independent analyst John Burns, which I cited in the e-letter early last year. What they both agree on is that it will take at least until 2012 to work through this excess inventory, and that assumes that foreclosures do not increase as housing prices drop.

Excess supply of anything means lower and continuously falling prices, and that has certainly been the case in housing. Here is what Shilling writes:

"We believe that if nothing is done to eliminate surplus housing, prices will fall another 20% between now and the end of 2010 for a total peak-to-trough decline of 37% (Chart 1 below). The resulting further negative effects on the economy will be devastating. At that point, almost 25 million homeowners, or almost half the 51 million total with mortgages, will be underwater… That's also a third of the 75 million total homeowners, with the remaining 24 million owning their houses free and clear. It would take a little over $1 trillion to reduce their mortgages to the value of their houses, compared to $449 billion for the almost 14 million currently underwater."

This is not inconsistent with similar projections by other acknowledged experts and independent analysts like John Burns and Professor Robert Shiller of Yale. If nothing happens to stimulate buying, there is a great deal more pain ahead for American homeowners.

For the great majority of Americans, their homes represent the largest portion of their assets. This is particularly true of Americans of more modest means, who have been hit the hardest. Watching their single biggest assert drop another 20% will be devastating and for many will mean they will not be able to retire as they had planned. More Americans own homes (68%) than own stocks (50%). This helps explain a recent poll which shows more Americans are worried about house prices than about the decline in stock prices.

Falling home prices means that consumers have to save more for retirement, which results in lower consumer spending, which translates into lost jobs and more homeowners coming under stress -- a vicious spiral that is increasing unemployment. Realistic estimates of unemployment rising to over 10% within the year abound.

Two years ago I and a few others foresaw the current housing crisis (and an accompanying credit crisis), predicting a protracted recession and a slow, multi-year Muddle Through recovery. Sadly, I was right about the housing crisis. Without some intervention, there is little to suggest that the prediction of a long, protracted recovery will not come true.

Lowering rates, as is being discussed in various circles, will help homeowners who can make their payments, but it does nothing to really bite into excessive inventory. Until we reduce the inventory, housing prices in many neighborhoods all across America are going to continue to come under pressure. And as Barry Habib points out, while the Fed may be lowering rates for securitized packages of loans, those low rates are not available to the average home buyer. The cost of packaging and securitization adds considerable cost.

Shilling discusses the "traditional" options for reducing home inventories, but in the end there is no real solution other than time, or massive amounts (read trillions) in taxpayer money being given to homeowners, which will be very unpopular, as homeowners who were responsible and are paying their mortgages would get no benefits. Waiting another two and a half years for the excessive inventory to sell will keep this country in a very slow or no-growth economy, and devastate the wealth of millions of homeowners.

But there is a solution. There are millions of foreigners throughout the world who would like to come to live in the US. In 2006, there were 1.1 million immigrants allowed into the US, some 63% of whom were allowed in simply because they already had relatives here. Only 13% of visas were granted to people because of their skills. While allowing relatives of current residents to come to the US may be a humane and reasonable policy, it does nothing to assure they bring more than that relationship to help them make their way in the US.

Buy A Home, Get a Green Card

What if we changed the rules for a few years? Starting as soon as possible, we should allow anyone to come into the country who would buy a home. They would be given a temporary visa which would become permanent if they had no problems after, say, five years.

While Gary proposes that they be allowed to borrow against the value of their homes, I lean toward suggesting that initially we take those who buy their homes outright (with a few exceptions). That means they have enough capital to purchase a home to begin with, which probably means they are educated and have skills. In fact, if they have enough cash to buy a home, that means they would have more actual savings than most US citizens. We would be attracting future citizens with the capital to invest in job-creating businesses and/or who have useful skills to assist in the recovery of the US economy.

Of course, there should be some rules that go along with this proposal. Background checks and references should be required. The home could not be rented for a period of time (at least two years), to help reduce the supply of available housing, and could not be resold for at least two years unless another home was purchased. There should be a minimal price, which could be somewhat different for various regions, but $100,000 would seem to be a good minimum for most areas, with higher minimums in certain areas.

The immigrant should demonstrate the ability to support himself and his family for a period of time (at least one year, preferably two), including the purchase of health insurance. Cash or letters of credit or other guaranteed commitments would be required. Only immediate family members (spouse and children) would be allowed to come with the immigrant. Cousins and siblings must buy their own homes. The permanent visa should be contingent on not having gone on welfare or public assistance at any time in the past five years. We are trying to solve a housing problem, not looking to create others.

I would make an exception in having 100% financing for immigrants with advanced degrees or special skills, especially those who did their schooling in the United States. If the US is to remain competitive in an increasingly technological world, we need more scientists and engineers. But getting permission to stay is becoming increasingly difficult. We are seeing a brain drain of those who would like to stay and create new jobs and technologies (and buy houses) here in the US. Shilling and Le Frak write:

"The authors of this report believe that a number of people have given up waiting for those visas or don't want to put up with the hassle and are leaving the country. This "brain drain" is unfortunate since many of these foreigners are highly productive. In 2006, foreign nationals residing in the U.S. were named as inventors or co-inventors on 25.6% of the 42,019 international patent applications filed from this country, up from 7.6% in 1998. Studies of the authorship of academic papers show the same trend.

"U.S. educational institutions are considered the best in the world by many and are magnets for foreign students, especially at the graduate level. Many of them are inclined to settle and work in this country after completing their studies, if they can obtain permanent resident status.

"The Council of Graduate Schools survey revealed that in the fall of 2007, 241,095 non-U.S. citizens were enrolled in graduate programs. Technological progress and the productivity it generates depends on people educated in biological sciences, engineering and physical sciences, but only 16% of U.S. citizen graduate enrollment was in these three disciplines. In contrast, 55% of total non-U.S. citizen enrollment was in those fields. Conversely, 53% of graduate enrollment by Americans was in education, business and health sciences while those three fields accounted for only 24% of foreign graduate students."

(There is a great deal more background detail in the second white paper. See link below.)

Much can be learned from similar programs already in place in immigrant-hungry countries such as Canada, Australia, and New Zealand. The United Kingdom has recently added new programs. Many countries realize that in the coming years there is going to be increasing competition for the best and brightest of the world. Again, there are more details in the white papers, but let's turn to the effects that would result from such a program.

A Real Stimulus Package

First, upon Congressional approval, it would almost immediately stop the seemingly inexorable slide in house prices, as initial demand would be significant. Let's assume one million new immigrants would buy homes. At an average price of almost $200,000, that would be $200 billion injected into the economy. And each of those homes has to be furnished, food has to be bought, clothing will be needed, local taxes will be paid. Airplane tickets to research potential areas, hotels needed during the interim period, and other related expenditures would add up. Over two years, this could easily be another $100 billion.

Couple 1 million new buyers with current US demand, and the excess inventory would be worked through within a year, and possibly faster. This puts a floor under the housing market, and home values could once again to begin to rise in line with a growing economy.

Such a program would have a salutary effect on the value of the dollar, as not only the initial purchases of homes and materials would need to be converted to dollars, but it is likely that immigrants would bring even more capital into the country.

By stemming the fall of home values, it would decrease the likelihood of foreclosures and help homeowners get refinancing at lower rates. Refinancing now is difficult because most lenders want a substantial slice of equity to go along with any new mortgage. If your home value has dropped 20% and is likely to fall another 20%, it is hard to have enough equity to qualify for a new mortgage. Stopping the fall in prices is critically important; and maybe if prices rise in some areas, homeowners will be able to refinance at better rates, giving them more cash each month to save or spend.

As I have written in previous letters, the psyche of the American consumer is permanently scarred. We are on our way back to a savings rates that will look more like 1987 than 2007, when it was almost zero. Just a few decades ago, we saved 7-10%. Consumer spending was only 64% of US GDP in 1987. It was 71% in 2007. It is on its way back to that lower level.

Lower consumer spending will be a drag on growth for years. But bringing in 1 million already middle-class new immigrant families will help make up for a lot of that reduced spending. If you can spend $200,000 on a home, you are likely skilled at something and well-educated. You will find a job, or create one, as many immigrants do, and then you will add to our total consumer spending.

If you are a real estate agent, you should love this proposal, as it would result in an additional $12 billion in commissions.

If you are a home builder, what a great way to reduce inventory and get back to the conditions where there is a demand for your product. This would help put back to work those who have lost their jobs in the home construction collapse. Home Depot and Lowe's and local stores? It would help them to increase sales, which leads to more jobs.

We are on the cusp of the Baby Boomers beginning a huge wave of retirement, both in the US and elsewhere in the developed world. There is going to be a need for skilled workers to replace those Boomers, as well to provide services to the retirees. Further, the promised Social Security and Medicare expenditures are going to start increasing at a significant rate. We are going to need immigrants to help pay for those benefits. Given the controversy over immigration, we will look back with some irony in ten years when we find we are in a serious competition with other nations to attract skilled immigrants. We should start now. I think the concept is, let's not waste a good crisis.

Let's look at some of the potential critics of this proposal. I was on Yahoo Tech Ticker yesterday talking about this, and got a few irate emails and phone calls.

"Why," I was asked, "do I hate American workers? Isn't there enough unemployment? Why do we need more immigrants taking American jobs?" And there was considerable angst about illegal immigrants.

First, I am suggesting we transform the already existing legal immigrant flow, which is going to happen anyway, into a form which helps us solve a major crisis. I am not talking about adding another 1 million immigrants on top of the current legal inflow. Just change the nature of that inflow until the excess housing inventory is settled, and then we can go back to the current program, if that is what is wanted (more on that below).

Second, I am not suggesting we bring in or condone illegal immigrants. That is another issue altogether, for another debate at another time.

If we do nothing, unemployment is going to rise to at least 10%. That is certainly not good for the American worker. Home values are going to continue to fall. That is certainly not good for the American worker. The economy is likely to be stagnant for an extended period of time, which means job growth in a Muddle Through recovery will be slow and stagnant. That is not good for the American worker.

Hundreds of billions more of taxpayer dollars will have to go to banks to keep them solvent as falling home prices and increasing unemployment increase foreclosures. That is not good for the American worker and taxpayer.

And further, I am not talking about bringing 1 million foreigners to this country. I am talking about bringing 1 million future Americans, who want to work hard and live the American dream.

Let me say a few words to those who are opposed to immigration -- and I have heard from you. With few exceptions, US citizens reading this have an immigrant in their genealogies. Some of mine go back to the 1600s. Some of mine were not exactly considered welcome. "No Irish and Dogs allowed" read the signs. But immigrants and their children have been the driver for growth in this country for generations. It is hard-working immigrants who leave their homes for the dream of being Americans that have been the backbone of the building of the nation -- the hewers and shapers, if you will.

It is precisely that melting pot of human diversity that is the strength of the American idea. Each new wave of immigrants has been viewed with trepidation or scorn, yet within one generation they have become American. And in turn, their children's children forget that their forebears had to deal with discrimination.

America -- the US -- is not so much a country as it is an idea, the idea that anyone, regardless of race or religion or gender, can come here and with hard work and determination make their own way. Some end up owning the local deli, and some end up founding Google. Some 25% of Silicon Valley start-ups, I am told, are by immigrants, creating jobs at the bleeding edge of technology. They see the US as a land of opportunity. That is why so many want to come and that is why we can attract a new generation of affluent, self-reliant immigrants who can help us solve a problem that we created.

I can see no downside to changing our immigration policy for a few years. We solve the housing crisis, stabilize home values, brings hundreds of billions in stimulus to the US, and with no taxpayer outlay. For a short time, we substitute one class of immigrant for another, to solve a serious crisis. It is not a matter of immigrants or no immigrants, just which immigrants

So which do you want? 10% unemployment and a decade of lower home values and increasing foreclosures, with a slow, Muddle Through, jobless recovery, or a stable housing market and home construction back to trend?

If you agree with me, I suggest you contact your Congressman. You can go to http://www.visi.com/juan/congress/ (selected at random from many such sites) and type in your address and get the name of your congressperson and senators. Just tell them you like this idea, and cut and paste the link where you read this into the letter. And tell them to get into gear! I would like to point out that this proposal is not Republican or Democrat, it is just common sense. I hope we can get broad bipartisan support.

The link to the Wall Street Journal editorial is: http://online.wsj.com/article/SB123725421857750565.html

The links to the white papers are:

http://www.investorsinsight.com/samples/Housing_Whitepaper_1.pdf
http://www.investorsinsight.com/samples/Housing_Whitepaper_2.pdf

Las Vegas, La Jolla and the OC

I expect I will get a few new readers from this letter. Normally, at the end of my regular weekly letter, I make a few personal comments. I write this free weekly letter to my 1 million closest friends, and you can add yourself to the list at http://www.investorsinsight.com. You can find out more about me at www.johnmauldin.com.

Parts of this letter have been written in New York and Dallas, and as I write this I am on a flight to Las Vegas to speak at a conference on natural resources. I am sure the recent Fed actions will be at the center of conversation. There is not enough space now to comment on that; but I did do a few segments on Yahoo Tech Ticker (one of which evidently made the Yahoo home page), which you can listen to at the following links.

Links to the Yahoo segments:

D.C. to America: You Can't Handle the Truth
http://bit.ly/10rUiF

Plan to Solve Crisis: Let Immigrants Buy Houses 2
http://bit.ly/W0XLq

Fed Strategy: Spread Economic Pain Over Multiple Years
http://bit.ly/wgGjA

I will be in La Jolla for my annual Strategic Investment Conference in two weeks, as well as hosting the Richard Russell Tribute Dinner. The dinner is shaping up to be a big event, with hundreds of attendees and many of the brightest lights in the investment writing world present to honor Richard for 50 years of brilliant commentary.

I really enjoyed my trip to NYC. I had a great steak dinner with Art Cashin, everybody's favorite commentator on CNBC. Breakfast with Tom Romero and then a meeting with Jim Cramer, who I found to be very personable and genuinely likeable. Meetings in the afternoon with business partner Steve Blumenthal, then breakfast the next day with Barry Ritholtz, Yahoo at the NASDAQ, and then a speech at noon, back on the last flight and up writing -- and then this plane, which I hope ends up in Las Vegas.

In addition to being with old friends Doug Casey and David Galland (and their posse), I intend to see the inside of the gym and spa. I need it. Tiffani has been gone for two weeks, working on our book, and will get back on Monday; and the new chapter I was supposed to have for her has disappeared in a reboot from this laptop. I am quite distressed, but evidently the book gods decided it needed a major rewrite.

Have a great week, and find a few friends and share some laughs and your adult beverage of choice.

Ok, the computer crashed again, and this letter is going out on Saturday rather Friday night. But I did get to see the Jersey Boys (The Story and Music of Frankie Valli and The Four Seasons) here in Vegas last night. One of the best shows I have seen in years. See it when it comes near you.

And if you are in Las Vegas, eat at Wolfgang Puck's new place, called Cut. One of the best pieces of steak I have inhaled in years. And now it really is time to hit the send button and go attend the conference.

Your wondering if we can actually get some action analyst,

John Mauldin

Further Thoughts on the Continuing Crisis

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

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

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

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

The Right Direction, At Least

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

All of the above leads me to the following conclusions.

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

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

The Jobs Will Come

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

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

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

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

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

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

Can We Have a Little Inflation, Please?

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

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

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

Those Wild and Crazy Analysts

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

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

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

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

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

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

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

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

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

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

La Jolla, Conversations, and Richard Russell

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

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

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

And the first of the "Conversations with John Mauldin" is up! We recorded it last week, with Ed Easterling and Dr. Lacy Hunt. I thought it went very well for an inaugural talk. The complete audio and transcript are in the Membership Library already. For those who have subscribed, you should have received an email and be able to log in and listen or read the transcript. We are getting very favorable reviews. Multiple readers have let us know that the first Conversation was worth their entire year membership. I am quite pleased with the first transcript and the response to it. My next Conversation is in two weeks, with Nouriel Roubini; and then after the release of banking data in early March, I will do a Conversation with good buddy Chris Whalen and a few real banking experts, on where the US banking system really is. I will offer it as a bonus to those that have already subscribed, as it will be more me asking questions than a real Conversation. I expect it to be very informative.

The regular price for a yearly subscription is $199, but you can subscribe now for $109, and still get access to the timely Conversation with Ed and Lacy. Don't wait, as I am sure my staff will only keep raising the price. To find out more, just click on the link and put in code JM77, which will give you the discounted price. https://www.johnmauldin.com/newsletters2.html

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

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

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

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

Your really optimistic for the long run analyst,

John Mauldin

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