Thoughts From The Frontline : Inflation

Where the Wild Things Are

John Mauldin — Sat, 21 Nov 2009 05:49:00 GMT

Where the Wild Things Are
It Is Not Just Japan
The Euro-Yen Cross and the Dollar Carry Trade
New York, London, and Switzerland

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.

It Is Not Just Japan

Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

Look at the graph of the yield curve below. It is as steep as we have seen it in a long time. But that is almost the point. Banks are essentially getting free money. If you are a banker and can't make money in this environment, you need to quit and find meaningful employment.

And that is part of the rationale that the Fed espouses with its low interest rate regime. Not only does it allow banks to repair their balance sheets, it also encourages investors to put money into riskier assets in order to get some return on their investments. Over $260 billion has gone into bond funds this year, and just $2.6 billion into stock funds. However, you have to balance that with the fact that some $400 billion has left money market funds paying less than 0.2%. So there is some movement to capture yield.

But is it just banks that are getting cheap money? And is encouraging investors to find riskier assets a sound policy? Maybe not.

The Euro-Yen Cross and the Dollar Carry Trade

I wrote a great deal in the past few years about the strong correlation of the euro-yen cross to stock markets all over the world in general. (The euro-yen cross is the exchange rate of the euro and the Japanese yen.) This was a proxy for the Japanese carry trade. The stock markets of the world rose and fell in synchronization with the yen versus the euro.

A currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

The Japanese drove their rates down to essentially zero in the 1990s. By early 2007, it was estimated that the yen carry trade was over $1 trillion. But when the world credit crisis hit, the world wanted dollars. They paid back the yen and bought dollars, driving the yen higher and killing the yen carry trade. Who wants to borrow in a currency that continues to rise, even if the costs are low? And often, large leverage was used, so small movements in the currency could destroy outsized amounts of capital.

But now, there are some who are beginning to ask whether there is a dollar carry trade. In the last nine months, the correlation between the dollar and the stock market has gone to about 90%. If the dollar rises, the stock markets and other risk assets tend to fall, and vice-versa. It would appear that investors and funds are borrowing cheap dollars on a short-term basis and investing in all sorts of risk assets. Not only have stock markets risen, but so have high-yield bonds, commodities, and so on.

We have seen the steepest rise in US stock markets coming out of a recession since the end of the last world war. The market is "discounting" a 5% GDP next year and a profit rebound beyond anything in past experience. Depending on the quarter, operating earnings are expected to rise by anywhere from 30-40%. P/E ratios are back at 23, well above the 17 we saw in the summer of 2007 (I am using 4^th quarter 2009 estimates so as to not have to take into account the disastrous 4^th quarter of last year.)

Worrying about a dollar carry trade is not just a preoccupation of my friends Nouriel Roubini or David Rosenberg or Frank Veneroso. Look as this story from Bloomberg:

"China's Liu Says U.S. Rates Cause Dollar Speculation

"Nov. 15 (Bloomberg) -- The decline of the dollar and decisions in the U.S. not to raise interest rates have caused "huge" speculation in foreign exchange trading and seriously affected global asset prices, said Liu Mingkang, chairman of the China Banking Regulatory Commission."

"The continuous depreciation in the dollar, and the U.S. government's indication, that in order to resume growth and maintain public confidence, it basically won't raise interest rates for the coming 12 to 18 months, has led to massive dollar arbitrage speculation," he told reporters in Beijing today at the International Finance Forum.

"Liu said this has 'seriously affected global asset prices, fuelled speculation in stock and property markets, and created new, real and insurmountable risks to the recovery of the global economy, especially emerging-market economies.'

"His view echoes that of Donald Tsang, the chief executive of Hong Kong, who said the Federal Reserve's policy of keeping interest rates near zero is fueling a wave of speculative capital that may cause the next global crisis."

"'I'm scared and leaders should look out,' Tsang said in Singapore Nov. 13. 'America is doing exactly what Japan did last time,' he said, adding that Japan's zero interest rate policy contributed to the 1997 Asian financial crisis and U.S. mortgage meltdown."

It is not just China. Brazil has moved to impose a tax (or tariff) on investment money coming into the country on a shorter-term basis, as they are worried about both a bubble in their markets and in their currency. Russia is openly considering similar policies.

I have been doing a lot of speaking in the last month. In almost every speech, I warn of the significant imbalance in the dollar. I walk to the very end of the stage to help illustrate that the world now has on a massive ABD trade. By that I mean Anything But Dollars. Everyone is now on the same side of the boat. They have borrowed dollars to buy other risk assets, assuming that the dollar, like the yen in the glory days of the yen carry trade, will continue to fall. Dollar bears are everywhere.

Explanations abound for why the dollar is a trash currency. It is Fed policy, or the Obama administration's willingness to run massive deficits, or the trade deficit or our health-care policy or (pick any number of issues). But I wonder.

Global trade collapsed last year and well into this year. Global trade was essentially done in dollars. If global trade is down 20% or more, then there is less need for companies in various countries to hold dollars and more need for local currency because of the crisis. Thus, after a rush to safety in the credit crisis, there is a rational selling of dollars by business.

Look at the above chart. Notice that the dollar is roughly where it was 20 years ago. And notice the recent jump during the credit crisis. We are not even back to where we were before the crisis.

What happens if world trade picks back up, as it appears to be doing? Admittedly, it is not a robust recovery as yet, but it is rising. That means more need for dollars. And dollars which are being borrowed (and probably leveraged!) on the assumption the dollar will continue to fall.

And I agree that, over time, the case for the dollar is not as good as I would like. But in the meantime, we could have one very vicious dollar rally, which would take equity markets down worldwide, along with other risk assets. Why? Because it would be a major short squeeze.

Barron's just did a survey. It revealed that the bullish sentiment on stocks is quite high and almost everyone hates US treasuries (graph courtesy of David Rosenberg of Gluskin, Sheff)

Whenever sentiment gets too strong in one way or the other, it is usually setting up the markets for a rally in the despised asset. Mr. Market like to do whatever he can to cause the most pain to the largest number of people.

I am not predicting a near-term crash or imminent precipitous bear, although in this environment anything can happen. I am merely noting that there is an imbalance in the system. The longer this imbalance goes on, the more likely it is that it will end in tears. And the irony is that a recovering world economy could be the catalyst.

The Wild Things? They may be hiding in a portfolio near you. Just food for thought. Stay nimble.

New York, London, and Switzerland

I am going to hit the send button on what may be the shortest e-letter I have ever done. The travel is catching up with me and I need some rest.

I am looking forward to Thanksgiving next week. It may be my favorite holiday. Family, friends, food, and football. My usual pattern is to get up very early Thursday and start the prime slow-cooking, and then turn to the side dishes. It will be no different this year. My brother will bring the smoked turkeys, which he has down to an art form. And then there are the over-the-top wines I was so graciously given this past birthday by so many friends. I will bring a few of those bottles out.

The next weekend I am in New York for Festivus with the crowd from Minyanville, and then I am home for over a month before I go to London and Switzerland in late January. Then not much is currently scheduled until April, although it always does seem to change. After the recent hectic schedule (15 cities and even more speeches in just a little over three weeks), I look forward to some home time.

I wish those of you in the US the best of Thanksgivings, and the rest of you a great week. And thanks for all the very kind words of late about Tiffani. She seems to be doing better. She is due in a month, so she is still moving slowly, but you can sense the excitement in her and Ryan. I find it all very pleasant.

Your "there's no place like home" analyst,

John Mauldin

Catching Argentinian Disease

John Mauldin — Sat, 31 Oct 2009 02:47:00 GMT

Catching Argentinian Disease?
The Ascent of Money
The Independence of the Fed Threatened
A Few Quick Thoughts on the Dollar, GDP, and the Recession
Uruguay, Philadelphia, Orlando, and then...

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether "it" - hyperinflation - can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson's recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn't happen more often.

In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp."

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20^th century, Argentina was the seventh richest nation on earth. It's very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors."

Argentina had actually defaulted on its debt in the late 19^th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let's look at some quotes from Ferguson (emphasis mine):

"The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement... To understand Argentina's economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon...

"To put it simply, there was no significant group with an interest in price stability...

"Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy."

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it's not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today's thought process is about what happens if they don't.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don't have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

"It's now official. The proposed legislation to reform America's financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America's central bank.

"The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

"The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

"The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

"In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis."

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

"Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more."

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go -- and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom -- imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally -- not the onset of a new bull market) has not swayed their view (or ours for that matter)."

Uruguay, Philadelphia, Orlando, and then...

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed 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

Elements of Deflation, Part 2

John Mauldin — Fri, 11 Sep 2009 16:59:00 GMT

Elements of Deflation, Part 2
The Velocity Factor
Y=MV
Sir, I Have Not Yet Begun to Print
There Are No Good Choices
Washington DC, San Diego, and New Orleans, etc.

Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

It is not a matter of pain or no pain; it is a matter of choosing which pain we will face and for how long, and perhaps in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We are now in a scenario where there are no good choices, just less-bad ones.

In a normal world, the amount of monetary and fiscal stimulus we are witnessing would produce inflation in very short order. That is what has the gold bugs of the world excited. It is their moment. They keep repeating that Milton Friedman taught us that inflation was always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. Let's review something I wrote last year about the velocity of money, and this time we are going to go into the concept a little more deeply. This is critical to your understanding of what is facing us.

The Velocity Factor

When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And what about my business? Travel costs are way, way up; and as aggressive as we are on the budget, expenses always seem to rise. Compliance, legal, and accounting costs are through the roof. I wonder how those costs are accounted for in the Consumer Price Index? About the only way to deal with it, as my old partner from the 1970s Don Moore used to say, is to make up the rise in costs with "excess profits," whatever those are.

Is the Money Supply Growing or Not?

But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money, and how it affects the growth of the economy. Let's start with a few charts showing the recent high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast, or just about right, depending upon which monetary measure you use.

First, let's look at the adjusted monetary base, or plain old cash plus bank reserves (remember that fact) held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. Until very recently, there was very little year-over-year growth. The monetary base grew along a rather predictable long-term trend line, with some variance from time to time, but always coming back to the mean.

But in the last few months the monetary base has grown by a staggering amount. And when you see the "J-curve" in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don't see that is important.

Now, let's introduce the concept of the velocity of money. Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M.

Now let's dig a little deeper. Y, or nominal GDP, can actually written as Y=PQ, that is, GDP is the Price paid times the total Quantity of goods sold. Therefore, since Y=MV, the equation can be written as MV=PQ. But the point is that Price (P) is tied to the velocity (V) of money. You can increase the supply of money, and if velocity drops you can still see a drop in the "P," or inflation.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few paragraphs, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If the central bank increased the money supply too much, you would have too much money chasing too few goods, and inflation would rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

No, because only 20% more goods is produced from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services, which only grew by 20%. They would start to bid up the price of the goods they want, and inflation would set in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon down to the local dry cleaners, and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month, and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, plus some more for new population, and you have to factor in productivity. If you don't then deflation will appear. But if the money supply grows too much, then you've got inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts, the first from Stifel Nicolaus Capital Markets.

Here we see the velocity of money for the last 109 years. The left side of the chart shows the velocity of money using both M2 and M3 (measures of the money supply.)

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Lacy Hunt, in a conversation that helped me immensely in writing this letter, explained that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let's look at the first chart.

Y=MV

And then let's go back to our equation, Y=MV. If velocity slows by 30% (which it well has in terms of M3 – and it is down more than 15% in terms of M2) then money supply (M) would have to rise by that percentage just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which mean M (money supply) would need to grow about 5% a year, even if V were constant. And that is not particularly stimulative, given that we are in recession. And notice in the chart below that M2 has not been growing that much lately, after shooting up in late 2008 as the Fed flooded the market with liquidity.

Bottom line? Expect money-supply growth well north of what the economy could normally tolerate for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

But this is important. The Fed is going to continue to print money as long as they are not confident deflation is no longer a problem. They can't tell us what that number is because they don't know. My guess is if they did tell us the markets would simply throw up, especially the bond market, which would of course make the situation from a deflation-fighting point of view even worse.

Sir, I Have Not Yet Begun to Print

Remember the story of John Paul Jones? An American naval officer during the American Revolution (the French gave him a medal, although the British referred to him as a pirate), he engaged a larger British ship off the coast Yorkshire. He literally tied his boat to the larger ship and they shot cannons and guns at point blank range. Legend has it that he was asked to surrender, as his ship was sinking. He is supposed to have replied, "Sir, I have not yet begun to fight!"

When faced with the possibility of deflation, I can almost hear Bernanke saying, "Sir, I have not yet begun to print!"

When will they know when enough is enough? When the velocity of money stops falling. When we see two quarters in a row where the velocity of money is rising, then it is time to start investing in inflation hedges.

Now, why is the velocity of money slowing down? Notice the significant real rise in velocity from 1990 through about 1997. Growth in M2 was falling during most of that period, yet the economy was growing. That means that velocity had to have been rising faster than normal. Why? It is financial innovation that spurs above-trend growth in velocity. Primarily because of the financial innovations introduced in the early '90s, like securitizations, CDOs, etc., we saw a significant rise in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. The absence of new innovation and the removal of old innovations (even if they were bad innovations, they did help speed things up) are slowing things down. If the money supply had not risen significantly to offset that slowdown in velocity, the economy would already be in a much deeper recession.

The Fed has more room to print money than most of us realize. How much more? My bet is that we'll find out. Will they print too much at some point? Probably.

There Are No Good Choices

What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find that a boring and almost pointless argument.

The people in control don't buy Austrian economics. It makes for nice polemics but is never going to be policy. My friend Ron Paul is not going to be allowed to make monetary policy, although he might get a bill through that actually audits the Fed. I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly.

A mentor of mine once told me that the market would do whatever it could to cause the most pain to the most people. One way to do that would be to allow deflation to develop over the next few quarters, thereby probably really hurting gold and other investments, before inflation and then stagflation become (hopefully) the end of our perilous journey. Which of course would be good for gold. If you can hold on in the meantime.

Is it possible that we can find some Goldilocks end to this crisis? That the Fed can find the right mix, and Congress wakes up and puts some fiscal adults in control? All things are possible, but that is not the way I would bet.

While there are some who are very sure of our near future, I for one am not. There are just too damn many variables. Let me give you one scenario that worries me. Congress shows no discipline and lets the budget run through a few more trillion in the next two years. The Fed has been successful in reflating the economy. The bond markets get very nervous, and longer-term rates start to rise. What little recovery we are seeing (this is after the double-dip recession I think we face) is threatened by higher rates in a period of high unemployment.

Does the Fed monetize the debt and bring on real inflation and further destruction of the dollar? Or allow interest rates to rise and once again push us into recession? (A triple dip?) There will be no good choice. The Fed is faced with a dual mandate, unlike other central banks. They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other. There are no good choices. I can construct a number of scenarios. All end with the same line: there are no good choices.

Washington DC, San Diego, and New Orleans, etc.

It is time to hit the send button. I have struggled through this letter with a very upset stomach. I rarely eat pizza, but my son and his friends ordered and I ate half of a very good pizza with everything, which I very rarely do. It really kicked my gut. Maybe that is why I am a little more bearish than normal tonight.

I fly to Washington, DC on Sunday and will have dinner with good friend Neil Howe (of Fourth Turning fame). I am really looking forward to that. Neil is a very interesting dinner partner. I do some consulting on Monday and then catch a long night flight to San Diego. I will be at the Schwab conference on Tuesday, September 15. If you are going to be there, look me up. I will be at the Altegris booth at the first break and then the Gemini booth with my partners from CMG, where we will be talking about the new mutual fund. (You can learn more about it by reading a report I have prepared, entitled "How to Deal with Volatility in Extraordinary Markets - Introducing the CMG Absolute Return Strategies Fund." Simply click here.) And there will be books there!

That is my only trip in September. But then it gets interesting. I celebrate my 60th birthday the first weekend of October, then fly to New Orleans to be at the annual New Orleans Conference, October 8-11. The speaker line-up is better than ever. I find this to be one of the best conferences I go to very year. I have been attending on and off for over 25 years. You should think about this one. http://www.neworleansconference.com/speaker-eblast-JohnMauldin/

Then I will spend the next weekend in Detroit, then probably go to New York, then Philadelphia for a CMG conference October 20, then down to Houston, over to Orlando, stop to change clothes and pack at home, and then fly off on a whirlwind trip to Argentina, Brazil, and Uruguay, speaking at a series of CFA conferences. Denver and Orlando in mid-November, and nothing else so far. Switzerland and London in January.

Trey came home tonight a little discouraged, with four of his friends. He had been at his first school dance (8th grade). "Dad, I got a Bohac." This is bad. Mr. Bohac is a very reasonable, pleasant enough fellow. However, he is also the vice-principal, and as such is the nemesis of 8th-grade boys. When you get called down for whatever reason, you get what they call a Bohac, which means you have to go to his office. I grimaced. What had he done? A fight? Girls? My mind went through a dozen bad scenarios in about 3 seconds. My stomach, already roiled, immediately got worse.

As it turns out, he simply wore the wrong kind of shorts to the dance. Seems he didn't know the dress code for the dance here in Highland Park. He evidently was not the only one. When he changed and all the kids left the house, I must confess I did not see any difference. Oh well. With any luck, this will be his only Bohac this year. And Dad can live with that.

I'll leave you with this thought I gleaned from a newsletter from Australia called The Privateer (www.the-privateer.com).

"In 1909, the US federal government had an annual budget of $US 0.8 Billion. With this it governed a population of just over 90 million people. The cost of government was about $9 per capita. In 2009, the US federal government has an annual budget of $US 3,550 Billion. With this it governs a population of just over 300 million people. That's a cost of about $11,675 per capita."

Are we 1200 times better off?

Have a great week. With all my flying, I might make it through a few books on my desk this week. I will let you know if anything should be on your radar screen.

Your trying to Muddle Through analyst,

John Mauldin

The Great Reflation Experiment

John Mauldin — Fri, 31 Jul 2009 15:04:00 GMT

The Great Reflation Experiment
The Debt Super Cycle
Some Background on US Inflation
Implications for Investors
A Beach, New York, and Maine

The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.

One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention. Central bankers do. You can read his extensive bio at www.boeckhinvestmentletter.com and I will tell you how to get his letter free of charge at the end of this letter. And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let's just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies. Inflation doesn't stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash was a "black swan" event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion of money and credit that substantially exceeds the growth requirements of the economy. As a consequence of excessive monetary expansion, prices rise. Which prices go up and at what rate depends on a number of factors. Sometimes it is the prices of goods and services that are the most visible symptom of inflationary pressures. That was the case in the 1970s when the Consumer Price Index (CPI) hit a peak rate of 14% per annum. Sometimes it is the prices of assets such as homes, office buildings, stocks, or bonds that reflect the inflationary pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw this in the financial sector in the period leading up to the crash. The supporting conditions or "displacements," to use the terminology of Professor Kindleberger, were financial innovation, deregulation, and obscene profits and salaries. These drew millions of bees to the honey. All great manias are accompanied by malfeasance, in this case the biggest Ponzi scheme in history and many other lesser ones. It is relatively easy to steal when prices are rising and greed is pervasive. Overspending and a general lack of prudence always become widespread when a mania infects the general public. Rational people can do incredibly stupid things collectively when there is mass hysteria.

The origins of post-war inflation go back to the late 1950s and early 1960s, though some would take it back much further. In the 1960s, the US dollar started to come under pressure as a result of US inflationary policy and foreign central banks' ebbing confidence in their large and growing dollar reserve holdings. The US responded with controls and government intervention in a number of areas: gold convertibility, the US Treasury bond market, the Interest Equalization Tax, and, ultimately, intervention on wages and prices. These moves clearly flagged to the world that external discipline would be subjugated to domestic employment and growth concerns. The policy was formalized when the US terminated the link between gold and the dollar in August 1971, essentially floating the dollar and setting the US on a course of sustained inflation. Of course, the dollar floated down, which, among other things, triggered the massive rise in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered by the success of Paul Volcker's move to break the spiral of rising general price inflation through very tight money. He succeeded famously, and the CPI headed sharply lower along with interest rates, setting the stage for the massive US debt binge and the series of asset bubbles that followed. It was easy for the Federal Reserve to pursue expansionary credit policies while inflation and interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative to GDP from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash, and is continuing to rise. The current reading has debt close to 180% of GDP, about double the level of the early 1980s. The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years.

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage - from banks to consumers to supposedly blue-chip companies - and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus - the end of which we won't see for a long time - aborted the meltdown. However, the story is far from over.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve's balance sheet. Both are unprecedented since World War II. US federal government debt is likely to reach close to 100% of GDP over the next 8 to10 years, according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed's balance sheet and consequent rise in bank reserves - the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20%, to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living that could not be attained from regular income alone (Chart 4). They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people's appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties. Reasonable-quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate "bullet-proof" stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years, and China will also be important in keeping inflation down. Its capital investment is larger than the US's in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor, means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high-quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over, say, a five-year time frame, and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five-year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the US dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The US role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil, and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don't want more dollars, and yet they don't want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s the US has never subjugated domestic concerns to external discipline. Officials may talk of a strong-dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, "We didn't ask you to buy the dollars." The US has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, "a balance of financial terror." The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is a fragile, unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk. There are three obvious ways.

The first is investing in high-quality US equities that have a majority of their earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over U. monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering US economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in early 2000. The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags. The exceptional circumstances of the current environment make any assessment of time lags extraordinarily difficult, and mistakes will continue to be costly. For that reason, holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence. Warren Buffet has properly reminded us on numerous occasions that a price has to be paid for waiting for such a time, but then most of us aren't as rich as he is.

A Beach, New York, and Maine

I want to thank Tony and Rob for writing this week's letter. You can go to their website, www.boeckhinvestmentletter.com and see some of their recent letters, or send an email to info@bccl.ca and get put on their regular list for the free letter.

As you are reading this, I am hopefully reading on a beach, relaxing under an umbrella. Tiffani and Ryan are on a cruise in the Caribbean. They just got back the wedding videos from last year, and they are a hoot. They had one cameraman with an old Super 8 camera, so that video looks like something from the 60s. At some point they will put it on You Tube. Interesting to contrast the old format with the new.

I get back late Monday, and then leave early Wednesday for a quick trip to New York and then on to the Shadow Fed fishing weekend organized by David Kotok. My youngest son, now 15, will be with me for our fourth trip. Maybe this year I can catch more than he does. So far, it has not even been close in either quantity or quality.

Each year, we make small bets (bragging rights are more on the line) on where the markets will be the next year. So far, I am money ahead, as I get a few calls right. Last year the financial markets were just starting to melt down as we met. It will be interesting to see if any of us came close this year. There are some fairly well-known names in the room, so it will be interesting to see who got it right. And even more interesting to try and figure out where we will be next year at this time. I will report back.

And that blank spot that was my fall travel calendar? Looks like I will be going to South America in the fall (Argentina, Brazil, and Uruguay). A few other dates look to be firming up. It has been way too long since I was in South America, and I am looking forward to it.

Have a great week.

Your going to mix in some sci-fi with the economics reading 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

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

I Meant to Do That

John Mauldin — Sat, 20 Dec 2008 02:28:02 GMT

I Meant to Do That
The Lights of Myanmar
Some Good News for Borrowers
Madoff May Give Us a Sell-Off
Conversations with John Mauldin
New Orleans, La Jolla, and Merry Christmas

The Fed has taken interest rates to zero. They have clearly started a program of quantitative easing. What exactly does that mean? Are we all now Japanese? Is the Fed pushing on a string, as Japan has done for almost two decades? The quick answer is no, but the quick answer doesn't tell us much. We may not be in for a two-decades-long Japanese malaise, but we will experience a whole new set of circumstances. In what will hopefully be a shorter holiday version of the e-letter, I will tackle these questions and more.

The Lights of Myanmar

Most of us are familiar with the devastating hurricane that hit Myanmar (Burma) this last year, and the difficulty in getting aid to those who were suffering. My friends and colleagues at Knightsbridge were able to get in and help where others couldn't.

Knightsbridge International is a small group of volunteers who go to places that are definitely not safe but where the need for help is critical. Like the knights of old, who ran hospitals and relief efforts, these modern-day knights go to where the need is greatest. They took food and medicine to northern Afghanistan before the troops went in (very dangerous!). They went to rebel-held territory in Sri Lanka after the tsunami, when no one else could get medicine and other aid in. Whether it's driving in to rescue nuns in Rwanda (fascinating story!) or taking solar power to clinics in Myanmar, or water purification units and medicine to Darfur, they go where other groups fear to tread. They have no political or religious agendas, just the drive to get aid to where it can do the most good.

Last year an award-wining documentary was made about three of the Knightsbridge men, Ed Artis, Dr. Jim Laws, and Walt Ratterman. It was shown on PBS and viewed all over the world. These men are the real deal, heroes who like to do good deeds but get an adrenaline rush at the same time. Some of the things they do I cannot write about, as it would put them and others in serious danger. They are a little bit crazy, but then you'd have to be to accomplish everything they do.

Last year you generously supported missions to both Darfur and Myanmar, where a team led by Walt Ratterman (a leading expert on solar power) put into place solar power systems that help power clinics. Walt once showed me a photo of a doctor in Myanmar who had to do an amputation on a child (as a result of a land mine) in the dark, holding a flashlight in his teeth. You can bet that doctor was very happy about getting solar power.

For the past few years your generosity has helped provide solar power for health clinics for refugees in Thailand, as well as in villages in Myanmar. Walt wrote me about the project he recently finished:

"The project we just completed provided solar power for a medical and training facility in the Karen State that is operated by the Free Burma Rangers (www.freeburmarangers.org) The project started with a 4-day journey on foot to get into the area. Equipment for the solar systems had to be carried in by over 100 people prior to our arrival. After we all got in place, and completed the training for the solar installers, we installed twelve 2-panel solar systems. These systems provided electricity for the central communications center, the medical training center, the human rights training center, and other miscellaneous buildings. Once the work was done, we had to take the same 4-day hike back out of the area."

This is not an easy hike. It is through very dense, mountainous jungles, over rivers, and through deep valleys. The Free Burma Rangers have trained over 110 multi-ethnic relief teams, and there are 43 full-time teams active in the Karen, Karenni, Shan, Arakan, and Lahu areas of Burma. Seven more teams have been formed recently in the Chin area on the Indian Border. The teams have conducted over 350 humanitarian missions of one to two months into the war zones of Burma. On average, between 1,000 and 2,000 patients are treated per mission. You can see more about this last project at www.sunepi.org/SunEPI/Burma_files/PP_FBR.pdf

Partially due to your generosity, there are literally thousands of people (many of them young children) who are alive today. This year Walt wants to complete another clinic on the Thai border and then one on the India border with Myanmar. It will take approximately $75,000 to do both.

We are grateful for any donations to this year's project. Donations can be made at the website, www.sunepi.org or by directly going to our Funding Burma page, www.sunepi.org/SunEPI/Funding_Burma.html. Checks can be made out to SunEnergy Power International and sent to 11 Laurel Lane South, Washougal, WA 98671.

As I said, these guys are the real deal. They are helping people who the world has mostly forgotten yet who work hard day in and day out to keep their families alive. I know we are in a recession, but when you compare what is happening here to the devastation in Myanmar, our plight does not seem so bad. Please give generously.

By the way, Walt is in Palestine right now, installing more solar power for clinics. I can't mention where some of the other teams are, but a little extra prayer wouldn't hurt. (Did I mention that none of these guys take any money, and pay their own way? And if you too are a little crazy and are in decent shape and you want to join in some of the projects, drop them a line.)

I Meant to Do That

In my house, when someone stumbles or does something odd, they quickly say, "I meant to do that." It's a running joke, and we all have fun with it. This week the Fed did something rather interesting. Quoting from the release after their two-day meeting:

"The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent."

Normally they have a specific rate and not a range. But for the last few weeks the market has pushed the Fed's fund rate close to zero, making the Fed look like they were behind the curve at the then-official rate of 1%.

Now the Fed, with a range rather than a specific rate, will be able to say, "I meant to do that." They can keep the Fed funds rate from rising over 0.25%. And if it stays near zero? Well, now they can say it is within the target.

And with Fed funds at an effective zero, it is having the effect of bringing down other rates as well. I wrote in 1998, and have repeatedly made the point over the past five years, that deflation will be the primary force that must be dealt with, rather than inflation, before we are done with the current credit cycle. Over the last year, when CPI (Consumer Price Index) inflation was high and rising, I kept insisting that the problem would be deflation in 2009. (That brought more than a few letters telling me I was wrong.) Because of my view about deflation, I have long held that, ultimately, interest rates on the US 30-year bond would fall below 3%. That was rather bold in 1998, or even last year.

Now, that prediction seems rather tame. We went right through 3% this week, and as I write we are at an astounding 2.54% on the 30-year and 2.1% on the 10-year!

Note that the 3-month is at zero. Indeed, to get even 1% you have to go all the way out to a 3-year maturity. This is going to make it very hard on money market funds to offer any type of yield. Indeed, several large firms have closed their Treasury money market funds, as it costs more to operate the fund than the interest paid on the bills, notes, and bonds.

And this is precisely what the Fed wants to see. Investors are going to have to start looking to other avenues to get yield. If you can't get a return on your money market, why not put it in a bank certificate of deposit? You can get a federally insured CD for one year at over 3% at many institutions, and 4% if you want to tie your money up for three years. Making the competition - money market funds – less profitable is one way to recapitalize banks.

The Federal Reserve, as noted last week, has significantly increased the monetary base, but the money supply has not risen in concert. I failed to explain why last week. It is because banks have not taken those reserves and lent them out. Until that happens, the Fed is not really "printing money," they are just making it available. At some point, let's hope the banks decide to use it.

This week's FOMC statement was rather remarkable, in that it was very clear. Normally, and especially under Greenspan, you had to take each sentence apart to try and divine the meaning of the release and what that meant for the future. And the statements are typically short. Not this one. Let's look at three paragraphs from it (emphasis mine).

"Since the Committee's last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.

"Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.

"The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time."

The Fed expects inflation to fall well into next year. They have noted their concern. They have also said they will hold the Fed funds rate at these low levels for a long period of time. This is to encourage longer-term lending at low rates.

How serious are they? Richard Fisher is the President of the Federal Reserve Bank in Dallas (just down the road from my new office). Over the past few years, he has been the most outspoken "hawk" on inflation of all the Fed governors and presidents. He spoke yesterday at the Dallas chapter of the World Affairs Council. Let me quote a paragraph:

"Price pressures now are in the other direction...[and] we have to do everything we can to lift the economy up and prevent deflation from taking [hold].... We are well aware that at some point, God willing, we'll have to tighten and we'll have to act; and I'm here to tell you that my voice will be very loud at that juncture, but right now that's not the issue."

That is a rather remarkable statement for Fisher. I don't ever recall him talking about preventing deflation. The FOMC meeting this week (where he is currently a voting member) must have been a real eye-opener for him.

The Fed has already committed to buying mortgages and consumer loan securities. In Ben Bernanke's famous "helicopter speech" in November of 2002, he stated that one of the ways the Fed could fight deflation would be to "move out the yield curve" and set target rates for longer-dated securities, like 2- or 3-year US notes. In the FOMC release, the Fed noted that they might indeed use that tool. That is one of the reasons interest rates are falling, as the market must sense that the Fed is prepared to do just that. This meeting simply put the market "on notice" that at some future meeting it is quite possible for them to set a target rate on longer-dated securities.

Some Good News for Borrowers

Remember that ARMs (Adjustable Rate Mortgage) reset problem I was writing about late last year? This includes all the alphabet of ARM mortgages, interest-rate-only mortgages, pay-option ARMs, etc. Resetting the rates has been a problem up until now, as the rates which are the usual base for the resetting have been high, forcing mortgagees to pay a much higher monthly mortgage when the rates reset. However, given the current environment, that may no longer be a problem in the near future.

The large majority of ARMs are linked to either 1-year LIBOR or 1-year Treasuries. We saw above that 1-year Treasuries are 0.39%, and 1-year LIBOR is 2.09. Both were at 4.5% in 2006. Those getting ready to reset in the near future are actually going to catch a break and see their payments go lower!

Fellow analyst Mish Shedlock writes that he has an interest-only mortgage tied to 1-month LIBOR, and his annual rate is going to drop to 1.75%.

You can bet that between the Fed and the incoming administration they are going to pull out all the stops to get 30-year fixed-rate mortgages to drop along with the 10-year US bond, with which mortgages normally move in tandem. The spread is now as wide as I can remember, at well over 3%. Not all that long ago it was 1%. It is quite possible that we will see mortgage rates below 5% and approaching 4% in the next year, at least for conforming mortgages. Since I have two kids that have bought homes this year, I hope they will be able to get refinancing at lower rates with whatever new program the administration introduces.

Madoff May Give Us a Sell-Off

Much of the selling pressure that has come in the stock and credit markets has been rightly attributed to forced selling by hedge funds in an effort to meet redemptions for January 1. I wrote a few weeks ago that this could be the kicker for a powerful rally in the first quarter. Most of those redemptions will show up in the last two weeks of January, with the rest by the middle of February. Institutions, which are the bulk of redemptions, are going to have to put that money to work. Do you put it into bonds at 2%? That is not going to get you to the target returns that you need for the future if you are a pension or insurance company.

Much of that money is going to go back into either the stock market or into other hedge funds. This could be the fuel for a real rally. However, that was before Madoff. I have no hard evidence, but I know a lot of funds of funds had exposure to Madoff. Those funds are likely to see further redemption requests and face the need to further liquidate underlying hedge fund positions. Also, a lot of people who did have investments with Madoff are now going to need to get their liquidity somewhere else.

This all has the potential to put more selling pressure into the market. Enough to overcome the tsunami of money that is coming back into the market? I don't know, but I think it could put a damper on the rally I was predicting. The actual redemptions for most funds of funds will be next April 1, as only a few offer monthly liquidity, but the selling will have to be in the months before. This will need to be closely watched in March.

Conversations with John Mauldin

Yesterday, some of you got a special email from me talking about a new subscription service that we will be offering beginning next month, 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). Each month, I will call up one of my special contacts in the investment and economic world and hold a conversation with them about the important topics of the day - how we should be investing, what opportunities and pitfalls are out there in the world, etc. Some will be names you recognize, and others you should. You will get to listen in, download to your computer, or read a transcript, whichever you prefer.

Right now, we are offering a subscription for $99, half off the regular $199 price. This is only available for the Holiday season. You can click here and subscribe, if you haven't already. Insert code JM44 for this special offer.

And for those of you who experienced errors signing up, please email eu@2000wave.com and we will let you know whether your subscription and credit card went through.

If you like my regular e-letter (and it will still come to you each week), then you are really going to like this new service. This letter will not change at all. This new service is to let you look over my shoulder as I talk things over with colleagues who are in the know. I hope you join in and get to hear the January conversation, where we will discuss the forecast for 2009. You won't want to miss it.

New Orleans, La Jolla, and Merry Christmas

It is time to hit the send button, as I am off to New Orleans, where I'll spend the next four days with Tiffani, working on our new book, Eavesdropping on Millionaires. I really am looking forward to getting out of the office and focusing on the project. It's a lot of fun to interview millionaires and get their stories. There are just so many ways to achieve wealth, and so many interesting paths and personal insights that we have come across.

Tiffani and I will be in La Jolla in mid-January to have our annual planning meeting with my partners at Altegris Investments. I always look forward to meeting with Jon Sundt and his team, and feel they do an excellent job for our mutual clients. After that, I have a few trips planned in the US, but no trips lined up yet outside the country. That means I will have to get my travel "kicks" by reading International Living. It is an inexpensive way to learn about traveling and living outside your home country. For me, it is cheap fantasy about that beach home in Paradise. You can get your own subscription at http://web-purchases.com/ILV2008/WILVJC04/

The move into the new offices has been rather hectic, to say the least. Getting used to a new phone system, trying to unpack boxes, traveling to Phoenix (where it was rainy and cold), getting Trey ready for a new school, and more than the usual number of distractions has all made life more interesting. But then I have so many blessings that complaining about the small hassles seems out of line this season.

I am not sure if I will write another letter between now and January 9, when I will do my annual forecast issue. Let me take the time to wish you, gentle reader, a heartfelt Merry Christmas and the best ever New Year. While the economy may be a tad bumpy, the important things like family, friends, and health are where our real wealth is. Enjoy this season and all that it means.

Your still having to pack analyst,

John Mauldin

The Rise of A New Asset Class

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

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

The Rise of A New Asset Class

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Maine, Maryland, and Weddings

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

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

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

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

Your ready for some fishing analyst,

John Mauldin

The Slow Motion Recession Re-visited

John Mauldin — Sat, 28 Jun 2008 04:45:55 GMT

The Slow Motion Recession Revisited
Inflation, Deflation and Stagflation
An Update on Myanmar
New York

"We appear to be entering a period of serious stagflation with sharply rising expected and actual inflation combined with large downside risks to growth and employment."

"I would argue that what we are seeing is an acceleration of expected consumer price inflation in the context of a sharp expansion in global liquidity. It is hardly surprising that the prices of those commodities, such as oil, for which the short-run price elasticities of supply and demand are low move upwards strongly when there is a rise in expected general inflation. The oil market is a very convenient vehicle to speculate on expectations of higher levels of general price inflation. Hence my view is that the 40% jump in oil prices that has occurred over the past few months - roughly the period during which financial conditions have been loosened sharply - is a reflection of the expectation of either an acceleration of global inflation, or a depreciation of the US dollar, or some combination of the two."

- Malcolm D Knight, General Manager, Bank for International Settlements

It was only five years ago that the central bankers of the world, and especially the Fed, was worried about deflation. Ben Bernanke was introduced to the world at large with his famous helicopter speech about how the Fed could deal with a deflationary environment. Who would have thought that what passed as humor to a group of economists would be taken so seriously by the rest of the world?

Today the worry on the mind of investors and central bankers is inflation. It is causing havoc with the markets. In this week's letter, we look at whether we should be worried about inflation, take a mid-year check on the economy, muse on the malaise in the stock market and offer a very contrarian possibility for a positive shock to the world. It should make for a thought-provoking letter.

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

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

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

Inflation, Deflation and Stagflation

The quote at the beginning of this letter is from the managing director of the Bank of International Settlements, or the central banker to the central bankers of the world. (Thanks to Simon Hunt for the quote.)

Stagflation is a strong word to use, but Knight is surveying a world that is increasingly looking like it is in trouble. A Morgan Stanley study suggests that 50 countries around the globe have inflation running at 10% or more, and that this represents over 3 billion people.

Almost all of those countries have negative real interest rates, or interest rates that are below inflation (as here in the US). Central bankers around the world are slowly raising rates and tapping on the brakes, but they are going to be under increasing pressure to do so. Thus, Knight suggests that global growth is due to slow down even as inflation is rising.

A quick sidebar. I am often asked what I think about the inflation numbers produced by John Williams of Shadow Government Statistics. His number, using the methodology to figure inflation that existed in the late 70s and early 80s suggest that inflation in the US is over 11%. That certainly corresponds to what many of us feel like as we see food and energy prices rise. If you are bearish, a high inflation number makes your case easier.

But let me make a few of you mad. I think what Williams' number actually do is show that the government did not know how to calculate inflation back then. If inflation were actually 11.8%, then that would mean that GDP was a negative 6% today, and that the US would have been in a recession for several years. That is obviously not the case. You can simply look at corporate profits and tax receipts to see the economy has been growing the past five years.

The recovery after 2003 was in fact robust, and corporate earnings were solid, and tax collections went through the roof after the Bush tax cuts. That is not something that would happen in a high inflation environment.

That being said, let me make two observations. Inflation for much of America is much more than the headline CPI of 4%. If you make $40-60,000 for a family of four, the cost of food, gas, medicine, insurance, etc. is causing the inflation you personally experience to be much more than 5%. The CPI reflects the inflation of all items, but your personal inflation rate depends on what you actually buy. And it seems like a lot of the necessities are running well north of 4% inflation.

Secondly, there are some of the statistical methods used to measure inflation which I think are quite suspect, like hedonic measurements. Just because the computer I buy today is twice as powerful as the one I bought three years ago does not mean that the price of a computer dropped in half. I seem to still spend about the same amount on my new computers or cars. It is still the same percentage of my budget.

If we used the same methodology as Europe (for instance), US inflation would be somewhat higher. And that is a number I would find useful for comparison's sake. But let's get back to main thought.

Louis Gave recently wrote a very interesting essay on inflation. He makes the point I have made often, that the Fed is not really increasing the money supply. If you look at the growth in adjusted monetary base, which is the only measure that the Fed actually can control, it has not been all that much over the past four years. But M2 and other measures of money supply have skyrocketed. What gives?

Two things. One is the extraordinary growth in credit offered by banks around the world. We saw a true inflation in financial assets of all types.

Secondly, and this is less intuitive, the US consumer has been a large supplier of money to the world by running a massive trade deficit. We have seen trillions of dollars flow into the world markets which has to find a home. Those dollars have been part of the growth in the supply of dollars around the world.

Now, let me offer a hypothetical series of events which could alter the current environment and maybe even bring back the specter of deflation.

The US trade deficit is roughly where it has been for four years, running in the neighborhood of 6% of GDP. Only a few years ago, less than 30% of that was for oil. Now, that has changed. Roughly 60% of our trade deficit is spent on oil, much of it sadly going to countries that are not necessarily our friends.

The US consumer has cut his spending on non-oil items by almost 40% in terms of GDP over the past few years, and the trend is clearly down every quarter.

Financial assets are clearly deflating. Banks are cutting leverage as aggressively as they once expanded their balance sheets. Even though the data shows that bank assets (lending) are increasing, it is because they are being forced to take assets that have been off the balance sheet and put them on the balance sheet. That trend in the data is going to reverse, and with a vengeance.

We are also watching home values decline, not just here but in the United Kingdom and soon to be so in a lot of Europe, which will put European banks under even more pressure. That is serious wealth deflation.

I have been pounding the table for over a year that financial stocks are going to continue to show losses for at least through the end of this year. Dividends will be cut. More shares will be sold and further dilution will be a fact for many banks both in the US and in Europe. Trying to pick the bottom in the financial stocks is like catching a falling anvil.

And their distress is going to translate into distress for businesses and individuals who need to borrow money. All of this is deflationary. It is a strange world indeed in which we are in the middle of two bubbles bursting and for inflation to be the headline topic of every financial medium.

The source of the inflation is clear. One is rising food costs. World demand for grain is growing at 1.2% a year, yet yield increases are growing at 1.1% a year. The developed world, both the US and Europe, uses a lot of food for bio-fuels. The major areas where we could increase production are areas like Africa where the infrastructure and production methods are poor.

Everyone now believes that food costs are going to go up, energy will continue to rise and the dollar will continue to fall. And maybe all these trends continue. But let me offer a very contrarian thought or two.

Farmers around the world are going to respond to high food prices and by this time next year we could see a rise in supply that more meets the rise in demand. Prices might begin to actually fall.

Energy prices have risen so much that demand destruction is beginning to happen. US drivers are using less gas, and as Asia takes away its subsidies demand will fall as well. You could see oil prices drop over the next year.

And if oil prices drop, that means the US is shipping less of our dollars offshore, which slows the growth of available dollars, raises the price of the dollar which further lowers the cost of commodities.

In a world of decreased leverage, debt and housing deflation, coupled with lower food and energy costs and a higher dollar, it is possible that inflation drops below 2% by this time next year. Maybe more.

Far-fetched? Maybe. But it is a possibility that few are considering. In the inflationary commodity boom of the 70's, there was a 30% correction, which most don't remember. Everyone was convinced that commodity prices could only go one way. And we do not have the wage pressures and inflation that we did in the 70s.

The cure for high prices is high prices. High prices stimulate production and reduce demand. I see no reason that this could not happen again. Over time, I am along term commodity bull. I think oil could indeed go to $200 or more in the next decade, and as a developing world increases its need for commodities of all types, I see growing demand and prices. But that is then long term.

Stagflation on a world wide basis is going to have an effect on demand in the short term. I would be cautious about long only commodity funds. While I do not expect anything to change abruptly, I would be more vigilant and recognize that trends which look so good now can change. I am not suggesting that you get out, just pay attention to supply and demand figures coming out of the developing world.

Five years ago everyone was worried about deflation. A lot can happen in a short time. Ben Bernanke may be dusting off his helicopter speech in a few years, as deflation once again becomes the concern.

The Slow Motion Recession

Last October 5, I wrote a letter called The Slow Motion Recession. The basic premise then and in this space since then has been that we are either in recession or a lengthy period of very slow growth and that this slow growth will continue for some time. The cause of the lackluster growth is the bursting of the two bubbles of the housing market and the credit crisis. These are not problems that can respond quickly to the Fed cutting interest rates, but will need several years to correct. These deflating bubbles will put pressure on consumer spending and thus on corporate profits.

At the end of the day, it is earnings which drive the price of stocks. And if earnings are under pressure, we are going to see the stock market to continue to be under pressure. In a Slow Motion Recession, with growth depressed in the latter half of this year, it is going to be hard for the stock market to gain any real traction. As I have been writing for some time, in a recession the US stock market typically falls 30% or more. We are now down almost 20%. It would not be surprising to see the markets fall another 10%, at least from the perspective of history.

And inflation is not helping. Inflation is often more damaging to stock prices than a slow economy. Inflation, especially in a slow growth economy, eats into profits and can be hard to pass on to customers who are under spending pressure. And while inflation may slowly go away over the next year, it could be a factor for the remainder of the year.

While we should see some rallies in July and August, I think the trend is going to be lower, as the earnings projections are going to come down, and guidance is likely to be soft for many companies.

A Slow Motion Recession, a Muddle Through Economy, and inflationary pressures are not a prescription for a robust bull market. Further giving cause for concern, the recent rise in consumer spending is largely attributable to the stimulus checks being spent. This will be largely over by the middle of the next quarter. As gas and food prices eat into more and more of the average US consumer's ability to spend money on other discretionary items, there will be pressure on almost any company that has exposure to the US consumer.

An Update on Myanmar

My good friend Ed Artis and a team of workers are currently in Myanmar helping the victims of the recent hurricane. His stories are heart- wrenching. My readers have been very generous in helping provide relief. They are one of the few teams that have been able to get in and direct help to exactly where it is needed.

They are working to help re-establish an orphanage, help farmers, supply needed food and medicine to families. The need is overwhelming. He is going to stay a while longer and asked me to ask you, gentle reader, if you could send a donation to help purchase more supplies. The need for food for families is large.

One of the real needs is for more water buffalo. They cost about $500, but allow a farmer to feed his family and more. And it is not as easy buying a buffalo as it looks. Ed tells me that many are in shock. Many of the ones that did not die will not work because they are scared silly. "I never considered that as a possible problem but it is BIG TIME," he writes. "Buffalo with Post Traumatic Stress Disorder just stand there and stare into space."

Donations made thru Pay Pal with a credit card are best as they get quicker access to funds. Go to www.kbi.org and scroll down till you find the donate button. Click on it and it takes you to Pay Pal. "We can also accept checks made out to Knightsbridge International, PO Box 4394, West Hills, CA 91308-4394, they just take longer to get funding to us here in the field."

These are the good guys. They are there on their own nickel. Not a penny goes to overhead or salaries. I cannot say too much about them. I can personally vouch for them. They are a small operation, but their efforts are very large. They get in where other groups just can't. Pony up some money for a buffalo.

New York

This next Tuesday Tiffani and I go to New York. I will be on the Larry Kudlow show that afternoon and then we will get to have dinner with Larry and Charles Gave, co-founder of GaveKal. The next morning we head out early to Philadelphia. My friend Thomas Fischer from Jyske Bank in Denmark is coming in and we will be going to see Steve Blumenthal and three of the mangers on the platform that I mentioned above, and another two that evening back in New York. We will be at the Bull and Bear for Happy Hour so drop by.

I am really excited about the line-up that we have with all the partners. They (and I) all do a lot of work looking for managers on behalf of our clients and I think it is paying off. I am proud of the work they do.

As long time readers know, I have an office that is physically in the Ballpark in Arlington. You can watch the Texas Rangers game from balcony in right field. My lease is up on my office this time next year, and if we can get someone to take it before then we will move, as Tiffani and I could each save about 200 hours per year by not having to commute. But I will admit that tonight, with the Rangers playing Philadelphia outside while I write, I will miss it. And tonight, when the two hottest hitting teams in baseball are in the park, it is fun. Even better when we win 8-6. If we only had some pitching.

Have a great week.

Your ready for the Big Apple analyst,

John Mauldin

Whip Inflation Now

John Mauldin — Sat, 14 Jun 2008 05:06:39 GMT

Whip Inflation Now
Where Can We Get Help on Inflation?
The Patient Died Anyway
Inflation in Asia and Europe
There Are No Good Solutions

President Nixon instated price controls on the 15^th of August, 1971. Inflation was a little over 4% at the time. Price controls manifestly did not work (resulting in shortages of all sorts and a deep recession) and were rescinded a few years later. President Ford went to Congress with programs to fight inflation that was running closer to 10% in October of 1974, with a speech entitled "Whip Inflation Now" (WIN). He famously urged Americans to wear "WIN" buttons. That policy too was less than effective, and the buttons, in a history replete with silly gestures by governments, should stand on anyone's top ten list of such silly gestures.

Cynics more thoughtfully wore the buttons upside down and said the inverted letters (which looked like NIM) stood for "No Immediate Miracles." They were right. There was no miracle, just eventual pain and lots of it. Ultimately, Paul Volker defeated inflation, but at the cost of two serious recessions and a lot of economic misery, with unemployment levels over 10% for nine months in 1983.

This week we were given the data that inflation as measured by the Consumer Price Index (CPI) over the last year was 4.2% and unemployment is now 5.5%. Some call for the Fed to raise rates so that we do not have to experience another lost decade like the '70s and then ultimately see some future Volker forced to raise rates and drive unemployment back to 10%. Others suggest that "core" inflation is what should be paid heed to, and urge caution.

This week we look at the cost of what could be a renewed effort to Whip Inflation Now, not just here but in countries worldwide. Will Trichet in Europe raise rates even as the European economy seems to be slowing down? If you think inflation is bad in the US and Europe, take a peek at Asia. And I ask, "What will Ben do?" It should make for an interesting letter.

Whip Inflation Now

Nixon and his advisors thought inflation at 4% was serious enough to institute price controls. Headline inflation in the US is now 4.2%. What kind of economic policy should we pursue to bring inflation back into the Fed's comfort zone of 1-2%? Would it work and would it be worth the pain? To get a handle on the question, let's go to the data from the Bureau of Labor Statistics and see where inflation is coming from.

And let me note, this is the same exercise we could do for a host of countries. The answer will be roughly the same: there are no easy solutions.

Core inflation, or inflation without food and energy, grew at 2.3%. Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.

But the recent trend in rising inflation is even more worrying. If you look at just the last three months of data and compute an annualized rate of inflation, you find that overall inflation has risen to 4.9%, energy inflation is running at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core inflation during that period dropped to 1.8%. You can see all the data at http://www.bls.gov/news.release/cpi.nr0.htm.

Now, gentle reader, let's think about these numbers. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation. By the way, housing was up 4.9% and transportation up 8.7%, so it was not just food and energy.

What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall. Let's look at the possibilities.

As Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season. You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.

This growing season is not off to a good start. It looks like the yield on the corn crop will be lower than normal, and that is if we get very benign weather this fall. Given how late much of the US corn crop was planted, and how torrential rains in the corn belt have devastated crops (not to mention flooding cities, and our thoughts and prayers go out to those who have lost their homes to flooding), an early frost would be disastrous.

Because we have devoted so much of our arable land to corn (in a very misguided policy to turn food into ethanol), we have less for soybeans, which is putting upward price pressure on beans and other grains that are used to feed cattle, hogs, chickens, etc. In fact, it costs so much to feed livestock that ranchers are shrinking their herds.. This means more meat is coming into the system now, which is dampening prices. Increased supply will reduce prices in the short term, but next fall we will find that supplies of all types of meat will be short. That will potentially send meat prices soaring. Cereal and bakery products are up 10% over the last year. They could continue to rise in the fall if the corn crop does not yield more than currently projected. It will cost even more to feed your household and feed the animals we need for meat.

Food is the most basic of commodities. Demand is fairly consistent, and supplies may come under pressure. Looking for food inflation to drop back by the fall to 2% is not realistic in the current environment.

What about energy? There is some more hope there, at least on the oil front. High prices have reduced demand in the US, with gasoline usage down about 4%.

I think we have reached a tipping point. The psyche of the US consumer has been permanently scarred. Slowly, this country is going to replace its fleet of cars with smaller, more fuel-efficient cars. Over time, we will see demand continue to fall. We could see further drops in the demand for gas in the next few months.

Much of Asia used to subsidize oil prices to their consumers. That is changing, as Indonesia, Sri Lanka, and Taiwan have announced they are decreasing their subsidies, as the cost is simply too much. Malaysia now spends 25% of its budget on oil subsidies, and must raise prices or cut other services - or watch inflation get worse. India is now contemplating how to cut its subsidies. Even China is likely to start to raise costs after the Olympics. These countries are going to go through their own price shocks. All this will reduce world demand for oil.

And while there are those who are convinced the high price of oil is due to speculators, there are reasons to think the real culprit is still demand. Refiners are paying anywhere from $5-7 more per barrel than futures prices for "light sweet" crude (oil with low sulfur content) and $7 less for heavy sour crude. Much of the oil from the Middle East is of the latter variety, and supplies are increasing. There is not enough refinery capacity for heavy sour crude. That is why you see OPEC representatives say there is enough supply. For the crude they produce, there is. Spot prices are reacting to supply and demand and not speculative futures prices.

Over time, reducing demand should reduce price. I would expect to see oil get back to $120 or lower by the end of the year. But by year-over-year comparisons, inflation will still be ugly for some time. Oil prices have risen approximately 90% in the last 12 months (the actual percentage is highly dependent upon which measure you use). The bulk of that has been in the last four months. For energy inflation to go down on a year-over-year basis, we would need to see oil drop below $100. How likely is that in the next two quarters?

Where Can We Get Help on Inflation?

So, the two main sources of inflation are unlikely to drop in the next two quarters. If we want to get overall inflation down to 2%, we will need to look for help in other areas of the economy. How about medical care? Not likely. Education costs? Get real.

Housing costs make up 42% of the CPI, and thus are the biggest component. That is broken down into several categories: owners' equivalent rent for those who own their homes (32%), actual rent for those who do not (around 6%), utilities, furnishings, etc.

Rents have been up by 3.5% over the last year and owners' equivalent rent by 2.6%. If rent increases were to drop to zero, that would just about get us to 2% overall inflation. But let's think about that. Such a low number would mean an economy on its heels and a lack of buying power on the part of consumers. The only way that happens is with serious unemployment.

You can go to http://www.bls.gov/news.release/cpi.t01.htm and look at the various components of the CPI. Spend some time thinking about what costs are likely to drop. New and used vehicles are now dropping year over year, but only by a little, and that is only 7% of the index. Most items are rising at least a little.

Now, in a second thought exercise, think about what would happen if Bernanke decided to raise rates. A rising Fed funds rate is unlikely to have much effect on oil or food prices, unless he raises them enough to put the US and world economies in a serious recession.

How much would he have to raise rates to really slow the rest of the economy down? If you push up rates by 2% with the economy either in recession or close to it, you risk putting the economy into a much deeper recession.

Look at the yield curve below. This is exactly what the banks and financial services lend. They like to have a nice positive differential between the cost of their deposits and what they can charge for lending.

If you raise rates by 2%, you would more than likely invert the yield curve, making it that much more difficult for financial service companies to be able to recover. Given that they are already in trouble, and therefore less able to lend to businesses and consumers, do you really want to make things worse?

Look at the banking index below. This is an ugly chart. Another inverted yield curve would do serious damage to an industry already reeling. We are going to see more write-offs from banks. This chart will get uglier, but it will collapse without a positively sloped yield curve. (chart courtesy of www.fullermoney.com)

Further, raising rates would make it more difficult for consumers whose mortgage rates are tied to short-term rates. Is that what a housing industry needs right now?

Bottom line, Bernanke is in a very difficult position. Inflation by any standards is too high. But the cause of the inflation is not something in the Fed's control. To bring inflation back to 2%, he would have to savage the economy, perhaps at least as much as Volker did. Do you want to see unemployment go to 8-10%?

Volker was dealing with wage inflation. Everything had cost of living adjustments (COLAs) back in the late '70s and early '80s. Spiraling wages were one of the primary causes of inflation, if not the most important. A higher Fed funds rate could do something about rising wages by increasing the unemployment rate. Tough love, but effective.

Volker had to kill inflation expectations. Today, that is not (so far) Bernanke's problem. If you look at the implied inflation in the TIPS market, which is the difference between a ten-year treasury note and the ten-year TIP rate, it has only risen from a recent low of 226 bps on May 1 to 249 bps on June 10. Look at the following chart from Asha Bangalore of Northern Trust. Note that inflation expectations are not at recent highs.

The Patient Died Anyway

An expected inflation rate of 2.5% is well within "contained." It would be irresponsible to put the economy into a serious recession under such a set of circumstances. My Dad had a saying, "The operation was a success, but the patient died anyway." Raising rates in any serious manner would whip inflation but would kill the economy at this point. Rates will need to go back up at some point, but not until the economy shows signs of a rebound. I think the chances of the Fed raising rates by the 75 basis points, by January, that the market has priced in, is quite low.

What will happen is that over time the annual comparisons will begin to be less problematic. The cure for high prices is high prices, as the true cliché goes.

Sadly, we may get some help on the housing inflation component. Foreclosure filings last month were up nearly 50% compared with a year earlier. Nationwide, 261,255 homes received at least one foreclosure-related filing in May, up 48 percent from 176,137 in the same month last year and up 7% from April, foreclosure listing service RealtyTrac Inc. said Friday.

The prices of homes in many areas are going to fall to the level at which they can be rented. As more homes come onto the market for rent, the pressure on rent prices will fall. And the measure of owners' equivalent rent will fall along with it. Mark Zandi, chief economist of Moody's Economy.com (and an adviser to Republican John McCain's campaign), wrote earlier this week that "the Bush administration's efforts to encourage loan modifications and delay foreclosures are being completely overwhelmed."

Separately, a Credit Suisse report from this spring predicted that 6.5 million loans will fall into foreclosure over the next five years, reaching more than 8 percent of all US homes. (AP) That is going to keep pressure on housing prices for several years at the least.

Thus, it is likely that Bernanke and company will continue to talk tough on inflation. But, as noted above, I also doubt that they will raise rates this year, and probably not until well into the next.

The only reason to raise rates would be to protect the dollar from a serious collapse. I think it more likely the Treasury would intervene in the markets to prevent such a collapse. Dennis Gartman, at dinner Wednesday night, suggested that if the administration really wanted to get the market's attention, they could intervene in the currency markets and release oil from the Strategic Petroleum Reserve at the same time. While it would only be a temporary fix, it would make speculators nervous. However, they might consider such an experiment preferable to having the Fed raise rates during the middle of a slowdown/recession.

And the dollar seems to have found at least a temporary bottom, and we could see further strengthening next week, as Ireland voted today to reject the proposed European central government. Since it takes an absolute 100% consensus among all member nations, that kills the deal. Europe now has a very odd shape. They have a commercial union. Some of the members share a currency. Some of them share actual membership in the EU. Some of them are in NATO. They have competing and very different needs for monetary policy.

In fact, it will be hard to get anything done in Europe apart from commercial treaties, etc., as any one country can veto any particular item which is not to their advantage. Over time, this is going to be seen by the world as an issue for the euro. And given the demographic and pension problems of "Old Europe," the currency is going to come under increased pressure from competing needs for funding, taxes, and an easy monetary policy.

Six years ago I talked about the euro rising to $1.50, but I also noted that by the middle of the next decade it is likely to come back to par. We are halfway on that journey, and I still think we will arrive at my predicted point.

I think it is possible that the dollar could rise 10% or more this year against the euro, which would help inflationary pressures. Import prices into the US are up 17.8% year over year. A stronger dollar will help alleviate that.

Inflation in Asia and Europe

Countries throughout Asia would love to have a 4.2% inflation rate. Indonesia is at 10.4%, almost twice what they were a year ago. Vietnam would love to have such mild inflation, as its own level is up over 25%. Inflation in China is 8%. Inflation is up throughout the continent. And oil and food are the culprits.

Korea is particularly strained. Korea has seen its import prices rise by almost 45% in the last 12 months. Read this note from Stratfor:

"South Korea is among the most vulnerable of Asia's top economic players to global price increases due to its heavy reliance on imports for many of life's basic essentials - including oil, wheat, corn and coarse grains. At least 96 percent to 100 percent of its annual consumption in each of these items is imported. With global supplies in these basic necessities set to tighten, South Korea's inflation and the associated social unrest can only rise. (Protests in South Korea can draw hundreds of thousands of marchers.)

"Interest rate hikes are one of the most readily available tools for fighting inflation and for propping up a weak currency. In theory, raising rates would help attract foreign money into South Korea by raising the rate of return on investments in the country, thus helping to increase the value of the local currency and to contain rising energy import costs and inflation. But just June 12, South Korea's central bank decided to keep interest rates frozen at 5 percent. This was because the potential economic slow-down an interest rate increase could trigger is too politically risky for the government, and because there are less controversial means to bolster the won.

"If interest rates were raised to tackle the problem of increasingly expensive imports, the access of Korean businesses and households to credit to fund their operating costs or mortgage payments would shrink. This would make the government of President Lee Myung Bak even less popular."

What to do? Each country will try its own particular witch's brew. China is raising interest rates, increasing bank reserves, and allowing its currency to continue to rise. But make no mistake, there are no easy answers. Each choice has its own unintended consequences.

But a large part of the problem in Asia is food and energy. And monetary policy alone cannot address world supply imbalances. To a greater or lesser degree, every country is faced with the same conundrum. Do you risk higher unemployment and your economy to fight inflation that is not strictly speaking a monetary problem? If food is rising 40% in Vietnam, its workers will have to make more in order to eat? Will such a price increase force higher wages and perhaps a wage increase spiral like the US saw in the '70s? If you increase the value of your currency too fast, you risk losing your competitive price advantage and thus losing business and jobs.

There Are No Good Solutions

Over in Europe, I noted last week that one Jean Claude Trichet, the president of the European Central Bank, virtually promised the markets a series of rate hikes. This sent the dollar into the tank and the euro back to new highs. Gold loved it.

But this week has seen a very unusual set of speeches by fellow ECB members disavowing Trichet's promise, and even Trichet had to try and "explain" away what he had said. "We aren't talking about a series of rate hikes. Maybe, just possibly, we would raise in the event of more inflation." Confusion reigns. There is clearly not consensus at the ECB.

You can bet Trichet heard from various finance ministers in the countries whose economies are weakening. They are not interested in a stronger euro or higher rates. What one person called the PIGS countries are surely objecting (Portugal, Italy, Greece and Spain, whose economies are not exactly robust).

And their objections are the same ones that would be made here. What good would a rate hike do? How much more oil or corn would be produced? Why increase our pain when there could be no positive result?

The central banks of the world got by for years with easy monetary policies (think Greenspan) because of rising productivity, cheap energy, increased international trade, a disinflationary environment because of cheap Asian labor and imports, etc. Now that economic regime has come to an end. Stability had bred instability in a very uncomfortable Minsky Moment.

There are no good solutions. There will only be a choice of how much and what type of pain. The US, Europe, and Japan are entering Muddle Through World. The rest of the world is faced with increased volatility. This is a tough environment in which to be a central banker.

New York, "Chicago," and Wedding Showers

It looks like I am going to have to go to New York and Philadelphia the first week of July for a day of meetings with partners. Larry Kudlow has asked me to come on his show July 1, and that sounds like fun. And then I am looking forward to the annual Maine fishing trip hosted by David Kotok of Cumberland Partners. A lot of good friends will be there. And I get to go with my youngest son Trey, who always catches more fish than I do. Maybe this year I can manage to at least stay competitive.

Tomorrow is Tiffani's wedding shower, and it looks like there will be a lot of friends at my home. Her wedding is August 8, and it gets closer every day. There is so much that has to be done. While I am not doing any of the heavy lifting, I am amazed at how much the coordination resembles the Normandy invasion.

I will be speaking at the National Association of Business Economists at the Dallas Fed this next Wednesday, on the assigned topic of how I use earnings forecasts in my economic analysis. That portends to be a very contrarian speech, as long-time readers know my view of the value of stock analysts and the reliability of their forecasts.

On a very sad note, I am distressed to learn that Tim Russert passed away. I have thoroughly enjoyed his analysis and interviews over the years. He has been like an old friend coming into my home each week, and I will miss him. Rest in Peace.

On a lighter note, this Sunday evening The Doobie Brothers and Chicago are in town for a concert, and I am going to go for a little nostalgic evening. Can you believe it has been almost 40 years? Where has the time gone?

Let me say thanks to Pierre and Guy Casgraine, who hosted your humble analyst, Martin Barnes and Dennis Gartman, and a few friends in Montreal on Wednesday. It was an exceptionally fine evening. I so enjoy good food and wine and great friends and conversation. It is one of the true pleasures of life.

Enjoy your week, as I know I will. And look for a major announcement from me this Tuesday, as Tiffani and I need your help on a new project. (No, not the wedding!)

Your getting ready to be an old rocker for a weekend analyst,

John Mauldin

When Bubbles Collide

John Mauldin — Sat, 07 Jun 2008 06:47:00 GMT

When Bubbles Collide
Unemployment Jumps to 5.5%, On Its Way to 6%
What the Tax Numbers Show
What's Up With Oil?
America on a Diet
Montreal, a New Book, and a Wedding

I remember in the summer of 2006 I would face my blank computer screen on a Friday and wonder, what I could write about? The media was all Goldilocks, all the time. Today, there is such a target-rich environment. I could probably write three letters a week, there is so much happening that is worthy of our attention. The problem today is trying to decide what not to write about, which means I get emails from readers wondering why I don't mention their areas of particular interest. But at eight pages, I just have to stop. You need a break!

Today, we have to look at the unemployment numbers, and the connection between the credit crisis and the rise in oil of about $16 dollars a barrel in just two days! If there is still room, the dollar is certainly being pushed and pulled by central bankers, who are also worried about inflation. And I doubt we will have room to cover what is a very important rise in inflation in Asia. It is all connected. (And you HAVE to look at the picture of my daughter and associate Tiffani at the end of the letter. Too much fun!)

But first, a quick note. I will be in Las Vegas July 10-12 for the annual Freedom Fest Conference, where I will speak several times, and the line-up of speakers is as strong as for any conference I have ever been to: Denish D'Souza will debate Christopher Hitchens; and Steve Forbes, Ron Paul, Stephen Moore (Wall Street Journal), Charles Murray, George Gilder, John Goodman, and about 100 other speakers, each impressive in their own right, will be there, as will 1,500 freedom-loving attendees. You can go to http://www.freedomfest.com/promo.htm and click on the list of speakers to register. Mark Skousen is the driving force behind the conference, and he does it right. I hope to see you there.

Unemployment Jumps to 5.5%, On Its Way to 6%

The headline number said the US lost 49,000 jobs in May, somewhat fewer than expected. The details were much uglier. It is no surprise that construction saw losses of 34,000, but "goods production" also saw a drop of 57,000 and manufacturing was down 26,000. What was up? Health care (34,000), bars and restaurants (11,000), and government added 17,000 (though, as Phillippa Dunne and Doug Henwood of The Liscio Report noted, the gain was all from local governments, as federal and state governments shed jobs).

So, with all the large losses and few gains, how did we show a loss of only 49,000 jobs? As long-time readers will guess, it is our old friend, the birth/death model, which is the estimate of new jobs created by new and small businesses, which are not covered in the survey. Contrary to some opinions, it is not a conspiracy by a government agency to "cook the books" in an attempt to show a number better than it really is. (If it was, they are doing a really bad job!) It is simply a moving-average projection of the past few years. Like any trend-following system, it will be wrong (sometimes badly) at the inflection points of the change in the trend.

Thus, the Bush administration was right to be upset when the birth/death model significantly understated the growth in jobs during the recovery from the last recession, as Democrats talked about the "jobless recovery." Subsequent revisions showed that in fact there were a lot of jobs being created.

And now? As the economy rolls through a recession, the system is overstating the number of jobs created. It is just a function of the model. The BLS is very open with the numbers it uses, if you care to dig into them. In October the BLS will announce new benchmarks and apply them in March 2009, although they will only be applied through March 2008. The number of lost jobs through last March will be revised significantly upward, just about the time the recovery is underway. And also in time to help modestly understate the jobs being created in the recovery. As my friend Dennis Gartman likes to say, anybody who trades on the employment numbers deserves the spanking they get.

For the record, "March was revised down by 7,000, and April by 8,000. We've now had four consecutive months of downward first revisions, and also four consecutive downward second revisions - unusual strings that support the picture of a weakening employment trend." (The Liscio Report)

And the birth/death model? This month it added in an estimated 217,000 new jobs. But looking into the details, the model suggested that 42,000 construction jobs were added. The survey showed lost jobs in construction, but the birth/death model added more construction jobs than were lost. Given the current economic climate, that is highly improbable. Ditto for the 77,000 in leisure and hospitality. Do we really think 9,000 jobs were added in financial services or another 9,000 in small manufacturing start-ups?

The reality is that we probably saw a decrease in jobs of at least 100,000. The market was upset with 40,000. What will it do when the monthly number prints 100,000 later this year? And it likely will. The Federal Reserve projects that unemployment will rise to 6%. That means there are a lot more jobs to be lost. And that is if unemployment stops at 6%, which would be a very mild recession indeed.

There are two unemployment surveys. One is for businesses, called the establishment survey, and for whatever reason that is the one most people pay attention to. When they do the household survey, they found that the number of employed people fell by 617,000 last month, spiking the unemployment rate to 5.5%. Some on CNBC said it was just teenage unemployment showing up in the numbers, but that is not true. Teens, according to Phillippa, accounted for just 0.2% of the rise. Adult unemployment rose to 4.8% and accounted for 0.3% of the rise. (By the way, technically, for the three people with no social life actually watching the scorecards, the household survey dropped 250,000 jobs; but after you adjust for factors in the establishment survey and seasonally adjust, you get 617,000.)

One of the best indicators of the direction of employment is temporary employment. If the workload is shrinking, the first thing you do is lay off your temporary help, or simply do not hire them. Normally, unemployment is a lagging indicator, but temporary help is at least a coincident if not a leading indicator. Temporary employment is down 5.7% year over year and is showing continued monthly deterioration with each passing month since last October. That does not bode well either for future employment or consumer spending. We will watch to see when temporary help begins to rebound, to give us a hint that a recovery may be in our future.

What the Tax Numbers Show

Philippa Dunne & Doug Henwood write The Liscio Report. They focus on interpreting the employment numbers and doing in-depth research on tax collections at the state level, plus a lot of interesting "inside" information not typically known by the public. When you see an analyst talking about tax collections at the state level, there is a high likelihood that the source of the number is actually the work of Dunne and Henwood. I find their letter very useful, as I get analysis very quickly after the report comes out, and you always get "the rest of the story" not revealed in the press releases and the media. (www.theliscioreport.com) If I ran a trading desk I would want their reports on my desk.

I called Phillippa about a report they sent out this week. Basically, sales tax and income tax collections at the state level are either down or flat. You can do all the surveys and polls you like, but one of the rules of life is that no one pays a penny more in taxes than they have to. The flip side of that premise is that sales tax collections are a VERY good barometer of economic activity.

Phillippa was kind enough to send me a chart to share with my readers. The have a diffusion index which tracks how well states are doing in meeting their projections for tax receipts. This does not show the level of receipts, as a state could be "positive" in this index if it projects lower receipts and meets that target. In general, states have been lowering their projected income.

As it turns out, this index is a fairly consistent indicator of the direction of retail sales, as the graph below will attest. The green bar line is their sales tax diffusion index, and the red bars are retail sales growth. Their index has dropped precipitously in the last few quarters, leading retail sales down. And it suggests there is more pain in retail sales to come.

But wait, didn't we read yesterday that retail sales were up? "Wal-Mart sales, for stores open at least one year, increased 3.9%; Costco US showed a 7% US gain and a 15% foreign gain. BJ's Wholesale Club sales surged 13.4% on gasoline and food sales. BJ reports gasoline sales jumped 6.6% and perishable food sales surged 11% but general merchandise was flat!!!" (The Bill King Report)

Retailers that did not have food and gas to boost their sales showed considerable weakness. GAP was off 14%, JCPenney down 4%, and Limited Brands down 6%. Even the high-end stores like Saks (-9%) were down, and Nordstrom projects that June will be down 22%. Given the sales tax numbers, I would not be buying the retail stocks on the dips. There is an old saying about trying to catch a falling knife.

Auto sales have fallen precipitously on the lack of demand for trucks, which were the most profitable item for car manufacturers. Is it any wonder they are cutting back and closing plants?

Wages declined by 0.2 in April in nominal terms, and forget about it in real, after-inflation numbers. David Rosenberg of Merrill Lynch notes that the 0.2% decline in real spending on durables and semi-durables was the 6^th decline in a row, which has never happened in the 49 years that such data has been tracked. He notes there has never been a time when consumer spending on durables (like cars and appliances) and semi-durables (like clothing) have contracted for two quarters when the economy has not been in a technical recession.

But there are other reasons for the slowdown in consumer spending. Since 2001, the average income of the bottom 90% of wage earners dropped by 0.9%, from $32,371 to $32,080 in 2006, in constant 2006 (inflation-adjusted) dollars. The further down the income scale, the more pressure on the consumer. (source: Center for American Progress)

The top 10% have seen their incomes rise from $221,000 to $254,000, a rise of 15%. Side bet: we will see the average income of the top 10% come down in 2008 and 2009.

From Goldman Sachs: "We estimate that the US government ran a budget deficit of $160 billion in May, about $92bn wider than in May 2007. Most of this reflects tax rebates (about $50bn) and calendar effects (about $27bn). The remaining $15bn is true deterioration, reflecting reduced tax revenue growth as the economy stagnates. In particular, withholding of income and payroll taxes was flat and corporate payments (usually tiny in May) fell."

In short, wherever you look, tax receipts are down. That means income and sales are down. There is no spin that trumps tax receipts. And Phillippa told me that her sources at the various states she surveys are not optimistic about a real recovery in the latter half of the year.

I would not want to own any stock whose earnings are tied to the US consumer. Between rising input prices and falling sales, earnings are going to be squeezed. Today's almost 400-point drop in the Dow is just a precursor to the direction of the market, until consumer spending starts to recover. This time, there will not be large mortgage equity withdrawals to bail out the economy. We will see a slow growth/no growth Muddle Through Economy for at least another 12 months.

What's Up With Oil?

The price of a barrel of oil was up $16 in the last two days, to $138.54, a violent 13% move. Is it those nasty speculators? Are fundamentals at work? Is the world worried about Israel bombing Iran? There are numerous factors involved, but the combination produced a kind of perfect storm in the trading pits. Let's look at several items and see if we can find a connection.

First, there is a real connection between the price of dollar and the price of oil. In dollar terms, oil rises as the dollar falls and vice versa. The weak dollar policy that this country has had (in spite of denials) is having an effect. This week, Ben Bernanke took the very unusual stance of commenting on the weakness of the dollar and its possible role in inflation. Typically, the value of the dollar is the responsibility of the US Treasury Department, and the Fed does not get involved. You can bet that Secretary Paulson knew in advance and approved Bernanke's statement. That put a bid under the dollar and hit oil and commodity prices in general.

No one should think that the Fed or the Treasury is getting ready to intervene in the market, which would be a rather futile effort. Rather, it was a clear signal that the Fed is "on hold" and is unlikely to lower rates in the current environment. Since the market felt that the next move from the European Central Bank (ECB) would be to lower rates in response to a weakening environment in Europe, that served to push the dollar higher against the euro.

Note that a German 2-year bond pays 4.64%, and the US 2-year note pays 2.39%. That difference helps put a bid under the euro. Also, note that interest rates in Europe are starting to get flat across the curve.

Then, as the US markets opened on Thursday, Jean Claude Trichet, the president of the ECB, shocked the markets. Let's let Dennis Gartman rewind the tape for us:

"Mr. Trichet made it clear that a number of ECB policy committee members actually support raising rates very quickly, and he suggested that the committee could move to raise rates as soon as the next policy meeting in the first week of July! Mr. Trichet said yesterday that

" 'after having carefully examined the situation, we could decide to move our rates (by) a small amount in our next meeting in order to secure the solid anchoring of inflation expectations.... I don't say it's certain. I say it's possible [for] we had a

number of us thinking that, all taken into account, all information, analysis of risks, we had a case for increasing rates... A number of us considered that there was a case for increasing rates, but later some amongst us considered there was not necessarily that case... [yet].'

"Mr. Trichet went on further to say that the ECB is on "heightened alertness" about inflation. At recent meetings Mr. Trichet has made it clear that the decision to keep policy steady was unanimous, but yesterday he said the decision was a consensus, and was not a unanimous decision. That obviously suggested that some on the committee were already voting to tighten, and that, we must admit, caught us off-guard. At the question and answer period following the meeting, Mr. Trichet was asked, following his statement that the decision to hold rate steady was a 'consensus,' why the committee had not moved to raise rates. He said that firstly the committee had to signal to the market that it was on the alert; that the debate had shifted from dead center to the edge; that the needle on the monetary tachometer was moving off of top-dead centre. We do not wish to parse things too severely, but it does seem that the committee is prepared to move at the next meeting, and that is a material change from our perspective, for we had thought that the Bank was poised to do nothing for several more months, and that the next move would instead have been to ease, not tighten. Clearly we had that wrong, and now the facts have changed."

It is not just Dennis who was caught off guard. The entire currency and commodity futures trading markets were surprised (including your humble analyst). The euro exploded up from $1.5395 to $1.5555 in a matter of minutes. Oil rose $6. Gold and grains moved violently. Soybeans "gapped," as commodities of all sorts responded to a weakening dollar.

If Trichet wanted to "signal" the market, it worked. He got everyone's attention very quickly.

There was a lot of short covering in the various markets, but especially in oil. But let's dig deeper.

I have been pondering for a few weeks about whether the long-only commodity index funds are really affecting the markets. Basically, these funds have become a huge part of the commodities market. It is clear that enough buying and in size will affect any market, but these funds do not take delivery. They "roll" their exposure as they get close to expiration, so they are not involved in the spot price. In theory, the spot price should be a function of immediate supply and demand.

But, it is not that simple, as Louis Gave reminded me. Looking at recent CFTC data, investors known as "commercials" were long 827 million barrels of oil. In the early part of the decade it was 3-400 million barrels. Commercials are supposed to be those who are hedging their production of oil. But large oil companies rarely hedge, and smaller producers only hedge a portion of their oil (see more below). Has supply increased over 100%? I think not.

Where is the increase in commercial interest coming from? The clear answer is long-only commodity index funds and ETFs. They simply buy baskets of commodities at whatever the price is, speculating on the rise in the price of the overall commodity market. It is a one-way trade. Jim Rogers is probably the most famous exponent of such trades, but there are scores of funds which mimic what he does. But there are limits to how much exposure speculators can buy, because the CFTC will allow a speculator to only buy so much of any given market, to keep large players from getting a corner on the market and driving up prices, a la the Hunt brothers and silver in 1980. These limits are known as "position limits."

There are no position limits for commercials who are hedging. They are in theory hedging their physical exposure to a given commodity they are selling or buying. Think of a farmer and General Mills. Both want to lock in the price of wheat so they can plan for the future. Speculators are useful in that they provide liquidity to the markets. In fact, they are essential to a properly functioning market.

The CFTC created a loophole when they allowed investment banks to be classified as commercial investors. So, when a long-only commodity index fund wants to buy a million barrels of oil, they can go to the investment bank, who will sell them a "swap" on the price of oil, and then immediately hedge their exposure in the futures market.

To be sure, the long-only index fund can now create positions far in excess of the position limits that are enforced upon normal speculators. These funds can grow to be huge - multi-tens of billions of dollars. Even though they are speculators, they are not included in the data as speculators. Because they get their exposure from an investment bank, they are ultimately listed as a commercial. In total, they represent an enormous part of the commodities markets. But they are providing liquidity, so what's the problem? They are not actually hoarding the commodities. The price is still set at the spot price. But.

But that is not the whole story. They are making it difficult, if not dangerous, to short the market. When massive buying comes into the market, it moves the market and sends the signal to the market that prices are rising. Momentum players move in, and prices rise some more.

In fact, as the price of oil has risen from $90 to $100 and higher, normal speculative open interest has declined, as who can afford to fight the tape? At the least, I expect the CFTC to require those "commercials" that are really long-only index funds to provide transparency. Politicians are demanding that something be done. It is entirely possible that they will impose position limits on the long-only funds. As I said last week, when the elephants are dancing, the mice should leave the floor. And Congress and the regulators are very serious elephants indeed. Let's hope they do whatever they are going to do quickly.

I think smaller investors should take the profits they have made over the last few years in these funds and move to the sidelines until it becomes clear what the rules are going to be. Let me also make it very clear that I am only talking about long-only commodity index funds. Funds that are managed by commodity trading advisors which can go both long and short have the potential to profit from volatility (and of course, they can also lose). In these types of markets, I like funds which are "long vol." (To be long volatility means you have the potential to benefit from volatile markets.)

Now, let's look at how the credit crisis is contributing to the problem. Let's say you are a small oil producer or grain company. You go to the futures market and hedge your oil production or the grain in your silos; and if the price goes up, you don't care, because you are going to deliver the grain at a cost you already know. But there is the matter of that margin call, and you need to borrow from your local bank to meet that call.

You are hedged. Your profits are locked in at some point in the future. But the margin clerk is calling today. And your bank is having a small problem with its capital base. What is the cover story in the Wall Street Journal today? "Real Estate Woes of Banks Mount." Banks, mostly smaller ones, may have to write off as much as $165 billion in bad real estate loans made to developers and commercial builders. Regulators are "encouraging" banks to raise capital and increase their lending standards.

So banks have less capital to lend. Your banker looks at you when you ask for more money to meet those margin calls, and says, "There are two types of problems. Mine, and not mine. Yours is of the latter variety." And you have to cover your hedges. Enter the margin clerk (the person who calls you and tells you to come up with more money or they will sell out your position at whatever the market price is.)

When Bubbles Collide

So, what happens? Bernanke talks the dollar up and commodities and oil go down. Two days later a French president of the ECB gets inflation religion and the markets react swiftly. Commodity prices rise and more money comes into the market. Traders start covering their shorts as quickly as possible.

Then this morning, the margin clerks of the world go to work and oil spikes as the pits smell blood. Morgan Stanley issues a call for $150 oil in July. The euro rises to $1.5778! Interest rates drop. The stock market falls large at the open.

And rumors of an attack on Iran? An Israeli politician says that Israel would need to bomb Iran to keep them from getting a nuclear weapon, just as it becomes clear Obama might be the next president and would not act to prevent such a problem?

Who can aggressively short in this environment? In a conversation with Dennis Gartman this afternoon, he commented that it felt like the NASDAQ. But is it 1999 or 2000? The oil market will continue to go up until it doesn't, and no one knows when that is. It will continue to rise until all the shorts that are not strong hands have been covered. The margin clerks are in control, and they will have their way. Was it all over today? I rather doubt it.

I wonder if some of the majors aren't tempted to sell some of their production at $138? I mean, really. If you don't think that is a reasonable price, and they tell us they don't, then why doesn't Exxon just go in and start taking all the bids they can? They and the other majors would be the ultimate strong hand. But then, what do I know?

Central banks, short covering, a respected analyst issuing a near-term call for a $20 rise in oil, conspiracy theories and Iran, long-only funds buying, everyone scared to short, margin calls, and a credit crisis all give us the perfect storm.

Add to that the ugly employment numbers, and the Dow drops almost 400 points. The S&P 500 violates all sorts of technical signals to the downside. The market sold off big at the close. Monday should be interesting.

Three quick points. I think oil is lower at the end of the year. Inflation in Asia and rising subsidies are going to force more and more Asian countries to allow the price of oil to rise and send the proper signals to consumers to use less oil. Over the next decade, oil will be much higher, but I think the pressure over the next year will be to the downside. But don't ask me how high it can go in the short term. Ask the margin clerks.

America on a Diet

Second, corn is going to go higher. Bad weather has meant that not enough got planted, and that will probably hurt yields in the fall. This is going to mean even higher meat prices and ethanol prices. Corn ethanol is such a bad idea. This is what happens when government decides to mess with the market.

Anecdotal inflation note: I eat two chicken fajita pitas without cheese from Jack-in-the Box for lunch about three times a week (after the gym!). I throw away the pita bread and just eat the chicken at my desk. The last three days the price has been the same, but the amount of chicken is noticeably smaller, perhaps 25% smaller. Where's the hedonic price adjustment in the BLS statistics for that? A friend of mine notes that the filet from his favorite steak house is now seven ounces instead of eight. But the steak is still the same price. Maybe portion control will finally get America to go on a diet.

Finally: George Friedman told me that the Saudis are taking in something like $10 billion a week! The entire gulf is awash in dollars. He thinks it may have nowhere else to go but to the stock markets of the world. We'll see. Unintended consequences.

Montreal, A New Book, and a Wedding

Next week Tiffani and I go to Montreal to speak at a conference for Canaccord, and we will get to have dinner with Martin Barnes and Pierre Casgrain. And it looks like Dennis and Margaret Gartman may be able to join us. Now that will be a fun dinner. I should get some fodder for next week's letter.

Tiffani (my daughter, who in fact runs the business and lets me research, travel, speak and write - what a deal!) and I are going to take the train from Toronto to Montreal so we can work on a new project. Basically, she has an idea for a new book that we can write together, and we are going to use the time to think about how we go about it. But we are going to need your help. I will let you know in a week or so, but it is going to be great fun for all of us.

And speaking of Tiffani, she is getting married to Ryan on August 8 (08-08-08). Plans are coming together, as well as expenses. This is going to be a most different wedding, as those of you who know Tiffani might suspect. Not traditional at all. One of the best photographers in Dallas has been working with them. Because they are willing to try different things, he is getting them to do things he has always wanted to do but never had a couple adventurous or "fun enough" to do. The following photo is just a sample. This is a groom that is definitely in for a challenge. If you want to see more pictures (the underwater photos are fun, the "Hillbilly Tiffani and Ryan" is a hoot) you can go to www.fatedlove888.com and click on the picture. Dad is only a little proud.

There are 20 college-age kids from my daughter Amanda's cheerleading instruction team at the office watching the baseball game, and three of my other kids. (You can watch the game from my office balcony.) Of course, the Rangers are losing. I am literally writing with foam ear plugs, trying to concentrate, so I think I will just hit the send button and enjoy my kids.

Your doing my best to stimulate the economy with wedding expenses analyst,

John Mauldin

The Fed at the Crossroads

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

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

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

Retail Sales Take a Dive

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

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

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

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

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

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

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

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

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

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

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

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

Accounting for Inflation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Fed at the Crossroads

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

- Robert Johnson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sell In May and Go Away

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

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

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

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

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

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

South Africa, Flowers, and On the Road

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

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

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

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

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

Assumptions.

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

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

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

Have a great week. And avoid assumptions.

Your wiping the egg off his face analyst,

John Mauldin

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