Thoughts From The Frontline : Oil

Forecast 2009: Deflation and Recession

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

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

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

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

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

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

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

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

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

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

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

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

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Muddle Through on Hold

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

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

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

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect

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

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

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

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

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

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

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

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

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

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

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

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

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

Lies, Damned Lies, and Government Unemployment Numbers

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

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

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

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

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

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

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

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

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

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

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

Central Bankers of the World, Unite!

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

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

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

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

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

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

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

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

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

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

But there is a problem.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Predictions 2009

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

La Jolla, Bermuda, and Europe

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

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

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

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

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

Your more optimistic than this letter implies analyst,

John Mauldin

Some Things That Just Should Not Be

John Mauldin — Sat, 13 Dec 2008 05:01:52 GMT

Things That Should Not Be
I'll Pay You to Hold My Cash
Pushing on a String
Free Money with that Credit Default Swap?
Oil Does a Strange Contango Dance
The Tragedy of Bernie Madoff
Goodbye to the Ballpark

There are things in today's markets that are simply astounding. They should not exist, yet they do. Why should US bills trade at negative interest? How can oil be trading at all-time highs in terms of spreads over the next year? Bank debt and bonds are trading at discounts not to be believed. Want some free money? I show you a trade that gives you (almost) just that. Fed funds at zero? Are we starting to push on a string? We'll cover all this and more in this week's letter.

But first a quick commercial. Not all money managers and funds have had losses this year, even though it may seem like it. My partners around the world can introduce you to some alternative funds, commodity funds, and managers which you might find of interest as you rebalance your portfolio at the end of this year. You owe it to yourself to check them out.

If you are an accredited investor (net worth over roughly $1.5 million), you should check out my partners in the US, Altegris Investments (based in La Jolla) and my London partners (covering Europe), Absolute Return Partners. If you are in South Africa my partner there is Plexus Asset Management. You can go to www.accreditedinvestor.ws and fill out the form, and someone from their firms will be in touch. All three shops specialize in alternative investments like hedge funds and commodity funds, on a very selective basis. We will soon be announcing new partners in other parts of the world. And if you are an advisor or broker, you should call them (or fill out the form) and find out how you can plug your clients into their network of managers.

If your net worth is less than $1.5 million, I work with Steve Blumenthal and his team at CMG. I suggest you go to his website, register, and then let them show you what the blend of active managers on his platform would have done over the past few months and years. These are primarily managers who will trade a managed account (using various proprietary styles) in your name, and are quite liquid. Again, if you are an advisor or broker and would like to see the managers on the CMG platform and how you can access them for your clients, sign up and let Steve and his team know you are in the business. The link is http://www.cmgfunds.net/public/mauldin_questionnaire.asp. And now back to the letter.

I'll Pay You to Hold My Cash

In the last few weeks we have seen 30- and 90-day US Treasury bills trade every now and then at a rate of negative interest. That means someone is willing to pay for the privilege of having their cash in US Treasuries. This simply should not be. Why would anyone want to do this? Is this a sign the system is broken? Are we that scared?

Not really. There are some explanations for this seemingly bizarre behavior. First, banks are driving down the interest rates toward zero. Because their audits come at the end of the year, they want to be able to show a very liquid and pristine balance sheet. And what better way to do that than short-term US Treasuries? But that gets us near zero, not below. (And as noted below, the effective Fed funds rate is at zero, not the posted 1%.)

As David Kotok of Cumberland Advisors noted in a post: "We cannot find a single investor or institution or organization that would volitionally buy this T-bill at zero interest, let alone a negative yield. We have polled firms and agents and portfolio managers. We've asked people who range from sophisticated, high-net-worth individuals to multi-billion-dollar institutions. None would do it. We have asked professionals and skilled and trained consultants. All answer 'not me.' Foreign currency traders would not do this trade; they have other ways to hedge or structure without buying a negative yield.

Another possibility is market manipulation or a pricing error. Not this time. All evidence points to the negative yield as seeming to be a market-driven price. This is a real puzzle on the surface."

I have spent more than a little time over the years looking at alternative fund prospectuses and back-room operations, and have been involved in a consulting role for a few funds. Let me tell you how I think interest can get below zero in a perfectly rational market.

Let's say you are trading futures or other leveraged products. You don't need to put up all the money in order to buy a futures contract on oil or the S&P 500. You simply have to have a typically small amount of margin money at the clearing broker, depending on the nature of the contract. Many funds are required by their organizational documents to hold their cash in short-term Treasuries for liquidity purposes. They have no choice but to buy Treasuries. Some of these funds are quite large, and when they come to the market they come, as we say, "in size."

If you are a trader on the other side of the trade and can make a little extra for scalping such a fund, then you do it. It doesn't happen often, but it can and does happen when the demand for liquidity is as high as it is today.

I also called my long-time friend Art Bell, whose eponymous firm Arthur Bell and Associates audits a rather large number of commodity and hedge funds. He is one of the best in the business. He confirmed that he knew of at least one fund that had bought Treasuries at a negative interest rate, not because they were forced to but because they wanted instantaneous liquidity in case they got margin calls on some of their trades. They did not want to be forced to sell something at a larger loss than they would normally take, just because they did not have the cash. The very small negative interest was the price they willingly paid not to be put in the position of taking larger losses on a trade in a forced sale. Sounds like smart risk management to me.

I bet if we checked around we would find more than a few funds and managers who for one reason or another are willing (or forced to) buy Treasuries at negative interest rates. Such is the way in today's surreal investment world. Art says that if this current environment persists, funds will find an alternative, such as third-party collateral deposits, rather than leaving deposits at a brokerage firm.

Pushing on a String

Speaking of zero interest rates, the posted Fed funds rate may be at 1%, but the actual market is trading at very close to zero. That means that banks can get money that is effectively free. The Fed meets next week in what was supposed to be a one-day meeting but which has now been scheduled for two. Guess they think there is a little more to talk about.

The Fed will cut rates next week. But with the effective real market rate now at zero, what difference does a cut make? I hope they do the right thing and go ahead and cut at least 75 basis points, if not more. That would stop the speculation and let them move on to quantitative easing and other allied policies, which we will explore in some future letter. Whether they should pursue some of the more radical policies is open for debate, but it is more important today for us to figure out what they are going to do and adjust our portfolios correctly than to debate policy.

As an aside, if it looks like Bernanke and Paulson are making all their policy moves "on the fly," it is because that is exactly what they are doing. As would any person in their respective offices. There is no playbook with a set of standard policies and procedures that can be used in case of a credit crisis. They have to make up the plays as the game progresses, much as we did in pick-up football games as kids. "John, go long and make a left cut at the trashcan. And try not to drop it this time."

There are very few real rules and laws, and Bernanke and Paulson have shown a willingness to ignore them if they seem to get in the way. This is a very pragmatic group that is trying to keep the economy from imploding. They only have a few theories and some loose analogies to what happened in Japan and maybe the US in the 1930s as guidelines. But those times had such major significant differences that it is hard to make a direct inference as to what did and did not work. As Yogi Berra is alleged to have said, "In theory, there is no difference between practice and theory. In practice, there is." And when theories meet the rough hand of the market, they will be changed.

We are getting to ready to run a grand experiment on many theories in the world of economics. Will Ben and Hank (soon to be Tim) get it precisely right? And what is precisely right? Does the avoidance of a second Great Depression mean success? Will anyone be grateful? We all have seen pictures of Paulson looking so very tired and worn. I actually feel sorry for him. Who would want that job? I know this will not sit well with many readers, but I think he has done about as well as could be expected given the circumstances. Look at the previous Treasury secretaries under Bush. No disrespect to Mr. O'Neill or Mr. Snow, but would you really want someone with so little exposure to the capital markets in the current position? Compared to so many Treasury secretaries over the past 30 years, we are lucky to have Paulson at this time.

In any event, Paulson is pouring water on the fire as fast as he can. I doubt that Tim Geithner will do any different. If Geithner has a play book for avoiding deflation and depressions, he has not shared it with anyone. They will still be making the plays up as they go along next year. I just hope they call the right plays.

Free Money with that Credit Default Swap?

Today there are bonds you can buy and get the interest coupon, and then purchase a credit default swap (insurance) on the loan that is less than the interest you will get on the loan. Assuming you have a creditworthy seller of the credit default swap, it is risk-free money. You can make almost 1% on the spread! Lever that up a few times and it becomes interesting. (Except that you can no longer get money to really leverage it enough.) This should not be. Then why is it?

Because "... assets everywhere are being dumped in favor of cash, and corporate bonds are no exception. Second, corporate bonds are no longer that attractive as collateral for funding because counterparts are demanding more onerous terms in exchange for lending out cash in return." (The Financial Times)

The corporate bond market is assuming an Armageddon Scenario. Barclays Capital writes that one would have to assume that US GDP will contract by 15% to make sense of the current bond spreads.

My friend and partner Nick Rees at Absolute Return Partners in London dropped me this note (emphasis mine):

"Leveraged loans had a particularly rough month with the average senior secured loan losing over 20 points in value and now trading in the mid 60s. The sell-off was largely driven by forced liquidations as hedge funds face substantial redemptions in the run-in to New Year. This is how crazy the loan market is: The worst ever default rate for senior secured loans is about 8%. If you assume a 35% annual default rate and a 50% recovery rate, your IRR to maturity is now in excess of 22%, using no leverage whatsoever. Either this is the investment opportunity of the century, or equity markets have seriously underestimated the economic downturn, and things are likely to get a whole lot worse for equity investors."

Formerly stable credit funds that are mark-to-market are posting horrific numbers. Many of them have closed redemptions until the market comes back. Selling a fully secured loan at 60 cents on the dollar makes no sense; and many investors are happy the funds have closed, as forced selling by other investors would lock in their losses when the loans will surely recover much of the current markdowns over time. But forced selling by some funds mean that all funds have to mark down the loans to today's value. Mark-to-market in this context is appropriate but it is still hard on your psychology while you wait, and especially as loans seem to keep dropping in value.

Oil Does a Strange Contango Dance

The oil market is said to be in contango. The definition of contango is: "A condition in which distant delivery prices for futures exceed spot prices, often due to the costs of storing and insuring the underlying commodity. It is the opposite of backwardation."

This morning West Texas Intermediate January oil futures prices were (courtesy of Dennis Gartman) $45.80. This rises to $52.28 by just April. A few day's ago, Dennis reports, the spread between the first and fifth futures months had risen to $8.06, the highest ever. When oil was at $147, the spread was an average of $3.25, or about 2.5%. You can buy January 09 crude futures at a stunning 34.5% lower than January 2010.

That means if you could find a place to store that oil, you could lock in a guaranteed 34% profit, less the cost of storage. Sounds like easy money. This is just something that shouldn't be. But what this tells us is that storage for oil is very tight. Oil producers are leasing very large ships to store excess oil, as they cannot find places to store it on land. Storing oil on ships is expensive, so that cost of storage gets figured into the price of oil a year out.

The OPEC nations are not cutting back by any significant amount. Oil is backing up in the system. It is quite possible that oil could go a lot lower in the next few months as the world reels from a global recession, and that means the demand for energy will be down. Oil below $30? Without production cuts that is certainly in the realm of possibility.

As an example, let's look at how shipping is holding up. The graphs below picture a rapidly deteriorating shipping business. Korean exports fell by 18% and Taiwan's by 23% year-over-year ending in October. China's shipping is rumored to be down by 3% on a valuation basis and by 7-8% on a volume basis. Prices in China are actually starting to fall, and Chinese authorities may soon have to deal with deflation.

China is in a situation eerily reminiscent of the US in the very early 1930s. A large trade surplus, far too much production capacity, and falling exports with a whiff of deflation. Hopefully they have studied what we did wrong and will not copy it. But we should pay attention.

This is not a world economic environment that is friendly to oil producers. Could oil fall below $30? It could if producing countries do not start to cut back on production. But many of the larger producers need as much money as they can to keep the lid on civil unrest.

Deutsche Bank and a private consulting firm called PFC, based in Washington, have determined that Venezuela needs the price of oil to average $97 a barrel to balance its accounts, while in 2000 that South American country only required the price to be $34. Look at this chart, courtesy of Dennis Gartman. It shows the price of oil that various countries need to balance their budgets.

Russia will need $70 oil. These countries are going to need to produce and sell what they can, which is in conflict with the need to control production and move prices higher.

So far, the OPEC nations are not cutting back any significant amount of production compared with the destruction in demand. Oil is backing up in the system. Energy economist Philip Verleger suggests that OPEC should execute an "astounding 7.7 million barrels per day" just to restore market balance today. Global demand is down by over 5 million barrels a day to 81.6 million barrels a day. Non-OPEC countries produce almost 50 million barrels of oil. OPEC produces roughly 31 million, plus there are some other OPEC sources of about 5 million barrels equivalent in natural gas liquids. Thus, Verleger says OPEC oil production needs to drop by almost 25%, to somewhere under 24 million barrels a day. Think Iran or Venezuela will cut that much, given their need for cash to fund their regimes? Will Russia join OPEC and cut production? It will be interesting to watch Iran and Venezuela in the coming year scramble to maintain power.

It is quite possible that oil could go a lot lower in the next few months. Demand could fall further. If we are truly producing an extra 5 million barrels a day, the excess supply could be at all-time highs within a few months. Longer term, I still think oil is going higher; but it could be wild ride, and the longer term is now a lot further off. I would not want to be long oil for the next few quarters, until there is some serious growth in demand and some cuts in production.

The Tragedy of Bernie Madoff

And speaking of things that should not be, yesterday I was talking with a few fellow money mangers on a conference call when the news came that Bernie Madoff had been arrested and his fund was missing at least $17 billion, and maybe losses were as much as $50 billion. This is so very, very tragic, as it is not just large investors with well-diversified portfolios who lost here. Many smaller investors around the world had significant sums of money with Madoff. Far too many were not as diversified as they should have been. Some of the stories already surfacing are of horrific personal losses to investors and retirees who have no way to come back from such losses.

The fact that Madoff will spend the rest of his life in jail in no way compensates for the loss of so many people whose lives have been seriously impacted. It is just so terribly sad.

Madoff is a topic that comes up very often in alternative investment circles. I have been talking about his fund with friends at various conferences for almost a decade. "How does he do it?" we wondered. His fund posted steady 1-1.5% monthly returns since 1996, with only a few losing months in all that time. Supposedly he was doing something called split strike conversions. Some speculated that he was actually front-running trades in his market-making business. (Interestingly, regulators who looked at his market-making business never investigated the fund to see if he was doing just that, although I believe there were suggestions and other hints to them.) But arbitrage traders in the same arena could never figure out how he did it, and many were openly sceptical. Everyone, even the smartest trading shops, had losing months and quarters. But not Madoff. The fund was a complete black box and no one knew exactly what he did. Oddly, I have never met or known of anyone who has ever met a trader who came out of Madoff's shop. I run into resumes of ex-traders at various other funds all the time. No one knew what he did, even employees in his (what seems to be legitimate) market-making business, which was walled off from his investment funds. This was a man who was once chairman of the Nasdaq Stock Market. He was trusted and looked up to.

There were signs if you looked for them. The lack of transparency, for starters. The fact that he did his own trades with his own firm and made commissions on them. There was no prime broker where the real assets could be seen. How do you run a $17 billion fund without a room full of traders? I have been on the trading floors of smaller funds, and there are scores of people. A fund that size should have a football field-sized trading floor. Even if it was computerized, there had to be programmers. And lots of them. And where were the geniuses who designed these programs? Jim Simons at Renaissance has hundreds of support staff for his operation. He is one of the best, and he has losing periods. The "auditors" of the Madoff fund was a firm that was located in one 13x18-foot room. For a $17 billion dollar fund? Really? Real audits take lots of manpower.

That being said, a lot of smart people invested in the fund. They trusted Bernie. And anyone who looked at those returns had to be a little tempted. After all, weren't regulators looking at it? (The answer is no.)

Now we know how he made those returns. It was a Ponzi. Except this may have been larger than Enron and ultimately more damaging to more people than any scandal in the past. I remember writing a few years ago, in response to an article in Forbes about some minor hedge fund frauds, that all the losses of all the hedge fund frauds combined did not equal an Enron or WorldCom or just the plain old loss in a few larger companies in the Nasdaq in 2000-2002. I can't say that now.

Note to my fellow alternative industry participants: There is going to be a rush by Congress to regulate hedge funds. The SEC tried to regulate hedge funds a few years ago but had to back away when the Supreme Court said they did not have the authority. When the stories come out over the next few weeks (and I have heard some that really cause me heartache), there will be hearings in Congress. Rules will be passed. Quickly. And they should be.

Instead of fighting regulation as many did last time, we should recognize that this is a war that cannot be won and bow to the inevitable and at least get a few benefits from regulation, like the ability to publicly post past performance (although given the carnage of late, that is not as attractive as when I suggested it a few years ago!). I am regulated by FINRA, the NFA, and the state of Texas. We have had an average of one audit a year by some regulator for the past five years. My firm is small and it does cost a lot, but it certainly does not keep us from operating and growing our business. And I must (grudgingly) admit it does keep us on our toes. So let's sue for whatever terms we can in what should be recognized as a total surrender. And then move on.

When I was a young man I wanted to grow up to be a science fiction writer. The real world has turned out much stranger than I could dream at that time. There are just so many things which should not be.

Goodbye to the Ballpark

For most of the last 15 years, my office has been in right center field of the Ballpark in Arlington, home of the Texas Rangers, the local professional baseball team. The entire center field in the Ballpark was made into an office complex, which has worked out very well for all. I can walk out on my balcony and watch the games and have as many as 25 friends into my office to watch with me. It has been the ultimate little boy's office, and I have enjoyed it. There have been many good times here.

But tonight we are packing up, and tomorrow we'll move the office to Dallas, where I will work in my home along with my small staff. More and more of what we do is now done elsewhere, so we don't need as much room. Not only do we save a very significant amount of money, Tiffani and I also save over an hour a day in commuting. As we began to think about it, that is about 225 hours a year, or almost five weeks of time. And the one thing we both need is more time. At the end of the day, it was the time savings. The office has been worth the money, I think. (I still have a few months on my lease and control the next five years, so if you are interested I would be glad to show it to you.)

There is a part of me that is a bit nostalgic, as I have spent so many Friday evenings here writing this letter to you, even when games were going on. I shall return, as I have friends in the office complex here. But that being said, I am really looking forward to the walk down the hall being my daily commute.

I am hitting the send button a little early, as they are literally going to take my computer in a few minutes. Monday I enjoy the new office for an hour before flying to Phoenix for a day, but back home Tuesday night. Then Friday I am off to New Orleans for a long working weekend with Tiffani, where we will do some real work on our next book, Eavesdropping on Millionaires. The deadline is rapidly approaching and we need to focus!

Have a great week! And remember to think about all the good times! And believe there will be lots more.

Your turning the page of life one more time analyst,

John Mauldin

The Financial Fire Trucks Are Gathering Again

John Mauldin — Thu, 27 Nov 2008 04:02:33 GMT

A Thanksgiving Fire Drill
The Financial Fire Trucks Are Gathering
The Millennium Wave
Thanksgiving, Moving, and New York

"It will therefore be crucial that you see the world anew. That means looking from the outside in to reanalyze much that you have probably taken for granted. This will enable you to come to an understanding. If you fail to transcend conventional thinking at a time when conventional thinking is losing touch with reality, then you will be more likely to fall prey to an epidemic of disorientation that lies ahead. Disorientation breeds mistakes that could threaten your business, your investments and your way of life."

-- James Dale Davidson and Lord William Rees-Mogg, The Sovereign Individual, 1997

The economic news just continues to be bad. New unemployment claims were over 529,000 on a seasonally adjusted basis. The "real" number was 606,877 lost jobs. New home sales were off by another 5% and down 40% from a year ago, as builders slash inventories. The Chicago Purchasing Manager index came in at 33.8, the weakest number since the serious recession of 1982. The national number due next Monday will be just as ugly, as durable goods were down far more than expected, by a negative 6.2%. But it is Thanksgiving weekend, and not a time for gloom. In this week's letter I am going to talk about why we should be optimistic about the future. Things will turn around. I will also make a few comments about the latest stimulus package.

As I will be moving my home this weekend, I am writing this letter early. I am going to use material from two previous letters, which I think will help give us perspective. The first is a personal anecdote from last Thanksgiving (2007), as a lead-in to comments on whether the Fed's latest monetizing action will end up spurring inflation; and then the second is part of an essay I did for my last book, Just One Thing, edited and updated.

A Thanksgiving Fire Drill

Last Thursday (2007), we sat down for a massive Thanksgiving dinner at my 21^st-floor apartment in Dallas. All seven kids, my 90-year-old mother, and an assortment of friends and relatives (about 15 of us) started to work on a 16-pound prime rib, 18-pound turkey, and massive amounts of potatoes, mushrooms, and lots more. Grace was said, the wine was poured, and we were feeling good about life.

And then about 15 minutes into the meal, the fire alarm went off, telling us to evacuate. This was annoying, as it seemed like we have had a false alarm at least once every few weeks in the past few months. So, we did what we have done in the past and ignored the alarm. After all, this is a modern structure (only 4 years old) with fire sprinklers everywhere. We assumed that someone had a grease fire in their kitchen that would quickly be put out.

But the alarm kept sounding quite loudly, which did tend to interrupt conversation. As my dining room table is near the floor-to-ceiling window, we tended to look out when we heard sirens. And sure enough, the fire truck pulled up alongside the building. "Good," we said, "they will get that grease fire under control." And we continued eating and drinking, although with a heightened sense of concern. Fires in apartment buildings are not to be taken too lightly. People do die from them.

And then a second and a third fire truck parked underneath the window. That was a tad disconcerting, but surely they were just making sure that there was adequate back-up. It was when the 8^th truck pulled up within a few minutes that I began to get more than a tad concerned. They were pulling hoses and running around very quickly.

At that point, we started trying to figure out how to leave; but how do we get a 90-year-old fragile lady down 21 flights of stairs? We spent a moment pondering that, and then my youngest son came back into the apartment to report that he could smell smoke a few floors down in the stairwell. Well, that was not good. #2 son said to come to his window at the back of the apartment, where we looked out and could see a rather significant amount of smoke coming from the 2^nd and 3^rd floors. No, this was not good at all. No one was panicking, but we began to think about how to get us down the stairwell and soon.

And then I got a call from a friend who was late coming to dinner. "The fire marshal told me that you have to get out of there NOW!" All this in just a few short minutes, mind you.

So, we started to move to the stairs. Fortunately, there were two rather big, strong young men at dinner (one was my oldest son and the other was a boyfriend who was just back from a tour in the army, but both chiseled out of granite). After several attempts, we decided that taking mother down piggyback would be the best. The young men took turns carrying her.

At first, I still thought it was overkill, but as we got to the 16^th floor the smoke in the staircase was very apparent. By the 12^th floor it was hard to breathe, and at the 7^th floor the smoke was too thick to go on. One of the kids opened the hall door and went and checked the next stairwell, which was freer of smoke. So we changed exits and got out to the street, smelling of smoke - but we were all safe.

It seems some idiot must have tossed a cigarette down the trash chute and started a fire in what is a rather large trash collection bin for hundreds of apartments on the bottom two floors. The fire should have been contained, but the concern was that if anyone had left a trash-chute door open, the fire could have easily spread to a higher-level floor.

And what about the modern fire sprinklers in the trash collection area – the ones I was relying on? They inexplicably did not go off in the trash bin, allowing the fire to blaze on garbage and grease; but the heat rising set off the sprinklers in the trash chutes on higher floors, causing a lot of smoke as the water fell onto the trash, with the smoke escaping into the stairwells.

But all was not lost. It seemed that three of us grabbed a bottle of wine and glasses as we left! ("Train up a child in the way he should go...") So, we sat outside and waited, sipping on a brilliant chardonnay and a full-bodied cabernet for an hour or so until the very professional firemen cleared the building of smoke and let us back up, where we finished dinner, with lots of stories to tell. And my middle daughter had her ten seconds of fame, as she made national news. It was more excitement than any previous Thanksgiving, and one we will talk about for years.

The Financial Fire Trucks Are Gathering

Last year I wrote, after the above story: "I rather think the stock market is acting like we did at dinner. When the alarms go off, we note that we have heard them several times over the past few months, and there has never been a real fire. Sure, we had a credit crisis in August, but the Fed came to the rescue. Yes, the subprime market is nonexistent. And the housing market is in free-fall. But the economy is weathering the various crises quite well. Wasn't GDP at an almost inexplicably high 4.9% last quarter, when we were in the middle of the credit crisis? And Abu Dhabi injects $7.5 billion in capital into Citigroup, setting the market's mind at ease. All is well. So party on like it's 1999.

"However, I think when we look out the window from the lofty market heights, we see a few fire trucks starting to gather, and those sirens are telling us that more are on the way. There is smoke coming from the building. Attention must be paid."

I had been pounding the table for over a year to get out of the stock market. All of the signs of upheaval were there. And now many portfolios are down by 50%. And the fire of a credit crisis is blazing all around us. The firemen in the form of the Fed, the US Treasury, and central banks all over the world are trying to put it out.

And while the stock market may enjoy a serious rally over the next few months, we are not out of the woods. The fire is still raging and we are witnessing ever-more aggressive attempts to get the fire of the credit and housing crisis under control.

Yesterday the Treasury announced yet another huge $800 billion bailout, but this one has a different flavor. Much of the previous bailout money has come from the Treasury either borrowing money and buying assets (which does not create new dollars) or simply taking assets onto the national balance sheet, guaranteeing the debt. With this latest move, the Fed is going to buy $600 billion in mortgage bonds by monetizing, or creating, new dollars.

Normally this would set off more alarm bells, over worries about inflation. But these are not normal times. With the twin bubbles of the credit and housing crises still imploding, we are seeing a massive deleveraging and the disappearance of multiple trillions of dollars from consumers and businesses. And the bond market clearly expects more softening and maybe even deflation. The 10-year bond is below 3%. I wrote 10 years ago that we could see the 30-year US bond below 3% by the end of this decades-long cycle, which we began in the early '80s with Paul Volker.

As I wrote last April, the velocity of money (how fast a dollar moves through the economy) is slowing rather dramatically. It could fall another 10% and just get back to the average for the last 107 years. Given the growth in population, inflation, productivity, and other factors, the money supply will need to grow by 7% annually for the next several years to keep the economy at equilibrium. Remember, GDP (gross domestic product) is essentially the velocity of money times the supply of money. If the velocity slows down, the money supply needs to rise just to stay even.

The Fed is going to have some room to pump up the money supply without seeing inflation rise precipitously. I think this is the first of what will be several large injections, as they will keep it up until the economy begins to recover. They will especially do more if it looks like we could roll over into a deflationary environment next year. I will be writing more about this in the coming months.

And now, the beginning of my essay in Just One Thing (written three years ago, but still quite timely!).

The Millennium Wave

Over the next ten to twelve years, we will see three recessions that will slowly move the average price-to-earnings ratio of stocks to historic lows. Rising oil and energy prices will be a main culprit of both the slowdown in the economy and an increase in inflation. Ever-increasing monetary inflation will, in fact, trigger a huge increase in all commodity prices, as well as a decline in bonds. Asset inflation will show up in the housing markets as home values continue to skyrocket. The dollar will continue to weaken against major foreign currencies. The current war will become increasingly unpopular, and the next administration will be forced to withdraw troops, under the guise of declaring victory. The American voting public will be split as never before, with major patterns in voting habits making a generational change. The newspapers will continue to write about how an Asian country will dominate the world economically in less than a few decades.

Following this period of malaise, there will be an amazing cycle of new technical innovation that will spark yet another major bull market. The new technologies will change the world in ways that simply cannot now be imagined and will lead to whole new industries, putting amazing new power and abilities into the hands of individuals and governments.

The preceding scenario would, in fact, all come to pass. Except that the year that was written was 1970, and not 2005. The forces that have changed the world in the decades following 1970 were only foreseen in science fiction and a few obscure books and journals. Who dreamed of the Internet in 1970? Who could envision that the Berlin Wall would come down in 1989? That Japan would not, in fact, dominate the world of economics and overwhelm the United States? Or that the China of Mao would become a capitalistic growth machine, and that the USSR would break up? A personal computer on every desk and more computing power in an automobile than existed in the largest computers of the time? A globalized world economy? The prospect that a falling population (and not overcrowding) would be a problem, or that a Green Revolution would mean enough food for all (except where governments kept out a free market)?

In the 1970s, the mood of the country was decidedly negative. Japan was eroding our manufacturing base and unemployment was increasing. Reagan spoke of the Misery Index, which was a combination of inflation and unemployment, in his race against Jimmy Carter.

And yet it all changed. In fact, the one constant in the modern world is that the pace of change is accelerating.

In his groundbreaking book The Third Wave, Alvin Toffler depicted the First Wave as the agricultural revolution, the Second Wave as the industrial revolution, and the Third Wave as the electronic data and communication revolution. He depicted a society that would be working in "electronic hamlets," sending their daily work over "electronic highways" to "virtual places of business."

Written twenty-five years ago, The Third Wave was an amazingly prescient book. Toffler saw a world of mass customization, with government and business interwoven and a world filled with ambiguity and change. Although some suggest that we're still in the middle of Toffler's Third Wave, I would suggest that what we are facing is different in both substance and character.

The Third Wave was actually the result of an innovation cycle that we can call the Information Age. I believe we are only halfway through the Information Age, with more profound changes as to how we work and play just around the corner.

But this time something is different. Instead of one wave of innovation following another, I believe that we are going to see multiple waves of significant change and innovation surge all over the world at roughly the same time. The combined effects are going to produce a period of change unlike anything seen in the history of man.

I call the combination of these factors the Millennium Wave. It will change things in ways that almost defy the imagination and at a pace that will leave one breathless. On the one hand, the Millennium Wave will be seen as a source of good, as we will live healthier and longer and there will be more of the basic necessities of life and more life options. On the other hand, the very ground we walk on will seem like it is shifting. The roadmap we have in our minds for our future will require a constant fine tuning (if not major reprogramming) in order to determine our position.

The more precisely you plan your future, the harder that change will hit you. Flexibility will be the order of the day. To paraphrase the prayer from Alcoholics Anonymous, "Please grant me the knowledge of what will change, the understanding of what will not change, and the wisdom to understand the difference."

As I pondered the question I put to the other writers in this book, "What is the one thing you have learned that you want to pass on?" I came to realize that the key talent in the future would be the ability to deal with the tremendous technological and cultural changes that are coming at an ever-increasing pace, while developing an understanding of how those changes will evolve in the age-old patterns of life. There are patterns that change very slowly or cycle or trend. Learning how all these patterns fit together with the changes of the Millennium Wave is at the heart of not just the investment enterprise, but modern life in general.

But let's deal with the investment enterprise first. Anyone familiar with the research on the psychology of investing knows that it points to the overwhelming conclusion that the broad class of investors (which does not include you or me, of course) consistently assumes that the current trend will continue long into the future.

They may give lip service to believing things will change, they may constantly worry about changing trends, but they do not invest that way. The late and deservedly famous economist Herbert Stein taught us the simple concept, "An unsustainable trend will not be sustained." And yet investors (and indeed all humans on almost every level) allow the current trend to be the primary force in their vision of the future. As Mark Finn noted in Chapter 5, we use past performance, even when we know we shouldn't, to be the guide in picking our future investments.

Investors all too often rationalize their actions with the mantra of "this time it's different" or assume they will be able to nimbly react to or avoid the affects of the change when it happens. It never is and they hardly ever do.

My personal career path has been one of almost constant change. Yet it is but an echo of a million other entrepreneurs and businessmen and women. We all deal with change. In fact, the amount of change that I have had to deal with is rather unremarkable, in the grand scheme of things. There are millions - perhaps billions - of people who go through far more abrupt changes almost daily.

How well we deal with life (not just our investments!) in the next 20-30 years is going to be directly related to how well we deal with what will be an accelerating rate of change.

My personal experience of continuing change will be echoed throughout the world. Some of the changes were forced upon me. Some of them I willingly embraced. I told friends on the occasion of several of these changes that I hoped this was the last time I would have to "reinvent" myself. I succumb to the fantasy that most investors share: that the trend of today will continue. And yet, I know that this is not likely. The field in which I plow and reap is changing under my feet, and it is unlikely that in ten years it will even look the same.

When I began my career thirty years ago, there was no fax, no overnight delivery, and phone service was expensive. Computers? Not until twenty years ago, and they were toys compared to today's machines. It cost a lot of money to deliver a newsletter up until just a few years ago. Now the marginal cost is almost nothing. One or one million is pretty much the same to me.

Research was a visit to the library, in addition to a personal collection of books and a few magazines and newsletters. Now I get scores of letters and articles every day delivered to my "mailbox," plus an almost infinite amount of data at my fingertips using something called Google. I have almost five gigabytes of research and articles stored from just the past few years on my computer, which I can search with a few strokes. To write an eight- to ten-page weekly letter as I do would have taken a week, plus a month of research, just a decade ago. Now I can access huge amounts of data each week, and I write my weekly letter on a computer in about five hours on a Friday afternoon. (I read where they will soon have pills that will help our memories. I am going to need them.)

International readers? Very few ever graced my musings in the last decade. Now, I have tens of thousands of international readers, often in some amazingly remote locations.

In short, the changes have been dramatic. At times, I complain, it has been hard to adjust. A lot of times those changes were just plain not fun. Some of them were very expensive lessons. Yet, I continue on down my current business path. But I know that change is coming. Change is like a train. It can either run over you, or you can catch it to the future.

But I can hear that peasant from China, as he follows an ox on the way to the city, telling me I can't even begin to imagine the speed of change. Think about the changes in China and Russia or other parts of the developing world in the last ten years. My less-than-sainted Dad last hitched a wagon to drive to town in the 1920s. He saw a man put on the moon with a slide rule, a yellow pad, and pencils forty years later. That pace of change has only increased.

In 1967, the movie The Graduate was the hit of the season. We remember that famous scene where a young Benjamin Braddock (Dustin Hoffman) was told to seek a career in plastics. That was the rage at the time. But it turns out that was bad advice. Over 40 percent of jobs in plastics have disappeared since 1967.

And yet, there has been plenty of job growth. There were clearly better opportunities than plastics. Princeton Professor Alan Krueger tells us a quarter of all workers are now in occupations that were not listed in the Census Bureau's occupation codes in 1967. In 1967, if asked where the jobs and opportunities were going to come from, the proper and correct answer would have been, "I don't know, but they will." That was the correct answer in the malaise years of 1976-80. It is still the correct answer today.

Personal computers were yet a dream. AT&T was still a monopoly. Fiber optics? The Internet? Cell phones? Robotics? Biotech? Global positioning? Faxes? Video? MP3? Computer–aided design? They didn't exist.

In less than 30 years, we will look back at the changes that are still in our future and realize they were far, even vastly, more revolutionary than what we have seen in the last 30. But just as in 1975, when it would be hard to imagine the coming changes, in 2005 it is even harder to imagine what 2035 will be. We delude ourselves into thinking we know, but we really don't. Many of the truly amazing inventions we will enjoy in the future are still not even on a drawing board or in a garage.

There is plenty of entrepreneurial activity in the world, and the foundation for future large companies that will reward their investors is even now being laid. The driver for the next Microsoft, eBay, or Amgen will be the new opportunities brought about by the pace of change.

[Update in late 2008: within the last six months I have talked with two different researchers who believe they are on track for an altogether new form of power production, which would be cleaner and far cheaper than anything we have today. I have also interviewed another inventor who has patented a process which reduces by as much as 20% the electrical energy used in many of our electrical devices. And there are tens of thousands of inventors who are working on such breathtaking ideas. If only a few succeed....?]

What kind of pace of change are we talking about? Ray Kurzweil, the inventor of speech recognition, scanners, music synthesizers, and many other technical marvels, has a team of ten who track the progress of technology and predict where it will be in ten or twenty or one hundred years. He is an unabashed enthusiast when it comes to thinking about the future. It helps that he has been right so far, so it behooves us to pay attention when he notes (this was written in 2001):

"The first technological steps - sharp edges, fire, the wheel - took tens of thousands of years. For people living in this era, there was little noticeable technological change in even a thousand years. By 1000 A.D., progress was much faster and a paradigm shift required only a century or two. In the nineteenth century, we saw more technological change than in the nine centuries preceding it. Then in the first twenty years of the twentieth century, we saw more advancement than in all of the nineteenth century. Now, paradigm shifts occur in only a few years time. The World Wide Web did not exist in anything like its current form just a few years ago; it didn't exist at all a decade ago.

"The paradigm shift rate (i.e., the overall rate of technical progress) is currently doubling (approximately) every decade; that is, paradigm shift times are halving every decade (and the rate of acceleration is itself growing exponentially). So, the technological progress in the twenty-first century will be equivalent to what would require (in the linear view) on the order of two hundred centuries. In contrast, the twentieth century saw only about twenty-five years of progress (again at today's rate of progress) since we have been speeding up to current rates. So the twenty-first century will see almost a thousand times greater technological change than its predecessor."

What Ray is saying is that most people project future growth in technology at today's rate of change. But the rate of change is accelerating, so that more and more change is packed into smaller and smaller amounts of time. Although the vast majority of the thousand times greater technological change Ray is talking about happens in the last part of this century, some of it happens in the next twenty years. How much change are we talking about? Well, from when he first penned those words, the pace of change has picked up. At current levels, that means the twentieth century was equivalent to about twenty years of progress at today's rate of change. That pace will continue to increase the amount of innovation we pack into just a few years. From his book Fantastic Voyage:

"...And we'll make another twenty years of progress at today's rate [of growth], equivalent to that of the entire twentieth century, in the next fourteen years. And then we'll do it again in just seven years."

That means in the next twenty-one years we will see double the technological change that we saw in the entire twentieth century. At that pace, we will see almost four times the rate of change within twenty-five years.

More and more money is being invested in a wider array of research and development all over the world. There are millions of projects by inventors looking to improve a product or service. Some changes will be small and some will have enormous implications. When the steam engine was being invented, there were just a handful of inventors who understood the steam engine and could work on one. Today, we have the luxury of having thousands of scientists, engineers, programmers, and inventors working on all manner of projects large and small. And as cheap and fast broadband becomes ubiquitous in the developing world, we will be adding tens of millions more to the process. A few of these multiplied millions will invent radical new products, adding to the pace of change.

As our knowledge expands, as our tools grow in number and decrease in cost, our ability to find useful products increases at an ever-growing rate. The tools that our current and future horde of inventors will create will allow for all sorts of new products and discoveries.

There are thousands of such tools, big and small, being created by scientists and inventors in research labs all over the world every month in scores of different industries. Each one allows the next group of inventors to create even more and better tools and ultimately products. Globalization is not just a manufacturing and sales process. It is also an intellectual process, as scientist from many parts of the globe can collaborate on a project, each bringing their specialized knowledge to the project. That allows scientists in smaller countries or in countries without significant resources to add to the sum total of brainpower being thrown at a project.

All this means change is going to come faster than ever before. And with these new changes will come renewed economic growth, and millions of new jobs in the US and all over the world.

Today's current crisis will pass, just as past crises have. And this will not be the last crisis or recession of our lives. We will sadly create whole new ways to foment a crisis. But in 20 years, no one is going to look back and say I wish I could go back to the good old days of 2007. We will then be living in the most exciting age in the history of man.

Thanksgiving, Moving, and New York

Thanksgiving is my favorite holiday of the year. In the US, families and friends get together and feast and enjoy one another. And while we do that at Christmas as well, on Thanksgiving we do it "just because," with no need to buy last-minute presents, just last-minute food! It is a time to remember and be grateful for the grace of God in our lives.

Tomorrow morning will find me in the kitchen very early, cooking a 16-pound prime, five pounds of mushrooms, and lots of veggies. There are now about 25 family and friends coming for dinner, and most people are bringing something, so there will be lots of food, wine, and good times. Then the Dallas Cowboys game in the afternoon, while eating my mother's banana nut cake. It just doesn't get much better than this.

Then on Friday and Saturday we pack up and move a few miles up the road. I am actually looking forward to the move. I have enjoyed my urban apartment life, with the incredible view of downtown Dallas, and may move back to the Uptown area in a few years; but right now I want to cut my commute time and move my office into my home and into a good school district for Trey. He has been "going" to school online, but it is time for him to get into a more social setting. And the house we are moving into is very family-friendly, so I expect the kids who are "out" will be back even more.

Next Thursday I am off to New York. I will be on Happy Hour on Fox Business News at 5 pm Eastern with Cody Willard, and then at the Minyanville Festivus party that evening. The next night we go to see the hit musical Rock of Ages on Broadway as the guest of Barry Habib, one of the producers. My good friend and venture capitalist extraordinaire Bart Stuck will be there as well. And then Saturday is some sightseeing and dinner with friends and my South African partner Prieur du Plessis, who is in town for Festivus as well. It looks to be a great week!

Let me wish those of you in the US a very warm and sincere Happy Thanksgiving. We have a lot to be grateful for.

Your more hopeful for the future than ever analyst,

John Mauldin

Housing: Are We Near the Bottom?

John Mauldin — Sat, 13 Sep 2008 00:12:30 GMT

The Headwinds to Growing Your Wealth
The Wealth of Nations
Housing: Are We at the Bottom?
Alt-A is the New Subprime
3.5 million Unemployed and Counting
La Jolla, South Africa and London

This week we look at the housing market in some detail. When can we expect it to turn around? Part of the problem is a new wave of foreclosures is coming due, and this time it is not subprime. And that means more problems for the large financial companies. Also, as predicted here, consumer spending is taking a hit as consumers are finding it increasingly difficult to get credit and a deteriorating labor market hits total spending. There are some very interesting details in the data that was released this week. And we take a quick peek at the outlook for inflation. What is in the pipeline, so to speak? It should make for an interesting letter.

But first, it is finally time to make a very special announcement. Readers are aware that we have been asking you to take a survey on your financial and personality profiles. We are grateful for your response. Tiffani said that she has that nervous/excited feeling right before a long anticipated moment that makes your heart race a little faster. In early summer of next year, we will be releasing our first book written together to be called "Eavesdropping on Millionaires."

The data we are getting is simply amazing. I have seen nothing like it. And to make it more than just a book of numbers, over the next few months Tiffani and I will spend countless hours interviewing millionaires about their personal journeys, philosophies, investments, business successes and woes, lessons learned, families and lifestyle. We have had over 1,000 millionaires (net of their homes) and counting volunteer for the interview. This is the fun part! Listening and exchanging life stories with other people has to be one of the most satisfying and connecting joys of our lives. We plan on doing a series of books, so these interviews will go on for the next year, at the very least.

As you know, I consider my readers to be above par in their insightful feedback (good or critical) and intelligence. Tiffani agrees and we want to know, if you could sit in a room with these millionaires and ask anything, what would you would want to ask?

Please send any and all suggestions to us at EU@2000wave.com. And I mean anything, no question is too generic or outlandish for us to consider.

Not only have we had over 1,000 requests for interviews, we have had over 7,000 millionaires (so far) take our extensive survey out of a total of 16,342, with over 25% coming from outside the US. We have not been able to find a survey done in the past ten years with even half that number! (If you know of any surveys or articles that you think we might have missed, send those along to the above email as well.)

Let me tell you how fascinating it is to start digging into this data. We are comparing our data with other books, surveys and articles we are researching, not only confirming things we already know but, now, we are finding new and important information.

If you haven't taken the survey yet and want to participate in this research (and we want everyone to take it as you don't have to be a millionaire, if you are reading this you can take it), please visit: http://survey.frontlinethoughts.com/index.php?sid=12431&lang=en

The Headwinds to Growing Your Wealth

One thing that I find interesting in our research will help me illustrate a very important point I have made in the past few months, and that is the difficult headwinds that people are going to have in their efforts to grow the investment portfolios.

In the Millionaire Next Door, written in 1996, approximately 3.5 million households in America (out of a total 100 million households) had a net worth of $1 million or more. Millionaire households accounted for nearly half of all the private wealth in America.

During the ten-year period from 1996 through 2005, the authors projected the wealth held by American households to grow nearly six times faster than the household population. Quoting: "By the year 2005 the total net worth of American households will be 27.7 trillion or more than 20 percent higher than in 1996."

As it turns out, the numbers are far better. Today there are 9.2 million households worth more than $1 million, not including the value of their primary residence. The net worth is almost double their estimate. However, the numbers of new millionaires grew by 21% in 2004, 11% in 2005, 8% in 2006 and 2% in 2007. Can you see a trend here?

In fact, this year it may even reverse. If you go the Federal Reserve data, you find that US national net worth has dropped by over $2 trillion in the two quarters ended last March (that is the latest data). Given the continued drop in home prices and the stock market, it is likely those losses will mount. (http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf)

Now, it is not all bad news. We still have total assets of $70 trillion against liabilities of $14.5 trillion. However, much of that wealth is concentrated in the hands of the wealthy, and the real imbalance is in lower income households. And cash savings are rising at a healthy pace for a change.

The Wealth of Nations

Now, let's review a few factors as to why I think it is going to be harder to get that millionaire status over the next decade than it has been in the past. From 1981 to 2006, our national wealth in terms of the houses we own, stocks we own, real estate, bonds, businesses - everything - our net national wealth (or maybe it's better to say, the prices we put on our assets) grew from $10 trillion to $57 trillion. Over very long periods of time national wealth is by definition a mean-reversion machine. Over 40 or 50 years national wealth has to revert to the growth in nominal GDP. That's just the way the economics and the math work out.

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

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

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

I have written extensively about how stock market valuations are mean reverting. We have a long way for valuations in terms of Price to Earnings Ratio to get to the mean, and typically (as in almost always) we see P/E ratios drop far below the mean. It is hard to see portfolio increases in such a mean reversion period. We are also watching housing values come down (see more below). What we are going to see is a very difficult period for asset growth in precisely the two areas where investors tend to concentrate their portfolios: US stocks and housing. Using history as our guide, that period could last for another 5-7 years. That is why I keep suggesting you look for alternatives to traditional stock market allocations.

Housing: Are We at the Bottom?

The short answer is no, but let's look at the data from one of the most knowledgeable sources on that topic. John Burns of John Burns Real Estate Consulting consults with over 2000 of the largest banks and homebuilders in the country (his client list is a who's who of banks, builders, and hedge funds). He has a reputation for solid research and pulling no punches. Some of his hedge fund clients were the ones you read about who made billions. (He wishes he had negotiated a percentage!) He is deeply involved in analyzing trends in the housing market. His web site is www.realestateconsulting.com. He has graciously sent me the executive summary of his latest posting (a 27 page executive summary) that we will be looking at for the next few pages.

Let's start with a quote from John at the beginning of his report: "The prospects for the U.S. housing market have changed for the worse. It has become increasingly clear that the U.S. economy is on the brink of recession, as overall job growth has slowed to zero and retailers are reporting abysmal results. New home sales, traffic and pricing are all heading down according to the results of our survey of over 300 builder executives. Resale [existing home] sales are starting to plateau in some markets, but pricing continues to fall as distressed sales dominate the market. The new housing bill will help in some ways, but will first serve a devastating blow to homebuilders, with the elimination of seller-funded down payment assistance, which accounts for 17% of new home demand by one estimate."

How far along are we? Burns thinks that home prices will drop by 22%, 12% which has already occurred. His analysis differs from that of the Case-Shiller Indices, which suggests a much steeper decline. Note in the graph below that the Case-Shiller Index shows home prices rising more than does Burn's work. Part of it is different methodology and part of it is the CS index focuses on major markets and Burns work is more broadly based.

However you slice it, there has been a lot of pain. Shiller's work shows home prices in the areas he measure to be down about 17%. He said last week that he does not think it unlikely that we sill see home prices drop by as much as 30%, or about the same as during the Depression of the 30s. Burns see less of a drop, but from not as high a point, so they both end up close to the same end point.

The graph above shows Burns' projection for the next few years. He thinks it will be 2011 before housing prices begin to turn back up on a nationwide basis, with national prices continuing to fall into 2010. That will not sit well with the pundits who keep telling us each month that we have seen the bottom.

For the difference in his numbers with Case-Shiller, he offers the following explanation: "The Case-Shiller national number, which is a "paired sales" analysis, showed much more price appreciation than other indices based on median prices. We suspect that there was a shift in the mix of homes sold to lower priced homes in 2006 due to subprime lending, which depressed the median value and showed large % increases in the paired sales index."

Sales volumes are suffering. "We believe sales volumes have already fallen back to 1995 levels and will hit 1992 levels sometime next year, when they will begin to slowly rebound later in the year. We are already seeing rebounds in some of the hardest hit markets, such as Southern California, where sales fell to below the levels of the early 1990s. The rebound in sales will be driven by foreclosure buying activity and demand from real households that need to move for personal reasons and have been delaying their purchase for fear of further price corrections. Our 8% per year projected [starting in 2010] increase doesn't get us back to normal sales volumes until after 2012, and that is because the tremendous excesses of this cycle moved many renters into homeownership earlier than usual, and allowed existing homeowners to "move up" to their dream home earlier than usual. Conservative mortgage lending will also prevent a sharp turnaround."

On a more optimistic note, he thinks new home prices, which started to correct much earlier than existing home prices, should bottom out in 2009, although some particularly overbuilt areas will suffer longer. We are actually close to a bottom in new home construction, and he thinks we will be back to 900,000 new homes by 2012. But that is a far cry from the 1.68 million in 2005, but is also a sustainable number.

There is a problem though, and that is the recently enacted housing bill eliminated seller-funded down payments, and this was 17% of new home sales. Watch for a rise in the number of new homes sold in September, as the new law does not take effect until October. Home builders will be telling people to buy now before this ability to help with the down payment goes away. But cheerleaders on TV will be telling us the market has turned. They won't be saying that in November.

Alt-A is the New Subprime

By now, everyone in the world is aware of how bad the subprime mortgage business was. But now it is time to get ready to hear the same tale, told again, about Alt-A mortgages. Alt-A mortgages are mortgages made to borrowers with better credit scores than subprime borrowers, but could not or decided not to document their income. One estimate is that 70% of Alt-A borrowers may have exaggerated their incomes (Wholesale Access). More than half to those were people who exaggerated their incomes by 50% or more! (Mortgage Asset Research Institute)

How much are we talking about? Around 3 million US borrowers have Alt-A mortgages totaling $1 trillion, compared with $855 billion of subprime loans outstanding. $400 billion of that was sold in 2006. Almost 16% of securitized Alt-A loans issued since January 2006 are at least 60 days late. Many of these loans (around $270 billion) were interest only or with a low teaser rate, and the resets were at 3 and 5 year lengths. These are called Option Arms. That means starting next year we are going to see a wave of mortgages re-setting to new rates. And it is no modest increase. Rates can jump as much as 4-8% or more from teaser rates. Some Option ARMs are re-setting at 12.25%. That can double a payment.

Wachovia and Washington Mutual were big sellers of Alt-A loans, and had $122 billion and $53 billion, respectively, on their books at the end of the second quarter. Is it any wonder that their stocks are under pressure? That is why bit is so hard to quantify how much more write-offs there will be. You don't write down a mortgage until it starts to develop problems. These problems may not show up for a few years. I continue to stress I do not want to own a financial stock that has exposure to mortgage paper. Write downs are going to continue to come for a long time.

This means there will be a steady wave of foreclosures for the next two years in communities all over the US. As long as these homes keep coming onto the market, they are going to exert downward pressure on prices. Foreclosure sales are up by 109 from this time last year.

3.5 million Unemployed and Counting

The number of people receiving unemployment benefits jumped to 3.525 million, the highest level since 2003. My friend and Chief Economist John Silvia at Wachovia forecasts that unemployment will rise to 6.7% in 2009 (from 5.5% today) and above 7% in 2010. Given the inability of US consumers to borrow against their homes, with rising unemployment, is it any wonder that consumer spending data released this morning showed retail sales dropping 0.3% in August, for the second month in a row (July was down 0.5%)? Excluding automobiles, sales dropped 0.7% in August, the most this year.

Look at the chart from Greg Weldon (www.weldononline.com). As he notes, retail sales are posting their worst reading since the last recession.

Prices at the wholesale level actually fell. Silvia thinks the consumer price index will be in the neighborhood of 2%. Right now, a lot of people think that sounds crazy, but I agree. First, remember that CPI measures changes over the last 12 months. As an example, look at the oil price chart below. Starting next spring, unless energy prices rise a lot, we are going to see year over year comparisons for energy prices that will be negative. If oil drops to $80, which it very well could, that would have the affect of decreasing inflation next summer, by a significant amount. And given that Europe and Japan are in a recession, and emerging markets have reduced the demand because of high prices, thinking that oil in the short term could be lower is not unreasonable. (Long term I think oil will go MUCH higher, but that is another story.) A 40% reduction in gas prices from their peak is not out of the question. That would impact inflation by pulling it down.

You can make the same case for a lot of commodities and some of the food complex as well. Year over year comparisons in a few quarters are going to start to look good. In absolute terms looking back a few years, it will still feel like inflation, but the numbers don't have feelings.

With Europe and Great Britain central banks likely to cut rates, the dollar is going to get stronger (as predicted here long ago). That will also help hold inflation down. Consumer spending is going to continue to be under pressure, which will not be good for stocks, which means that those facing retirement are going to have to save more and spend less. I think this time next year we will start to see stories about deflation. I know, call me crazy, but given that we have seen two major bubbles burst in the last year (housing and credit), it is not out of the realm of reason. It is what SHOULD happen. Bursting bubbles are by definition deflationary events.

Within a few quarters the Fed will not be under pressure to raise rates, especially with rising unemployment and what is clearly an economy on the ropes. Further, banks need lower rates in order to re-liquify. Home buyers will need lower rates as well. I think, as I have written for a long time, that the Fed is on hold for a very long time. And I am not sanguine that the next move will be a rate hike. This time next year when inflation is seen as yesterday's problem and unemployment is rising, the drums may be pounding for a rate cut. We live in interesting times.

La Jolla, South Africa and London

Next Monday Tiffani and I get on a plane, assuming the hurricane is out of town by then and fly to La Jolla to be with Jon Sundt and the team at my US partner Altegris Investments, coming back Tuesday. Then next Friday Chuck Butler from Everbank and Thomas Fischer from Jyske Bank and a crew from the Sovereign Wealth Society are going to show up at my office to watch a Texas Rangers game. Chuck is a huge baseball fan and he is always fun to be around.

Then Saturday morning I fly to South Africa for a speech the next Tuesday. I will be speaking at the ABSIP (Association for Black Securities & Investment Professionals) Annual Conference in Cape Town on September 23. To obtain more information, contact my Spouth African partner Prieur du Plessis through the contact facility on the Investment Postcards from Cape Town blog.

That night I fly to London and spend the day there with my Niels Jensen and his team at my London partners Absolute Return Partners. We will be meeting with clients and I have some time available there. Contact me and I will put you I touch with them.

There are a lot of things happening in the alternative investment world, and I try and stay on top of them. If you are interested in looking at hedge funds, commodity funds and other alternative funds, go to www.accreditedinvestor.ws and sign up and I will have one of my partners contact you and show you what is "behind curtain #3". (I am president and a registered representative of Millennium Wave Securities, LLC., member FINRA.)

My travel and writing schedule is pretty rough right now. When I get back I have a trip to Europe in Mid-October (Sweden, Malta, London, maybe the Mid-East) and then I am coming home for awhile to catch up and finish the book with Tiffani and try to get my own book, way past due, finished as well.

I am going to hit the send button a little early so I can make sure everything is ready for Ike to show up tomorrow. We are 250 miles inland (Dallas), but they are expecting some bad weather and the real problem here will be that the conditions will be perfect for tornadoes. It should be an interesting weekend. Right now the weather is perfect, but in 24 hours it will be very wet. The real problems will be in Houston and Galveston. I wish my fellow Texans well.

I see some time to stay home and read science fiction in my near future. Enjoy your weekend, wherever you are.

Your hoping it does not get that bad analyst,

John Mauldin

Earnings and Mr. Bear

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

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

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

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

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

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

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

Earnings and Mr. Bear

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

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

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

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

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

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

Earnings Before Bad Stuff

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

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

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

How Ugly Can it Get?

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

"Forecast addendum: Adjusting to the new reality

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

"Less consumer, more unemployment, profit squeeze ahead

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

"Back to the 1970s

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

"2008 stimulus - round two?

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

"Housing still in the weeds

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

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

Can you say Muddle Through?

A Lean Mean Reversion Machine

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

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

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

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

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

Some Thoughts on Energy Policy

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Oregon, Maine, and a Wedding

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

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

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

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

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

Your hoping he can catch more fish this year analyst,

John Mauldin

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 Problem with the Euro

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

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

By John Mauldin

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

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

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

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

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

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

Swapping out Commodities

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

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

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

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

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

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

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

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

The Euro at Par with the Dollar

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

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

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

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

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

The Change In Policy

The Divergence in European Spreads - Why Now?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

A Final Thought

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

Laguna Beach, Montreal and Las Vegas

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

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

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

Your having more fun than ever analyst,

John Mauldin

Whither the Price of Oil?

John Mauldin — Sat, 24 May 2008 06:23:00 GMT

Those Nasty Index Speculators
Is Correlation Causation?
Where Are All the Tankers?
Where Will Oil Prices Go?
Is it 1980 All Over Again?
The Middle East, California, and Help for Myanmar

Why has the price of oil risen so much in the past few months? Is it a supply and demand issue as some believe; or is it because of an out-of-control futures market driven by the proliferation of commodity index funds and rampant speculation, as everyone tries to get in on the rise in commodity prices? This is a very complex issue, with a lot of emotion attached to it.

This week I try to give you an understanding of why oil prices have risen and whether they are likely to stay at such lofty heights or maybe even fall! And we look at a very odd statistic: where are all the tankers? There are some very unusual things happening in the oil patch. If you are currently exposed to the energy or commodity markets, or are thinking about it, I believe you will find this letter of interest. At the end of the letter, I also tell you how you can personally see that help gets to the victims of Cyclone Nargis in Myanmar. It is a desperately needy situation. There is a lot to cover, so we will get to the essay right after this quick note.

I have talked for the past few months about why I feel we may be in for a tough investment environment and a Muddle Through Economy. I think in this type of market cycle it is important to increase your portfolio allocation weighting to noncorrelating investment strategies. I work with Steve Blumenthal and his team at CMG to help investors find managers who can take smaller minimums and who have such alternative strategies. We are creating a platform of managers that you can access for your personal portfolio. I recently completed a special write-up on Eric Leake of Anchor Capital, an investment advisor I am particularly impressed with. For the last 12-1/2 months, he is up 16.77%, in comparison to the S&P 500 index that is down -2.08% (net of fees from April 30, 2007 through May 15, 2008). Past results are not necessarily indicative of future results.

You can get this report and others I have written by going to https://cmgfunds.net/public/mauldin_questionnaire.asp and filling out the form. If you are a manager and would like to be considered for the platform, drop a note to PJ Grzywacz at pjg@cmgfunds.net. And if you are an investment advisor and would like to see the managers that are on our platform and determine whether they might fit into your client portfolios, we do have a program to work directly with you. Please remember to read all important disclosure and risk information available at the site.

And as always, if you have a net worth of over $2 million, I strongly suggest you go to www.accreditedinvestor.ws and register there. My partners in the US (Altegris Investments), London (Absolute Return Partners) and South Africa (Plexus) have spent years working in alternative investment strategies, including hedge funds and commodity funds. We have a very strong selection of funds in a wide variety of styles to help you diversify your portfolio. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now, let's jump into the oil patch.

Those Nasty Index Speculators

Are institutional investors in the form of large commodity index funds the reason behind the current rise not just in oil prices but in the prices of seemingly all commodities? Michael Masters, a long-short hedge fund manager, in testimony before the Congressional Committee on Homeland Security and Governmental Affairs, said:

"You have asked the question 'Are Institutional Investors contributing to food and energy price inflation?' And my unequivocal answer is 'YES.' In this testimony I will explain that Institutional Investors are one of, if not the primary, factors affecting commodities prices today. Clearly, there are many factors that contribute to price determination in the commodities markets; I am here to expose a fast-growing yet virtually unnoticed factor, and one that presents a problem that can be expediently corrected through legislative policy action."

You can read the entire testimony at http://www.mcadforums.com/forums/files/michael_masters_written_testimony.pdf, but let's hear the basics of his argument:

"What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.

"These parties, who I call Index Speculators, allocate a portion of their portfolios to "investments" in the commodities futures market, and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy: they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices - the Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index."

These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals, and livestock. When you buy one of these funds you are buying a basket of commodities.

Why would an investor want exposure to a long-only index of commodities? Perhaps for portfolio diversification, as commodities are uncorrelated with the rest of the portfolio, or as a way to play the growing demand for commodities of all sorts from emerging markets, as a hedge against inflation, and so on. Mainline investment consultants began to suggest a few years ago to their clients that they get into the commodity market on a buy and hold basis, just like they do with stocks and bonds.

And they have done so in a very large way. As the chart below shows, at the end of 2003 there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion. Masters also shows that this corresponds with the stratospheric rise in commodity prices. In many commodity futures markets, index speculators are now the single largest participant.

Is Correlation Causation?

There is no doubt that the rise in the investment in commodity indexes and the rise in prices correlate significantly. But does correlation necessarily mean that there is a direct cause and effect? Masters says it does. (Later we will look at arguments against this view.)

As an illustration, he shows that the rise in demand for oil from China in the past five years has been 920 million barrels of oil per year. But index demand (the word Masters uses) for oil has risen by 848 million barrels, almost as much as another China.

And Masters gives us facts that are interesting. There is enough wheat in the index speculator "stockpiles" in the US to feed every many, woman, and child all the bread, pasta, and baked goods they can eat for the next two years - about 1.3 billion bushels. Yet wheat has soared in price.

As the prices of the indexes have risen, the demand for the indexes has grown. And these indexes are not price sensitive. If a billion dollars is invested in a given week, the index funds simply buy whatever allocation of futures contracts is needed to make up their index, at whatever price is offered.

For the first 52 trading days of the year, demand for commodity index funds grew by more than $55 billion, or more than $1 billion a day. And as Masters points out, "There is a crucial distinction between Traditional Speculators and Index Speculators: Traditional Speculators provide liquidity by both buying and selling futures. Index Speculators buy futures and then roll their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefit to the futures markets.

"Index Speculators' trading strategies amount to virtual hoarding via the commodities futures markets. Institutional Investors are buying up essential items that exist in limited quantities for the sole purpose of reaping speculative profits."

And now we get inflammatory:

"Think about it this way: If Wall Street concocted a scheme whereby investors bought large amounts of pharmaceutical drugs and medical devices in order to profit from the resulting increase in prices, making these essential items unaffordable to sick and dying people, society would be justly outraged."

What about position limits? Aren't there real limits to the amount of a physical commodity that a fund or speculator can accumulate? Masters points out that there is, but the CFTC has given investment banks a loophole, in that they can sell unlimited size positions in the OTC swap markets if they hedge the positions.

So, a hedge fund could buy $500 million worth of wheat, which would be way beyond the actual market position limit, through a swap with a Wall Street bank, without having to worry about position limits. And there is no doubt that large purchases of any commodity will drive up prices, at least in the short term.

What does Masters think Congress should do? Prohibit pension funds from commodity index buying, close the swaps loophole on speculative positions, and make the CFTC (Commodity Futures Trading Commission) provide more transparency as to who is buying commodities. That would stop those nasty index speculators from driving up food and energy prices. Prices would come back down and we could all go back to driving our SUVs without having to worry about the cost.

Well, then, maybe not. It is not that simple. While there is no doubt that excess demand in the form of index buying can have a very real effect -on prices, it is not the whole story.

What an index funds does is buy a futures contract for a given commodity when money is first invested. Say that contract is six months out. When the contract is one month from expiration or delivery, the index fund sells that contract and buys another contract six months out. They sell before the contract could have an effect on the cash price of the physical commodity. The cash price is determined by supply and demand.

Let's look at supply. Masters mentioned wheat. Yes, the index speculators have built up a large futures position. But that is not the same as a large physical position. With demand soaring abroad and droughts crimping supply, the world's wheat stockpiles have fallen to their lowest level in 30 years, and stocks in the United States have dropped to levels unseen since 1948. That could go a long way to explaining rising wheat prices.

Corn? The USDA is expected to report corn stocks for the year ending Aug. 31, 2009, to fall to 685 million bushels, according to analysts surveyed by Thomson Reuters, down 47% from 1.283 billion bushels in 2008. The corn crop season ends on Aug. 31. (They expect wheat and soybean stocks to rise, for which we can be thankful.)

Bob Greer, executive vice president at PIMCO, rebuts Masters arguments in a very cogent paper recently sent to me. He argues that index funds do not affect the price but may contribute to volatility.

"Some market observers have tried to tie the level of inventories to index investment, most notably in crude oil. Their arguments take one of two forms:

"1) The indexer's act of selling the nearby and buying the distant contract forces the futures curve to be upward sloping (future price is higher than nearby price). This creates an incentive to own inventories and earn the "return to storage" represented by the slope of the futures curve. The act of increasing inventory keeps the commodity off the market, thus decreasing supply.

"2) A variation of the above argument is that the short seller, who takes the other side of the indexer's purchase, needs to protect their position by buying and holding the physical commodity.

"It would be nice if either of these arguments were true, in which case, the developed world would not be hostage to the Organization of the Petroleum Exporting Countries (OPEC). Any time we needed to increase crude inventories, we need merely to bring in more indexers, and the inventory would appear. In fact, the explanation for inventory levels of any commodity is much simpler. If, in the cash markets, production exceeds demand, inventories will rise. Otherwise they will fall. That is why, in six of the last eight years, global wheat inventories fell, regardless of index investment (USDA). That is why from 2006 to 2008, crude oil inventories declined and the crude oil curve went from upward sloping to downward sloping, in spite of increasing index investment (EIA). Furthermore, the second argument above breaks down when applied to non-storable commodities such as live cattle."

Further, Greer shows a chart from Deutsche Bank which highlights the fact that many commodities which are not in the index fund portfolios have risen higher than exchange-traded commodities (rice, for instance). Look at the chart below:

Greer concludes with these important paragraphs:

"Regarding intrinsic value, commodity futures prices converge to cash prices, and cash prices are set by the level of demand to consume physical goods such as steak, gasoline, and Wheaties. The price setting mechanism is not based on possibly erroneous assessment of a financial statement, nor on irrational exuberance. In commodities there is an outside measure of intrinsic value--the cash market--that is not dominant in equity, real estate, or tulip bulb markets. As actual commodity prices go higher or lower, they reflect consumption requirements for actual products, many of which are not very storable.

"This is a sharp contrast from internet stocks or vacation condos, which are subject to speculative bubbles. Unfortunately, our conventional wisdom regarding factors that create bubbles is rooted in asset classes like stocks and real estate, asset classes that have fundamentally different characteristics than physical and futures markets.

"Coincidence is not the same thing as causality. It is a coincidence that commodity index investment has increased in the last few years just as commodity prices have increased. If there is any causality, it is the other way around. Rising commodity prices have caused an increased interest in commodity investment. And it is certainly causality that fundamental supply, demand and inventory factors have driven commodity prices in many markets higher, whether or not those are markets in which index investors participate. This is the same causality that has driven commodity prices both higher and lower for many decades."

Where Will Oil Prices Go?

So, let's look at the fundamentals for oil. While a large part of this week's rise in oil was short covering (you can tell that from open positions), the supply of oil was down 7% from last year, even with demand beginning to fall. But there is an interesting footnote to that statistic, which we will visit later. Look at the chart below from www.economy.com:

Notice that supplies turned down sharply this last month, while the momentum of falling supply had been dropping since January. That is to say, the change in crude oil stocks was a negative 10% in January and was a little over -4% a month ago, falling to -7% today. But this is in the face of demand slowing. Today we learned that gasoline usage was down 4.2%, as prices are finally changing American driving behavior.

Jakab Spencer noted in his always interesting Dow Jones column that there is a disconnect between the New York Stock Exchange and the New York Mercantile Exchange, just one mile apart. The NYSE is pricing in $75 oil in oil stocks, while the futures market is surging over $135, and there are calls for near-term $150-a-barrel oil. The stock market is telling us that oil, at least in futures terms, is in a bubble.

And frankly, if you listened to their testimony, and more importantly pay attention to their actions, oil company executives simply do not believe that the price of oil is going to be $135 a barrel for the next few years. If they did, they would be punching more holes in the ground in places where it might be expensive to get the oil to market - but at $135 a barrel it would be profitable.

And then there is an odd circumstance in the oil picture that I think may suggest that we could see a break, and perhaps a violent one, in the near term for the price of oil.

Where Are All the Tankers?

For a few weeks now, observers have noticed that Iran is leasing tankers and storing oil in them. At about $140,000 a week or so, that is expensive storage. At first, conspiracy theorists were wondering if they were preparing for some kind of war or attack. But more conventionally, it may be they are having problems selling their oil. Their oil is not very high-quality, and there are only a few places that can take it and refine it. India, China, and the US are among the countries with refineries that can take Iranian oil. (And yes, George Friedman of Stratfor tells me some of it does end up in the US from time to time.)

India's refiners are telling Iran they no longer want their oil, preferring the higher-quality oil that is readily available in the area. So Iran has to decide whether to send it to China or "repackage" it so that it can end up in the US, while they try to get refiners in India to change their minds. Thus, they are leasing tankers to store the oil they are pumping.

I called George about six this evening and asked him about the Iranian situation, as that is a lot of oil that could come on the market at some point, as well as a possible reason that oil supplies are down. George has analysts on top of this situation.

He told me, "John, it's more interesting than that. It is not just Iran. Today we started checking on how many tankers Iran had, and soon discovered that there is a serious tanker shortage. Lease prices have soared in the past few weeks. It is clear there are a lot of speculators betting that oil is going to rise to $150 or so and are willing to pay very high prices for keeping the oil on the seas waiting for higher prices. It is a speculative boom."

He then told me about flying into New York in the early '80s. Outside the harbor were 30 or so tankers just sitting, waiting for prices to continue to increase as they had been doing for some time. When they did not, they all tried to get into the harbor at the same time, and of course they couldn't. It was the top of the market. Prices dropped, and the owners of the oil had to go to the futures market to hedge what they could. I had heard that story, but George saw it with his own eyes.

Almost everyone (except the stock market) is convinced oil is going higher in the near term. As I noted above, this week's rally was partially due to short covering by large institutions and companies which had sold production far into the future at much lower prices. They finally threw in the towel and took off their hedges.

Is it 1980 All Over Again?

We may be getting ready to stage a very interesting economic experiment. Is Masters right that prices are driven by speculation, or is it supply and demand? Follow me on this one. I am not saying that this will happen, but it is an interesting scenario.

Many developing countries subsidize the price of oil to their citizens, so they do not feel the pain of higher oil prices. But the headline of today's Financial Times is that Asia is finally getting ready to cut their subsidies as oil rises to $135. The awareness that they need to allow market conditions to prevail is finally being acknowledged, as they cannot afford the subsidies. This is going to help drive down demand for oil over time.

As demand starts to fall, let's remember that the storage facilities for oil waiting to be refined are a finite item. If all those tankers end up needing to find a home at the same time, even as demand for oil is going down, you could see the price of oil go down rather quickly in the short term.

If you are leasing tankers to deliver oil that is already hedged in price, you want to get it to port as soon as possible so that your lease payments stop as soon as possible. You only hold it on the high seas if you think the price is going up by more than your carrying costs (the cost of money and leasing the tanker). If you start to lose money, you sell your oil on the futures market and get it to port as fast as you can.

Now, here is where it could get interesting. Oil is the biggest component of the commodity index funds. If oil drops and looks likely to go lower, then the massive buying of these funds we have seen in the past few months could dry up. As Dennis Gartman says, it takes a lot of buying to make the price of something to go up, but it only takes a lack of buying to make it go down. And if there is net selling?

If we see money start to flow out of the index funds (and ETFs) because of momentum selling, that means the funds are not only selling their oil components, but also the grain and metal and meat. If the index funds are the key component in the rise of prices, we should see the price of all commodities go down in tandem and in sympathy. If oil is the only thing going down as index funds go down, then it is a supply-related issue.

But what if index funds continue to grow? If there is an abundance of oil, it will eventually show up in the spot price, as storage will be lacking, no matter what the longer-term futures prices do. The market will soon tell us whether index funds are a major factor. I tend to think that even while index fund buying is bullish, it is not the major factor that is the driver of commodity prices. And even if it is significant in the short term, in the long term fundamentals will drive the true price.

If it is simply index speculation, it will end in tears when the fundamentals catch up.

Let me say that I believe the long-term price of oil is going much higher. I was writing about $100 oil two years ago. $150 and $200 oil is in the cards at some point in the future. If you have not read the Outside the Box from last Monday, you should. My friend David Galland points out that Mexico, which supplies 14% of US oil, is likely to be a net importer of oil by the middle of the next decade, as their internal demand increases and production decreases. Iran will be a net importer within six years for the same reasons. Russia's oil exports are down this year, as are Mexico's. Energy costs are going to rise in the next decade, and maybe much sooner.

You can click on the following link to read the Outside the Box on where oil exports are headed in our future. And Casey Research does some top-notch analysis of energy investments (not just oil) in a very reasonably priced letter, if you are inclined to invest in individual stocks.

As for today, if I was in a long-only commodity index fund, unless my time horizon was very long I would be watching it closely and have some close stops. And I might wait until I saw what the price of oil was going to do. If you have some profits, then you might want to think about taking some off the table. Just a thought.

The Middle East, California, and Help for Myanmar

Next weekend I will travel with Tiffani to Laguna Beach to be at good friend Rob Arnott's annual shindig for Research Affiliates. In addition to the high-powered brain trust he has speak (Peter Bernstein, Burton Malkiel, Harry Markowitz, Paul McCulley, Jack Traynor, etc. - now that is name dropping!), two of my good friends and science fiction hall of famers (as well as leading futurists) Vernor Vinge and David Brin are going to present an evening session on what they see in our future. I will be moderating and trying to keep David focused. It should be a fun evening.

My South African partner, Prieur du Plessis, is absolutely driven to get me to come with him to Dubai and Abu Dhabi this fall, and I am going to go. I have never been to those cities, but have read and heard amazing things, and look forward to seeing with my own eyes.

Now, as to Myanmar. By now, you know of the tragedy that is unfolding there. My great friends at Knightsbridge (Ed Artis, Jim Laws, and the team) are arranging to be allowed to go in with official visas to provide aid. These Knightsbridge volunteers are the best of the best when it comes to disaster relief. They know how to get medicine, food, and supplies to where it is needed most, and they personally take it in. They are staging in Thailand. Not only will they take in needed supplies, but they will be able to help coordinate with other NGOs (non-governmental organizations) that don't have "boots on the ground" to get aid to where it is needed. (Note: no dollars will be spent in Myanmar in keeping with current US government regulations.)

There will be two four-man teams going in. These guys all pay their own way. But they need money for supplies, transportation, etc. We need $150,000 to make a dent. I am going to give you a web link below. You can donate by check or credit card. The address is: Knightsbridge International, Post Office Box 4394, West Hills, California 91308-4394. If you write a check, please note on the check that the money is for Myanmar relief.

The Knightsbridge website is www.kbi.org. It is being changed as I write to update some of the more recent missions, but the link to donate by credit cards works just fine.

I know these guys personally and have spent a great deal of time with them. They have my full 120% endorsement. I am told all the time that I should charge for this letter. So, instead of paying for the letter, why don't you make a donation? If 10,000 readers sent $100 or $1,000, it would make a huge difference in the lives of desperate men, women, and children. Please consider helping people who have so little. And for some of you more adventurous types, maybe even think about going. And thanks.

Enjoy your holiday weekend.

Your hoping we can help in Myanmar analyst,

John Mauldin

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