Thoughts From The Frontline : The Fed

Where the Wild Things Are

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

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

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

--Old Scottish Prayer

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

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

It Is Not Just Japan

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

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

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

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

The Euro-Yen Cross and the Dollar Carry Trade

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

New York, London, and Switzerland

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

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

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

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

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

John Mauldin

Catching Argentinian Disease

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

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

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

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

The Ascent of Money

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

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

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

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

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

Catching Argentinian Disease

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Independence of the Fed Threatened

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Uruguay, Philadelphia, Orlando, and then...

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

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

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

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

Your ready to be in his own bed analyst,

John Mauldin

Back to the Future Recession

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

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

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

MV=PQ

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

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

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

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

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

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

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

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

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

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

Financial Innovation: The Round Trip

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2010-11: Back to the Future Recession

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

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

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

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

The Fed at the Crossroads

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

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

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

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

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

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

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

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

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

How Did We Get It So Wrong?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Trend Is Not Your Friend When It Ends

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

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

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

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

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

Orlando, Naples, Cleveland, and Grandkids

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

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

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

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

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

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

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

Your almost ready to be a grandfather analyst,

John Mauldin

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.

Fatten your 401K in 2009. Proven Trading System. AlphaKing.com

Quit worrying about your 401K and invest the AlphaKing way. We made money in 2008 while others lost big. Our Index Portfolio was UP 70% in 2008!

Free 30-day Trial to Portfolios, No credit card needed.

Proven trend following system. It works. Bull or bear, its all the same to us. Check us out. Read the Tours page. Read the Archives. See Performance page.

We do all the work. If your brokerage account or 401K needs fattening up then AlphaKing.com is for you. Click: http://alphaking.com

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

I Meant to Do That

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

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

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

The Lights of Myanmar

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

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

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

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

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

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

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

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

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

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

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

I Meant to Do That

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Some Good News for Borrowers

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

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

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

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

Madoff May Give Us a Sell-Off

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

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

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

Conversations with John Mauldin

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

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

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

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

New Orleans, La Jolla, and Merry Christmas

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

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

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

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

Your still having to pack analyst,

John Mauldin

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 Velocity Factor

John Mauldin — Sat, 06 Dec 2008 03:05:16 GMT

The Velocity Factor
Richard Russell Tribute

"A severe global recession will lead to deflationary pressures. Falling demand will lead to lower inflation as companies cut prices to reduce excess inventory. Slack in labour markets from rising unemployment will control labor costs and wage growth. Further slack in commodity markets as prices fall will lead to sharply lower inflation. Thus inflation in advanced economies will fall towards the 1 per cent level that leads to concerns about deflation.

"Deflation is dangerous as it leads to a liquidity trap, a deflation trap and a debt deflation trap: nominal policy rates cannot fall below zero and thus monetary policy becomes ineffective. We are already in this liquidity trap since the Fed funds target rate is still 1 per cent but the effective one is close to zero as the Federal Reserve has flooded the financial system with liquidity; and by early 2009 the target Fed funds rate will formally hit 0 per cent. Also, in deflation the fall in prices means the real cost of capital is high - despite policy rates close to zero - leading to further falls in consumption and investment. This fall in demand and prices leads to a vicious circle: incomes and jobs are cut, leading to further falls in demand and prices (a deflation trap); and the real value of nominal debts rises (a debt deflation trap) making debtors' problems more severe and leading to a rising risk of corporate and household defaults that will exacerbate credit losses of financial institutions."

- Professor Nouriel Roubini of New York University

I had breakfast with Nouriel this morning down in Soho (I am in New York today). I thought the above quote was an excellent way to lead off this week's letter. Some of the more important questions of the moment are whether we face a serious bout of deflation, and if so, what can be done about it. There are market observers who are looking at the graphs which show the meteoric rise in the monetary base (see below) and predict that we will soon see much higher and rising inflation and a seriously falling dollar (accompanied with a large rise in gold). Is inflation everywhere and always a monetary phenomenon, as Friedman taught us? Can we see a large rise in the monetary base that is not accompanied by inflation? As Frederic Bastiat said (roughly), "In economics there is what you see and then there is what you don't see." The more important of the two items is what you don't see. In this week's letter we talk about what most market observers are not seeing, and why you should be paying attention.

We are going to revisit portions of an important e-letter I wrote earlier this year about the velocity of money. I am updating the charts and adding a lot of new commentary. I cannot overly stress how important this is. If you want to understand the markets, the dollar, gold, and more, you have to have this information down. You will need to put on your thinking cap, as much of what I am writing is counterintuitive and certainly not considered as received wisdom in much of the financial-commentator media. (Note: this letter will print longer than usual as there are a lot of graphs.)

Also, I am going to make an important announcement at the end of the letter about a new information service, and I need feedback from some of you.

Richard Russell Tribute

But first, 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 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 would let us plan the dinner.

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

We really hope we can get a roomful of Richard's friends, writing colleagues, and fans who have benefited 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. Plan on the tickets being around $200, with any money left over going to Richard's favorite charity. I actually expect tickets to go rather fast, so let us know as soon as possible. We will get back into contact with you as to the exact time and place. Thanks.

The Velocity Factor

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

Is the Money Supply Growing or Not?

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

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

But in the last few months the monetary base has grown by a staggering amount - by over 1400% on an annual basis, as shown in the next chart from my friend Dr. Lacy Hunt at Hoisington Asset Management. And when you see the "J-curve" in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don't see that is important.

Now, the same graph but in percentage terms:

Several of my readers have sent me questions related to the chart below, which compares the above graph to the value of the US dollar, as measured in the trade-weighted dollar index. If the Fed is flooding the market with dollars, does that not mean a crash in the dollar is imminent? What foreign government or investor would want to hold dollars when the Fed is debasing the currency so rapidly?

Give Me Your Tired, Your Poor, Your Illiquid

The answer is that the Fed is not creating money in the sense of, say, monetizing the national debt (that comes later in the letter). Remember that the adjusted monetary base is cash plus bank reserves on deposit at the Fed. Banks have to hold a certain portion of their assets as liquid assets in order to meet potential demand from depositors for their money. If they go below that required number, the regulators come in and demand they increase their liquid assets immediately.

Various assets have been getting a "haircut" as to their ability to count as liquid reserves. With more and more assets becoming illiquid, the amount of money held in the liquid asset portion of many US banks assets has been dwindling. What to do? The Fed decided to take these assets and trade them (temporarily) for US treasuries, which are quite liquid. It's a kind of "Give me your tired, your poor, your humble illiquid assets yearning to be free" program to allow banks to stay in regulatory compliance.

But notice something. While the Fed did create the T-bills, they did not inject new capital into the overall system. If a bank had one billion in assets and gave the Fed $100 million to get liquid T-bills, it still just has $1 billion in assets. Yes, it could sell them to someone else to get cash, but that someone else would use already existing dollars. The Fed has provided liquidity but did not inject (yet) new cash into the overall system through this program. At some point in the future, when banks are once again doing business with each other and the system is more liquid, banks will take those T-bills back to the Fed and receive back whatever collateral they used to get them in the first place.

To illustrate what I am saying, let's look at MZM, or Money of Zero Maturity. Stated another way, you can think of it as cash, whether in a bank, a money market fund, or in your hands. We will look at the growth of MZM in the next two charts, one of which shows the actual growth and the other the growth in annual percentage terms.

Now remember, Friedman taught us that inflation is a monetary phenomenon. If you increase the money supply too fast, you risk an unwanted rise in inflation. If the money supply shrinks or grows too slowly, you could see deflation develop.

Note that MZM was growing at close to an 18% rate year over year earlier in the year but that growth is now down to 10%. Also note that less than three years ago MZM was growing close to zero. Since that time inflation has increased. Therefore, one could make the case that the Fed is causing inflation by allowing the money supply to increase too rapidly. Case closed?

Maybe not. Correlation is NOT causation. More cash sometimes means that people and businesses are taking less risk. The Fed cannot control what we do with our money, only how much bank reserves it allows and how much cash it puts into the system.

Forecasting inflation from a money-supply graph is very difficult. It used to be a lot simpler, but in recent decades has been very unreliable, for reasons we will look at in a moment. But it is much too simplistic to draw a direct comparison between inflation and an arbitrary money-supply measure.

If we look at a graph of M2, which includes time deposits, small certificates of deposit, etc., we again see a rise in recent growth. M2 is the measure of money supply that most economists use when they are thinking about inflation. And we see that M2 is growing at a sprightly 7% year over year. This is not all that high historically, but again it is up significantly from the past few years. See the graph below. Note that there have been several times (as recently as 2000) when annual M2 growth was over 10%.

But there is more to the inflation/deflation debate than just money supply. Money supply is what you see. And now we look at what most of us don't see.

The Velocity of Money

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

So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M. (In last April's discussion of the velocity of money I used "P" instead of "Y". Lacy Hunt tells me the more correct statement of the equation is Y=MV, and I defer to the expert. Sorry for any confusion.)

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

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

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

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

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

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

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

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

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

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

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

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

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts sent to me by Lacy. First, let's look at the velocity of money for the last 108 years.

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

Now, let's look at the same chart since 1959, but with shaded gray areas which show us the times the economy was in recession. Note that (with one exception in the 1970s) velocity drops during a recession. What is the Fed response? An offsetting increase in the money supply to try and overcome the effects of the business cycle and the recession. Y=MV. If velocity falls then the money supply must rise for nominal GDP to grow. The Fed attempts to jump-start the economy back into growth by increasing the money supply.

In this chart, Lacy assumes we are already in recession (gray bar at far right). The black line is his projection of velocity in the near future. If you can't read the print at the bottom of the chart, he assumes that GDP is $14.17 trillion, M2 is $7.6 trillion and therefore velocity is 1.85, down from almost 1.95 just a few years ago. If velocity reverts to or below the mean, it could easily drop 10% from here. We will explore why this could happen in a minute.

Y=MV

But let's go back to our equation, Y=MV. If velocity slows by 10% (which it well should) then money supply (M) would have to rise by 10% just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which means M (money supply) would need to grow about 5% a year, even if V is constant. And that is not particularly stimulative, given that we are in recession. And notice above that M2 is growing just about in line with that.

Bottom line? Expect money-supply growth well north of 7% annually for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

My friends at GaveKal have their own measure of world velocity, and as you might expect it is slowing too. This slowing is a global problem and is one of the reasons we are in a global recession.

A Slowdown in Velocity

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

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

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

While the Fed does not have control over M2, when they lower interest rates it is supposed to make us want to take on more risk, borrow money, and boost the economy. So, they have an indirect influence.

I expect the Fed to cut at least another 50 basis points next week, and to give us a statement with a nod toward difficult economic conditions. The latest Beige Book from the Fed was simply dreadful, so you can bet the governors will have a deteriorating economy in mind. Given the 25-plus-year low in consumer confidence, they have little choice.

I agree with Nouriel that the Fed will soon move rates close to zero. For all intents and purposes, the markets have already moved there. But is it having an effect on the willingness of banks to lend? Not hardly. Standards for lending are tightening every week. Look at the graphs below. The willingness of banks to make consumer loans is dropping to a 28-year low. And they are tightening standards on all sorts of business loans.

Now, I argued above that the Fed is not really expanding the money supply, so far. But within a few quarters, we will be facing outright deflation. The Fed is going to monetize at least a portion of what will be a $1+ trillion dollar US deficit. They have announced they are going to purchase $800 billion in mortgage-backed and other types of consumer loan assets. That will be a direct infusion of dollars into the economy. That is serious monetization. But they may feel they have no choice if they want to keep the US economy from going Japanese.

When someone becomes a Fed governor, they take them into a back room and perform a DNA transplant on them. They come out of that room viscerally, almost genetically, focused on preventing deflation from happening on their watch.

How much monetization will be enough to halt deflation and overcome the slowdown in the velocity of money and the rise in personal savings? No one knows. There is no fancy equation or model which can encompass all the factors, or at least not one I know of.

We will also soon see which of the additional deflation-fighting policies that Bernanke outlined in his 2002 "helicopter" speech the Fed will adopt. It is highly likely that we will see more than a few of them. It is quite possible that we will see the Fed start to set rates on longer-term bills and even bonds in an effort to pull down longer-term rates for corporations and individuals.

We will explore all the deflation-fighting options and what the results might be in future letters, but remember that there will come a time when the Fed will have to "take back" some of the liquidity they are going to provide. That means we could be in for a multi-year period of slow growth after we pull out of this recession. And this recession could easily last through 2009.

A Conversation with John and Friends

Next week, I will announce a brand new subscription service that we will be offering to you. I travel and speak all over the world, and during this time I get to have private dinners and personal telephone conversations with some of the best minds in this business. Tiffani has often remarked what an education she gets just sitting at the table with us, and wishes she could have recorded the conversations for everyone to listen to.

And that is what we have decided to do. We are going to invite you to regularly "meet me" at the table for conversations with my friends and colleagues. This will be the only place you will be able to listen to detailed conversations with my colleagues who are leading experts in their fields. These encounters will be designed so that out of the mountain of information available, you get a concise view of the current landscape and can be motivated to make better decisions in your personal and business economic life.

This week, would you please let me know what you think? Here are two additional ideas in the works:

1. George Friedman of Stratfor and I spent a day together last week, brainstorming. We decided we are going to have quarterly conference calls to analyze the geopolitical landscape and discuss the immediate economic implications. You will get to listen.

2. I get hundreds of intelligent questions each week that, if answered, could benefit all of my readers. We will be giving you a place to drop your questions into a "Virtual Hat," and I will then answer them on a protected website.

While the basic format and level of service in Thoughts from the Frontline is not going to change, in the first half of 2009 we will be launching these new, unique subscription services.

Which of these services would benefit your life? Do you have any compelling ideas that I haven't mentioned that you would like our firm to pursue? What do you enjoy about Frontline Thoughts? What changes if any would you like to see? Please let Tiffani and me have your feedback (good or constructive) and your ideas - send them to eu@2000wave.com. As an incentive, she will randomly pick 5 emails to receive a free annual subscription to one of the new services. Thanks very much.

The letter is already long, so I will refrain from personal remarks this week. Enjoy your week.

Your knowing that we will all get through this analyst,

John Mauldin

Leverage Is an 8 Letter Word

John Mauldin — Sat, 22 Nov 2008 04:52:29 GMT

Leverage Is an 8 Letter Word
If Loans Are So Cheap, Why Don't They Sell?
Deflation and Helicopters: Time for a Review
Commercial Property Loans Start to Haunt the Banks
Warren Makes a Bet
Thanksgiving, Moving, and New Orleans

Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain (or fill in your own four-letter words). This week I try to give some insight into what is happening in the credit markets, some of it below the radar screen of most analysts. We will look at the potential for deflation and the Fed's response. There is a lot to cover, so let's jump right in.

If Loans Are So Cheap, Why Don't They Sell?

I talked with a friend who runs a collateralized loan obligation fund, or CLO. There are a lot of these funds in the Shadow Banking System. Typically they buy certain types of debt, with a lot of it in the bank loan space. In the "old" days of the last few years, banks would make loans to corporations and then sell them to CLOs and other institutions, making a spread on the loan and a profit on the servicing business. Some funds would typically leverage up somewhat and make a decent return.

Today, many highly rated loans are selling for 80 cents on the dollar. There is nothing wrong with the collateral or the corporation which owes the money; there is just no one with ready cash to buy the loans. I asked my friend why he doesn't buy them, since they offer very good returns.

The problem is that his fund, and most other CLOs, have covenants in their offering documents that prevent them from buying debt at less than 85 cents on the dollar. That covenant is a good thing in normal markets, as it prevents possible mischief by the manager, but right now it means that a lot of opportunity is being missed. The only way he can buy these highly undervalued bank loans is to create a new fund, which he is in the process of doing. But getting the money is tough, as the pension funds and endowments who would normally be the investors are waiting for cash to come from their redemptions in other funds, which are of course selling whatever they can to raise money for the redemptions, including these very same bank loans. Can you say vicious circle?

The good news is that the market is (albeit slowly) responding to low prices and a market for undervalued assets. But the bad news is that it could be months before there will be meaningful recovery in asset prices. In the meantime, these and many other assets are being marked down and impairing the balance sheet of a lot of banks, funds, and institutions.

As an aside, the prices for loans made for leverage buyouts in the last few years have fallen significantly. Anybody want to buy some loans made on the Chrysler sale to private equity fund Cerberus? I think not. Just because a loan is cheap does not mean it is necessarily a reasonable value.

Commercial Property Loans Start to Haunt the Banks

As I have written for a very long time, there are two aspects to the current recession and financial crisis. The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.

The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages, and especially commercial property mortgages all suffer during a recession. As documented a few letters ago, default rates are soaring on all types of consumer loans. That is what you would expect to happen in a recession. The problem is that many of the larger banks have already had their capital depleted dealing with the credit crisis. Now they are going to have to raise even more capital (or reduce lending) to deal with the normal loan problems that come with a recession.

Let's look at a few charts from www.markit.com which show the stress in commercial property lending. A number of very large firms come together to create a market index for commercial mortgage-backed securities, or CMBS (which is listed at market.com). They put 25 different commercial property trusts, created by JPMorgan, Merrill, UBS (the usual suspects), and so on into the index. Traders can then trade on the market value of the underlying combined assets by trading the index. In principle, this is just like trading a stock index that gives you exposure to all the stocks included in the index.

If you have bought commercial mortgages and want to hedge your portfolio, you can do so with this index, or if you want to sell protection (insurance) you can also do so. The price is determined by the spread between the coupon and (I believe) the 10-year US Treasury bond. From trading at a spread of 100 basis points in May and 200 basis points (bps) in July, the spread on AAA-rated commercial mortgages skyrocketed in the last few weeks to 850 before settling back to 667, or more than six times what it was just a few months ago.

According to the Wall Street Journal, at the peak a few days ago this meant that the AAA part of this index was trading at $.70 on the dollar. That suggests there will be losses of 70% on the lower tranches!

Every six months the 12 investment banks that help create the index build a new index comprised of recently created trusts composed of hundreds of individual mortgages. As with most asset-backed paper, these trusts are divided into different tranches, with the highest-rated tranche getting the lowest return but first call on the return of principle and interest. Lower-rated tranches take successively more risk.

There are seven different indexes on the Markit platform, from AAA to lowly BB. Each index is composed of the corresponding tranche in the 25 trusts within the index. Let's look at what the lowest-rated tranche has done.

The lowest tranche is now trading at 4,750 basis points or, if you add in the Treasury price, at over 50%! If you were an institution or fund and wanted to buy protection on a BB-rated CMBS in your portfolio, you would have to be willing to pay 50% annual interest!

On the web site, they note that they have not created a new series that was planned for October 25^th of this year, as there have not been enough new commercial mortgages created to actually build an index. Why? Because any commercial mortgages that the banks now make will have to be kept on the books of those banks, since the price to securitize the loans is prohibitive. Is it any wonder there has been a serious reduction in large commercial property loans?

On a rather sad note, look at the logos of the banks involved in creating this index, from the marketing brochure that Markit uses to inform potential buyers and sellers of the CMBS index:

Fourteen banks were involved as of a few months ago, but now? Bear, Lehman, Wachovia, and Merrill have either passed from this world or have been swallowed up. It makes you wonder who is next. (Side bet: the Treasury or Fed will inject some capital into Citibank this weekend.)

We could do the same analysis on high-yield bonds. Interest on high-yield bonds is now approaching 20%. Credit default swaps on many issues are simply out of sight. That means that if a lower-rated company wanted to issue bonds, they would have to pay 20% or more! There are very few projects that can justify 20% in a low-inflation world. And without access to capital, it will be difficult for businesses to grow. It also means they have to cut costs and jobs. As noted above, even highly rated corporate bonds are selling at steep discounts. Deleveraging is going to be a problem for a few years. We need to get used to it.

Deflation and Helicopters: Time for a Review

I wrote six years ago (November 2002) about Ben Bernanke's speech on deflation, where he tried to make a joke about beating back deflation by dropping money from helicopters. He was immediately tagged as "Helicopter Ben." My thoughts on that speech took up about half of one chapter in Bull's Eye Investing, and I still think it is a very important speech.

I have been saying for a long time that we would be dealing with deflation next year, and that has been met with a lot of reader skepticism. And when inflation hit 5.6% last July, that skepticism was understandable. But this would be a strange world indeed if you had the twin bubbles of housing and credit burst and didn't see a whiff of deflation. Recessions and the bursting of bubbles are by definition deflationary.

And I have been giving thought to the idea that we may have seen a mini-bubble in the price of many commodities, and that bubble has been bursting as well. And since commodity prices were the main cause of inflation, as they retreat the rise in the inflation rate is retreating. This week the latest inflation numbers showed a drop to 3.7% on a year-over-year basis.

But the Consumer Price Index (CPI) fell by a full 1% in October. You have to go back to the 1930s to find a one-month drop as large. And I don't think this is just a one-month anomaly caused by falling energy prices. The housing component, which is 32% of the index, is based on Owners' Equivalent Rents (OER). As I have written elsewhere, over very long periods of time this works as well as actual housing prices. You simply have to pick your basis for comparison and stick with it.

If, for instance, we had been using house prices for the last ten years, we would have seen large increases in inflation up until a year ago, and since then the index would have been in outright (and serious) deflation. But we use OER, so prices in the CPI have been more stable. But that looks like it could be changing.

OER has been rising steadily over the last decade as rents went up. The index showed a 3% rise in 2007, for instance. The recent trend has been down from there, and last month there was no rise in the cost of shelter. Given the number of houses for sale and a weakened economy, I think it is likely we will see outright reductions in the cost of rent, which will translate into a much lower inflation number.

Lower prices are a two-way street. When they result from improved productivity and efficiency, that is considered to be a good thing. But when they are the result of lower demand, that can be problematic.

There is the likelihood that the Fed will lower rates to 50 basis points, and some major and very seasoned economists are now predicting a zero percent Fed funds rate early next year. Given that Fed funds are actually trading at 38 basis points, a drop to 50 basis points would change nothing on a practical level. (Can we say Japan?)

With that in mind, let's revisit Bernanke's speech. Every central banker is mindful of Japan and the 1930s in the US. Deflation is something that will not be allowed. But what if the Fed lowers interest rates to zero and demand does not pick up, along with a little inflation? Quoting Ben:

"To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys. Alternatively, the Fed could find other ways of injecting money into the system -- for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic. One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

Just a thought here. We could see real drops in the CPI next year. We could also see a US government deficit approach $1 trillion and go right on through that heretofore unthinkable number. As I wrote last week, a reduced trade deficit means that there will be fewer dollars abroad to buy our debt. The difference will have to be made up by either increased savings in the US or higher rates to attract buyers OR the Fed monetizing the debt.

I think the Fed would be highly reluctant to monetize debt in a period of inflation like we have been in, no matter what problems we face. But in a period where we could be facing deflation? It is very possible they would consider monetizing the debt, as will central banks all over the world.

We are in unprecedented times. A (1) deep recession coupled with (2) financial institutions deleveraging, added to (3) a consumer who is going to be forced to save more and spend less while (4) commodity prices are falling, on top of (5) a serious slowdown in the velocity of money, and you have the makings of a perfect deflationary storm. The Fed would be forced to fight it.

What would they do if lowering the Fed rate to zero was not enough? As Bernanke stated, they would simply set the rates for 1- and 2-year notes and further out the curve if they felt they needed to. And if Goldman Sachs is right in its latest revised forecast, the economy is going to need some help:

"Goldman said it now expects U.S. GDP to fall 5 percent in the current quarter, with unemployment rate reaching 9 percent in the fourth quarter of 2009. It also forecast the 10-year yield to fall to 2.75 percent by the end of the first quarter of 2009, as compared to previously estimated 3.5 percent.

" 'The combination of weaker real activity and slower inflation means that profits of U.S. companies will fall even more sharply than we had previously expected,' Goldman said in a note to clients. Goldman now sees economic profits falling 25 percent in 2009 on an annual average basis, the biggest drop since 1938. It had earlier expected a fall of 20 percent. Goldman expects unemployment rates to further go up in 2010 as well, as there is little chance of the economy returning to trend growth by that year."

Other mainstream economists think GDP might fall this quarter by as much as 5%. That does not bode well for retails sales this Christmas.

Warren Makes a Bet

And let's close on this note brought to my attention by Bill King.

"MSN Money's John Markman: Shares of Warren Buffett's insurance holding company are on the ropes this month, plunging 30% in part because the famed investor dabbled in an area of the market he has long publicly derided: derivatives. And due to a tangled web of financial relationships, they may be taking Goldman Sachs shares down with them. Investors are concerned about a $37-billion bet that Buffett made last year that U.S. and world equity values would be higher in 15 to 20 years than they were then, when the Dow Jones Industrials were trading around 13,000. Through his firm, Berkshire Hathaway, Buffett sold option contracts, known as "naked puts" to an undisclosed group of investors for around $4.85 billion, reportedly using Goldman as broker...

"Because of its solid-gold credit rating, Berkshire Hathaway was not required to put up collateral to make this trade. But now rumors are flying on Wall Street that the owners of the contracts have demanded that broker Goldman Sachs put up collateral for the rest of the amount due. Since the value of the trade could be infinite, the collateral demands are said to be large, and fears that Goldman will struggle to make good on its obligation has panicked shareholders. Indeed one theory making the rounds this week is that Buffett put $5 billion into Goldman at around $125 per share in September not as an investment but to help provide funds for the collateral.

http://blogs.moneycentral.msn.com/topstocks/archive/2008/11/20/buffett-s-huge-derivatives-bet-proves-costly.aspx

"Isn't this the oracle that called derivatives, 'financial weapons of mass destruction'?"

I personally think that Warren made a very good bet. I would be shocked if the Dow was not at 13,000 in 20 years. Inflation will do most of that heavy lifting. But it does make for an interesting discussion now.

Thanksgiving, Moving, and New Orleans

Tiffani has decreed that I am going with her to New Orleans in a month to spend four days huddled away from the office, pouring over the research for our new book Eavesdropping on Millionaires and getting started on the actual writing. Somehow, she thinks I will be distracted if I am in the office.

I am looking forward to Thanksgiving next week. Most of my kids and some of my family will be coming to my apartment. I will be cooking all morning, preparing prime, lots of mushrooms and veggies, and more. I really get into it when I get the chance. And a very thoughtful reader has sent Tiffani and me some really great wines, which we will uncork.

Hopefully, this year we can avoid a fire in the building and having to carry my 91-year-old mother down 21 flights of stairs. And then the next day we pack everything up and move a few miles away to a house that will become my office a few weeks later. I am really quite excited about the move, as I really do like the house and am really enamored of the thought of a ten-second down-the-hall commute. Ask me in three years how I like it.

Congratulations are in order to my assistant of the last three years, Sommer Dooley, who has passed the exams for her nursing degree. She will be leaving us soon. She has been a real help the last few years and will be missed.

Next week I am going to write a special letter on why I am optimistic that we will come through this whole financial mess, but now it is time to hit the send button. Have a great week and enjoy your family and Thanksgiving! I think it is my favorite holiday.

Your thinking life is really pretty good analyst,

John Mauldin

The Curve in the Road

John Mauldin — Sat, 04 Oct 2008 03:23:33 GMT

The Curve in the Road
Necessary but Not Sufficient
Why the Government Had to Step In
All the King's Horses
How Can I Be 59?

The "Bailout Plan" was passed. Will it work? The answer depends on what your definition of "work" is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no. But there are things it will do. This week I try to help you see what might lie ahead around the Curve in the Road. We look at how the rescue plan will function, see what is happening in the economy, and finally muse as to whether Muddle Through is really in our future. It will make for an interesting, if not very upbeat, letter, so strap in. I would like your promise to not shoot the messenger. I am just trying to give you some of my thoughts as to what may lie in our future. And remember, as you read this, we will get through it. There are better days "a'coming."

But first, a few housekeeping items. Let me welcome some 200,000 new readers from EQUITIES Magazine. I have recently joined EQUITIES Magazine as a regular contributing editor. My column, Back to the Frontline, is featured in both their print publication and at equitiesmagazine.com. I am excited to be associated with this esteemed magazine with a rich history covering the global markets for over 57 years.

They've once again agreed to offer any reader of mine a free subscription to EQUITIES Magazine. For those who did not take advantage of the free subscription the first time, here is your chance. You can go to http://www.equitiesmagazine.com/mwi and simply register to get the magazine sent to your home or office. There is also a link to an interview I did in April with them. They have a lot of content and free resources like "live" real-time stock quotes and "live" real-time portfolio managers. Check it out!

Second, a quick commercial. There are managers who are successfully navigating these markets. If you would like to learn more about who they are and how you can put them to work for you, my partners would be delighted to introduce them to you. If you are an accredited investor (generally, net worth of more than $1.5 million), please go to www.accreditedinvestor.ws, register there, and my partners in the US (Altegris Investments) or London (Absolute Return Partners) will show you various alternative investments like hedge funds and commodity funds which might help diversify your portfolio. You really should see what is available behind curtain #3.

And for those with not quite that amount of net worth, I work with CMG in Philadelphia. They have developed a platform of money managers who can take direct accounts, and I recommend that readers interested in outside money management take a look at them. If you would like to talk with Steve Blumenthal and his team about the managers on the platform, simply click on the following link, fill out the form, and they will call you. http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

(In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA. And please read all the risk disclosures.) And now, let's jump in to the letter.

The Curve in the Road

When you are out driving on a strange new road, you can't see around the curve ahead. But you can read the warning signs to get an idea of what might be coming. And while we can't really know how the developments in the economic world will actually unfold, there are some signs we can point to that might give us a few ideas.

First, let's look at the "rescue plan" as passed by Congress. As I pointed out last week, this is a bad bill. But it was necessary to pass something, and soon. Earlier this week I sent out a report that reviewed a study of 42 major baking crises. The conclusion: navigating them successfully depended upon quick action.

As everyone should know, the credit markets are almost completely frozen. LIBOR is bid only, no offers. Commercial paper markets are imploding. And what is trading is often at rates that are much higher than they were a few months ago. Corporations are being strangled on high rates. Corporations have little or no access to normal credit markets, and they will face massive problems when it comes time for them to roll over short-term debt.

LIBOR has gone crazy. This is not an orderly market.

Look at the following chart from friend Greg Weldon. For most readers, the commercial paper market is something you don't think about. But it is the lifeblood of business. We have seen this market drop by almost 30% in a year and by 10% in just the last three weeks! I simply cannot overstate how serious this is. Left unchecked, business activity in the US would soon slow enough to bring thoughts of the Great Depression. It will not be left unchecked.

The credit crisis is not simply a Wall Street issue. It has fast become a Main Street issue. And Main Street is where jobs are created and maintained.

As I have said repeatedly for months, the problem is that financial institutions are having to deleverage. They have massive losses and simply have to raise capital in order to survive. If you can't raise equity capital (and most can't), one of the ways you do that is to make fewer loans and to take less risk. You also charge more for the loans you do make.

Larger institutions cannot raise capital on competitive terms. GE is an AAA-rated company. Yet they had to pay Warren Buffett 10% to get $5 billion, plus in-the-money warrants worth at least another 10%. Buffett is likely to double his money on this deal over 4-5 years. A short while ago, GE could get short-term commercial paper for a few percentage points. That difference is going to significantly impact GE's bottom line. But they had no real choice. They took the money.

As did Goldman Sachs. Yet another Buffett $5 billion preferred-share purchase (with more warrants) at a rate that even Goldman will find it hard to make money on. But they had to raise capital quickly, and they had little choice.

I had lunch with Michael Lewitt and Joe Harch yesterday. They were in town to meet with a client, and we took the opportunity to get together and share notes. They run (among other things) a collateralized loan obligation fund. They buy bank and corporate debt. They now have the opportunity buy well-collateralized loans from rated companies at prices well below par. They related story after story of debt from quality, highly rated companies selling below $.90 on the dollar, and some much lower.

If GE and Goldman are paying 10%, what do you think it costs a firm with "only" a B rating? 15%? More? Junk bond yields have simply gone ballistic. Firms which used the credit market to access capital now are simply shut out. If they are a small public company, they can go to what are known as PIPE hedge funds (Private Investment in Public Equity) and sell equity at usurious rates (which is what Buffett does but on a larger scale). But a small or medium-sized private company? It is a hard time to go looking for money.

Left alone for the markets to work out, the economy of the US and the world would be in a depression within two quarters and would need years to recover. Think Japan.

Necessary but Not Sufficient

Now for the bad news. The Rescue Plan was necessary but not sufficient to fix the crisis. There is going to have to be more heavy lifting, I am afraid. Let me offer a few ideas about what possible actions might be taken in the future. I am not advocating these actions, I am simply telling you what might happen. These are possible, because authorities will do whatever they deem necessary to avoid a systemic economic meltdown and a potential depression.

If you are a large investor or sovereign wealth fund which put money into banks last year, you are down anywhere from 35-50% (unless you invested in Washington Mutual, and then you are down 100%). You are unlikely to invest more in any financial institution without some very real understanding of what is on the balance sheet of the bank that is asking for your money. What the Paulson plan potentially does do is remove the questionable debt. The bank may have to write down assets in order to sell the debt to the government, but they end up with a transparent balance sheet with hopefully known risks. Then they can go to the market and try and raise capital. Shareholders will get diluted. Such is the way of the world.

Sidebar: taxpayers really must demand that someone like Bill Gross of PIMCO and/or other savvy market specialists run this new government operation. He offered to do it, and I think we should take him up on his offer. Taxpayer losses should be kept to a minimum, and I believe someone like Gross would do his best to see that would be the case. The point of this exercise is to restart the frozen credit markets, NOT to bail out banks. Some banks may get bailed out in the process, but it should be at a cost to their shareholders and management, not to the taxpayer.

I am asked, why can't private money solve the problem? Because there is simply not enough private money. Buffett offered to take 1% of the new government pool. If that is all the largest pile of free money in the world can take, why does anyone think there is enough private capital to take the other 99%? Insuring the mortgage bonds is not sufficient, because there is not enough money to buy them in this market. When things have sorted themselves out in a few years, I think the bonds can be insured and sold, and likely at a profit if bought correctly. But we do not have the luxury of waiting a few years.

Between the relaxation of the mark-to-market rules and removing ambiguously priced loans from financial institutions at prices which allow the government pool to make a small profit, if held for five years, that part (the lack of a known price) of the problem can be solved. Banks can hopefully buy themselves time in which to work their way out of the problems they created.

It is much like 1982, when every major US bank thought it was a good idea to loan lots of money to Latin American countries. It was a most profitable business, right up until the countries decided to default. Then every US bank was more than just technically bankrupt. In a mark-to-market world, every large US bank would have collapsed. It would have been the end of the world as we knew it.

What did they do? The Fed let the banks keep the loans on their books at face value. Over time, they worked their way through the debt, making enough money to be able to write down the loans. That was done simply to give the banks the ability to buy time.

We are in a very similar situation. We have to buy some time in order for financial institutions to heal.

Why the Government Had to Step In

I had a lot of readers write me very nice letters this week, starting out with how much they like my letter, my insights, etc. Then they (mostly - but not all – and politely) launched on me for backing the rescue plan. Many of you had much better ideas than what was passed by Congress, which is not surprising.

I really do hate the idea of having to support a rescue plan. It goes against my every instinct. But I also know that doing nothing would result in an economy which would blow right through 10% unemployment within a few quarters, and take years to recover. The stock markets and the savings of millions of retirees would be wiped out. Home values would really go into a tailspin. Being right in theory is not worth seeing that kind of devastation.

Herbert Hoover sat by and decided to let the market solve the problems of 1929. He decided to run budget surpluses and ignore collapsing institutions. Combined with disastrous Federal Reserve policy (raising rates in a recession) and Smoot Hawley (which caused major trade wars and a slowdown in global trade), what should have been a serious recession turned into the Great Depression and resulted in the conditions for World War II.

The rescue plan does not address the need for the increased levels of capital needed by banks. As noted above, it simply creates the conditions under which capital might be raised. Banks have already raised $440 billion. They have written down $590 billion. Losses are estimated from a mere $1 trillion to as much as $2 trillion. About half of those losses would be in banking institutions worldwide. That means anywhere from $200 to $400 billion more must be raised in order for banks to get back to capital adequacy. It is probably closer to the latter number.

Until banks are adequately capitalized, they are not going to be able to do normal business lending. Further, large deposits are fleeing banks. Even with the new level of $250,000 of FDIC insurance, there is $1.9 trillion in uninsured deposits. These are mostly deposits of small to large businesses and financial institutions, which can leave a bank at the push of a button.

Nouriel Roubini tells us that there are 800 billion dollars deposited in US banks by foreign counterparties. Up until this week, if you were a foreign operation, would you rather be in large money-center US banks or European banks? Tough choice, but on balance you would pick the US. Then this week Ireland decided to simply insure every deposit in Irish banks, no matter the size. Predictably, money started flowing from all over Europe into Ireland. National banks and finance ministers are furious with Ireland.

However, Ireland may have no choice but to backstop its own depository institutions to keep them from losing deposits and becoming insolvent from a bank run by corporations acting in their own best interests. Belgium, The Netherlands, and Luxembourg each took 49% of their respective parts of Fortis Bank in return for a massive injection of capital, declaring the bank too big to fail – also wiping out a lot of already diminished shareholder equity. Europe has its own quite serious problems.

But what if the various countries, one by one, decide to guarantee deposits in order to protect their own banks? If you are an international corporation, especially if you are outside the US, do you want your $10 million in Europe or the US if Europe guarantees your deposits with no limit? Could we see silent runs on US banks?

I think it is about an even chance that the government will have to guarantee for a period of time (say 6 months to a year) every bank deposit, regardless of size, in the US.

That is a staggering thought. The potential will be large for almost-insolvent banks to pursue risky behavior to try and work their way through problems. If such a policy is pursued, tight controls must be administered so risky banks do not offer high CD rates in order to garner assets. The FDIC must closely monitor such activity. Perhaps such guarantees should be for existing depositors and not new customers. Insolvent banks and those on the edge must be shut down quickly in such an event, to prevent risky behavior.

Unthinkable? I bet you there is a working committee of government and Fed officials thinking about just that very thing and how to do it. It would be even more scary if there is not one. We are in completely uncharted waters, and every contingency needs to be thought through well in advance. We simply don't need more last-minute Paulson plans.

In the next few weeks and months, I think you can count on more extraordinary actions by the Fed and Treasury to try and jump-start the credit markets. Actions which were highly improbable a few months ago will be on the table. Will the Fed open its balance sheet to non-banks? Possibly. If they can guarantee money markets, will there be a scheme to insure commercial paper at some price? Not out of the question. Will European governments take more equity in large European banks? Very likely. Will the Fed and/or the Treasury invest even more capital in larger financial institutions? Given that We the People now own 80% of AIG and 100% of Fannie and Freddie, it is certainly within the realm of possibility that we will be the proud owners of even more private institutions.

Again, this is not just a US issue. We will likely see similar actions in Europe and some of the developing world. This is a worldwide crisis, and the response will be from central banks all over the world.

Understand, I am not advocating these actions. I am simply trying to help you understand what actions might be put into place by the various government of the world in an effort to avoid systemic economic collapse.

All The King's Horses

The reality is that the rescue plan does not fundamentally alter the US economic landscape. There can be no doubt we are in a recession. I think it will be dated from the beginning of the year, notwithstanding the odd 2^nd quarter growth. The manufacturing ISM was a dismal 43.5 (under 50 means a contracting US manufacturing industry). Such a level is typically associated with recessions, as the chart below shows. Given the financial crisis and the freefall in auto sales, this index is likely to fall further.

The "good news" is that the service portion of the economy is right at 50, which means that at least that important area is not contracting.

Unemployment rose by 159,000, with nearly every sector affected. Almost 1,000,000 jobs have disappeared over the last 12 months, and it is likely that we will lose another 1,000,000 jobs in the coming year. Since December, the ranks of the unemployed have grown by 1.8 million, and those not in the labor force but wanting a job by 370,000. Almost 3/4 of the increase in the unemployed have been job losers, with half the increase from permanent job losers (not temporary layoffs). (The Liscio Report)

Next week we will explore the economic landscape in detail, but let me provide a few thoughts. As I have said for a long time, we will be talking about deflation this time next year. Recessions are by definition deflationary events. Given that we have had two bubbles burst (housing and credit), there is even more potential for deflationary pressures. Add into the mix the deleveraging process, which will take years to finally abate, and the recent bout of price inflation caused by energy and food will pass, as demand destruction for oil will hold oil prices in check.

As I have said for a long time, the next move of the Fed is likely to be a cut. We are now close to such an action. A 1% Fed funds rate is again a real possibility. I am not sure it will help as much as some market participants think, but I think it likely the Fed will move before the end of the year, if not much sooner.

Europe and Japan are also probably in recession, and it is likely we are going to see a worldwide global slowdown. It would be nice if the European Central Bank, the Bank of England, and the Fed could coordinate a joint rate cut to signal that they are working together on the problems. I would not want to be short the markets that day.

At the beginning of the year, I was predicting a small recession with a lengthy and slow recovery period. I now think that the recession could be deeper than a 1% contraction. I think we could see a rather lengthy recession. Quite simply, the credit crisis has been allowed to spin out of control. That Congress almost failed to act is beyond belief. Given the above circumstances, it is not out of the realm of possibility that a recession lasts through the middle of 2009. As recessions go, that is a long time. But trust me on this, it will pass. The recovery will be a slow Muddle Through affair, though. It will be a few years before we are growing at a sustained 3%. Over the next few weeks, we will look at what that means for earnings and the stock markets. Investors who utilize a traditional 60% stocks, 40% bonds portfolio are not going to be pleased. We will look at alternatives.

Stay tuned.

How Can I Be 59?

This has been a particularly hard letter to write, as I know it is rather gloomy, and I wish had more encouraging news. I have been writing this letter for over eight years. Every letter since the beginning of 2001 is in the archives, so my record is open for inspection. I have no particular axe to grind. Since I basically help investors (in conjunction with my partners) find investment managers and funds, we can adjust the choice of funds and management ideas to suit the times, and frequently do make changes in the mix. My goal in this letter is to help us all think about the economy and our investments and to be as "right" as I possibly can. Sometimes, like today, that means not being very upbeat. But it also means looking for ways to go with the tide rather than against it. I actually hope I am wrong and the bulls are right. But that is not the way I see it tonight.

Tomorrow is my birthday. The years seem to roll by at an ever accelerating pace. (I had the reason this happens explained to me once. When you are 10, a year is 10% of your life. When you are (sigh) 59, it is 1.6% of your life. It makes some sense.) It is hard to believe I am 59. Maybe it is because I am around my kids so much, but I don't feel that old. Seven kids from 31 to 14 (plus assorted spouses and their friends) can do that. And they are all coming to town to celebrate next weekend, so tomorrow will be a quiet day. And Tiffani is already planning for a serious 60^th birthday weekend next year.

Life has been good to me, for all its ups and downs. And I firmly believe that my best years are ahead of me. I am simply having more fun than at any time in my life, with more opportunities than I know what to do with. I am blessed with great business partners. I have the best readers of any analyst anywhere. One million closest friends. I am truly one of the world's wealthiest men when it comes to friends and family, and at the end of the day that is what counts.

Thanks for being part of my life. I plan on writing for a long time, so take care of yourself so you can keep reading. And have a great week!

Your actually optimistic analyst,

John Mauldin

Who Holds the Old Maid?

John Mauldin — Sat, 30 Aug 2008 05:47:50 GMT

It's All About the Spread
The Coming Bank Credit Crunch
More Thoughts on Fannie and Freddie
Who Is Holding the Old Maid?
Baltimore, La Jolla, South Africa, and London

When is the credit crisis going to end? How will we know? The credit crisis is getting ready to enter its second phase. This week we examine what that means, and what the economic environment will look like over the coming quarters. We also (sadly) re-visit Freddie and Fannie and examine the risks that they put into the markets. Risks, by the way, that were sanctioned by regulators and encouraged by a Congress that took in hundreds of millions in campaign contributions and lobbying fees. We (the US taxpayer) have taken on a huge risk and potential loss for that paltry few hundred million. Sadly, those who encouraged that risk will by and large be voted back into office rather than ridden out of town on a rail (an old US custom, rather barbaric, but one which should maybe be revived for this purpose). It should make for an interesting letter as we count down the last days of summer.

But first, last winter I mentioned that I am looking for private equity and venture capital funds and investment professionals who specialize in those deals, and asked those who would be interested in looking at the potential deals I see from time to time to write me. I had a nice response, but my filing system is somehow inadequate to the task and I seemed to have misplaced about half the respondees. If you have not heard from me lately and would like to be "at the table," just drop me a note at this email address. And now, let's jump into the letter.

It's All About the Spreads

Credit spreads have been increasing and getting ever more volatile. We are going to look at them in detail this week, as one of the signs that the credit crisis is waning will be when spreads start behaving more normally.

Briefly, when we talk about credit spreads we are generally talking about the difference between a benchmark cost of a bond or index and the higher cost for another unrelated loan or bond. As an example, as of Wednesday, a high-grade corporate bond yielded 3.15% more than US Treasury bonds, based on a Merrill Lynch index. Very roughly speaking, in finance terms that means a typical corporation paid 315 basis points more than a similar longer-dated US Treasury. Thus we talk about the spread being 315 basis points or bps. (A basis point is 1/100 of a percent, which means that there are 100 basis points for each 1% difference in interest rates.)

To see how much credit spreads have moved over the past year, let's look at a few charts (I apologize for some of the fuzziness, but I had to resize them). The data is from www.investinginbonds.com . First, let's look at the cost for a typical US financial firm. The cost has gone from 70 bps to 390 bps! That is over a 500% move - a big hit to margins and profitability.

Merrill Lynch US Financials Index

And it can get much worse for some banks. In the "for what it's worth" department, Iraq's bonds are now considered safer than those of many US banks. The country's $2.7 billion of 5.8% bonds due 2028 have gained 45% since August 2007, according to Merrill Lynch & Co. indexes. Investors demand 4.84 percentage points more in yield to own the debt instead of Treasuries, down from 7.26 percentage points a year ago. The spread is narrower than for notes of Ohio banks National City Corp. and KeyCorp, suggesting Baghdad may be safer for bond investors than Cleveland. National City and KeyCorp, based in Cleveland, have debt ratings of A and spreads of 959 basis points (9.59%) and 7.55 basis points (7.55%), respectively. Iraq debt has no ratings. Clearly the market is ignoring the rating agencies which give the banks an "A" rating. Their debt is priced at the junk level. Go figure. (Source: Bloomberg)

Utilities, which you would think would be somewhat immune to the economic crisis and the recession, have seen their borrowing costs rise by almost 300%.

Merrill Lynch US Utilities Index

Your basic investment-grade corporate bond has risen threefold, from just over 90 bps to almost 280 bps. Again, that puts a real squeeze on profits.

Merrill Lynch US Industrials Index

That's the short-term view. Now, let's drop back and look at what has happened since 1997. Credit spreads are now much higher than even in the worst of the last recession. (Source: Bespoke)

And if you have to go into the high-yield market, which is now once again referred to as the junk bond market, you have really been hit. Your spreads, on average, have risen from 240 bps to over 860 bps in the last year. That means IF (and that is a Big IF) you can find someone to loan you money, you will likely be paying an interest rate close to 13% for your money. (The spread is the green line in the chart below.)

Merrill Lynch US High Yield Index

One last chart. This one is the spread between LIBOR and the Fed funds rate. LIBOR is the London Inter Bank Offer Rate. This is what banks charge each other to lend money among themselves. (This chart courtesy of my friends at GaveKal.) Notice the spikes since 1988: the recession of 1991, the 1998 Long Term Capital Management crisis, and then the lead-up to Y2K. After that, LIBOR went flat.

LIBOR may be the most important rate of all, as so many contracts, including many US and European mortgages, are based on LIBOR. Hedge funds, mortgage banks, large and small corporations, and a host of interest-rate-sensitive investments borrow money based on LIBOR. Few of them anticipated such wild swings.

Bottom line? One of the clues as to the end of the credit crisis will be when credit spreads move back closer to historical norms. And we are not close to that yet.

The Coming Bank Credit Crunch

Banks in the US are going to need to roll over almost $800 billion dollars in medium-term debt in the next 16 months. Banks borrowed heavily in 2006, a lot of it in 2-3 year floating-rate notes, and now they must refinance those notes. Say a bank borrowed at LIBOR plus 50bps. In today's environment, many banks are not going to be able to borrow at such low rates. Remember the two Ohio banks mentioned earlier? These regional banks will have to pay spreads of 7-9%, based on the price of their debt today. If you have to pay 12% to borrow money when prime is at 5% and you are lending at 6-8%, you clearly cannot make a profit. That means they will have to sell assets or raise very expensive equity capital.

There are a lot of small and regional banks that are in trouble. The FDIC has a list of 117. Out of (I think) 8500 banks that does not sound bad. But remember, Indy Mac, which failed a few months ago, was not on that list. Banks can get into trouble rather quickly if they cannot raise capital, sell assets, or borrow money due to perceived distress.

The problem is that these banks will have less money to lend and will be calling loans from otherwise good customers, which of course makes the economic situation even worse. It is a vicious cycle.

Even many mainstream economists are now suggesting we will be in a recession by the 4^th quarter, if we are not in one now. (The 2^nd quarter revised GDP was 3.3%. This is an anomaly, and is highly unlikely to be repeated.) The recovery, when it comes, will be tepid until credit spreads signal an end to the credit crisis. It is going to be Muddle Through for 2009. This is NOT going to be good for the stock market. When will it be safe to get back into the water? Pay attention to credit spreads.

One other thing to watch. When the Fed feels it is no longer necessary to offer "temporary" Term Auction Facilities (loans) to commercial and investment banks, that will be a significant event. Notice that these were to be temporary. These auctions will last well into 2009 and maybe longer.

More Thoughts on Fannie and Freddie

First, let me correct an error. It was not JP Morgan that Treasury Secretary Hank Paulson asked to come up with a plan to fix Fannie and Freddie. It was Morgan Stanley. Sorry.

Warren Buffett has stated that Freddie and Fannie are toast, as have many establishment analysts. Buffett told CNBC that the firms had no net worth and would need tens of billions of capital to shore up their balance sheets. Since their combined capitalization is less than $6 billion, it is unlikely that there is any way they could get even a sovereign wealth fund to come to their aid in the form of stock.

Congressional oversight committees estimate losses for Fannie and Freddie to be $25 billion, given current housing values. As home values drop, those estimates keep going up. Also, as the economy gets worse, those losses will increase. Independent estimates are double that or more. If only that were the extent of the problem.

There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities. As an aside, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Care to make an over/under wager on a 1% loss by this time next year? I don't think I would want the under.

Gretchen Morgenstern reported last week that there are - drum roll - $62 trillion (with a "T") in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt. Even if you cut this in half - because technically, when a buyer and a seller enter into a single transaction they create twice the value of the transaction in credit derivatives - this is a huge sum, far out of proportion to the underlying assets. More on this later.

The team at Morgan Stanley has a very interesting problem to solve. It is not just about putting $25 to $50 billion into Fannie and Freddie (assuming that would be enough). If that's all it was, just issue preferred shares, wipe out the current shareholders and, as the smoke cleared in a few years, even with less leverage the actual value of the two companies might actually approach that number and some private equity firms could take out the US taxpayer. But it is not that simple.

What do you do with the current preferred shares? A significant portion is held by banks in their capital base. JP Morgan Chase just wrote down $600 million in Fannie and Freddie preferred shares this week. Many other banks will be doing so as well. As noted last week, there are banks that have more than 20% of their capital base in these shares. In today's current environment, do we want to deal with the costs to the FDIC of even more failed banks? And even if you don't force a bank into outright failure, you at best limit its ability to function as an efficient market lending agency to local businesses and consumers.

But you can't just say, "We will cover the preferred shares in banks but not in personal accounts or in the accounts of other institutions." It is an all or nothing proposition. A $36 billion proposition. It is a potential Hobson's choice. Wipe out the preferreds or wipe out the shareholders of a lot of banks and have the FDIC pick up the costs. By the way, Congress and bank regulators encouraged banks to buy preferred shares by giving them special status and tax breaks.

But what about the $19 billion subordinated debt? That $19 billion is actually on the banks' books as capital for Fannie and Freddie and not as debt, because there is a clause in the bond that says if the bank is in a situation where it must be bailed out, the interest payments on those bonds can be postponed for five years. That allows them to count the debt as capital. If the companies are declared insolvent by their regulators, it could trigger the credit default swaps.

I say could, because depending on how the "credit event" is characterized, it may allow the seller of the insurance to postpone payment for five years as well. Just a technical loophole that I am sure most buyers of said credit insurance did not notice.

And even then, I think it is unlikely that many of the sellers of such credit insurance could make anywhere close to the amount of payments they have contracted for. And since the subordinated debt is precisely what you would want to buy credit insurance on, I bet a disproportionate amount of that $62 trillion in credit default swaps is on the lower-rated debt.

Who Is Holding the Old Maid?

And here's the ugly truth. No one knows who is ultimately on the hook for these derivatives. If I sell a credit default swap (CDS) to you and then buy a CDS on the same issue from Joe down the street for a small profit, my "book" looks neutral. And as long as Joe has the capital, I am. But at 12 times the actual underlying debt instruments, there are not just three parties to my mythical transaction, but at least 10. Joe sells to Mary who sells to Bill, etc., etc. Where does the real guarantee ultimately reside?

Like the children's card game, someone is stuck with the Old Maid at the end.

If there is a problem, you are going to come to me but I am going to tell you to go to Joe who will tell you to go to Mary and on down the line until someone tells you to go to hell. Then you come back at me and take me to court. That's the way it works.

This is why I keep pounding the table that CDS transactions must be moved to a regulated exchange. There has to be transparency and provisions for adequate capitalization of these instruments. Bear Stearns was too big to fail not because it was too big, but because of its derivative book of $1.9 trillion. We would have awoken on that Monday morning and, if Bear had been allowed to fail, the markets would have been frozen, because no one knew who was on the hook to Bear (and vice versa) and for how much. And if you don't know, you don't invest or lend to any financial institution or fund, because you put yourself at more risk.

That was just a lousy $1.9 trillion (admittedly at one institution). But $62 trillion? Where is it? Who owns it? Who thinks they are covered and may not be, but their balance sheet reflects a fully valued bond because "I have insurance?" How long will it take to find out where the real problems lurk?

So, let's add up the damage. $50 billion for loan losses in a market where home values will be down 20% at the least - but let's be optimistic here. Add in another $36 billion for the preferred shares, because if we let the banks go down, we just have to pay it through the FDIC. And add in another $19 billion for the subordinated debt, because the risk of setting off a firestorm in the CDS market may just be too great. That adds up to $105 billion.

Maybe those sharp guys at Morgan Stanley can figure out a way to get around these problems. The regulators recently forced buyers of Ambac CDS to take anywhere from $.13 to $.60 on the dollar. Maybe they can make everybody play nice in the sandbox, but this is a very big sandbox, far larger than Ambac.

And why? Critics have said that Fannie and Freddie were nothing but hedge funds with an implicit government guarantee. This is an insult to hedge funds. Hedge funds don't pay hundreds of millions in campaign contributions so that they can risk taxpayer dollars, prop up their profits, and pay huge bonuses to executives. They risk their own capital with no safety net.

Fannie and Freddie are banks that are levered between 40 and 50 times. I can think of two hedge funds, Carlyle Capital and Long Term Capital Management, that had leverage at those levels. They both went bankrupt, as will any such levered business.

As long as the prices of homes kept rising, Fannie and Freddie had no problems. That extra leverage allowed them to post record profits every quarter, boosting stock prices and keeping those bonuses and options for executives rising. And Congress let them do it. In fairness, there was a significant minority who wanted tougher regulations, including the Bush administration. But a bipartisan majority decided to take the campaign contributions and listen to the fabrications about how much Fannie and Freddie did for the country and how there was no risk.

And so now we are at a point where we are going to be forced to pick up the very expensive pieces. The alternative is to let the world as we know it go up in smoke. The mortgage market is dysfunctional now without Freddie and Fannie. The housing crisis would be far worse if you let them die. And once you determine to pick up the costs, you have gone down a very slippery slope. Yet if we don't do it, the systemic crisis will be far worse than the problems resulting from Bear, and those would have been horrific.

This is the Savings and Loan Crisis, Part 2. Maybe they can figure a way to lessen the cost. And the hope is that at some point the companies once again regain their value and the costs will be somewhat mitigated.

But if we don't get credit derivatives on an exchange, we are going to have to continue to do this. It is all so maddening. The only bright side to bailing out Freddie and Fannie is that it will make Bill Bonner wrong in his prediction of a soft depression.

Baltimore, La Jolla, South Africa, and London

On a personal note, things are going well. My arm is much better. The doctor said I tore a pronator muscle which broke a vein and resulted in some serious pain for about a week and a very ugly bruise along my whole arm. Who knew golf was such a rough sport?

My oldest son Henry just graduated from the University of Texas at Arlington with a degree in history, after going part-time for eight years. He has worked at UPS all that time, but kept at his school work. I am proud of him. He turned 27 yesterday. Tiffani is back from her honeymoon with Ryan. She says she will have pictures up in a week or two, and I will post a link.

Business is good. I am amazed at the opportunities out there. I will be in Baltimore next weekend for Bill Bonner's birthday. Then on to La Jolla to meet with my partners at Altegris (and drinks with Richard and Faye Russell). The next weekend I host Chuck Butler of Everbank and his compadres from the Sovereign Wealth Society at a Friday night Rangers game, and then take off the next morning for South Africa for a speech, then back to London for a day to meet with the team (and my partners) at Absolute Return Partners.

Life is busy but good. And this weekend I am going to take it easy and fire up the grill for some steaks and barbecue at Tiffani's new home. It will be a great weekend. And I hope your Labor Day will be as enjoyable. (There will be no Outside the Box on Monday.)

Your happy I don't have to figure out the Freddie and Fannie mess analyst,

John Mauldin

The Fed at the Crossroads

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

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

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

Retail Sales Take a Dive

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

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

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

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

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

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

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

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

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

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

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

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

Accounting for Inflation

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Fed at the Crossroads

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

- Robert Johnson

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Sell In May and Go Away

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

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

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

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

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

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

South Africa, Flowers, and On the Road

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

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

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

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

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

Assumptions.

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

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

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

Have a great week. And avoid assumptions.

Your wiping the egg off his face analyst,

John Mauldin

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

Thoughts on the Continuing Crisis

John Mauldin — Sat, 22 Mar 2008 05:51:46 GMT

Thoughts on the Continuing Crisis Margin Clerks of the World, Unite! Where Do We Find New Sources of Credit? In Defense of Alan Greenspan What Now for Gold, Oil, Etc? Baseball, Mexico, and Travel Costs My essay in Outside the Box last Monday seemed to...(read more)

Muddle Through and Your Long Term Returns

John Mauldin — Fri, 14 Mar 2008 19:28:39 GMT

Muddle Through Gets A Boost Honey, I Vaporized My Customers Consumer Spending is Going, Going...South The Boomers Break the Deal Today we drop back to take a look at the economy and its long term effect on our portfolio returns. I am in Orlando this week...(read more)

What's That Hissing Sound?

John Mauldin — Sat, 08 Mar 2008 06:02:11 GMT

The BS from the BLS Help Me, Obi-John A New Program for All Investors 2,500,000 "Lost Jobs" and Counting Taking a Long-Term Perspective Leverage in Reverse Gear What's That Hissing Sound? A Response from Tiffani The official number for employment...(read more)

Stagflation and the Fed

John Mauldin — Sat, 01 Mar 2008 04:47:16 GMT

How Do You Spell Stagflation? Memo from the Fed: Inflation? What Inflation? The Fed Will Cut and Cut Again Damn the Inflation Torpedoes! Full Speed Ahead! Apple, Sprint, AT&T, and Going to the Dark Side This week's topic was inspired by a discussion...(read more)