Search results matching tags 'The Fed' and 'Bubble'

A Bubble in Search of a Pin

JohnMauldin — Sat, 06 Feb 2010 05:16:00 GMT

A Bubble in Search of a Pin
Unemployment Numbers: A Mixed Bag
A Bubble in Search of a Pin
And Speaking of Bubbles
Help in Europe, California, and Tampa, and Becoming our Parents

Should Greenspan and Bernanke have seen the bubble in housing and other assets and acted, or should we accept their defense that you can't know whether there is a bubble until after the fact? We will look at research that suggests they should have known, and, at the least, policy makers should no longer be allowed to say, "How could I have known?"

Of course, the employment numbers came out this morning, and the results are mixed; but that is better than they have been for the past two years. We dig into the numbers to see what they are really saying. And finally, we examine why the markets are so volatile. Is it just Greece, or is there more? There's a lot of very interesting, and important, material to cover.

But first, and quickly, as I wrote in Outside the Box a few weeks ago, I am starting to very selectively buy biotech stocks, and mostly, though not exclusively, companies associated with the regenerative genetic revolution that is coming our way. I am convinced that this is going to be a decade of the most amazing medical breakthroughs, which will literally change (and in many cases extend) our lives, as therapies to treat all sorts of diseases become available.

This is the last time I am going to mention it, but here is the link to that OTB, which analyzes why we may see a bubble in biotech stocks before the end of the decade. The OTB was written by my friend Pat Cox, who covers these stocks and other technological marvels in his newsletter, Breakthrough Technology Alert. I have been following Pat for some time now, have talked extensively with him, and think he is one of those guys who have a handle on what by all accounts is going to be an amazing decade of breakthroughs.

I have asked his publisher to offer my readers a very discounted subscription price for one more week. (Ignore the deadline of February 5.) And yes, the promotional piece is a little over the top, as it is for most subscription newsletters (I am lucky mine is free - I don't have to do that). But I think his letter has a lot of substance. The link to the site is in the Outside the Box. Don't procrastinate. Join me, because for once in my life, dear God, I want to be in at the beginning of a bubble. And now to our letter.

Unemployment Numbers: A Mixed Bag

January employment numbers are characteristically volatile, as the birth/death ratio numbers are typically the largest of the year. This month the birth/death model subtracted (rather than added) 427,000 jobs (yes, I wrote that correctly). This is a very large "adjustment" month, and the volatility gets smoothed over in the seasonal adjustments. It is part and parcel of the process, as making estimates about how many new businesses are formed or die is extraordinarily difficult at turning points in the economy.

As an acknowledgment of that, the employment level for March 2009 was revised down by 930,000 jobs, and by December it was a total of almost 1.4 million extra jobs lost. That means that the Bureau of Labor Statistics overestimated the number of new jobs significantly. December's job loss was really 150,000, not the 85,000 originally reported. How would the markets have reacted to a number that large?

January saw a slightly larger than estimated loss of 22,000 jobs, which would have been 53,000 without new federal employees, 9,000 of whom were hired to perform the census. (By the way, federal employment is absolutely exploding!)

Now, the somewhat good news. I have been writing about how the household survey has been much weaker for almost two years than the establishment survey. For instance, the total number of unemployed rose by 589,000 in December, while the number of people not classified as looking for work rose by 843,000. No matter how you spin it, those were very ugly numbers.

This month the household survey showed the largest one-month turnaround that I could find. As The Liscio Report noted:

"Adjusting for the changes in the population controls, total household employment rose by 784,000 - and when further adjusted to match the payroll concept, employment was up 841,000. Moves of this magnitude (regardless of sign) are unusual, but not unknown - and frequently undone in subsequent months. The less volatile ratios were also up, with the participation rate up 0.1 point, and the employment/population ratio rose a nice 0.2 point, its first increase since last April. While it's too early to say whether this strength in the household survey is a harbinger of an upturn that will soon show up in payrolls, it's something to be filed under 'tentatively encouraging.'"

The work-week hours rose slightly. Income growth was better than it has been. Temporary workers rose, which is typically a harbinger of an increase in full-time employment. The number of people working part-time for economic reasons plummeted by 849,000.

And finally, the unemployment rate fell 0.3% to 9.7%. This of course means that more people are dropping out of the labor pool, and it also means they will at some point come back.

On the negative side, a loss of 22,000 jobs is nowhere close to the 100,000 new jobs that are needed just to hold unemployment steady. 41% of those unemployed have been so for over 6 months.

And quoting David Rosenberg:

"While there will be many economists touting today's report as some inflection point, and it could well be argued that we are entering some sort of healing phase in the jobs market just by mere virtue of inertia, the reality is that the level of employment today, at 129.5 million, is the exact same level it was in 1999. And, during this 11-year span of Japanese-like labour market stagnation, the working-age population has risen 29 million. Contemplate that for a moment; fully 29 million people competing for the same number of jobs that existed more than a decade ago. That sounds like pretty deflationary stuff from our standpoint.

"Not only that, but consideration must be taken that in 2009, we had a zero policy rate, a $2.2 trillion Fed balance sheet and an epic 10% deficit-to-GDP ratio. You could not have asked for more government stimulus. Yet employment tumbled nearly 5 million in 2009."

Finally, a very sad chart, courtesy of David. Those in the 25-54 year-old male category have seen their total number of jobs fall back to the level it was in 1996. Fourteen years later, and the "breadwinners" who are supposedly in their prime have seen an almost 10% drop in employment.

As noted above, January employment numbers are very volatile, and are likely to be adjusted either up or down by a lot in coming months. But this report was not the disaster of December. It still shows a very weak economy that certainly does not need a large tax hike next year. I hope we start seeing some positive numbers soon, but I am not optimistic that we are going to see the 200,000-plus new jobs per month we need to really start denting the unemployment numbers, for some time. Not when the National Federation of Independent Business says 71% of small businesses do not plan to hire this year.

The Fed is taking away quantitative easing. Stimulus spending is exiting in the last half of the year. States and communities are having to either raise taxes or cut spending by $350 billion! I heard on the radio coming back from the gym (I think it was my friend Steve Liesman on CNBC) that there are now 55,000 fewer teachers than a few years ago.

And again from the NFIB, small businesses see very tight credit conditions, which makes it hard for them to expand (see chart below). The headlines this week from the Fed banking survey said that banks were prone to be less tight, but the NFIB writers went deep into the report. What they found is that very large banks are willing to be less tight in their lending standards. Smaller banks were in fact not as easy. Loan demand is falling. Consumer credit actually declined slightly in December, after plunging in November. If you can't count on Americans to buy during Christmas, the world is in fact moving to the New Frugal.

All this is not the stuff that robust recoveries are made of. We drift back into Muddle Through the last half of the year, I think. And if Congress does not act to postpone or mitigate the enormous tax increases due in 2011, we slip back into recession. It will be a policy error of major magnitude to raise taxes with 10% unemployment and a weak economy.

A Bubble in Search of a Pin

We are going to once again return to the book highlighted the last few weeks, This Time Is Different, by Carmen M. Reinhart and Kenneth Rogoff. This is a book you should buy and read, especially the last 4-5 chapters, and try to get your Congressman to read it as well, so he or she can see what happens to countries that run up their debt. It makes no difference if it is small or large, the end result is the same.

Last week we looked at the role of confidence in allowing governments to borrow money. This week we ask whether Greenspan and Bernanke, along with the entire Fed, should have been able to determine whether a bubble was building in the US economy and lean against it, preventing the debacle we are now in. Reinhart and Rogoff gently come down on the side of those who think they should have, and that we need to implement changes in our institutions. Others, as we will see, are not so gentle. Let's look at a few selected paragraphs I pulled off my Kindle (all emphasis mine).

"As we will show, the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output - standard leading indicators of financial crises - all revealed worrisome symptoms. Indeed, from a purely quantitative perspective, the run-up to the U.S. financial crisis showed all the signs of an accident waiting to happen. Of course, the United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms.

"... On the one hand, the Federal Reserve's logic for ignoring housing prices was grounded in the perfectly sensible proposition that the private sector can judge equilibrium housing prices (or equity prices) at least as well as any government bureaucrat. On the other hand, it might have paid more attention to the fact that the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006. Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated. Although this work was not necessarily definitive, it certainly raised questions about the Federal Reserve's policy of benign neglect.

"The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that "this time is different" - because this time the U.S. had a superior system - once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watchdog declares that there are no risks, there is no surer sign that this time is different. [By that they mean that the attitude of the market in general and central bankers in particular was that "this time is different" and so we did not need to worry about the warning signs. The entire point of the book is that it is never different. We just somehow believe we are in a special situation.]

"... We have focused on macroeconomic issues, but many problems were hidden in the 'plumbing' of the financial markets, as has become painfully evident since the beginning of the crisis. Some of these problems might have taken years to address. Above all, the huge run-up in housing prices - over 100 percent nationally over five years - should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker.

"... The signals approach (or most alternative methods) will not pinpoint the exact date on which a bubble will burst or provide an obvious indication of the severity of the looming crisis. What this systematic exercise can deliver is valuable information as to whether an economy is showing one or more of the classic symptoms that emerge before a severe financial illness develops. The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often that not. That is why we also need to think about improving institutions.

"... Second, policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial."

The evidence is there. So why did the Fed miss it?

A more pointed critique is leveled at the Fed and Greenspan, and at Bernanke in particular, by Andrew Smithers in his powerful book (now updated) Wall Street Revalued: Imperfect Markets and Inept Central Bankers. The foreword is by one of my favorite analysts, Jeremy Grantham. This is on the top of my reading list for the coming week. I am loving the first part, which ties nicely into the themes explored by Reinhart and Rogoff.

The book is a withering critique of the Efficient Market Hypothesis (EMH), among other economic theories. Smithers argues that because the tenets of EMH are so ingrained, Greenspan and Bernanke could not recognize the bubble, because they believed in the efficiency of markets. "Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of theory." Which they did.

As Grantham wrote in the foreword: "My own favorite illustration of their views was Bernanke's comment in late 2006 at the height of a 3-sigma (100-year) event in a US housing market that had no prior housing bubbles: 'The US housing market merely reflects a strong US economy." He was surrounded by statisticians and yet could not see the data... His profound faith in market efficiency, and therefore a world where bubbles could not exist, made it impossible for him to see what was in front of his own eyes."

Reinhart and Rogoff show time and time again that bubbles always end in tears. Markets and investors are in fact irrational. What kind of Fed governor would it have taken to suggest that housing was in a bubble and we were going to have to take steps to slow it down - raising rates, analyzing securitization and ratings? It would have taken one tough hombre. In fact, we had Greenspan, who encouraged the unchecked expansion of the securitized derivatives market. And a Congress that would not allow proper supervision of Fannie and Freddie (which is going to cost US taxpayers on the order of $400 billion). The list is long.

And Speaking of Bubbles

This week the turmoil that is Greece continues. One of my favorite quotes comes from Donald Morris, writing in June of 1993 (hat tip to Dennis Gartman):

"If all of the Greek islands were merged with the mainland, it would be about the size of Alabama; there are 10 million Greeks - and perhaps another 4 million living throughout the world, who still think of themselves as Greek. They are, thanks to their history, magnificent patriots and nationalists - and abominable citizens, who deeply mistrust every government they've ever had. Essentially they are fierce individualists, who mistrust not so much whatever government happens to be in power as the very idea of government. The have almost no sense of civic responsibility - Pericles complained about this at length - and History has never given them much of a chance to work out a stable system of government. Democracy, yes (the Greeks invented it!!), but stability, no."

Have things changed? From here it does not seem so. Greece apparently hid about 40 billion euros of debt from the public and EU governing bodies. (If the government can hide that much, is it any wonder that individual Greeks themselves can hide their income and pay so little in actual taxes? They have made it an art form!) In response to just the initial phase of belt tightening, unions are launching strikes and protests. What will happen when it gets serious? Stratfor estimates that Greek deficits may actually run as high as 15% of GDP rather than "just" the 10% or so publicly revealed. That will require far more than a little belt tightening.

Let's look at the record. Greece has been in default for 105 years out of the last 200. They have never had a balanced budget, at least not willingly.

The EU is backed into a corner. They have this treaty that says governments will act in certain ways. Greece is flaunting that treaty. Everyone acts as if Greece defaulting on its debt would be the end of the EU. Will the EU force Greece to withdraw if they do not control their budget? Upon reflection, I am not so sure.

Let's take that proposition to the US. What if Illinois defaulted on its debt? Would we kick them out of the Union? Hardly. A default would mean a severe loss of credit, a forced retrenching, and a severe economic crisis in Illinois. The losses would be serious for banks and investors. There would be negotiations on how to deal with the debt, who gets a haircut on their bonds, what pension assets and expenses would be cut, and so on. A crisis? Yes. End of the world? No.

So what if Greece does default? The banks and those who lent them the money would take a loss of some amount. The cost of borrowing for Greece would rise dramatically, if they could even get into the debt market. If they actually cut their budgets enough to deal with the deficit in a responsible way, it would mean, at best, a severe and prolonged recession. If Stratfor is right about deficits reaching 15% of GDP, it could mean a depression. They have no good choices.

It is doubtful that German and French voters will be happy with any bailout using their tax money that does not impose serious cuts in Greek budgets, with realistic controls as a condition for the bailout. Can Greece live with that? We'll see.

(I am sure I have hundreds of Greek readers. I would love to hear from you as to your views, from the inside.)

But is it so unthinkable that Greece could simply default and then be forced by the market to get realistic about its deficits? The same market forces that work in Illinois can work in Greece.

But if the EU does bail out Greece, what then of Ireland, which is making the tough choices? Will Portugal be next? If Greece is allowed to fail, or better, actually shows some fiscal discipline, that bodes well for the EU in the long run. It will be a lesson that each nation is responsible to maintain its own house.

The data presented by Reinhart and Rogoff show clearly that adding yet more suffocating debt to a bloated debt crisis is not the solution. It simply puts off the inevitable. Greece is an intractable problem. From here it looks like default or a very serious recession, with large unemployment numbers.

But in the meantime the Greek situation is adding volatility to risk markets of all types. I have written before of the connection between what is called the euro-yen cross and risk markets all over the world. Right now, you can borrow money very cheaply in dollars and yen (the so-called carry trade). When investors want to reduce risk, they pay back those loans, which has the result of increasing the value of the dollar and the yen.

That is what is happening with the euro-yen cross as of this morning. It is in the process of falling out of bed. And so are risk markets. Markets do not like uncertainty. And Greece and Portugal and Spain are uncertainty in spades. If Greece defaults, who owns the debt? Which banks? My bank? Will they call my loan? This happened in 2008 a lot! Can it happen again? We still have banks all over the world that are too big too fail. Credit default swaps are not on an exchange (because to do that would make them less profitable for the investment banks that sell them, and thus the lobbyists have convinced Congress to ignore them).

Are we at the place where we can think the unthinkable? That sovereign nations can in fact default? I think we see a de facto default by Japan this decade.

Do not assume that we have weathered the storm. We may just be getting ready for the next one.

Help in Europe, California, and Tampa, and Becoming our Parents

Tiffani wanted me to ask some of you for help with our vacation. I am taking all seven kids, four spouses, and three grandkids to France and then to Italy in June. We could use some suggestions, especially for how to accommodate 14 people. We will spend most of the time in Italy, after stopping at Bill Bonner's French chateau for a few days. I am checking out the International Living website for ideas. I really enjoy each issue, as I dream about having a retreat in some less hectic locale. You should check it out if you have that dream as well. It is inexpensive inspiration.

Tomorrow Tiffani, Ryan, and I head for a last-minute important meeting in LA. This will be interesting, as we are taking 2-month-old granddaughter Lively and the nanny as well. "Dad, I am just not prepared to leave my baby yet. I have to have more notice to get used to the idea." The bonus is that I get to have dinner with Rob and Marina Arnott on Sunday before we head back Monday morning.

And then next week is the NBA All-Star Game, which most of my kids will be attending with me. What a fun day!

And the following weekend I am off to meet with Jeff Saut, the chief investment officer of Raymond James. But we may slip in a little fun on his boat in the bay in Tampa. It's going to be a good, good month.

It seems that more than a few times lately that Tiffani has turned to me and said, "Dad, don't you remember telling me that just a few days ago?" It is almost a running joke. Then as I was drifting off the other night, I remembered telling my Dad the same thing - only when he was a lot older than I am now! I am becoming my Dad. Sigh. And I would give a great deal to still be able to chide him on his failing memory.

Have a great week!

Your going to eat Greek food this weekend (but no ouzo) analyst,

John Mauldin

Should the Fed Cut Interest Rates?

JohnMauldin — Fri, 07 Sep 2007 08:10:00 GMT

Should the Fed Cut Interest Rates?

The Shocker in the Employment Numbers
Should the Federal Reserve Cut Interest Rates?
Will A Cut Make Any Difference?
How Housing Woes Hurt the Rest of the Economy
Home Again, Home Again

The unemployment numbers came in today, and if you look under the hood of the data, it is worse than the headline loss of 4,000 jobs. Should the Fed cut the interest rates in two weeks? Will it make a difference? Are we headed into recession (as predicted here in my January 2007 forecast issue)? When do we see a bottom in the housing market? Are we there yet? We look at all this and more. It should make for an interesting letter, if I can get my jet-lagged body to cooperate.

But first (and quickly) let me mention that I will be at the venerable New Orleans Investment Conference October 21-25. This is the grand-daddie of all investment conferences and features some of the top investment analyst and minds in the country. Among the many speakers are James Grant, Ann Coulter, Lawrence Lindsey, and good friends Marc Faber, Dennis Gartman, Doug Casey. Click on the link and then click on faculty to see what is one of the highest quality gatherings of top-notch speakers at any conference anywhere. You should check it out, especially if you have an interest in gold and natural resources, as some of the top investment analysts in that area are always there. If you are there make sure and look me up.

And quickly, speaking of gold, it is soaring. It closed at over $700 today, in partial reaction to the awful employment numbers, which was not good for the dollar. But there is another interesting story going on in the background, pointed out to me earlier this week by that South African gold maven Prieur du Plessis. He points out there is a massive build-up of call options in the October and December Comex gold contracts, similar to a period in November 2005 prior to the gold price surging by more than 50%. Smart money? Maybe. But the recent 6% move or so may not be all there is in the "barbarous relic."

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The Shocker in the Employment Numbers

Economists surveyed by Bloomberg expected that payrolls would increase by 100,000. Instead they dropped by 4,000. That is the first drop since August of 2003. The weakness was broad based and payrolls for both June and July were revised down, from 92,000 to 68,000 in July and from 126,000 to 69,000 in June. That is an average of less than 46,000 a month for the last three months. The economy needs to create 150,000 jobs a month in order for employment not to rise.

Technically, there was a drop of 35,000 in September of 2005, but it was later revised upward to 105,000, a rather large swing. But that brings up a point. The employment numbers are subject to large revisions, especially at major turning points in the economy. The employment data is based on a survey of businesses called the establishment survey. It tends to miss jobs created at small businesses at the economy expands. Thus, the jobless recovery of 2002-2005 was not really jobless at all when the revisions came in over the next few years. The Bureau of Labor Statistics (BLS) makes the survey and then based on past data trends, heavily influenced by recent trends, makes an estimate as to the number of new jobs.

A large part of the unemployment figure is from the so called "birth/death ratio." They estimate the numbers of new jobs created or destroyed each month based on past history. This is the main source of the "under" during the recovery phase, but the converse is also true. It will almost always overestimate the number of new jobs as the economy slows, and especially before a recession.

This month the BLS estimated 120,000 new jobs in the birth/death column. These jobs may not in fact be there if the economy is slowing as it seems to be. There are good reasons to suspect that the August number will be revised down at a later date, as were June and July.

But it may be worse. The BLS conducts two surveys. One is the "establishment survey" mentioned above. The second is the "household survey" where they phone households and ask how many people in the household are employed, are seeking employment or are not in the market for a job.

I reprint the table from their website below (www.bls.gov). The number of unemployed people in this survey actually fell slightly, but notice that it also shows a drop of 316,000 jobs last month. Further, they show a rise of 592,000 people who are no longer considered to be in the work force! That is a total swing of over 900,000 workers, or about 0.5% of the labor force. That is a rather large swing in this series.

Finally, and in the "it's probably just a coincidence category," all the research that shows that employment for low wage jobs, especially among teenagers, actually decreases, especially initially, as the minimum wage rises. The new minimum wage kicked in starting July 24, with the rate rising from $5.15 to $5.85. And teenage unemployment rose by almost 6% from July to August. Got to be coincidence. Congress wouldn't do anything to hurt teenage employment, would they?

Should the Federal Reserve Cut Interest Rates?

Looking at the chart below, notice that 2 year rates on US government is at 3.9%. The rate on the ten year bond is at 4.38%. The spread on TIPS (the markets best guess on inflation) is hovering just above 2%. And Fed funds are at 5.25%. The market is screaming for a rate cut.

As I have noted in previous letters, getting an inflation number lower than 2% in the next few months is going to be hard because of the rather low year over year comparison numbers of the latter part of 2006. And the various Fed governors have been telling us that inflation is their primary concern in speech after speech. Cutting rates before we see a lower inflation number is something they have clearly indicated that they are not interested in.

Bernanke and others have made it clear that they do not see it as their job to bail out borrowers who took out home loans they could not pay, or lenders who made risky loans or investors who bought the loans. The fact that the Fed helped create the low interest rate environment which fostered such excessive risk taking is not something they have yet acknowledged.

After today's unemployment number, the futures market is pricing in a rate cut for the September FOMC meeting. If they do not get it, their will be lynch mobs forming. You do not want to be long the S&P of there is no rate cut. It will be ugly. The arguments I have heard and read (not necessarily mine) go like this:

The economy is slowing down. We may even be looking at the possibility of a recession. Recessions are by definition deflationary, so whatever concerns you have about inflation will go away. If the Fed waits until the backward looking inflation data comes in, it almost guarantees a recession.

Further, the credits markets are in the worst crisis in decades. Financial institutions do not trust each other, as there is not transparency. The commercial paper market is in the process of imploding. Mortgages, except for government back agency paper, are not being written or is being done is at very high rates. Want a jumbo loan today? It could cost you 9%, if you can find it, even with good credit. Please, Chairman Bernanke, could we have at least 50 basis points to make the problem go away?

Finally, the housing market is on the verge of a collapse. Foreclosures are high and rising. We need lower rates to help homeowners and jump start the housing market so it can recover.

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Will A Cut Make Any Difference?

Now, for what it's worth, here's my view. I think the Fed should cut rates in September. The economy is indeed in the process of slowing down and I think, for the reasons I outline below, is on the verge of a recession. The Fed policy is now clearly quite tight. A 50 basis point cut will still leave real rates at around 2.75%, which is not exactly an easy monetary policy.

But let's be clear. A fed cut is not going to solve, or even help much, the current credit crisis. The problem, as I have repeatedly said, is not a liquidity problem but a credibility problem. There is plenty of cash, and central banks around the world are adding to it daily.

The problem is that no one wants to buy debt that they do not completely understand. If you are a bond buyer for an institution, it is a career ending decision to buy an asset backed investment grade bond even rated AAA if it goes bad. You might be able to explain buying such assets last spring. Buying a problem bond today and it is now your fault, not to mention your job.

And commercial paper from another financial institution? How much subprime debt do they have hidden on off-balance sheet vehicles? Why loan anyone money for just a few extra basis points when you can't be 100% sure? Especially if you are looking at your own exposure and you see how easy it might be to hide a few problems here or there.

These problems are going to be worked through. I have personally talked to more than a few managers who are raising money to create distressed debt funds to buy this paper at discounts, as there are going to be lots of funds and institutions that will be forced to sell asset backed paper. For instance, if you are a pension fund, bank or insurance company that by law can only hold rated paper, and when the ratings agencies mark the subprime paper that you own down below investment grade, you will be forced to sell.

But the question is who will buy? Those who own these bonds and are forced to sell are going to take large losses. The hedge funds that buy them will have the potential for some very good profits. That helps the markets in general, as it helps "clear" the market and allows things to get back to normal more quickly. But the losses for those who are forced to sell will be larger than for those who can sit it out. (It might help for regulators to relax the holding period for those assets as long as they are properly priced in the portfolio.)

A lower Fed funds rate might make the bonds slightly more valuable. But if your A-rated subprime paper is selling for 50 cents on the dollar (and some are), the extra value that even a 150 basis point Fed funds cut would make is only a few points in value. Small consolation.

On a side note, the higher rated asset backed paper is bouncing back rather significantly from the lows of mid-August, although still at steep discounts. The lower rated (BBB and below) is still near their lows. The market is starting to make the distinction between various types of debt, and that is good. The first part of the process, which is to establish some realistic pricing, is at least starting.

Second, a lower fed funds rate is not going to bail out the housing market. It will of course help some, but again, it is not the interest rates that are the problem. The problem is that we are talking about the 20% plus of the home buyers in the last two years that were able to buy homes because of poor lending practices on the part of mortgage companies. Those home buyers are not going to be there to support the market.

Further, let's say that we could wave a magic wand and allow the millions of home buyers who bought homes on adjustable rate and teaser rate mortgages to somehow refinance their homes at reasonable rates, even though their homes are going down in value. For those who qualified on 2% teaser rates, even if they could get a 7% mortgage, the payment might be too much.

Goldman Sachs suggests home values could drop as much as 20%. Gary Shilling has been saying 25%. We don't have time and space this week to go into housing prices, but many of the mortgages sold in the past two years only made sense in a housing market that was rising by 10-15% a year. A market that is dropping 10-15% a year, as it may do in the next 12 months, is only marginally be helped by a Fed funds cut.

But that does not mean they should not cut. They should, simply because the economy is clearly slowing, and the risks are now to the downside.

How Housing Woes Hurt the Rest of the Economy

I have maintained for a long time that the bursting of the housing bubble would cause a serious slowdown or a recession in the economy. My critics would counter that housing is only 5-7% of the economy and a housing recession would not be enough to drag the whole economy down.

They are wrong for the following reasons. First, rising home values have allowed homeowners to use their homes as an ATM through mortgage equity withdrawals, which have added almost 2% to GDP annually over the last five years. That is now evaporating.

Secondly, falling home construction and lower home sales means fewer jobs not just in the direct home building market, but in the parts of the economy related to the home building markets, like mortgage brokers, real estate agents, hardware and furniture, etc. As an example, Countrywide announced a planned 10-12,000 person lay-off, when just a few weeks ago they were thinking of expansion, as they now think new mortgages may drop 25% in 2008. Fewer jobs mean lower consumer spending.

Consumers are not going to spend as much due to the wealth effect. If you feel your house was going to be a major part of your retirement, and now the value is going down, you are going to be more cautious and actually think about saving. This has been a dangerous prediction for 50 years, but I think consumer spending, some 71% of the US economy, is due to slow down. Year over year growth could drop below inflation later this year.

Further, with all the additional homes coming onto the market due to foreclosures, hone values are going to drop even more, and new home construction, which peaked at an annual run rate of 2,000,000 homes per year, is likely to fall to less than 1,000,000. We are currently at a level of 1,400,000, so we are not yet close to the bottom.

Rising unemployment. A housing market looking at the deepest recession in values since the Great Depression. A consumer under siege. A visibly slowing economy.

The Fed should cut rates. It will not be enough, but it will be something.

The Bush administration needs to augment those cuts with programs to help those who could make their mortgage payments if they could get a reasonable rate to be able to do so. Not a bailout of lenders, but help to those caught in the whiplash of a mortgage market that is rapidly freezing up for many.

Further, the rating agencies need to quickly move to increase transparency on the ratings of structured vehicles, investment banks need to figure out how to create credible structured products, etc.

But that is another story for another letter. For now, the Fed needs to cut. And at least 50 basis points, please.

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Home Again, Home Again

I rather enjoyed my vacation, but now I need to rest up. As usual for me, I tried to do too much in too little time, but it was fun. I want to thank Tom Fischer at Jyske Bank in Denmark for being such a perfect host in Denmark. Rarely have I been treated so well. Warsaw was interesting. I loved Krakow, and Prague is beautiful. I met so many new friends.

I had dinner in London Wednesday night with old friend Bill Bonner of Daily Reckoning fame, but he and I met almost 25 years ago as (then young and struggling) publishers of investment newsletters. He went on to build one of the largest investment publishing businesses in the world, and I left the business five years later for the investment management side of the business, but we have stayed close all these years. We have seen a lot of changes over that time, and I trust we will see a few more over the decades.

He brought me his new book, Mobs, Messiahs and Markets, which will go to the top of my reading list. I love the way Bill writes. Interestingly, I looked at this book on Amazon, and noted that they have his book paired with Alan Greenspan's new book.

I am not certain what it says about the world, but I note that Bill's book is at #10 on Amazon and Greenspan's is at 265. I intend to review the book in the near future, but you can get it at Amazon.com.

It is good to be home. I look forward to being here for awhile. And while I have had major writer's block on the book I am supposed to be writing, I think I worked my way through my problems these past two weeks. Trying to convey the nature of the changes we will be facing in the next 20 years has been a much more daunting task than I had first supposed. But then most things that are worthwhile, it seems, end up taking more effort than we first thought. It is good to be somewhat overly-optimistic, at least for me, for if I was a realist, I would start way fewer projects and end up accomplishing less.

We celebrate my oldest son Henry's birthday tomorrow. It was actually last week while I was on vacation, but nearly everyone, including me, was gone. The twins are down from Tulsa and Henry wants sushi, although that may be tough for me as I did have some bad sushi at the Park Plaza in London on Tuesday and have been sick since then, although I am getting better.

Here's to old and new friends and family. Have a great week.

Your thinking a lot about life analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2007 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp.; and EFG Bank. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Honey, I Created A Bubble

JohnMauldin — Fri, 10 Nov 2006 08:06:00 GMT

Introduction

We have been told for months that the next interest rate move by the Federal Reserve is dependent upon what the data tells us prior to each meeting. If the data tells us that inflation is too high and/or the economy too strong, the Fed will continue in its pause mode or maybe even hike rates. If inflation comes down and the economy begins to soften, the next interest rate moves will be down.

But that begs the questions, "How reliable is the data?" and "How does one interpret the data?" This week we start with a look at a remarkably candid speech by Richard Fisher, the president of the Dallas Federal Reserve. We then look at what the data tells us about inflation, the relationship between housing construction and GDP, and the disconnect between the bond and stock market.

Honey, I Created a Bubble

The more I learn of Richard Fisher, the more I like. He is refreshingly clear, as well as candid, in his presentations. He will tell you he is not a trained economist, but rather a Harvard MBA with a focus on decision making under conditions of uncertainty. In a speech this week to the New York Association for Business Economics, he talked about the need for more and better data to help in the decision-making process.

"I hardly need to explain," he said, "the importance of good data to any of you. We all know the consequences of data being wrong or arriving too late. Our reputations rest on the data we use. The better the data, the less our uncertainty. And the less our uncertainty, the better our ability to make sound decisions.

"... To begin with, most economic data are inherently backward looking, often to a disconcerting degree. Obviously, there is no way around this. Obtaining completely accurate forward-looking data would require extensive investment and research into that other dismal science, science fiction. Yet time-travel aside, we must strive to develop reliable real-time data collection technologies and ever more practicable models based on the limited framework of historical observations. That process is ongoing. To paraphrase singer-songwriter Robert Earl Keen, the road goes on forever and the analytical party never ends.

"This is not to suggest that simply developing more enhanced models using available data is all that is needed for us to do our job better. In a rapidly changing world where microeconomic operators, enabled by expanding economic geography and technological innovation, are constantly pushing the envelope of production and profits, one can never be confident in the insights provided by even the most sophisticated econometric models."

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So far, so good. He makes a solid case in the speech for needing to incorporate more global data into the Fed models, as the global economy is influencing the US economy to an ever greater degree.

What if Texas issued its own currency and had its own central bank? Texas as a nation would not be a small player. In dollar terms, it is larger than Korea or Brazil or Mexico and 25% larger than India. But even given that, a Texas central bank could not discern proper and prudent monetary policy by just looking at Texas data. They would clearly have to take into account the data from the US and the rest of the world in order to maintain price stability and full employment.

All very reasonable and thoughtful, and an explanation why the Dallas Fed is beefing up its economic staff in search or more and better data. But that, gentle reader, is not the reason we are looking at his speech today.

What if the data we so meticulously collect is wrong? Might that not lead to mistakes in policy? Then he gives us the following paragraphs, saying out loud what everyone knows but no Fed official has uttered: the Fed lowered rates too far and held them down too long, based on faulty inflation information. (Emphasis below is mine.)

"A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent 'lower boundary.' At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

"In retrospect, the real Fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth."

Talk about an "oops" moment. I remember clearly writing in 2002 about an inflation rate that was below 1% and the danger of deflation. But now we find out that the published figures were about a half percent to low. Not seem like all that much? That is a large and critical difference in the realm of monetary policy.

(You can read the whole rather thoughtful speech at http://dallasfed.org/news/speeches/fisher/2006/fs061102.cfm)

Inflation falling below 1% in a recessionary environment, as we were in, is quite worrisome. Economists openly speculated about the problems of keeping an economy from entering a deflationary cycle. Ben Bernanke gave his famous helicopter speech assuring the markets that the Fed had the policy tools do deal with deflation. We were not going to succumb to "Japanese disease."

But as the revised data comes in years later, we find that inflation was not below 1%, but around 1.5%, right in the middle of the Fed's comfort zone of 1-2%. It was right to lower rates, as the economy was slowing, but there was no need to do so as much or for as long. Turns out that deflationary scare was based on bad data. What in effect happened was a monetary policy fighting the wrong data that encouraged speculation in all sorts of financial assets and eventually brought back inflation to levels well above 3%, too high for a central banker's comfort level.

Besides hurting those retirees dependent on interest income, it aided and abetted what became a housing bubble, as people bid up housing prices as the cost of financing plummeted. And the housing construction market responded, building more and more homes to satisfy that demand. Now, we can see they overestimated demand and built too much. But that is the way of all booms.

How much of a boom? Housing construction soon rose to over 6% of GDP, higher than at any time since the immediate post WW2 construction boom. Vancouver buddy Matt Blackman, sent me the following chart.

"Residential fixed investment (RFI) topped 6 percent of U.S. GDP in 2005, the highest level since the early 1950s. Since WWII, every time RFI has topped 5.5% of GDP and then dropped 10%, a recession has followed, according to Hugh Moore of Guerite Advisors. RFI declined 10.1% from its peak of 6.3% of GDP in Q4-2005 to 5.66% in Q3-2006 and then dropped another 17.4% in the latest quarter."

RFI is going to continue to shrink. Look at the chart. Drops of over 30% are common when FRI is above the 5.5% level. We are a long way from a bottom.

And a recent article on Fortune makes that very case. "In many once-hot regions, order cancellation rates are running above 40%, new home sales volume has dropped 50% and new home prices are down 10 to 25%. Bruce Karatz (CEO of national homebuilder KB Homes) says the current downturn is worse than any he has seen - even the early 1990s market that left so many big builders reeling.

"If housing starts and sales were the only casualty, the economy probably wouldn't be in such peril. Gary Gordon, an executive vice president at mortgage investment firm Annaly Capital and a former chief US equity strategist at UBS, expects construction to fall to 4% of gross domestic product from 6% today - itself not enough to push the economy (now growing at 2.6%annual rate) into recession.

"The big risk is the ripple effect." New home buyers typically buy new furniture as well. "Housing turnover is a leading indicator of furniture sales, which is why analysts keep trimming earnings estimates for home furnishing retailers."

Not to mention the problems if falling values make it more difficult for homeowners to borrow against their equity. Gordon estimates that if cash-out refinancing falls to 2001 levels, it would drain $300 billion from the economy, or roughly the same impact as another $60 increase in the price of a barrel of oil. And did I mention the increase in interest expenses for adjustable-rate mortgages?

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The Complications of Fed Policy

The bubble and its aftermath are "complicating" the role of monetary policy, says Fisher. In speech after speech, Fed governors are telling us that they are concerned about inflation, and that inflation is going to have to fall into a comfort zone before they can move to lower rates. Even if the economy is moving into recession, if you can believe them, they will not lower rates until inflation is under control.

The good news on that front is that last month we finally saw the inflation data begin to recede. One month does not make a trend, but it is a start. Let's look at the data from the last month. Again we will look at the Fed's favorite measure of inflation, the PCE (Personal Consumption Expenditures) and the alternative trimmed mean PCE inflation rate, calculated by staff at the Dallas Fed, using the same data from the Bureau of Economic Analysis (BEA).

Basically, the trimmed PCE includes food and energy but factors out the volatility, giving a more balanced and full view of inflation. Pay particular attention to the 6-month inflation, as that is probably the best judge of recent inflation. What we see is that inflation did indeed drop by all measures in September, and is likely to be dropping again in October. But it is not yet below 2%, which is where it will need to be to make central bankers comfortable. Or at least that is what they are saying.

It is not just a housing slowdown pointing to a recession. Paul Kasriel of Northern Trust writes:

"The ISM survey results, year-to-year change in seasonally unadjusted initial jobless claims, the 10-year federal funds rate spread, and the average manufacturing workweek are strong leading indicators of economic activity. Each of these indicators is pointing in the same direction, at the present time, warning of weakening economic conditions. There is sufficient evidence to justify a lower federal funds rate, but the FOMC is unlikely to take action until inflation data show moderation."

And the growth in consumer spending is slowing down. Wal-Mart is slashing prices on a number of items in advance of the normal Thanksgiving sales. October sales were punk and they are projecting flat November sales, the worst performance for Wal-Mart in a decade. Upper-end stores seem to be holding up, but those are typically the last to feel the pinch.

Yield Curve Says Probable Recession

The yield curve became more inverted this week, with the negative differential between the 3-month and the 10-year at -49 basis points and a -76 basis point differential between the 10-year and the Feds fund rate. According to a Fed paper, that level of an inversion suggests there is now an over 40% probability of recession next year. This same model only predicted a 50% chance of recession in 2000, and as the paper authors acknowledge, the model probably understates risk in recent decades.

For the record, the yield curve and interest-rate data as of Friday afternoon looks like this:

The Disconnect Between Stocks and Bonds

We are watching yields on the 10-year drop back into the lower end of its recent range. The yield curve is seriously inverted. That is the bond market clearly projecting a slowing economy. Third-quarter GDP was anemic at 1.6%, with a statistical overstatement of 0.7% because of the way they calculate auto sales. There is nothing to suggest that a strong rebound is in the offing this quarter, as same-store sales are flat, auto sales are sluggish, manufacturing is almost in recession, and consumer durable goods (furniture, home appliances, etc., which are allied with the housing market) are not healthy.

Yes, the service sector, which is 70% of the economy, is strong. And that is going to be important. It is one reason I think we get another mild recession rather than the typical serious recession that normally follows a housing bust. The overall economy is not as dependent on manufacturing and housing as it has been in past cycles.

But that is not what the stock market is saying. Even though S&P projects lower real earnings in the last two quarters of next year, the stock market is acting as if double-digit growth is still in the cards.

And that brings us full circle back to the problem with data we began discussing at the top of the letter. Even if the backward-looking data is calculated correctly, it is subject to interpretation. And market players bring their biases to the table with them.

When you hear or read someone who is bullish, check to see what they do. If you make your money by running a fund that is long-only the stock market, the glass has to look half full. Otherwise, you have to tell your current and potential investors that they should take their money off the table.

Of course, if you are running a short or hedged portfolio, it is tempting to see the glass as half empty. But the problem with almost all data is that it looks backward. We take the current trends and project them out.

Thus the bond market focuses on its biggest risks and sees a slowdown (and rising value in bonds), and the stock market sees the double-digit growth in earnings and a rise in the value of stocks.

We have very few reasonably reliable forward-looking indicators. But all the ones I look at suggest a slowdown next year, perhaps as early as the first quarter. And I still think this makes it a tough environment for stocks at some point in the not too distant future. It is a frustrating and somewhat lonely position, although there are a few more of us with each passing month and more housing data.

The End of The Contract With America

A number of readers have asked me my opinion of the last elections and whether they will affect the economy. Full disclosure requires me to say I used to be on the Texas State Executive Committee for the Republican Party, so I do have a bias.

Was I surprised? No. The GOP had forgotten the reasons voters put them in power. It was a sad ending to The Contract with America, which was the reason the GOP came into power. Rather than stick to those original principles, they chose to become part of the problem. Budget deficits, sex scandals, corruption, and a frustrating war was simply too much. The voters took the party to the woodshed and gave it a good working over. And frankly it was well deserved.

For my foreign readers, despite the headlines in your papers, such a turn of events is actually quite common in American politics. Such a large swing has happened a dozen times or more in the past. And it will happen again. That is the nature of our system.

But what will this mean for the economy? Probably nothing. Gridlock is now the order of the day. Most of the new Democrats who were elected are actually more conservative than the national party, and will have to go back to conservative districts in two or six years. If they move too far to the left, they will be one-term politicians. It is going to be hard for the Democratic leadership to forge a real working majority for their national liberal agenda. You can expect immigration reform, but this time it will be the reform George Bush was working for and that was rejected by his own party. Beyond that? Not much, although there is a drum beat for a carbon tax (which the Democrats love) in exchange for making the Bush tax cuts permanent.

No social security reform. Little in health care reform. It is doubtful that taxes will be raised over a Bush veto. There are some compromises that could be had, but that would take some real leadership on both sides, and right now it looks like the Democrats want to start holding hearings and blasting their opponents. Not a good atmosphere for compromise.

Republicans should change their leadership. Perhaps they will remember what fiscal responsibility looked like. If that is the case, by simply holding down the growth in spending, the budget will start to balance. What a concept. Spend less than you make.

If we enter a recession, there is little Congress can do anyway. Stimulus in the form of tax cuts is a non-starter. Maybe a program to help those who are threatened with losing their homes, but that is a minor economic deal.

In short, little will change. There will be a lot of rhetoric, a few compromises for appearance sake here and there, but not much else. Gridlock was not all that bad for the economy during the '90s. The reality is that Congress can mess things up with bad legislation, but it takes time to get bad or good legislation through. I doubt that much will happen one way or the other in the next two years.

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New Orleans and New York

I fly to the Big Easy next Wednesday. I have been to New Orleans scores of times over the years and love the city. It will be interesting to see firsthand how she fares. I love the New Orleans Conference, as it brings a lot of old friends together. If you are coming, I look forward to seeing you. I will be doing some receptions and dinners, so let me know if you are coming.

I will be going to New Orleans with my oldest daughter and business associate, Tiffani. She is a very integral part of the business, and literally runs most of our operations, leaving me more time to think and write. Besides being young, beautiful, and smart, she is just a lot of fun. I get a lot of pleasure working with her. If you are in New Orleans, make sure you get to meet her.

It looks like I (and Tiffani) will be doing a quick trip to New York after Thanksgiving to meet with partners and a few managers. Funny, my trip last month had me paying an outrageous almost $700 a night for an average hotel room. This trip I am paying $250 for a much nicer room. I was expecting to have to pay a lot more because of the holiday season. Not sure what that means. Other than hotel occupancy is down for some reason.

It is time to hit the send button and go home. I intend to relax and enjoy the weekend, and see if I can work off a few pounds, because I know what will happen in New Orleans. Laissez les bon temps rouler.

Your seeing some serious culinary adventure in his future analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Copyright 2006 John Mauldin. All Rights Reserved.

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; and EFG Capital International Corp. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

The Fed Targets Your Home

JohnMauldin — Fri, 26 Aug 2005 15:40:00 GMT

Introduction

What is the relationship between housing prices and stock market forecasting? What will happen if the housing market begins to falter? Exactly what did Greenspan say about housing at Jackson Hole? We explore these topics and a whole lot more and hopefully we can tie them all together by the end of this letter as we meditate on the potential risk of the recent housing boom.

The Problem With Forecasting

Let's start with forecasting. Every few weeks I get a wonderful letter from good friend James Montier, who is the global equity strategist of Dresdner Kleinwort Wasserstein. James is an expert on behavioral psychology and investing. This week's letter is lamenting the rather poor track record of forecasting by economists and analysts.

Let me give you a summary of the paper and a few of his graphs.

"Both an enormous amount of evidence and anecdotal experience suggests that people are very bad at forecasting. This is often because we all tend to be massively overconfident. This begs two questions, firstly why do we persist in forecasting despite the appalling track record? And, more importantly, why do investors put forecasts at the heart of the investment process?

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» "Lao Tzu, a 6th century BC poet observed, "Those who have knowledge don't predict. Those who predict don't have knowledge". Despite these age-old words of wisdom our industry seems to persist in producing and using forecasts. This is all the more puzzling given the easily available data on the appalling nature of track records in forecasting. Economists, strategists and analysts are all guilty. In general, forecasts seem to be a lagged function of actual outcomes - adaptive expectations dominate forecasts.

» "The two most common biases are over-optimism and overconfidence. Overconfidence refers to a situation whereby people are surprised more often than they expect to be. Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. That is to say, experts are more overconfident than lay people. This is consistent with the illusion of knowledge driving overconfidence.

» "Several studies confirm professional investors to be particularly overconfident. For instance, one recent study found that 68% of analysts thought they were above average at forecasting earnings! I've found that 75% of fund managers think they are above average at their jobs.

» "Why do we persist in forecasting given such appalling track records? There are two avenues to explore - simply put, ignorance and arrogance. Dunning and colleagues have documented that the worst performers are generally the most overconfident. They argue that such individuals suffer a double curse of being unskilled and unaware of it. Dunning et al argue that the skills needed to produce correct responses are virtually identical to those needed to self-evaluate the potential accuracy of responses. Hence the problem.

» "Tetlock argues that experts regularly deploy five ego defense mechanisms. Experts use various combinations of these defenses to enable them to continue to forecast, despite their poor performance.

» "Why do we persist in using forecasts in the investment process? The answer probably lies in behavior known as anchoring. That is in the face of uncertainty we will cling to any irrelevant number as support. So it is little wonder that investors cling to forecasts, despite their uselessness.

» "So what can be done to avoid these problems? Most obviously we need to stop relying on pointless forecasts. There are plenty of investment strategies that don't need forecasts as inputs such as value strategies based on trailing earnings, or momentum strategies based on past prices. Secondly, we need to redeploy the armies of analysts. They should return to doing as their name suggests: analyzing, rather than trying to guess the unknowable!"

He gives us a number of charts showing the relationship between forecasts and what actually happened. Let's look at two of them. What I particularly want you to focus on is how the forecasts lag reality. Essentially, we clearly take the current trends and project it into the future.

And the next one is even clearer as to how we use past recent performance to project future trends.

The Nobel Prize in economics in 2002 went to a psychologist, Dr. Daniel Kahneman, who helped pioneer the field of behavioral finance. If I can crudely summarize his brilliant work, he basically shows that investors are irrational. But what gets him a Nobel is he shows that we are predictably irrational. We continue to make the same mistakes over and over.

What makes for a bubble? Why do things get so out of hand? One of the reasons is simply human behavioral psychology. The longer a trend is in place the more confident we are in our belief that it will continue. Especially if we are participating in the trend to our benefit, we find all sorts of reasons that reinforce our belief that the trend will continue.

Gary North writes in today's Reality Check: "But is it a mania? This week, I spoke with a friend who bought a 2,000 square foot house in Orange County, California, in 1999. He paid $235,000. Two years later, he sold it and moved out of state. He got $350,000 for it. His son, who remained in California but did not buy a home, tells him that it just sold for $800,000."

Let's break that down. A 30 year loan at today's jumbo rate of 5.63% will give you payments of $4,607.78 a month. You can count on taxes, insurance and other costs to be another $2,000. That's $80,000 a year before you pay electricity, water, etc. or any maintenance. If your total tax rate in California is 40%, that means you have to earn around $10,000 a month or so (even after the mortgage interest break) just to make you house payment. Using a rule of thumb that says you should not buy a house with payments that are more than 1/4 your after tax income, that means over $500,000 per year! Of course, many people are paying twice that percentage (or more!) in housing costs in order to be able to buy a home.

(As an aside, you can buy a very nice 2,000 square feet home in Texas or almost anywhere in middle America for $150,000. You can buy one with some character in a very upscale community (if you can find one that small) in the Dallas area for $250,000.)

Put simply, there are many areas of the country where even above average income earners can simply not afford to own a home. They are being forced to move further and further away from where their jobs are, which is starting to really hurt a close to $3 gas in California Who is buying these homes? And more importantly, how are they doing it?

Writing machine Robert Kiyosaki, author of the "Rich Dad/Poor Dad" series of books recently wrote (courtesy of Gary North):

Nothing Down, Interest Only

"On Friday, June 23rd 2005, I was on Your World with Neil Cavuto on the Fox Network. He asked me what I recommended when it came to investing in real estate. I replied, 'If you're new to real estate investing, this is not the time to get into the game.' Unfortunately, many people are in the market late and not only have paid too much for their homes, they are over-leveraged. (quoting from an article in The Economist) he went on to say, '42% of all first time buyers and 25% of all buyers made no down-payment on their home purchase last year.' That is what I call over-leveraged. They bought late in the cycle, probably paid too much, and have signed their lives away on the dotted line. I am concerned for these people."

I read elsewhere that in some markets as high as 40% of all loans are interest only. So we have a significant number of people who have paid top of the market prices, have no equity in their homes and are not doing anything to pay down the mortgage. They are betting the trend will continue. Even though they cannot really afford the home, they believe they will be able to sell it later for a nice profit and help them buy a home somewhere else they can afford.

These homebuyers are making the same mistake as professional stock analysts and economists: they are projecting recent past performance well into the future. It is sadly part of the human condition.

One of my favorite analysts is John Bartlett, of the National Center for Policy Analysis. He suggests that US homeowners are highly leveraged and therefore are more vulnerable to a housing price decline. Some of the points from his essay are sobering:

In the last four years, homeowners have taken $559 billion in equity out of their homes. The Federal Reserve says that 16% of that money was simply consumed (short term non-capital purchases). Cash-out refinancings have risen to 18.1% of all refinancings, up from 7.2% in 2003. According to the Federal Reserve, home equity has fallen to 56.3% of real estate, down from 75% a generation ago. More and more homeowners are buying and refinancing with unconventional loans (such as adjustable-rate and interest-only mortgages) rather than traditional fixed mortgages. Such loans have lower initial payments but will rise automatically when interest rates go higher. The Federal Reserve says that 47% of all residential mortgages by dollar volume are now non-traditional.

How did we get here? A major part of the reason is the ever lower interest rates of the last 20 years. As mortgage rates came down, housing has become more affordable. Secondly, our country is growing in population (which is a good thing), people are living longer and thus demand for housing has increased.

Demand is a big part of the equation. The Economist reports that in some areas of Germany, where population is falling, that home prices are falling as well. There are homes in rural America, where fewer and fewer young people are staying in the small towns, which have seen little price appreciation on existing homes, and in some cases significant drops.

But in general, demand has been rising as the cost of a mortgage has been dropping. This week we saw existing home sales fall and the inventory of existing homes rise close to a 4.6 month supply. That doesn't seem so bad, does it? But that is not the whole story. Existing home sales are actually going along at quite a torrid pace. There have only been two months with slightly more sales.

The inventory of homes in 2002 was 2,108,000 and sales were 5,631,000. Back then that was a 4.7 month supply. But today we find an inventory of 2,751,000, but because we are buying at such a hot pace, the monthly supply is still calculated to be almost the same. (http://www.realtor.org/Research.nsf/files/REL0507EHS.pdf/$FILE/REL0507EHS.pdf)

If sales really start to slow down, then that inventory could rise very dramatically. If a slowdown in the economy caused home sales to drop to the level of 2002, which was not a bad year for home sales, inventory could easily rise to 6 months or more very quickly.

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Greenspan Gives a Very Clear Warning

Now, let's turn our attention to Jackson Hole, Wyoming, to the annual Kansas City Federal Reserve Bank meeting. (My invitation got lost in the mail again this year.)

For the last four years, Greenspan has given his clearest, easiest to understand speech for that year at Jackson Hole. This year was no exception. His speech was on the evolution of central bank policy decision making.

Let's look at five key paragraphs. (Emphasis throughout is mine.)

The first part of the speech Greenspan talked about how Federal Reserve policy has moved to a risk management philosophy. They look at a wide range of possibilities, and work to try to make sure that the worst of the outcomes do not happen. Thus, says Greenspan, even though lowering rates at the pace and extent they did in 2002-2003 might have created a problem, they felt the risk of deflation was the greater concern and did what they felt necessary to stave off any risk of deflation.

(Please note that in 2003, when I was writing Bull's Eye Investing, I wrote a chapter emphasizing this very point. I had more than a few critics who thought I was wrong in interpreting Fed policy. At least in this instance, I think this speech puts my analysis in the category of dead on target. Not that I'm sensitive or anything.)

"The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes."

Read that last sentence again. I have been writing for months that I think the Fed is targeting asset prices, and specifically home prices. They are worried about a bubble creating problems in the economy.

The Fed Is Targeting the Price of Your House

And now, Greenspan says above they are targeting asset prices. Can it be any clearer? You think they are worried about a stock market bubble? Commodity or gold prices? What other asset price is driving Fed policy? I think they perceive the greatest risk to be a continued housing bubble, and they are going to move to do what they can to let the air out of the bubble. Continuing:

"The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses. Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.

"The lowered risk premiums--the apparent consequence of a long period of economic stability--coupled with greater productivity growth have propelled asset prices higher. The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions. The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.

"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums."

Again re-read the last paragraph, especially the last three sentences. Greenspan is clearly saying that you should reduce your risk in your investments and business. He is saying that you should not project the current trend into the future. There is more risk than most investors are assuming. He is warning, in as clear as possible terms, that housing prices could easily go down. And in fact, he is all but saying that he intends to help them do just that!

He, and the rest of the Federal Reserve board, seems intent upon raising rates. We have had several speeches in the past few weeks by Fed governors making that clear. This seems to me like a mindset that suggests the Fed is going to do what they have historically done in the past. They raise rates until the economy slows down or the yield curve inverts, or both!

Why would they do that? Because they think the worse risk is letting the housing bubble continue. In the 1960s, William McChesney Martin described the Fed's role as taking away the punch bowl before the party really gets going. Greenspan is taking the punch bowl away in measured steps. He is being as transparent about his intentions as a Fed Chairman can be.

He started out using the word froth a few months ago and now he characterizes the housing market as an imbalance. Quoting:

"If we can maintain an adequate degree of flexibility, some of America's economic imbalances, most notably the large current-account deficit and the housing boom, can be rectified by adjustments in prices, interest rates, and exchange rates rather than through more-wrenching changes in output, incomes, and employment."

Who will get hit first? Speculators in housing markets that have borrowed with no (or little) money down at short term interest only rates. Look around at your home town. If there are a large percentage of homes being bought as "investment" property which could not be rented out on a positive cash flow basis, you are probably in a bubble. You should carefully weigh your options.

Let me speculate, despite the fact that the first part of this letter was about the uselessness of forecasts and speculation. I think the Fed is going to increase rates until the rampant speculation (no pun intended) in the housing market goes away. They are going to raise rates until housing slows down. Of course, since 40% of new jobs in the last 4 years have come from the new housing sector, and since a great deal of the increase in new consumer spending has come from cash out financing, this is likely to slow the economy as well. They are prepared for that.

When the housing bubble starts to deflate, when the speculators have been put away, when the economy starts to slow and roll over into recession, they will once again lower rates, slowly providing a prop to the real housing market that 90% of the country participates in. That $800,000 home in Orange County? It is going to be along time before that house will sell at that price again once the Fed is finished. But most of us will do just fine. And maybe we get to re-finance our homes at an even lower rate.

What should you do if you are in a bubble area? Think about how much equity you could get for your home today. How much income will that money generate in a bond or CD? Look around at your rental market. If you can rent a comparable home to what you have today for a good deal less than what you are paying plus the income you will get from your equity, then consider selling. My bet is you will get to buy another property back in your area at a much lower price in a few years.

All housing bubbles have this in common. At first, people refuse to sell at a loss (another common psychological trait). It takes a while, but as banks start to repossess properties in your area, they will put them on the market. Prices start to drop. Then the psychology changes. The same human beings that thought that houses could only go up now think they can only go down. They start waiting. Prices go lower. Inventories build.

The Fed starts lowering rates and you will get a chance to buy a home at a lower price at interest rates lower than they are today.

By the way, I am not against buying investment real estate if you can find properties that can offer positive cash flow. Lots of people have made solid fortunes doing that. But I think in the coming slowdown/recession you are going to have better opportunities to buy investment real estate.

You have been warned.

Final thoughts: the housing bubble can go on longer than one might think, and the Fed can raise rates more than anyone now suggest. It is going to be a very interesting ride. Strap yourself into your seats. But as I will re-visit in a few weeks, I still think we are in a Muddle Through Decade.

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New Orleans and Birthdays

Starting September 16, I am on the road to seven countries and about 12 cities in the following 9 weeks. I am enjoying my time at home before I have to once again become a road warrior.

Let me invite you to meet me in New Orleans at the New Orleans Investment Conference October 30-November 3. This is the grand-daddy of all investment conferences, and they always have a great line-up of speakers. This year Steve Forbes, Ann Coulter, Jim Rogers, Marc Faber, Dennis Gartman and for fun P. J. O'Rourke will be there, along with your humble analyst, as well as scores of great speakers. There is a great deal of emphasis upon gold and natural resources, as well as other types of investments. You can click on this link to register for the conference: https://www.jeffersoncompanies.com/registration/confreg.php?acode=JM

My friends and business associates from Altegris Investments will be there as well, and we will be meeting with clients and prospective clients. Jon Sundt (president), Matt Osborne and *** Pfister from Altegris Investments (as well as my daughter and right-hand Tiffani) will be there to meet clients and potential clients. Basically, we help clients develop portfolios of hedge funds, commodity funds and other alternative investments. If you would like to know more about what we do, you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds that is just for accredited investors (essentially net worth of $1,000,000 or more). If you want to be able to go into specifics about your portfolio with me and Jon or *** in New Orleans, you must sign up soon and start a conversation with a representative from Altegris at least 30 days prior to the conference. We will not go into specifics with anyone with whom we have not had a substantive relationship for at least 30 days. Those are the rules and we follow them.

(In this regards, I am president and a registered representative of Millennium Wave Securities, LLC, which is a member of the NASD. Please see the specific risk disclosures which follow below as well as those on the website.)

Tomorrow is a special day. #1 son Henry will be 24, and a lot of the clan will be gathering for the celebration. Tonight starts the family gatherings, as my twins are in from college. I always like these times. Five kids are now 20 or older. They are growing up so fast. (two more at 16 and 11.) It is a lot of fun relating to them as adults. I like kids and all that, but the older they get, the more fun they are, at least to me.

Another Friday night baseball game is taking place outside my window, but the Texas Rangers have taken their traditional August swan dive. Something like 12 losses out of the last 16 games. I have had larger crowds at some of my kid's parties when they were in high school. Well, not quite, but there are not a lot of people outside. Oh well, maybe next year we will have some pitching. And the Cowboys and Mavericks are not looking that good on pre-season paper either.

Your still glad he is renting analyst,

John Mauldin
JohnMauldin@InvestorsInsight.com

Note: PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS OR ANY ALTERNATIVE INVESTMENT PRODUCT.

WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

The Accredited Investor E-letter is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments at www.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments and Altegris Investments are independent firms that cooperate in the consulting on and marketing of private investment offerings. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor's services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since Altegris and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

Copyright 2005 John Mauldin. All Rights Reserved.