Search results matching tag 'deleveraging'

Beyond the Sound Bite: An Interview with David Rosenberg

VinnyCatalano — Wed, 07 Oct 2009 14:39:00 GMT

"Hope always seems to spring eternal in liquidity-driven financial markets. That is very much the case today in the aftermath of the biggest liquidity injection in modern history." So wrote Stephen Roach, Chairman, Morgan Stanley Asia in today's FT. And liquidity is where my interview with David Rosenberg, Chief Economist and Strategist with Gluskin Sheff & Associates (formerly chief north american economist with Merrill Lynch) begins. We go on to discuss the state of the global consumer and new frugality, the continuing process of deleveraging, the probabilities of top line growth, and asset valuations, among other timely topics.

The length of the interview is 14 minutes 55 seconds.

(Please visit the site to view this media)

Vinny Catalano, CFA, Global Investment Strategist with Blue Marble Research publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

The Statistical Recovery, Part Three

JohnMauldin — Sat, 22 Aug 2009 04:00:00 GMT

The Statistical Recovery, Part Three
Capacity Utilization Set to Rise
A Real Estate Green Shoot?
The Deleveraging Society
Some Thoughts on Secular Bear Markets
Weddings and Ten Years of Thoughts From the Frontline

This week we further explore why this recovery will be a Statistical Recovery, or one that, as someone said, is a recovery only a statistician could love. We look at capacity utilization, more on housing, some thoughts on debt and deflation, and some intriguing charts on volatility in the last secular bear-market cycle. This letter will print a little longer, but there are lots of charts. I have written this during the week, and I finish it here in Tulsa, where Amanda gets married tomorrow. (There is no deflation in weddings costs!)

Thanks to so many of you for your enthusiastic feedback about my latest Accredited Investor Newsletter, in which I undertook to examine the impact of last year's dramatic increase in volatility on the performance of hedge funds and to ascertain those elements that led to success in the industry, such as select Global Macro and Managed Futures strategies, as well as the challenges. If you are an accredited investor (basically anywhere in the world, as I have partners in Europe, Canada, Africa, and Latin America) and haven't yet read my analysis, I invite you to sign up here: www.accreditedinvestor.ws

For those of you who seek to take advantage of these themes and the developments I write about each week, let me again mention my good friend Jon Sundt at Altegris Investments, who is my US partner. Jon and his team have recently added some of the more successful names in the industry to their dedicated platform of alternative investments, including commodity pools, hedge funds, and managed futures accounts. Certain products that Altegris makes available on its platform access award-winning managers, and are designed to facilitate access for qualified and suitable readers at sometimes lower investment minimums than is normally required (though the net-worth requirements are still the same).

If you haven't spoken with them in a while, it's worth checking out their new lineup of world-class managers. Jon also tells me they just added yet more brilliant minds to their research team, making it, in my opinion, one of the foremost teams in the industry, focused solely on alternative investments. I invite you to have a conversation with one of their professional and seasoned advisors. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) Now, let's jump into the Statistical Recovery.

Capacity Utilization Set to Rise

Capacity utilization is a concept in economics that refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output that is produced with the installed equipment and the potential output that could be produced with it, if capacity was fully used.

The chart below shows that capacity utilization in the US is at an all-time low, around 68%. That means that with the equipment we already have in place we could produce almost 50% more goods than we are now producing. However, most analysts think that 80% capacity utilization is a very good number.

If you look very closely at the bottom right-hand detail, you can see that there is a small uptick in last month's data. Whether or not this is the "bottom" remains to be seen. But if it is not the bottom, it is close. You can only shut down so much production before inventories fall to levels that require restocking. And we are getting close to that level in many industries.

Before we wander too far away from the graph, I want you to notice that past dips (circa the recessions of 1968, '74, and '80-'82) had V-shaped recoveries in capacity utilization. But in the 1990-91 recession it took longer than it did in past recessions, and in the most recent recession (2000-02) the recovery took longer and we did not actually "recover" for four years.

Again, most analysts feel that a capacity utilization of 80% or more is pretty indicative of solid growth. To get back to that level, we would have to see an almost 20% rise in manufacturing. That is unlikely to happen all that fast, for several reasons.

First, consumers are retrenching and saving. We just simply are not going to need or want as much stuff. Second, unemployment, as I noted last week, is crimping the ability of consumers to spend. The recovery we are likely to see is going to be sluggish and not produce new jobs for quite some time. Again, that stifles demand.

The country (and the world) is adjusting to the New Normal. It is some level of overall economic activity that is different than what we have enjoyed during the reigning paradigm of the last 30 years.

Manufacturers are going to ramp up more slowly than in the past, especially as many companies have the ability to tailor their production to consumer demand much faster now, due to automation.

As I have repeatedly said, the world is awash in excess capacity. We simply built too much productive capacity to be utilized in the New Normal. One way of dealing with too much capacity is to simply close the plants. That is what is happening in the paper and memory-chip industries. Other industries are engaging in mergers to reduce or "rationalize" capacity. While that process is a good thing, it does mean that unemployment rises or stays higher longer.

The building of inventories counts as a rise in GDP. Conversely, reducing inventories gets counted as a lack of growth. We have just about reduced inventories all we can. As companies begin to rebuild inventories, that will translate into a statistical increase in GDP. But if capacity utilization is still only (say) 73%, it still shows a weak economy with not many new jobs and reduced corporate profits, compared to a few years ago. It will be a rather long time before the jobs that have been lost this cycle will come back. Will the statistical comparison of data from a year ago look positive? Are things improving? The answer will be yes. But it will not feel like it for those who are looking for new jobs or higher income or more sales.

Look at it this way. We have dug ourselves into a 12-foot hole over the past two years. The data now suggests that we have stopped digging, which is always a good idea if you are in a hole. At some point we will have figured out how to add some dirt to the bottom to get us back up to an 8-foot hole. Will we be better off statistically? Absolutely. But we will still be in a hole. Unemployment falling back to 8% in 2011 will still feel like we are in a hole, but the statistics will say GDP is positive. And that is because we are so far down, the year-over-year comparisons are starting to look good.

As an aside, it would be highly unusual for inflation to show up with low capacity utilization and rising unemployment. Businesses and workers simply do not have pricing power.

A Real Estate Green Shoot?

The housing news has been less bad of late. Home-builder sentiment is marginally higher. Today we learn that sales are up month-over-month, and actually year-over-year, on a seasonally adjusted basis, which is some of the best news on the housing front we have had in two years. Sales of existing homes were the highest since August of 2007. Have we seen the bottom? The following chart shows that while actual homebuilding activity is still down, the annual comparisons are getting easier and activity seems to be leveling out.

Note, however, that this is yet another aspect of the Statistical Recovery. For two years, the continual drop in home building reduced the GDP numbers every quarter. If homebuilding activity simply stops falling, as it appears to be, then housing will stop being a negative as far as GDP is concerned. Will we get back to the levels of 2005? Not for many decades and with a much larger population. We are now finding the New Normal as far as home construction is concerned.

And before we get too celebratory, my friend John Burns of John Burns Real Estate Consulting suggests we may be seeing a false bottom. What we are seeing is the result of a government program that offers first-time home buyers $8,000 if they buy a home by November 30; and that program is working, especially at the lower end of home prices (as you would expect, and as it should.) 31% of home sales in July were involved with this program. But like Cash for Clunkers in automobiles, this is pushing demand for homes from next year into this year.

John offers us the following chart that gives us what he thinks is happening in the markets, from his surveys. He thinks that we saw a "false bottom" in April of this year and that activity will peak in November, before going on to the actual bottom, from which there will be a long, slow recovery.

There are millions of homes being brought onto the market through foreclosures -- two million vacant homes for sale, plus, builders are still building. It will simply take some time to work through the inventory.

There are some who wonder why home builders keep building if inventories are so high. First, for many of the larger public companies, to stop activity altogether would be commercial suicide. You can't just stop without dying. Further, many of them have financial commitments that require them to build in order to make something to pay back the loans, even if they lose money. Maybe they won't build McMansions or in Florida, but they will find out what will sell and where and build there. Smaller builders have the option of not building "spec" homes (homes built without a buyer already lined up, that is, on speculation). Like my neighbor who just tore his house down this week (can they ever do that fast!) and plans to build a large new home, much of the home activity will be pre-sold for the next few years. (I can't tell you how much I look forward to the sound of hammers and saws next door as I write and read.)

The Deleveraging Society

My friend Ian McAvity offers us the following chart, which shows the level of total debt to GDP. It has been rising steadily since 1981 and is now at a ratio of 3.75. Even though consumers and businesses are cutting back on borrowing, the US government is more than making up the difference; so for awhile, at least, we will see total debt to GDP continue to rise. Side note: even with all the money the Fed is printing, M-1 is flat for the last year.

One of the drivers of the growth of the last 30 years has been financial innovation and the ability to increase leverage. Specifically, securitization made it possible to finance a whole array of debt, from credit cards, student loans, and auto loans, to exotic residential mortgages of all kinds, commercial mortgages, corporate bonds, hotel financing, and regular bank loans that were spun out into SIVs and off the banks' books, thereby freeing up capital – and on and on. If it moved, someone could (and did) figure out how to get it into a security and sell it. And it was easy to sell as long as it had a rating from an established rating agency.

Much of this securitization is plain vanilla and a very good thing, as it gives investors a way to get more fixed income. But the rating agencies started using models that were obviously flawed to create the ratings. Massively flawed. Incompetence immortalized in a spreadsheet. When I and others began to write about the problems with CDOs and CDOs squared in 2006, they continued to rate them with the same flawed models. Even when the rules for getting a mortgage changed, they did not change their models. And it isn't that they couldn't have been aware. The TV was rife with ads talking about the various mortgages available, yet the rating agencies used models based on completely different types of mortgages.

And now? If you are sitting at the fixed-income desk at a pension or insurance fund, it is worth your job to take the word of a rating agency. Therefore, securitization is moribund. Will it come back? Yes. But it will take time.

But that is the problem. The world of finance is going to its own New Normal. It will be a world that is less leveraged. The growth in leverage that helped spur growth on the way up is a drag on growth as it is wound down.

Again, it would be highly unusual to see inflation in a deleveraging world. It would be a massive failure on the part of the Fed to allow serious inflation (as in the 1970s) to come back to the levels that some are talking about. I mean, it's possible, but it's far from the most likely outcome.

I had this conversation with Paul McCulley earlier in the year, as we were all deep in the deflation/inflation discussion. He looked at me and said, "John, we better hope the Fed can create some inflation. If they can't, we're in real trouble."

I will write about the current lack of inflation and its future prospects in a future letter; but producer price indexes are way down all over the world, and the CPI (consumer price index) is down year-over-year.

The single most important question for investors to get right over the next few years is whether we face an inflationary or deflationary future. And while there are many who are so positive that they know the answer, and we find people arguing all sides of the issue, I am not persuaded that we have the information we need to make that determination. It could go several ways. My best guess (hope?) is that we get through this bout of deflation and have to deal with some mild, 3-4 % real inflation, not the commodity price-driven kind, which is not monetary inflation. But this will be a multi-year cycle. I will be writing about this for a long time.

Some Thoughts on Secular Bear Markets

Yesterday my good friend Ed Easterling dropped by, as he was in Dallas, down from Portland. Ed co-authored a few chapters with me in Bull's Eye Investing, on secular market cycles. He had a chart that I asked him to get to me for your perusal. The last secular bear market was 1966-82. He charted the ups and down in that market and noted the percentage rises and falls. It was as volatile then as it is now. There were some breathtaking ups and downs. With every rise, pundits declared the end of the bear market, only to have the market fall dramatically again. Take a few moments to gaze at the chart:

What drives the volatility? My contention is that bull and bear cycles should be seen in terms of valuation instead of price. Markets go from high valuations to low valuations and back to high. It is an age-old story. We have done about half the work we need to do to get back to low valuations. These cycles average of 17 years. We are less than ten years into this one.

I believe we are going to lower valuations in terms of price-to-earnings ratios. This can be done by the market going sideways and earnings rising, or the market dropping, or some combination. Look at the graph below, and notice the slow and steady drop in P/E ratios (bottom chart) and the very volatile markets that accompanied that fall. I agree with Ed; we should not be surprised at today's volatile markets. And we should expect more volatility and large price movements. Both up and down. (Some of the best charts anywhere are at www.crestmontresearch.com.)

Weddings and Ten Years of Thoughts From the Frontline

This month starts my tenth year of writing Thoughts from the Frontline. I started the letter in August of 2000 with less than 2,000 readers. Every letter since January, 2001 is in the archives. The letter now goes to well over one million readers each week, plus is posted on dozens of independent web sites. I am somewhat overwhelmed at the response, but am very grateful. I can honestly say that I am having more fun today than at any time in my life. Thank you for being part of it all.

I have written this letter in airports, hotels, airplanes, cars (I am finishing this one in a car, riding to the rehearsal dinner for my daughter's wedding) and today wrote a lot at the Golf Club of Oklahoma, waiting for the wedding rehearsal. (First time writing in a golf club ... and now I'm about to walk into Dave and Buster's, where I'll wrap this up.)

It is going to be a beautiful wedding, outdoors with beautiful lake views, and the weather is slated to be perfect. We played golf today with the new inlaws, and surprisingly, the weather was pleasant for Tulsa in August. I fought the course and the course won.

Tomorrow is a late brunch with all the guys and then we go to watch Inglorious Basterds, which I have been waiting for for a long time. Good movie for a testosterone-laden crowd.

It is a little sentimental this weekend. My second daughter (Amanda) getting married. All the kids in one place. New grandson Caleb here. Tiffani (girl) and Chad's SO Dominique (another boy) very pregnant. New boyfriends here and there. 60 years looking at me in a few weeks. And thinking about how time just is flying by. How could it be nine years of writing every week to my closest friends?

It is time to hit the send button. I am sitting at the table with all my kids. They know Dad has to finish, but are tolerant. Have a great week. And remember that valuations, when it come to family and friends, only climb higher as time passes.

Your really happy with life analyst,

John Mauldin

Beyond the Sound Bite: An Interview with Michael Sheldon, CFA

VinnyCatalano — Sun, 16 Aug 2009 14:10:00 GMT

My interview with the Chief Market Strategist with the wealth management firm, RDM Financial Group, includes the prospects of a sub-par economic recovery due to rising US consumer savings, deleveraging, increased regulation, increased risk aversion, the structural advantages of emerging economies over developed economies, and the longer-term risk of deflation.

The length of the interview is 15 minutes 56 seconds.

(Please visit the site to view this media)

Beyond the Sound Bite: An Interview Dr. Neal Soss

VinnyCatalano — Thu, 02 Jul 2009 21:36:00 GMT

My interview with the Managing Director and Chief Economist with Credit Suisse (recorded Monday, June 29) includes the 2Q09 end to the US recession, expectations of a sub par recovery of 3 1/2%, a sustained level of relatively high unemployment, and a potential compositional shift in the US economy. The length of the interview is 16 minutes 58 seconds.

(Please visit the site to view this media)

To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, including the market beating Model Growth Portfolio - click here.

Long-Term Outlook: Slow Growth And Deflation

JohnMauldin — Mon, 16 Mar 2009 22:07:22 GMT

This week I am really delighted to be able to give you a condensed version of Gary Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I really look forward to getting Gary's latest thoughts on the economy and investing. Last year in his forecast issue he suggested 13 investment ideas, all of which were profitable by the end of the year. It is not unusual for Gary to give us over 75 charts and tables in his monthly letters along with his commentary, which makes his thinking unusually clear and accessible. Gary was among the first to point out the problems with the subprime market and predict the housing and credit crises. You can learn more about his letter at http://www.agaryshilling.com. If you want to subscribe (for $275), you can call 888-346-7444. Tell them that you read about it in Outside the Box and you will get not only his recent 2009 forecast issue with the year's investment themes, but an extra issue with his 2010 forecast (of course, that one will not come out for a year. Gary is good but not that good!) I trust you are enjoying your week. And enjoy this week's Outside the Box....

And if you have cable and get Fox Business News, I will be on Happy Hour tomorrow Tuesday the 17th at 5 pm Eastern. Have a great week.

John Mauldin, Editor
Outside the Box

Long-Term Outlook: Slow Growth And Deflation

(excerpted from the March 2009 edition of A. Gary Shilling's INSIGHT)

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP rising at a 3.6% average annual rate. Furthermore, this 18-year expansion, which cumulated to an 89% rise in inflation-adjusted economic activity, was interrupted by only one recession, the relatively mild 1990-1991 downturn, which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by basic measures of the economy's health. The stock market, that most fundamental measure of business fitness and sentiment, essentially reached its peak with the dot com blow-off in 2000 and has been trending down ever since (Chart 1). The same is true of employment, goods production and household net worth in relation to disposable (after-tax) income.

Nevertheless, the gigantic policy ease in Washington in response to the stock market collapse and 9/11 gave the illusion that all was well and that the growth trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile, federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense survived. It simply shifted from stocks to housing (Chart 2), commodities, foreign currencies, emerging market equities and debt, hedge funds and private equity. Investors still believed they deserved double-digit returns each and every year, and if stocks no longer did the job, other investment vehicles would. Thus persisted what we earlier dubbed the Great Disconnect between the real world of goods and services and the speculative world of financial assets.

Not Sustainable

Even before these final speculative binges, the forces driving the economy in its long expansion were unsustainable, as we've been stressing for years in Insight. These forces included the decline in the consumer saving rate and jump in consumer debt, the vast leveraging of the financial sector, increasingly freer trade and loose financial regulation, all of which are now being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their saving rate because they believed stock portfolios would continue to grow rapidly and take care of all their financial needs. Then, when stocks collapsed in 2000-2002, house appreciation (Chart 3) seamlessly took over to continue the push down the household saving rate from 12% in the early 1980s to zero. Americans saw their houses as continually-filling piggybanks because, they believed, home price appreciation would continue indefinitely. They tapped that equity freely with home equity loans and cash-out refinancing.

The flip side of saving less is borrowing more, as evidenced by the leap in all consumer debt and debt service, both in relation to disposable (after-tax) income and relative to assets. In relation to GDP, the cumulative outside financing of the household as well as the financial sector leaped for three decades, measuring the immense leveraging in these two areas. Not surprising, amidst this consumer borrowing and spending binge, consumer spending's share of GDP leaped from 62% in the early 1980s to 71% at its peak in the second quarter of 2008 (Chart 4).

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter 2008, homeowners with mortgages had on average 25% equity in their abodes after all mortgage debt was removed and that number will probably drop to the 10%-15% range with the further decline in house prices we are forecasting (Chart 3). At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners, or nearly half the 51 million with mortgages, will be under water, with their mortgages bigger than their house values. In total, the gap will be about $1 trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting layoffs (Chart 5), maxed out credit cards and tighter lending standards and weak consumer confidence. Rising medical costs are also a drag on consumers as their co-pays and deductibles mount. For decades, credit card issuers and other lenders encouraged consumers to indulge in instant gratification. Buy now, pay later. But now, habits are changing. Debit cards are becoming popular since they deduct charges directly from the user's checking account and, therefore, don't increase indebtedness. Layaway plans are back in style after nearly disappearing.

Financially Unprepared

Between low saving levels in recent years and weak stock prices, few Americans are prepared financially for retirement. About 54% of 401(k) assets are invested in stocks, which fell 39% last year as measured by the S&P 500 index. And except for Treasurys, almost all other investments suffered huge losses in 2008. Around 50 million Americans have 401(k) plans, with $2.5 trillion in assets, and in the 12 months after the stock market peak in October 2007, over $1 trillion in stock value was wiped out in 401(k)s and other defined contribution plans. Another $1 trillion in IRAs was lost.

After 401(k)s were initiated in 1978, those containing stock assets appreciated in the long 1982-2000 bull market, which convinced many that they didn't need to save, as mentioned earlier. In 1983, 33% of working-age households were financially unprepared for retirement, but the number rose to 40% in 1998 as a result of lower saving and more borrowing, and to 44% in 2006 as the 2000-2002 bear market also depressed retirement funds. Obviously, with the subsequent collapse in house and stock prices, many more -- over 50% -- are unprepared. In 2007, in defined contribution accounts administered by Vanguard, the median account balance for 55-64 year-olds was just $60,740 and only 10% of participants contributed the maximum amount.

Economic Effects

As households increase their saving rate, their spending growth will slow, a distinct contrast from the decline of the saving rate from 12% in the early 1980s to zero recently. That decline, which averaged about a half-percentage point per year, meant that consumer spending grew an average of around a half-percentage point faster than disposable income annually. For the next decade, we're forecasting a one percentage point rise in the saving rate annually. That still would not return it to the early 1980s level of 12% even though the demographics for saving have gone from the worst to the best in the interim. Applying a 1.5 multiplier to account for the total destimulating effects as those dollars are saved, not spent, this means a reduction of about one percentage point in real GDP growth, from 3.6% per annum in the 1982-2000 years to 2.6%.

Although the stock bulls may salivate over the prospect that increased saving will mean more equity purchases, we believe that most of the money will go to debt repayment--the flip side of a saving spree. Note that if the saving rate rises one percentage point per year for 10 years, the cumulative increase in saving will total about $5.5 trillion. That will go a long way in offsetting federal deficits and debt.

So will the deflation that we'll explore later. Incomes may grow on average in real or inflation-adjusted terms, but shrink in current dollars. But debts are denominated in current dollars and therefore will grow in relation to incomes and the ability to service them. This will be the reverse of inflation, which reduced the value of debts in real terms and makes it easier to service them as incomes rise with inflation.

Foreign Effects

The effects, then, of a consumer switch from a 25-year borrowing-and-spending binge to a saving spree will be profound for the U.S. economy. Even more so for the foreign economies that have depended for growth on American consumers to buy the excess goods and services for which they have no other ready markets.

In 2007, U.S. consumers accounted for 18.2% of global GDP, and that share has jumped from 14.9% in 1980 and 16.8% in 1990. Furthermore, the shares of American consumer spending on durable and nondurable goods accounted for by imports from Central and South America and from the Pacific Rim have leaped since the early 1990s.

A clear result of the upward trend in consumers' share of GDP (Chart 4) and declining saving rate for a quarter-century has been the downtrend in the foreign trade and current account balances. We can't overemphasize the importance of the profligate U.S. consumer in fueling economic growth in the rest of the world, as we've discussed in many past Insights. We have also published our analysis of Asian exports. The intra-Asian trade was much bigger than the direct exports to the U.S., but when we accounted for the components produced in, say, Taiwan that were sent for subassembly to Thailand, then to Malaysia for final assembly with the finished product destined for the U.S., over half of Asian exports ended up in America.

Export-Dependent China

In late 2007, most forecasters disagreed with us and said China's economy would continue to grow at double-digit rates, and even support the U.S. economy if it softened. However, in "The Chinese Middle Class: 110 Million Is Not Enough" (Nov. 2007 Insight), we explained that China was not yet far enough along the road to industrialization to have a big enough middle class of free spenders to sustain economic growth if exports fell with U.S. consumer spending, as we were predicting.

As we noted in that report, in China, it takes $5,000 or more in per capita income to have meaningful discretionary spending. The 110 million who fit that category are a lot of people, but only 8% of China's population. In India, the middle and upper income classes are even smaller, 5%. In contrast, in the U.S. it takes $26,000 or more to have middle-class spending power, and 80% of Americans qualify. So we wrote in that report that all the cell phones and PCs being bought by Chinese was not the result of domestic economic strength, but merely the recycling of export revenues and direct foreign investment funds. And we went on to forecast that U.S. consumers would retrench, resulting in a nosedive in Chinese exports and a deep recessionary slump in China's growth.

Well, as they say, the rest is history. It now seems likely that China's earlier double-digit growth rates will slip to the 5%-6% range that would probably constitute a major recession, and probably lower. About 8% growth is needed to accommodate the vast numbers who continually flood from the countryside to the cities in search of work and better lives. Of those who went back to their villages to celebrate the recent lunar new year, 20 million didn't return because their factory jobs had vanished along with Chinese exports. Worker unrest us mounting and just as civil disturbances have ended many past Chinese dynasties, the Mao Dynasty's days may be numbered, as we've discussed in past Insights.

No Winners

With subdued U.S. consumer spending in the years ahead and the resulting weakness in American imports, economic growth abroad will be even weaker than in the U.S. Note that in previous U.S. recessions, the current account and trade balances tend to rise as imports weaken with economic activity, but exports fall less as economic growth abroad persists. That's been true of late, even though most would prefer strengthening balances from strong U.S. exports, not weaker imports. In any event, falling economies overseas are already weakening U.S. exports (Chart 6) and subdued global growth in the years ahead will probably limit the improvement in the U.S. current account and trade balances. Notice the close link between world industrial production and merchandise exports (Chart 7).

First And Last Resort

Now, with American consumers embarking on a saving spree, the U.S. will no longer be the buyer of first and last resort for the globe's excess goods and services. Furthermore, with slower global growth for years ahead, virtually every country will promote exports to spur domestic activity. Already, China has stopped allowing her yuan to rise in order to gain a bigger share of a declining pool of global exports.

Financial Deleveraging

There's no question that the financial sector is deleveraging, and its embarrassed leaders, pressured by regulators and everyone else, will no doubt continue this process for years to come. Securitization, off-balance sheet financing, derivatives and other financial vehicles that both stimulated and distorted economic activity are disappearing.

Big banks are reducing exposure to volatile proprietary trading and emphasizing safer asset management. Hence, Morgan Stanley's interest in buying Smith Barney, the brokerage unit of cash-hungry Citigroup. Furthermore, banks are cutting their financing of hedge funds by concentrating on the likely survivors in the ongoing shake-out and cutting off the rest. This will hasten the demise of many less-successful as well as smaller shops that are also at risk of investor withdrawals.

Banks are retrenching from lending to the point that corporate borrowers are turning to the bond market instead for funding. Despite government bailouts, writedowns continue to erode bank capital. Many still hold some of the leveraged loans they made to fund private equity leveraged buyouts back in the boom days. Lenders normally recover 80% on those loans when borrowers default since they rank high in the recovery pecking order. But recent bankruptcies indicate 25% recovery rates. Earlier, Japanese banks were flush with cash, but sharply lower earnings outlooks suggest they no longer will be able to provide capital to international markets.

As banks retreat to their core competencies, they're selling non-essential units. Faced with lasting fear spawned by huge losses and pressed by regulators, these institutions are retreating to basic banking 101. That's spread lending in which deposits are lent with a market-determined interest rate spread that covers costs plus a modest profit. Banks are also consolidating in response to gigantic losses and bleak outlooks. France's BNP Paribas bought the Belgium and Luxembourg assets of Fortis. Spain's Santander is acquiring full control of Sovereign Bancorp based in Wyomissing, Pa. Large consolidated financial institutions don't tend to be big risk-takers, and often lack the entrepreneurial spirit that promotes productivity and economic growth. Also, with fewer institutions, there are fewer counterparts to share risks, and that also dampens activity.

Eastern Europe

Overseas, Western banks largely financed the rapid economic growth in the former Iron Curtain countries in Europe after the Soviet Union collapsed in 1991. In addition, many companies in those lands financed their domestic businesses by borrowing Swiss francs, euros and other hard currencies at lower rates than in their own inflation-prone countries. Individuals entered the same carry trade to fund their home mortgages.

Now, however, lenders are retreating as they delever. Exports to Western Europe, another important source of growth, are falling. Eastern European borrowers need to repay $400 billion owed to Western banks this year, much of it denominated in foreign currencies. Eurozone banks have outstanding loans to Central and Eastern Europe totaling $1.3 trillion. EU leaders, led by German Chancellor Merkel, recently rejected a $240 billion bailout of Eastern Europe proposed by Hungary.

Like Asia 1997-1998

The dependence of Central and Eastern Europe on foreign financing is painfully similar to that is Asia in the 1990s that led to the 1997-1998 financial and economic collapse--except it probably will be worse this time since banks are delevering this time and weren't back then. Also, these European countries were more leveraged in 2008 than their Asian counterparts a decade ago. This can be seen in their foreign debts in relation to GDP (Chart 8) and in their current account deficit/GDP (Chart 9) as well as in their currency declines.

Asian lands reacted to the 1997-1998 crisis by cutting foreign borrowing and building foreign currency reserves. Ironically, however, they still didn't escape the current global recession and financial crisis. They're no longer as dependent on inflows of foreign capital, but this time are highly dependent on exports, which are plummeting as U.S. consumers retrench.

Commodity Crisis

The collapse of the commodity bubble will also subdue global economic growth in future years. Sure, commodity consumers benefit from lower prices as producers lose. But the share of total spending on commodity imports by consumers, especially developed lands, is tiny while they account for the bulk of exports for producers, notably developing countries.

Budget Signals

The new Obama federal budget points clearly to more government regulation and involvement in the economy. Going well beyond dealing with the deepening recession and financial crisis, the President wants $630 billion to move toward national health insurance. Businesses that emit carbon dioxide and other greenhouse gases would have to purchase permits. Another $20 billion would go for clean energy technology. The government would essentially take over student loans while eliminating private lenders, and make them entitlements with no annual limits on loan totals.

Obama also plans to increase taxes in higher-income households and capital gains and estate while redistributing money to lower-income people, even those who don't pay taxes. This reflects his populist views on the campaign trail, but with considerably more edge. The President's budget document states, "Prudent investments in education, clean energy, health care and infrastructure were sacrificed for huge tax cuts for the wealthy and well-connected. In the face of these trade-offs, Washington has ignored the squeeze on middle-class families that is making it harder for them to get ahead. There's nothing wrong with making money, but there is something wrong when we allow the playing field to be tilted so far in the favor of so few." The President's budget message also attacks "a legacy of misplaced priorities...and irresponsible policy choice in Washington."

Corporations, the energy industry, hedge funds and large farmers would also pay higher taxes while families with annual incomes under $200,000 and especially the working poor would get government checks.

The budget calls for more enforcement money for the FDA to step up drug safety rules, more for the EPA to crack down on industrial polluters, additional funds to protect endangered species and land and water conservation and to protect wildlife from climate change. More money is also requested to enforce fair housing laws and better disclosure of mortgage terms and to reverse "years of erosion in funding for labor law enforcement agencies." Employers that don't offer retirement plans will be forced to open IRAs for employees. There's also additional funds requested for enforcing workplace safety rules.

Stress Tests

Major banks are being stress-tested to determine their volatility under adverse conditions. To date, Fannie and Freddie are in conservatorship and controlled by the government. The remaining major investment banks, Goldman Sachs and Morgan Stanley are bank holding companies with Federal Reserve regulation. Is it a big surprise that Litton Loan Servicing, owned by Goldman, recently changed its strategy on mortgage modification to reduce borrowers' monthly payments to 31% of income from 38%, the industry standard?

Citigroup and BofA are, for all intents and purposes, wards of the state while the media and Washington spar over whether they will be formally owned by the government. Those two banks recently agreed to suspend mortgage foreclosures until the Treasury sets up its rescue program.

AIG is 85% owned by the Fed, which probably wishes it owned nothing of that bottomless money pit that has already absorbed $150 billion in government money. Recently, the government initiated its fourth plan to rescue AIG,which just reported a $62 billion loss in the fourth quarter. The firm is so troubled that Washington has completely backed away from its role as a stern lender that forced AIG to pay high interest rates on what it assumed would be short-term loans. Now the government is relaxing loan terms by wiping out interest in hopes of preserving some value for AIG. And it will be more involved as it splits AIG into two pieces and gets preferred shares in each entity.

Auto Bailout Payback

Beyond the financial sector, the ongoing bailout of U.S. auto producers is leading to more government intervention in that industry. As usual, he who pays the piper calls the tune. The government has already pumped $17.4 billion into GM and Chrysler, and they say they may need $21.6 billion more. GM also proposes a $4.5 billion credit insurance program for the auto parts makers. Furthermore, GMAC may need more than the $5 billion sunk into it by the Treasury last December.

Bonuses

Of all the signs of opulence carried over from the bubble years, corporate jets and big executive bonuses seem to bother Washington the most. BofA is selling three of its seven jets, a helicopter that was owned by Merrill Lynch and one of two of its New York corporate apartments. Obama wants firms that accept "extraordinary assistance" from the government to cap annual pay at $500,000, disclose pay to shareholders for a non-binding vote, claw back bonuses of corporate officials who provide misleading information, eliminate golden parachutes for those terminated and adopt board policies for luxuries such as entertainment and jets.

This reaction to big bonuses in firms that are taking huge writeoffs, losing big money and requiring massive government bailouts was predictable. From 2002 to 2008, the five largest Wall Street firms paid $190 billion in bonuses while earning $76 billion in profits. Last year, they had a combined net loss of $25 billion but paid bonuses of $26 billion.

The Trouble With More Regulation

Increased regulation may be the natural reaction to financial and economic woes, but it is fraught with problems. It's a reaction to crises and, therefore, comes too late to prevent them. And it often amounts to fighting the last war since the next set of problems will be outside the purview of these new regulations. That's almost guaranteed to be the case since fixed rules only invite all those well-paid bright guys and gals on Wall Street and elsewhere to figure ways around them.

Furthermore, government regulators have never, as far as we know, stopped big bubbles or caught big crooks. Consider the dot com and then the housing blowoffs, both of which occurred while the SEC, the Fed, other regulators, Congress, etc. sat on their hands. Think about Enron, WorldCom and Bernie Madoff, all of whom went on their merry ways until their self-induced collapses, completely free of regulatory interference.

Most importantly, government regulation and involvement in the economy is almost certain to prove inefficient. Risk-taking has been excessive, but government bureaucrats are likely to eliminate much of it, to the detriment of entrepreneurial activity, financial innovation and economic growth. Fannie, Freddie and government-controlled banks are now being directed by the government to modify mortgages to accommodate distressed homeowners. That may implement government policy, but leads to bad business decisions.

Confusion

Furthermore, if financial regulation changes massively, it probably will create confusion and uncertainty to the detriment of adequate financing, spending and investment. Some academics believe that the Great Depression was prolonged because the New Deal measures were so disruptive that banks and other financial firms as well as individual investors, consumers and businessmen were too scared to do anything. Recently, Tadao Noda, a Bank of Japan policy board member, said, "We are in a position where the central bank needs to interfere in financial markets, but if we do too much, the market functioning in turn may be hurt." In any event, major problems inexorably lead to greater government involvement. The Bush Administration was staunchly deregulatory in philosophy but forced to intervene in the financial crisis. The 20th century saw tremendous growth in government involvement in all aspects of the economy and financial markets as a result of three tremendous traumas--World Wars I and II and the Great Depression.

Protectionism

Recessions spawn economic nationalism, protectionism, and the deeper the slump, the stronger are those tendencies. It's ever so easy to blame foreigners for domestic woes and take actions to protect the home turf while repelling the invaders. The beneficial effects of free trade are considerable but diffuse while the loss of one's job to imports is very specific. And politicians find protectionism to be a convenient vote-getter since foreigners don't vote in domestic elections.

U.S. Leadership

Sadly, the U.S. appears to be among the leaders for protection of goods and services against foreign competition. The auto loan program last year under the Bush Administration largely excluded foreign transplants. Obama advocates a super-competitive economy, which requires highly productive workers. Yet the recent fiscal stimulus law restricted H-1B visas, granted to foreigners with advanced education and skills, for employees of firms that receive TARP (bank bailout) money.

Some in Congress worried that tax credits for renewable energy should be confined to American-produced equipment. And recall that during the presidential campaign, Obama called for renegotiating the North American Free Trade Agreement. Furthermore, the President's emphasis on health care, education and renewable energy turns attention inward, toward self-sufficiency and away from a global focus.

Outside the U.S., protectionism is being promoted by labor unrest. In England, workers at a French-owned oil refinery struck because Total awarded a construction contract to an Italian firm that planned to use its own staff from abroad rather than local workers. Rioters on the French Caribbean island of Guadeloupe protested high prices for food and other necessities for a month recently. High unemployment rates, especially among younger workers, have precipitated riots in Latvia, Lithuania, Greece, Russia and Bulgaria as well as France.

Competitive Devaluations

Good old-fashioned competitive devaluations to spur exports and retard imports, a mainstay of the 1930s, are making a comeback. Kazakhstan recently devalued, in part because of devaluations of her trading partners. As noted earlier, China stopped allowing her yuan to appreciate, in part because her labor costs are being undercut by countries like Vietnam and Bangladesh.

With the understanding that protectionism helped make the Great Depression "Great," country leaders still publicly espouse free trade and reject protectionism. And they express confidence that global organizations like the WTO, IMF and World Bank will forestall protectionism and economic nationalism, and they engage in endless meetings to promote free trade as well as global standards and cooperation for handling the deepening financial crisis. But almost nothing happens, as shown by the recent EU refusal to bail out Eastern Europe.

Stealth Protectionism

In any event, protectionism is returning by stealth. U.S. steelmakers plan to file anti-dumping suits against foreign producers, a strategy they have employed successfully for decades, and India recently proposed increased steel tariffs. In the first half of 2008, WTO antidumping investigations were up 30% from a year earlier. Bank bailouts have been aimed at protecting local institutions, as discussed earlier, and the Japanese government is buying stocks of Japan-based corporations to help company balance sheets, but also giving them a competitive advantage over the subsidiaries of foreign outfits.

Like America, France is aiding its own auto producers, not transplants, and has created a sovereign wealth fund to keep "national champions" out of foreign ownership. Since last November, Russia has introduced 28 import duty and export subsidies affecting steel, oil and other products as well as imposed special road tolls on trucks from the EU, Switzerland and Turkmenistan. Russia's tariff on imported cars recently rose 5 to 10 percentage points, curtailing shipments of used cars from Japan to the Russian Far East.

Meanwhile, Argentina has imposed new obstacles to imported shoes and auto parts. The EU again is giving export refunds to dairy farmers, to the detriment of New Zealand, slapped anti-dumping charges on Chinese nuts and bolts, and threatens duties on U.S. biodiesel imports in retaliation for America's export subsidies. Not to be outdone, the U.S. plans retaliatory tariffs on Italian water and French cheese in reaction to EU restrictions on U.S. chicken and beef imports in the hormones war.

Ecuador lifted tariffs across the board recently, with the levy on imported meat rising to 85.5% from 25%. Indonesia is using special import licenses to limit the inflow of clothing, shoes and electronics and also is curtailing toy imports by allowing them to enter through only a few of its ports. And there's the old standby, health and safety standards that Japan relies on consistently to keep out unwanted products.

Deflation

Long-time Insight readers know that we have been forecasting chronic deflation to start with the next major global recession. Well, that recession is here. As discussed in our Nov. 2008 Insight, deflation results when the overall supply of goods and services exceeds demand, and can result from supply leaping or from demand dropping. We've been forecasting chronic good deflation of excess supply because of today's convergence of many significant productivity-soaked technologies such as semiconductors, computers, the Internet, telecom and biotech that should hype output. Ditto for the globalization of production and the other deflationary forces we've been discussing since we wrote two books on deflation in the late 1990s, Deflation: Why it's coming, whether it's good or bad, and how it will affect your investments, business and personal affairs (1998) and Deflation: How to survive and thrive in the coming wave of deflation (1999). As a result of rapid productivity growth, fewer and fewer man-hours are needed to produce goods and services. Estimates are that 65% of jobs lost in manufacturing between 2000 and 2006 were due to productivity growth with only 35% due to outsourcing overseas.

Similar conditions held in the late 1800s when the American Industrial Revolution came into full flower after the Civil War. Value added in manufacturing leaped, and at the same time, real GNP grew 4.32% per year from 1869 to 1898, an unrivaled rate for a period that long, and consumption per consumer jumped 2.33% per year. Yet wholesale prices dropped 50% between 1870 and 1896, a 2.6% annual rate of decline. Good deflation also existed in the Roaring '20s when the driving new technologies were electrification of factories and homes and mass-produced automobiles.

The 1930s

In contrast, bad deflation reigned in the 1930s as the Great Depression pushed demand well below supply. As in the 1839-1843 depression, the money supply, prices, banks and real goods and services all nosedived. Employment dropped along with prices in the Great Depression and the unemployment rate rose to 25%. That depression was truly global.

We've consistently predicted the good deflation of excess supply, but in our two Deflation books and subsequent reports, we said clearly that the bad deflation of deficient demand could occur--due to severe and widespread financial crises or due to global protectionism. Both are clear threats, as explained earlier in this report.

Furthermore, with slower global economic growth in the years ahead due to the U.S. consumer saving spree, worldwide financial deleveragings, low commodity prices, increased government regulation and protectionism, excess global capacity will probably be a chronic problem. So deflation in the years ahead is likely to be a combination of good and bad.

Supply will be ample due to new tech, globalization and other factors we've explored over the years such as no big global wars (we hope), continual inflation worries by central bankers, continuing restructuring, and cost-cutting mass retailing. But demand will be weak, as discussed earlier. The chronic 1% to 2% deflation from excess supply that we forecast earlier still seems likely, but now we're adding 1% due to weak demand for a total of 2% to 3% annual declines in aggregate price indices for years to come.

2009 Seems Easy

For four reasons, the deflation that started several months ago (Chart 10) is quite likely to persist along with the recession, or at least until early 2010. First, the collapse in commodity prices continues and past declines are still working their way through the system. Crude oil prices have collapsed from $147 per barrel to around $40. Steel semi-finished billet prices were $1,200 a metric ton last summer but now is $350. Iron ore costs per metric ton dropped from $200 early last year to $80. It takes time for steel prices to work through to final consumer goods prices such as for washing machines.

Second, producers, importers, wholesalers and retailers were caught flat-footed by the sudden nosedive in consumer spending late last year and continue to unload surplus goods by slashing prices. All the giveaway bargains at Christmas still didn't entice enough consumers to open their wallets. Spring apparel, ordered before consumer retrenchment, is clearly in excess and being marked down before it's put on the racks. Retailers from Saks on down continue to chop prices. Branded food product manufacturers are willing to promote their wares alongside the private-label goods that supermarkets shoppers increasingly favor.

Wage Cuts

Third, wages are actually being cut for the first time since the 1930s. Previously, labor costs were controlled by layoffs, which still dominate. Benefits have also been trimmed in recent years by switching from defined contribution pensions to 401(k)s and increasing employee contributions to health care costs. Most workers are less sensitive to benefits than to salaries and wages, but the deepening recession and mounting layoffs (Chart 5) are making them more amenable to wage cuts.

So is the growing use of this approach. In a recent poll, 13% of companies plan layoffs in the next 12 months, but 4% expect to reduce salaries and 8% will cut workweeks.

So it just isn't the CEO who is taking the symbolic pay cut to deal with tough times. We argued in our Deflation books that cutting pay rather than staff is more humane, better for morale and better for keeping the organization together and ready for a business rebound. Now increasing numbers of employers agree with us.

A final reason to expect deflation in coming quarters in the U.S. is the surplus of aggregate supply over demand. Notice that the supply-demand gap is an excellent forerunner of inflation six months later. And deflation this year is spreading globally. Japan is once again flirting with falling prices, Thailand's CPI in January fell year over year for the first time in a decade. In Europe, inflation rates are rapidly approaching zero.

Prices In Recovery

The real test of deflation will come when the economy recovers--in early 2010 or later, we believe. Inflation rates normally fall in recessions, but then revive when the economy resumes growth. This time, inflation rates started low, so declines into negative territory are normal, especially given the severity of the recession and the collapse in energy and other commodity prices. If we're right, however, aggregate price indices like the CPI and PPI will continue to drop in economic recovery and verify the arrival of chronic deflation.

Few agree with us. They've never seen anything but inflation in their business careers or lifetimes, so they think that's the way God made the world. Few can remember much about the 1930s, the last time deflation reigned. Furthermore, we all tend to have inflation biases. When we pay higher prices, it's because of the inflation devil, but lower prices are a result of our smart shopping and bargaining skills. Furthermore, we don't calculate the quality-adjusted price declines that result from technological improvements. This is especially true since many of those items, like TVs, are bought so infrequently that we have no idea what we paid for the last one. But we sure remember the cost of gasoline on the last fill-up a week ago.

Too Much Money?

The main reason most expect inflation to resume, however, is because of all the money that's being pumped out by the Fed and other central banks as well as the Treasury to finance the mushrooming federal deficit. When the economy revives, they fear, all this liquidity will turn into inflationary excess demand.

At present, the Fed's generosity isn't getting outside the banks into loans that create money.

When cyclical economic recovery finally does arrive in 2010 or later, it will probably be sluggish and lenders will still likely be cautious, as discussed earlier. Furthermore, any meaningful increase in loans will probably continue to be more than offset by the continual destruction of liquidity as writedowns, chargeoffs, elimination of derivatives, etc. persists for years. Derivatives represent liquidity. You can't use them at the grocery store, but at least until recently, they were interchangeable from money in many uses.

In Sum

The deepening recession and spreading financial crisis is the beginning of the unwinding of about three decades of financial leverage and spending excesses. The process will probably take many years to complete as U.S. consumers mount a decade-long saving spree, the world's financial institutions delever, commodity prices remain weak, government regulation intensifies and protectionism threatens, if not dominates. Sluggish economic growth and deflation are the likely results.

A. Gary Shilling's INSIGHT - March 2009
Telephone: 973-467-0070

Street Scan

VinnyCatalano — Tue, 10 Mar 2009 16:17:00 GMT

Billionaires are now Slumdog Millionaires because:

A. The credit markets remain frozen
B. The US economy is falling off the cliff
C. Corporate earnings are headed substantially lower (<$50 S&P 500 operating earnings)
D. The socialist programs of the Obama administration threaten capitalism as we know it
E. All of the above, and then some
***
from International Monetary Fund “Global Financial Stability Report (GFSR) Market Update”
January 28, 2009

“Until now banks have managed to obtain sufficient capital to offset existing writedowns, but that is mainly due to the massive public sector injections of capital in the fourth quarter. The worsening credit conditions affecting a broader range of markets have raised our estimate of the potential deterioration in U.S.-originated credit assets held by banks and others from $1.4 trillion in the October 2008 GFSR to $2.2 trillion. Much of this deterioration has occurred in the mark-to-market portion of our estimates (mostly securities)*, especially in corporate and commercial real estate securities, but degradation is also occurring in the loan books of banks, reflecting the weakening outlook for the economy.”
***
Aggregate assets in money market funds (institutional and retail): $4 trillion (approx.)
Total market capitalization of the S&P 500 as of March 9, 2009: $5.9 trillion
***
from Dave Rosenberg, North American Economist, Merrill Lynch
March 9, 2009

"Beige Book mentions nine positive areas
Even if we still do not see a bottom in sight just yet for the economy or the equity market, there are sectors that at least from a macro standpoint have a relatively firm underpinning even in the midst of this unbelievably severe recession and bear market phase. We have said it once and we will say it again, the Fed's Beige Book offers up the most timely and detailed information on sectors. The most recent report that was issued last week contained positive mentions on these nine areas of the economy:
􀂄 Food production
􀂄 Pharmaceuticals
􀂄 Apparel retailing
􀂄 IT services
􀂄 Biotech
􀂄 Aircraft manufacturing
􀂄 Fast food restaurants
􀂄 Discount stores
􀂄 Environmental services

Positives outperformed the market by 800 basis points
While these sectors, on average, were down 8% between the most recent Beige Book and the one that preceded it in early January, they collectively outperformed the market by 800 basis points.

21 negative sectors mentioned
At the same time, there were 21 sectors that received negative mentions in last week's Beige Book. They are listed below:
􀂄 Travel/tourism
􀂄 Education services
􀂄 Luxury goods (jewelry)
􀂄 Agri-business
􀂄 Banks
􀂄 Homebuilding
􀂄 Electronic equipment
􀂄 Computers
􀂄 Motor vehicles
􀂄 Staffing services
􀂄 Commercial real estate
􀂄 Rails/Trucking
􀂄 Furniture/Appliances
􀂄 Health care services (elective)
􀂄 Oil drilling
􀂄 Metals and mining
􀂄 Wood products
􀂄 Media services
􀂄 Petrochemicals
􀂄 Construction equipment
􀂄 Semiconductors

So, for every positive mention, there were more than two negatives. The S&P 500 sector equivalents, on average, declined 26% between the last two Beige Books, and underperformed as a group by 1,000 basis points."
***
email sent last night to "Kudlow Report" producer Donna Vislocky in response to Larry’s plea for bullish commentators:

“On tonight's program, Larry said his producers were having a hard time booking those who were bullish. Well, here I am.

As someone who is now 100% invested, I am at the opposite end of when I last appeared on your program in early 2007 when I was highly cautious. Today, however, the picture is swung completely to the other side of the pendulum.

Here are a few bullish reasons that I am more than willing to debate a bear:

1 - Investor psychology is so thick you could cut it with a knife. Too bearish now, just like they were too bullish two years ago.
2 - A mountain of cash sits in money market funds - nearly $4 trillion. The stock market value for the S&P 500 stands today at $5.9 trillion.
3 - Valuation levels in many areas are very attractive and any upside earnings surprise would drive stocks higher.
4 - Technical analysis has recently begun to generate some positive divergences - downward momentum pressures have diminished, divergences (emerging markets, for example) have, uh, emerged.

Moreover, as someone who has criticized mark-to-market since March of last year, I am in complete alignment with one of tonight's guests, Steve Forbes.”

*emphasis added

Beyond the Sound Bite: An Interview with Joe Battipaglia

VinnyCatalano — Wed, 18 Feb 2009 06:59:00 GMT

In my second conversation with the Market Strategist/Private Client Group for Stifel Nicholas and Chief Investment Officer with Washington Crossing Advisors we discussed his deep and long recession call, the consequences to earnings, the inefficiencies of government spending, and the lack of a central theme to the Obama stimulus plan.

The length of the interview is 15 minutes 35 seconds.

(Please visit the site to view this media)

*To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.

TARP Version 1 Revisited: Mark-to-Market Back in the Crosshairs

VinnyCatalano — Thu, 29 Jan 2009 00:38:00 GMT

“Senior Wall Street executives said yesterday that they had been sounded out on plans for an “aggregator bank” that would purchase toxic assets from banks. Under one of the plans discussed, toxic assets would be valued by an independent third party. Where assets are purchased at prices below their book values, the government might then inject common equity into the banks to make up for capital wiped out by the sales.”
Financial Times, January 28, 2009

On the surface, mixed signals are emanating out of the US Treasury department. Last week, Treasury Secretary Geithner stated that he was comfortable with mark-to-market accounting. Today, we learn of the above quoted plan, which is a direct assault on mark-to-market – the real villain in turning a recession into potentially a depression. What gives?

To refresh your memory, mark-to-market accounting is rooted in the failed ideology of the efficient market hypothesis, which (in its “strong” form) says that when it comes to determining the fair value of an asset the market knows best. This dogma is so entrenched in the thinking of mainstream economists and many naïve investors that even Nobel Laureates such as Paul Krugman ascribe to this fantasy of the “wisdom of the market” (see "More on the bad bank"). Moreover, there is little doubt on these pages that the primary reason why TARP Version 1 went from “price discovery” (code for attacking mark-to-market) to bank capital infusions was due to the intimidation of then Treasury Paulsen by mainstream, non behavioral finance economists.

Investment Strategy Implications

Conspiracy theorist alert: Clever guy this Mr. Geithner. Publicly advocate for free market principles (mark-to-market) while working behind the scenes to exploit it (through the aggregator bank and price discovery (courtesy the "independent third party")).

The significance of keeping mark-to-market intact is the extraordinarily positive impact it will have on bank earnings as assets held at 20 cents on the dollar are written up ("say what?" you say) thereby producing large earnings gains. Moreover, by stabilizing the valuations of “toxic assets”, write ups will thereby alleviate banks’ capital requirements, which is the primary reason why bankers are reluctant to lend. Under the bizarro logic of mark-to-market, they need the cash to remain solvent – hence no lending.

Once mark-to-market is replaced by something like mark-to-maturity (suggested by Bernanke during early days of TARP Version 1), then, miraculously, liquidity will begin to flow through the banking system to the real economy. Sounds too simple? Allow me to refresh your memory on another non real economy factor that wrecked a large amount of unnecessary havoc on the global economy – commodity speculation and the price of oil.

*To learn about "Sectors and Styles Strategy Report" newsletter and other subscriber benefits, click here.

Helicopter Hank

VinnyCatalano — Thu, 15 Jan 2009 00:30:00 GMT

“It is like if you are in an airplane and the oxygen mask comes down,” said Stefanie Kimball, (Independent Bank’s) chief lending officer. “First thing you do is put your own mask on, stabilize yourself.”

"In Michigan, Bank Lends Little of Its Bailout Funds"
NY Times, January 14, 2009

The above quote and article captures the essence of the TARP money dump by Helicopter Hank in 2008. This is, no doubt, a large part of the dynamic that has investors worried, but not in the way that may seem apparent.

Under Obama and the Democrats, TARP funds will be allocated in a striking different manner. And this fact justifiably has many investors concerned that a significant increase in bank failures will be a part of the economic landscape this year: something that the accompanying chart from the Economist strongly suggests. Moreover, with no political dynamic at work this year, it is hard envision any scenario in which the second wave of TARP money would find its way to undeserving banks and with such poor transparency and regard for the terms under which such money is made available. As a result, investors should expect that banks with shaky balance sheets are headed for the operational dustbin. And with them, the economic consequences of the deleveraging process will continue unabated.

Investment Strategy Implications

Were it not for the fact that the stock market is deeply oversold, this morning’s 10 to 1 down ratio (both the advance/decline and advance/decline volume) might lead some to conclude that a return to the really bad old days of last year (with 5% + down days, rising VIX levels, banking crisis du jour, and more pain to follow) is underway rather than a second selling climax based on fears well known, defined, and, yes, manageable.

On the assumption that the plethora of money already doled out and what’s in the monetary and fiscal pipeline (including the Fed’s acquisition of selected “toxic assets” and the prospects for bank “write ups”) will have the desired effect of injecting into the US economic body enough juice to trigger the badly needed multiplier effect on corporations and households beginning in the second half of the year, a cautiously optimistic view of equities does seem warranted - at least for the next several months.

Helicopter Hank did what he did and in a manner that only he fully appreciates*. In short order, his actions will be perceived as they should be – a prelude to the real work of restoring the US and global economy to a more balanced era of growth and stability.

*A more conspiratorial mind might suspect there was a political dimension to his largess as 2008 was a presidential and congressional year. Providing “walking around money” to banks who did not qualify under the agreement that healthy banks should receive TARP funds does make one wonder just what was Helicopter Hank thinking?

Forecast 2009: Deflation and Recession

JohnMauldin — Sat, 10 Jan 2009 14:38:00 GMT

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Muddle Through on Hold

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

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

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

Forecast 2009: Deflation, Deleveraging, and the Stimulus Effect

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

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

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

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

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

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

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

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

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

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

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

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

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

Lies, Damned Lies, and Government Unemployment Numbers

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

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

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

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

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

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

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

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

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

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

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

Central Bankers of the World, Unite!

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

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

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

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

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

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

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

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

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

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

But there is a problem.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Predictions 2009

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

La Jolla, Bermuda, and Europe

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

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

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

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

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

Your more optimistic than this letter implies analyst,

John Mauldin