Thoughts From The Frontline

The End of the Recession?

John Mauldin — Sat, 27 Jun 2009 02:55:59 GMT

The End of the Recession?
The New Normal Is Still In Our Future
The Hidden Problem Within Unemployment Data
Was Income Really Up?
Tulsa, London, and The Baltics

Last week we began a series on data abuse, about how various commentators twist and torture data to make it say what they want, or fail to look at the details underneath the headlines. Predictably, there is a lot of fodder this week as we forge ahead into this ripe territory. The headlines screamed that US income data went up unexpectedly. Green shoots were everywhere. But if you look at the actual data, you find something much different. And, I keep hearing the insistent refrain that the market is telling us that the recovery is around the corner. Well, the recovery may be, but can the market really tell us that? I have about 25 windows open in my computer, with tons of misleading data. Let's see how much we can cover in this week's letter.

But first, I want to focus your quick attention on a new "Conversation" I will have next Monday. (For those readers who are new, I have a subscription service where I hold conversations with friends on a variety of current topics. I am gratified that it's getting rave reviews.)

I have been writing about the New Normal of late, and for my next Conversation I have invited two of the sharpest analysts I know to talk about what the New Normal will look like.

What levels do we get to? What does the world economy look like? What will the path to recovery look like? And so on! David Rosenberg, former chief economist for Merrill Lynch, one of the few mainstream analysts who got it right (now with Gluskin Sheff in Toronto) and the brilliant Michael Lewitt of Harch Capital Management, someone who was writing about the credit crisis long before it happened, are both deep thinkers, and both have strong ideas about how our future will unfold. I can't wait to get them at the same table and see if we can flesh out a few concrete ideas.

And if you subscribe today, you also can get the recently released and widely praised Conversation I did with Donald Coxe and Gary Shilling on commodities and where those markets are going. That ended up as a very powerful debate, and one from which listeners said they really came away with meaty ideas.

You can subscribe now at $109 (using code JM75), before we raise the price when we add a new quarterly Conversation service with good friend and head of Stratfor, George Friedman. He gets back from Australia this week, and we will schedule a meeting soon!

And now to funny-looking data. Where to begin? There are so many targets of opportunity!

The End of the Recession?

I walked into the office yesterday evening and there was someone on CNBC talking about how the 50-day moving average of the S&P 500 rising above the 200-day moving average was telling us the market was getting ready to rise and the recovery had started. I listened to his babbling for another 2-3 minutes and couldn't take it anymore (and no, it was not my friend Larry Kudlow, who is a lot more balanced than whoever was on.)

We keep getting told that the market is telling us "something," usually that the recession is going to end. For some reason, people keep repeating the bromide that the market looks out about 6 months. To that I politely say, rubbish.

Riddle me this, Batman. Did the market see the recession in October of 2007? We were already in recession and the S&P 500 (see below) was making new highs! Where was the market prescience? Did it see the 25%+ drop in January of this year? And I could go back and cite scores of examples where the market "missed" the future turning points over the past ten decades.

What about the shibboleth that the market turns up 6 months before the end of a recession? Sometimes that is true. But does it mean anything? The same people who said it meant something last December and January are saying it means something now. But now it's June and the recovery is not here, so maybe the market wasn't telling us something in January after all.

Gentle reader, there will be a recovery. We will talk about what kind in a few pages, if we have the time. And it is (statistically speaking) likely that the markets will have turned up before the actual recovery. But does that mean anything today?

Go back to the chart above. Notice that in 2003, when the market finally turned up, we were already well out of recession. And the market had a very quick 12% or so drop while we were in recovery, while later we went on to a 90% run-up! Was the drop telling us anything, or do we explain it away?

"In the short run," St. Graham said, "the market is a voting machine. In the long run it is a weighing machine." The voting is based on current sentiment, but what the market weighs in the long run is earnings. The market tries to forecast future income streams. And it gets it wrong as often as it gets it right.

Let's look at this yet another way. This is an important concept, and it should be a component of your economic BS detector. The CNBC host talked in breathless terms about the importance of the 50-day average moving above the 200-day average. It means nothing until it means something, and we won't know what that something is for some time.

Earlier this week (Monday, I think) the 50-day average moved BELOW the 200-day average. The analysts at Bespoke Investment Group noted:

"Going back to 1928, this is the 25th time that the S&P 500 has declined through both of these levels on the same day. On page two we have provided a table showing each of these occurrences as well as the index's returns going forward. Based on those prior instances, the S&P 500's returns going forward have been notably negative. While the S&P 500 has averaged positive returns over the next week, average returns have been negative over the next month, three months, and six months." (emphasis mine)

But 33% of the time, the markets were up six months later, often by quite a bit. And sometimes down quite a bit, but on average only slightly. Which means that as a forward-looking indicator it is interesting but not anything I would put my money (or client money) on!

(I saw some reports that differed, selecting fewer such data points and suggesting that market returns were up after such an event. Logically, that can't be. Let's be generous and just assume sloppy research.)

Before major market moves down, the 50-day average will always move below the 200 average. And the reverse is also true. It is not a sign. It is just what statistically MUST happen. And sometimes they reverse themselves, and sometimes they don't. We have no way on God's green earth of knowing whether the two moves (both up and down) this week will be bullish or bearish six months from now, based simply on the moving averages crossing. You can make the data say anything you want, but you are still just guessing.

Sidebar note: Trend Following 101. I spend a lot of time analyzing trend-following money managers of one kind or another. Basically, they look at data and try to spot trends and then invest in them. A trader who is right 70% of the time is amazing and very rare. 50% is more like it for successful traders. But they have sharp risk controls that cut their losing trades and let their winning trades "ride." Being right 50% of the time can be profitable over time. (Being right 50% of the time is harder than it looks!)

But in the media you get these "analysts" who talk a good game, acting as if a 50-70% probability is something meaningful. "The market has turned. The recession is over." And they say that when we have the first balance-sheet recession in 70 years, yet they want to compare garden-variety recessions to what we have now. Again, we can only know which of the moves (above and below the 200-day moving average) will be the real "indicator" in six months. It is only an indicator today to the extent that we can drive our cars forward looking in the rear-view mirror.

The New Normal Is Still In Our Future

Now let's take that principle a little further. Last week I detailed how air, trucking, and rail shipping is down 20% year-over-year. Global trade is down about 30% in the major exporting countries (see below).

World trade shrinks : Chart 1: Year-over-year change in total exports from 15 major exporting
countries (1991-02/2009) / Chart 2: Year-over-year change in exports from 15 major exporters
between February 2008 and February 2009 (size of circles reflects volume of exports in 2008)

End of the world? Do we just keep falling? No. At some point, six months or a year from now, the year-over-year comparisons become easier. If you are at 100 and fall to 80, then a year later you are at 88 and voila! you have a 10% increase! And the perma-bulls will be talking it up. The fact that you are still down 12% from the peak is ignored.

The point is that we have fallen quite a bit in a lot of major categories. There is really only so much you can fall. And then when you reach that new lower level of the New Normal, you begin to rise. At some point, we will be on the path to "recovery." That does not mean that we will be back to the halcyon days of mid-2007 within a year. It just means that we have stopped falling and now have to adjust to the levels of the New Normal.

The Hidden Problem Within Unemployment Data

This is going to be most evident and painful in the unemployment numbers. Last month saw the number of unemployed rise by 345,000. What was not in the headline data was that 217,000 of those jobs were estimated from the "birth-death" ratio. The US economy creates new businesses that do not get counted in the data, so the BLS estimates what that number is, using previous data patterns. When the economy turns, it overestimates new jobs in recessions and underestimates them in recoveries. No conspiracy, it is just the best methodology we currently have.

But does anyone really think 200,000 jobs were created last month? The real number of lost jobs is worse than the headline. And next month the birth-death number will likely be over 200,000 again. Add another 100,000 or so to the headline number to get closer to reality,

Again, analysts talked about a turnaround because job losses were "just" 345,000. That is a higher number than any month in the 2001-02 recession, and larger than the month after 9/11. That is a green shoot? Yes, we will see the monthly unemployment numbers fall, but they are falling from historic highs. And based on some research by the San Francisco Federal Reserve, it is likely that we will see still higher unemployment that will persist for a while longer.

Let me quote and summarize through the research at http://www.frbsf.org/publications/economics/letter/2009/el2009-18.html. (It is not long, and worth reading.)

"Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market. Specifically, we suggest that the relatively low level of temporary layoffs and high level of involuntary part-time workers make a jobless recovery similar to the one experienced in 1992 a plausible scenario."

Essentially, there are always workers moving into and out of employment. What they note is that the patterns seem to be changing. In the '70s and '80s, job losses were quick and deep, but the recovery was also quick. In the last two recessions, job recovery was noticeably slower, giving rise to the term "jobless recovery." It was the lack of hiring, and not firing, that was responsible for the slow employment recovery. MY thought is that before 1990 many of the job losses in recessions were from manufacturing. Businesses were quick to lay off and quick to rehire. We now have fewer manufacturing jobs, so the rehiring process has been much slower in recent recessions.

"The long and gradual return to pre-recession unemployment levels implied by the Blue Chip consensus forecast is consistent with a labor market recovery that is slightly weaker than that experienced in 1983 and slightly stronger than that experienced in 1992. However, should labor market conditions instead proceed along the path taken in the 1992 recovery, the unemployment rate could peak close to 11% in mid-2010 and remain above 9% through the end of 2011."

That is not in any Congressional budget forecast. Want to run an election campaign at 10% unemployment levels?

"... What does all this mean for the course of the labor market? We combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization. We plot this measure in Figure 3, which shows that the labor market has considerably more slack than the official unemployment rate indicates. The figure extends this labor underutilization measure using the Blue Chip consensus forecast for the unemployment rate as a benchmark and then adding a share of involuntary part-time workers based on the proportion of workers in that category to the unemployed during the current recession. This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate. This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates." (emphasis mine)

Was Income Really Up?

Now, let's turn our attention to today's headline. Income is surprisingly up. That has to be a green shoot, right? Well, not if you look at the underlying data.

Personal income from wages and salaries was down $12 billion in May. So how did income go up? A large increase in "government social benefits" and a decline in personal taxes accounted for all the gain, and then some. The increase was the effect from the recent stimulus package, which is (for now) temporary, and not the result of a recovering economy. Hardly green shoots. It is just borrowed money from another (government) source. In principle, it is not much different than home equity withdrawal, except that taxpayers are on the hook.

And those government subsidies are going to increase. Look at the graph below. What it shows is that the average duration of unemployment is at a 60-year high, and rising. It is now at 22.5 weeks. Unemployment benefits stop at 39 weeks, temporarily up from 26 weeks. More and more people each week are thrown into very dire circumstances when they fail to find jobs and lose the benefits. Care to wager whether, when Congress comes back from vacation, the time people are allowed to be on unemployment will be increased?

And speaking of the increase in government payments to individuals, what did they do with them? In aggregate, what is happening to this stimulus? The data came out today, and I must admit I was surprised. I have been writing for years that American consumers would start to save in this recession, but I (and nearly every credible observer I read) thought that we would see a more gradual rate of increase in the savings rate. The increase in savings has been nothing short of remarkable. (See graph below.)

From a negative 3% in late 2005 (the result of massive borrowing, primarily mortgage equity withdrawal and credit cards), we have risen to a positive 6.9%. That is the highest rate since 1993. The savings rate was less than 1% last August. And totals savings (on an annualized basis) was $608 billion in April, rising to $768 billion in May. That is a 30% month-over-month increase! Maybe the American consumer has found a new religion!

But, there is more than just a new savings fervor at work. Spending rose more than disposable income, so without that increased level of government transfer payments, it is unlikely that savings would have risen as much. Before we get too giddy about savings going through the roof, we need to wait a few months to see if this was the result of new savings religion or government transfer payments (stimulus), which will soon wind down

That being said, given the sharp increase in savings, it's no wonder shipping is down 20% and global trade in the exporting economies by 30%. No wonder retail sales are down, except for Wal-Mart and other lower-price venues.

Final thought for today. The Congressional Budget Office released another report this week, saying that the current deficit levels are unsustainable. They suggest that either taxes must increase by $440 billion or spending must be cut by a like amount, or some combination. If you assume some of the new health-care and other programs are enacted, the number comes closer to $700 billion.

This is not a Congress that wants to cut other parts of the budget by $700 billion. Raising taxes by $700 billion (over 4% of GDP) will dip us back into recession. Not raising taxes will result in debt that cannot be funded at anywhere close to today's rates. A recent IMF study is very sobering about the worldwide problem of growing country debt. Finding a trillion dollars in the market every year, when every other country is also trying to raise debt is simply not going to happen. It will destroy the dollar. There are few good choices in front of us, and fewer still good choices that are likely.

OK. One final suggestion for your weekend reading. Atul Gawande, writing in The New Yorker, weaves a very sobering picture of the problem of reining in health-care costs. He contrasts two Texas border cities with similar demographics, yet one spends twice as much on health care. One town has doctors who order every possible test and the other doesn't. There is no real difference in outcomes. And then compare it to other areas, and the problem facing any health-care policy becomes all too evident. Reportedly, Obama has had everyone read this, and you should too. It provides a very different angle on the problem. http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?yrail

Tulsa, London, and The Baltics

Last Tuesday I went to an Eric Clapton and Steve Winwood concert. At 64, Clapton can still play the guitar as well as anyone on this planet. It is always fun to see a man at the top of his game.

I get up early tomorrow, flying with family to get to Tulsa to be at my daughter Amanda's wedding shower, and then celebrating the twins 24^th birthday tomorrow night. Amanda's wedding is August 22, right around the corner. If there is a recession going on, no one in the wedding industry seems to know. This is the second wedding in two years, and I still have two more unmarried daughters. It's a good thing the word retirement is not in my vocabulary. If we can't get the wedding budget under control, I am going to need about 600 new Conversations subscribers in July.

July 15^th I leave for London and will guest host CNBC Squawk Box from 7-9 on Friday the 17^th. Then on to Finland, St. Petersburg, and the Baltic capitals, and ending in Rome. (Why Rome? Because that is where we could get mileage tickets back to Dallas. But I might as well spend a few days.)

Then I (and my son Trey) will spend one evening and morning in New York August 5-6 before going on to Maine for the regular August fishing extravaganza with David Kotok and a rather fun crowd of economists and other ne'er-do-wells. It is a tough ticket to get, and I am glad to be invited.

There are lots of exciting things happening in my business, and we will be making announcements in the next few weeks. You have a great week.

Your going to listen to more hard blues analyst,

John Mauldin

This Time its Different*

John Mauldin — Sat, 20 Jun 2009 02:53:00 GMT

This Time It's Different*
Peter Bernstein, R.I.P.
Welcome to the New Normal
The Three Amigos
Credit Spreads - Bullish or Bearish?
ISM - Is Less Bad That Good?
Contain Your Enthusiasm
London, The Baltics, and Rome

I have often written that the four most dangerous words in the investment world are "This Time It's Different." If memory serves me, I have written several e-letters disparaging various personages who have uttered those very words, and gone one to confirm later that it wasn't different. It almost never is. And yet - and yet! - I am going to make the case over the next few weeks that it really is different this time, with only a lonely asterisk as a caveat. What prompts my probable foolishness to tempt the investing gods is the rather large amount of bad analysis based on unreasonable (dare I say lazy or surface?) readings of statistics that is coming from the mainstream investment media and investment types with their built-in bias for bullish analysis. Normally, gentle reader, your humble analyst is a paragon of moderate sensibilities, but I have been pushed over a mental edge and need to restore balance. I anticipate that this topic will take several weeks, as trying to cover it all in one sitting would exhaust us both. It should be fun. But first...

Peter Bernstein, R.I.P.

Sadly, Peter Bernstein passed away at 90 years young on June 5. One of the great honors and privileges of my life has been getting to know Peter and his lovely wife, Barbara. Introduced at a small dinner five years ago, I have been privileged to share many dinners and meetings with him in the years since, soaking up his wisdom. Only a month ago, he made a presentation (by satellite) to Rob Arnott's annual conference and was at the top of his intellectual game. His writing of late has been some of his best. Peter cofounded the Journal of Portfolio Management and truly was the dean of investment analysts.

He wrote 10 books (five after the age of 75!). I am often asked what books I would recommend for insight into the economic world. At the very top of my list has always been Against the Gods: the Remarkable Story of Risk. If you have not read it, then get it and put it on top of your summer list. Capital Ideas is also brilliant. The Power of Gold is a must-read. You can get all three in a set at Amazon.

Jason Zweig wrote a very moving obituary in the Journal and reminded me of a few quotes I've heard from Peter. "'What we like to consider as our wealth has a far more evanescent and transitory character than most of us are ready to admit.' He urged investors to regard their gains as a kind of loan that the lender - the financial market - could yank back at any time without any notice.

"Asked in 2004 to name the most important lesson he had to unlearn, he said, 'That I knew what the future held, that you can figure this thing out. I've become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the investment process.'"

Peter and I chatted several times during the last year, and he continued to tell me that those who thought we were in for a typical recovery were probably going to be wrong. In private conversations he was very worried about the world, and added much wisdom to those of us privileged to sit at his feet.

Isaac Newton once said, "If I have seen further it is only by standing on the shoulders of giants." In the world of investment wisdom, there is no shoulder higher than that of Peter Bernstein. Rest in gentle peace, my friend. You will be greatly missed.

This Time It's Different*

Ben Bernanke's career will be analyzed and written about for many years. But the one thing that has caused me the most pain is his bringing of the term "green shoots" into the investment lexicon. These may be the two most overused and annoying words of my investment career. Every possible sign of a recovery is anointed with the phrase.

Of late, there has been a tendency for analysts to see numbers or statistics that are "less bad" and interpret them as signs that we are in recovery or at least almost there. They glance back at previous recoveries and say, "Doesn't this look like the last time? When such and such happens it means that recovery is on the way. We should therefore buy stocks" (or whatever).

That we are condemned to read such musings is part of the investment landscape. But that does not mean we shouldn't take the time to look at what the writer of those words is actually looking at. All too often of late, I find these people grasping at straws or failing to understand the data.

My premise for uttering the heresy "This Time It's Different*" is that the fundamental nature of the economic landscape has so changed that comparisons with post-WWII recoveries is at best problematical and at worst misleading.

As we will see next week, we are on a track that looks far more like the Great Depression than the recessions of our lifetimes. To expect a normal recovery cycle, whether it is corporate profits or lending or consumer spending or capital investment or (pick a category) is just not reasonable. This is a period that is fundamentally, in so many ways, different. And the recovery (and there will be one!) will also be of a different warp and woof throughout the entire world economy.

Let me see if I can summarize my thinking before we get into the reasoning behind it.

First, we are at the end of a huge cycle of increasing private debt that ended in an overleveraged society. The process of reducing debt and unwinding leverage is going to take a rather long time. It will not be the typical one or two years and then things get back to an ever-higher normal. We are, using a phrase coined by my friend Mohammed El Erian at PIMCO, on our way to a new normal. We are hitting a massive reset button on our economic world, taking us to some new and lower level of consumer spending, leverage, etc. No one knows what the new level will be, although admittedly we are closer to it than we were a year ago.

At this new normal, we will not need as many malls or factories or stores or new-car plants or car dealerships or any number of other things to satisfy the new normal of consumer desires. As an example, and jumping ahead to a statistic for one minute, capacity utilization is now approaching 65%. Anything under 80% is anemic. Does anyone really think that businesses (in general) are going to invest more money in expanding capacity, in the face of the lowest level of production relative to potential since the 1930s?

The savings rate has shot up from zero to 6% in just a very short time. It used to be 12%. It would not be all that unusual historically for savings to go to 9% or more in a few years. That means that consumer spending will drop by 9%. Since consumer spending was 70% of GDP, that new lower level will become our new normal. And of course, due to population growth and hopefully increasing incomes, consumer spending will once again grow from whatever that new normal will be. But it is going to take some time for spending to reach the level of our productive capacity of a few years ago. We are going to have to shutter a few factories and businesses.

David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart ... the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

As we will see, the housing market is going to take at least two more years to truly recover. Looking at one month's data that shows housing starts up a few thousand as a sign of recovery in the housing market is, well, silly. Housing starts are anemic and the inventory of unsold homes is still at all-time highs (a ten-month supply) with more and more homes coming onto the market through foreclosure.

The multiple causes of the recession are not subject to a quick fix. Offering to pay someone $4,500 to trade in an old car for a new one is a rather pathetic way to try and jump-start consumer spending and the auto industry. Is it not enough that we will "invest" $50 billion in GM, while shrinking the company to a size where it will be difficult for profits to ever pay back that investment? We have to add insult to injury and borrow more money to buy cars. Care to wager whether GM will need more money within five years? (And by the way, I love my GM (Cadillac) car, and will likely buy another one at some point, so I wish them well.)

The "stimulus plan" was ill-conceived and not very stimulative. But the combination of the Fed and Treasury and massive monetary infusions has pulled us back from the brink of Armageddon. But we are not out of the woods yet. There is much heavy lifting to be done on the way to the land of the new normal.

Welcome to the New Normal

Secondly, my premise is that the recovery is going to take longer and be much less robust than any recovery since WWII. With unemployment likely to go over 10%, and with our new normal world not needing as much production of so many things, unemployment is going to stay stubbornly higher for longer than in any previous recovery. We are going to look next week at a very sobering report from the San Francisco Fed that suggests we may be for a longer than usual jobless recovery.

Thirdly, all this is going to affect corporate profits, especially for companies that depend on consumer spending. Those investors who expect corporate profits to rebound in 2010 are likely to be disappointed. (For the record, if you go to the S&P web site, analysts are projecting anywhere from a 40% to a 60% rebound in earnings for 2010 for the S&P 500. I would willingly take the "under" on that bet if I could find any takers.) I think whatever profit recovery that is built into the market at today's prices is generous. It is going to be tough to get much of a return from traditional buy-and-hold equity index investing for some time.

Fourthly, this is a global problem and primarily one in the "developed" world. I think we will find that much of Europe will be in a worse state of affairs than the US. If there are bright spots in the developed world, I tend to think they will be Canada and Australia/New Zealand. The opportunities are more likely to be in emerging markets, after they adjust to the new normal.

What this all means is that we as investors, entrepreneurs, managers, employees, and consumers need to adjust our expectations. For those of us in the US, this is complicated significantly in that we really have no idea what new level of government spending and taxation we will be faced with in 2010 and beyond. For one of the few times in my life, what the government does is likely to have a huge impact on the economy, as there is the potential for a significant shift in the very fundamental nature of government involvement in the economy. It is difficult to see what the new normal will be.

In Continental Europe, your new normal is going to be further complicated by an eroding banking crisis that is likely to put a real crimp in any recovery. China and Asia must adjust to lower US consumer spending. They have built too many factories to supply what seemed like an inexhaustible US consumer. They have to find new internal markets or face their own new normal.

All that being said, at some point, perhaps as early as the third quarter, we could see a positive number for GDP, although I think it will be later. Part of the reason that we will see some positive numbers is that year-over-year comparisons are going to get easier to make. Last summer, when inflation was close to 5% and I was writing that deflation was the real danger, oil was rising from $40 to $160 and food prices were going through the roof. Now oil is back to $70 and so we get lower year-over-year inflation numbers. Over the last two years the price of oil/energy is up, but we measure inflation on a yearly basis.

Housing construction was once about 5% of GDP. Obviously, the collapse of housing construction has had a rather negative impact on recent GDP numbers. But housing is probably close to, if not at, a bottom. Even if it dropped by another 20%, it would have far less of an impact on GDP at the much-reduced level where it is now.

It is similar with inventories. They can only drop so much, and eventually they get to the new normal and stop being a drag on the statistical GDP. We are not in an unrelenting death spiral. There is a bottom. It is like a person jumping out of an airplane. They fall rather rapidly until the parachute opens, and as they get closer to the ground they manipulate the chute to further slow the descent. But until they reach the ground, they are still falling. That is the case today. The economy is still falling, but the parachute has opened. We are going to reach the bottom at some point. We will find that new normal. We just need to adjust our activities and plans around that new destination.

I truly believe we get back to 3% GDP growth and 4% unemployment at some point in the future, but it is going to be more than a few years, especially if taxes are raised as much as is talked about in some circles. But just as in the late '70s, when the outlook was not very bright, things will change for the better. When asked back then where the new jobs would come from, the correct answer was "I don't know, but they will come."

It is the same today. There are whole new technologies and industries that are going to be created in the next decade. Entrepreneurs will respond with new innovations and businesses. Jobs that are not now on the horizon will spring up.

As a society, we are having to work through the excesses of a lifestyle that was propped up by ever-increasing debt and an out-of-control consumerism. That will happen in the fullness of time. But it WILL take time, and we need to adjust our expectations to account for that.

Over the next few weeks, I am going to drill down into the data to show why recovery will take longer and to help you withstand what will be an onslaught of out-of-control bullishness over data that is simply less bad. Let's start with a few easy targets.

The Three Amigos

In 2001, I wrote about what I called the Three Amigos that I watched to give us an indication of the direction of the economy. They were capacity utilization, high-yield bonds, and the (now-renamed) ISM numbers. Watching the direction they go gives us a good idea where the economy is headed. I have not written about them for years (as a trio), so let's revisit our old friends. We saw above that capacity utilization is still in a cliff dive. For there to be an actual recovery, we need to see capacity utilization start to climb back up. That is not currently a very positive indicator.

Credit Spreads - Bullish or Bearish?

A number of commentators have been effusive about how credit spreads have "come back in." And indeed, junk-bond yields have fallen. That is a good thing. Look at the graph below (courtesy of Tony Boehk).

Note that yields have simply come down to levels associated with recessions, and not with actual recovery. What happened last year is that junk-bond yields priced in Armageddon. Now they simply price in a recession and slow recovery. Could they improve more? Certainly. But the easy lifting is done. The direction is right. Let's see how they do the next few months. If those yields keep falling, that would be a very positive sign.

ISM - Is Less Bad That Good?

The Institute for Supply Management released their data for May, and again, commentators were enthusiastic about the increase in the manufacturing index. Green shoots and other signs and wonders were all over the media.

The ISM is a survey of manufacturers about how their businesses are doing. They are surveyed on ten criteria, like new orders, employment, inventories, backlog of orders, etc. (for the full report, you can go to http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942).

From these responses the ISM creates an index. An index number above 50 means that the manufacturing sector is growing, and below 50 means it is shrinking. At the web site above, you can get quite a bit of detail. It is quite true that we have come back from what was the lowest overall index number in 30 years. But we are simply back to the level that was the low in the previous two recessions. The ISM number is "less bad" and that is a good thing, but it is still a bad number. Yes, it is headed in the right direction. Let's look at the actual chart.

Of course, as businesses adjust to the new normal, whatever that level is, year-over-year comparisons will start to be positive. Simplistically, if a business makes 500 widgets a month and sales fall to 300, they will likely report falling production and rising inventories. Over time, inventories will finally settle out as management adjusts, and at some point inventories and production will (hopefully) start to rise. This gets reported as positive. The actual numbers may be down from the peak, but the direction of the company is once again on a positive slope.

When you look at the actual numbers comprising the release, the manufacturing part of the US economy is still contracting. Is it less bad than a few quarters ago? Yes, but it is still bad. The recent number is only slightly higher than the average for the last 12 months. We need this number to be above 50 to talk about an actual recovery in the here and now, as opposed to the future.

Contain Your Enthusiasm

Shipping containers moving into US ports rose by 2% in April, from March. That was cause for celebration in some circles. Buried way down, if mentioned at all, was the fact that compared to a year ago shipping is down 22%. And year-over-year comparisons have been worse for 22 months in a row. At some point, you get to a bottom. We find the new normal. But if the new normal is down 20%, that is a different-looking economy.

This quote came from good friend Dennis Gartman:

"'Stuff' moves by air when it is needed swiftly, but we can compare year-on-year data to get an idea of the relative weakness or strength of the economy. At the moment, the data is still very, very weak. According to the data reported out by the International Air Transport Association, after having touched just barely under $60 billion in '07 and '08, this year the IATA 'guesstimates' that only $40-$42 billion will move into the US.

"We are effectively back to the levels of '00-'04 and we are well below anything since '05. Having reached its worst year-on-year comparison back in December of last year when there was 23% air-transported cargo moving into the US from abroad, these yearly comparisons have remained about 20% lower since. Inventories of 'goods' on the nation's shelves remain high, and so long as that is true then we are going to see horrid, recessionary year-on-year comparisons in this very timely data."

Dennis also looked at rail shipments: "Since the start of this year this year, when the year-on year comparison was a relatively tepid -8%, the trend has been steadily 'from the upper left to the lower right' on the charts. By March, the year-on-year comparisons were averaging -15%. By April, -22%; by May -25%; and now, after a week or two of June, they are -26%. This is not a trend to be tampered with; this is a trend of some very real severity, and for now we fear that it is a trend rather firmly intact. Thankfully, it looks back, not forward; but if the past is prologue to the future, the future still looks rather bleak.

"Finally, there is a glimmering of hope on the rail horizon, and that is that the June figures, as they are compiled, are showing some signs of life. According to the AAR, 'freight traffic on US railroads during the week ended June 13 continued to show signs of gradual improvement ... [as] rail car loadings and intermodal were up from the previous week with carloads at their highest level in 10 weeks.'"

Welcome to the new normal. It is a quite distinctively different world than that of 2006. Global trade is off 10% and there is outright deflation in many places. We will have lots of data to look at over the next few weeks as we explore the new normal, but that is enough for today.

Oh, I almost forgot. The asterisk on "This Time It's Different*"? Human nature hasn't changed. We are still driven by fear and greed. The business cycle has not been repealed. Free-market capitalism will get us back (with a few new rules of engagement). What's different will be the nature of this recovery. All the other eternal truths will remain.

London, The Baltics, and Rome

I leave for London in mid-July and will co-host CNBC Squawkbox from 7-9 AM on Friday, July 17. Then the plan was to go to Eastern Europe. Things have changed, and now I am thinking of doing a tour through the Baltics, starting with Finland, then going down through the three Baltic nations, maybe a side trip to St. Petersburg, and then end up in Rome for a few days. That should be a fun vacation. We will see how much I can really pack in! But I do love to go to new places and meet new friends.

It is Father's Day weekend and all seven kids are in. The house is full. Tomorrow night we all go to see the new grandchild. Brunch on Sunday. The US Open at the Black. This weekend just can't hardly get any better. I may do my part to help the economy and go get the new Apple iPhone. My youngest son's phone broke, and my excuse is that I can give him mine and the new one then only "really" costs me $100. Consumer spending is not dead yet, to judge from the lines. But technology is a necessity, I keep telling myself.

Have a great weekend. I hope you enjoy yours as much as I am going to enjoy mine.

Your still missing his own dad analyst,

John Mauldin

The New, New Normal

John Mauldin — Sat, 06 Jun 2009 01:08:43 GMT

The New, New Normal
A Different Perspective on Health Care
Staying Rich in the New Normal
Eastern Europe, Maine and Tulsa

We are coming to a critical inflection point, perhaps the most critical point that we have had in 70 years for the US and to a great extent the global economy. The choices we make (or that Congress and the Fed make for us) will affect not just our investment portfolios but business and our jobs for a very long time. Last week I talked about the three paths we face as a nation. I want to go back to that theme and expand upon it. You need to clearly understand what the risks are so that you can interpret the actions and data that will be coming at us in the next few quarters. I am feeling a little tired today, so I am going to take the liberty to reproduce Bill Gross's latest comments as well, which are somewhat in line with my own.

A Different Perspective on Health Care

But before we jump into the letter, I want to acknowledge the very large response I got from readers about the cut and paste I did about the differences between the national health care systems of Canada and Great Britain the health care system of the US. To say that I touched a raw nerve is an understatement. I should also admit that I learned a great deal from some very cogent and thoughtful letters. I often write about the problems with using selective statistics in gauging the economy. I have learned that you can do the same with health care statistics.

There are many letters I could quote, but let me give you a counter for the statistics from last week from Raoul Pal of Spain. And of course, there are other statistics that can be brought in to make almost any case you want. But I found these to be very thought-provoking.

"Using the Economists World in Figures I think there is a very interesting and maybe appalling story to tell. In its simplest terms a healthcare system is there to extend the longevity of live of the population. It is the single best and simplest way to judge it because we can all find examples of where one country is better than another but the longevity stats don't lie. When we use that framework the picture is incredibly different. The US has many of the best doctors and medical care in the world but it doesn't work for the population as a whole and therein lies the problem.

"According to the Economist the total US spend on healthcare is 15.4% of GDP including both state and private . With that it gets 2.6 doctors per 1,000 people, 3.3 hospital beds and its people live to an average age of 78.2

"UK - spends 8.1% of GDP, gets 2.3 doctors, 4.2 hospital beds and live to an average age of 79.4. So for roughly half the cost their citizens overall get about the same benefit in terms of longevity of life.

"Canada - spends 9.8% of GDP on healthcare, gets 2.1 doctors, 3.6 hospital beds and live until they are 80.6 yrs

"Now if we look at the more social model in Europe the results become even more surprising:

"France - spends 10.5%, 3.4 docs, 7.5 beds and live until they are 80.6

"Spain - spends 8.1% , 3.3 docs , 3.8 beds and live until they are 81

"As a whole Europe spends 9.6% of GDP on healthcare, has 3.9 doctors per 1,000 people, 6.6 hospital beds and live until they are 81.15 years old.

"The list goes on. The truth is that in many cases as is pointed out the healthcare system is better in the US than in some other countries BUT US citizens must therefore get ill more often than any other country in the West in order to achieve the truly appalling statistic that they are the 41 longest living nation on earth with France, Spain, Norway, Switzerland, Italy, Austria, Andorra, Holland, Greece and Sweden all featuring in the top 20 longest living nations and the UK and Germany at 22.

"This is the big failure of the US system. It is unforgivable. You may get a better chance of recovering from certain diseases but as a whole you will die younger in the US than most developed countries. ... Something is severely broken."

I had many letters from all over the world on this issue both pro and con. And some very lively discussions with health professionals. One pointed out to me that the uninsured in the US when they need a doctor often go to an emergency room for what should be a $50 office visit and end up with a $5,000 bill, which does not get paid and runs up insurance costs for those who do have it. As Dr. Mike Roizen points out in his many books, simply eating right, exercising and other common sense things would cut out much of our health care costs. When one-third of children in elementary schools are overweight, we need to get a grip on what we are doing to the next generation.

In the US, many of us are worried about government rationed health care. Others are worried that they have no access to health care at all. It is a very complicated issue. Let's hope that whatever Congress does really does help. And that the coming revolution in new medicines and procedures gets here as soon as it can for all of us. And now to this week's main story.

The New, New Normal

Last week I outlined three possible paths for the economy based upon the political choices we make about the budget deficits.

First, there is the benign path, where we more or less roll back the Bush tax cuts, and do not increase spending for new programs. The fiscal deficit falls into a manageable range. We repeat the Clinton years where spending is help below increase in revenue so that over time the budget gets balanced. While a large tax increase would have negative consequences for the overall economy, it is far better than the other two paths strictly from the perspective of growing the economy as much as possible. This path also has a very small probability.

The second path is that the Obama budget is passed, the Bush tax cuts go away and we have a decade of projected trillion dollar deficits. By the way, those deficits assume 3% growth rates, low unemployment, low interest rates and very large health care savings, and a withdrawal from Iraq and Afghanistan. The deficits are likely to be MUCH larger then the CBO forecasts. This on top of exploding entitlement expenditures in the middle of the next decade, which are underscored in the opinion of more conservative analysts (including me).

The third path is the same as above expect that large new taxes are passed in order to bring the deficit to a manageable size relative to the growth of GDP. This means that a tax increase over and above those projected by the Obama administration of around $700 billion a year (about 5% of GDP!). Deficits would still be in the $3-400 billion range, but from a funding perspective, it could be done.

The second path is one that will end in heart ache. I do not think that the world or even US investors can buy multiple trillions of dollars of debt for more than a few years without rates rising significantly. That, as Gross points out, will affect both businesses and mortgage borrowers. It is a disastrous train wreck.

The third path is the more likely. I think (hope?) there are enough economically conservative Democratic that will realize the problems of trillion dollar deficits. But they do want a fully nationalized health care, and thus they will pass enough in taxes to pay for it. If they are going to do it, this is their one chance, as Republicans are likely to do better in the 2010 elections and get enough votes to push back any real tax increases other than letting the Bush tax cuts expire.

As outlined last week, it will be a combination of a VAT and taxes on health benefits. There is no other real source for the massive amounts of money needed. It will be a disguised tax on the middle class.

I do not believe they will want to wait until 2010 and an election year. Passing such a huge tax increase is very problematical from the standpoint of a growing economy. It will almost surely put us back into a recession. But it will not be a train wreck. As investors and businesses, we can survive and figure out how to deal with the realities of the new, new normal economy. It will be one in which growth is lower than what we are used to and unemployment is higher. Think Europe.

It will be difficult to ever go back. Perhaps new technologies and industries can develop and help get us back on a path to higher growth later in the next decade. We did survive the 70s, after all.

Now, let's turn to this latest column from Bill Gross, Managing Director of PIMCO. Next week I hope to be back to full speed.

Staying Rich in the New Normal

By Bill Gross

"Behind every great fortune lies a great crime."
Balzac

Balzac was on to something 200 years ago, but to be fair to modern day multi-millionaires, the only real way to accumulate wealth prior to the 18th century was to steal it, or tax it, I suppose, as was the case with kings and their royal courts. It was only with the advent of capitalism and annual productivity gains that entrepreneurs, investors, and risk-takers with luck or pinpoint-timing could jump to the head of the pack and accumulate what came to be recognized as a fortune. Still, the negative connotations persist. I remember a cocktail party in the early 80s where a somewhat inebriated guest engaged me in a debate about the merits of capitalism. "You're filthy rich," he said, which struck me as most unfair from a number of angles. First of all, he hadn't seen anything yet, I thought, and second, I wasn't quite sure where the "filthy" came from. Resentment that he'd missed out on my presumed good deal, I suppose, and in the process using a hackneyed phrase that was bitter and biting, yet had some context of historical sociological relativity. Still, he might have been on to something there - not about me, hopefully, because I've always felt that while PIMCO has prospered, it's only because its clients have benefitted even more so - but about the developing sense of one-sided, perhaps off-sided wealth generation that was to dominate the next several decades. Granted, we had Bill Gates and Steve Jobs and other true capitalistic dynamos who benefitted society immeasurably. But growing percentages of fortunes were being made by those who could borrow or aggregate other people's money. Because our economy was still in a relatively early stage of leveraging, those who borrowed money and used it to invest in higher-risk yet higher-return financial or real assets didn't require a lot of skill, they just needed to be able to convince a bank or an insurance company to lend them some money. After that, the secular wave of leverage would be enough to multiply their meager equity many times over and carry them to a beach where a fortune awaited them much like a pirate's buried treasure.

I remember as a child my parents telling me, perhaps resentfully, that only a doctor, airline pilot, or a car dealer could afford to join a country club. My how things have changed. Now, as I write this overlooking the 16th hole on the Vintage Club near Palm Springs, the only golfers who shank seven irons into the lake are real estate developers, investment bankers, or heads of investment management companies. The rich are different, not only in the manner intoned by F. Scott Fitzgerald, but also in who they are and what they do for a living. Whether some or all of them are filthy is a judgment for society and history to make. Of one thing you can be sure however: over the next several decades, the ability to make a fortune by using other people's money will be a lot harder. Deleveraging, reregulation, increased taxation, and compensation limits will allow only the most skillful - or the shadiest - into the Balzac or Forbes 400.

Readers who are interested in such things as the Forbes annual list of hoity-toities will have noticed that more and more of them are global, not U.S. citizens. The U.S., in other words, is not producing as much wealth in proportion to the rest of the world. Its fortune-producing capabilities seem to be declining, which might suggest that its relative standard of living is doing so as well. If so, the implications are serious, not just for Donald Trump but for wage earners and ordinary citizens, as reflected in their income levels and unemployment rates. Stockholders, 401(k) investors, and yes, bond managers will be affected too. Last week's furor over the possibility of an eventual downgrade of America's AAA rating demonstrates that only too clearly. On the night of May 20, Standard & Poor's announced a downgrade watch for the United Kingdom and since the U.S. and U.K. are Siamese-connected, financially-levered twins, the implications were obvious: the U.S. might be next. In the space of 48 hours, the dollar declined 2%, and U.S. stocks and long-term bonds were down by similar amounts. Such a trifecta rarely occurs but in retrospect it all made sense: a downgrade would cast a negative light on the world's reserve currency, and since stocks and bonds are only present values of a forward stream of dollar-denominated receipts, they went down as well.

The potential downgrade, while still far off in the future in PIMCO's opinion, seemed dubious at first blush. While country ratings factor in numerous subjective qualifications such as contract rights, military might, and advanced secondary education, the primary focus has always been on the objective measurement of debt levels, in this case sovereign debt, as a percentage of GDP. Yet, as shown in Table 1, both the U.S. and the U.K. entered the Great Recession with attractive ratios compared to such grievous offenders (and AA rated) as Japan.

Yet as the markets recognized rather abruptly last week, both countries seem to be closing the gap in record time. To zero in on the U.S. of A., its annual deficit of nearly $1.5 trillion is 10% of GDP alone, a number never approached since the 1930s Depression. While policymakers, including the President and Treasury Secretary Geithner, assure voters and financial markets alike that such a path is unsustainable and that a return to fiscal conservatism is just around the recovery's corner, it is hard to comprehend exactly how that more balanced rabbit can be pulled out of Washington's hat. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America's debt to GDP level to over 100%, a level that the rating services - and more importantly the markets - recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes as heavy as those "sixteen tons" in Tennessee Ernie Ford's famous song of a West Virginia coal miner. "You load sixteen tons and whattaya get? Another day older and deeper in debt." Pretty soon you need 17, 18, 19 tons just to stay even and that describes the potential fate of the United States as the deficits string out into the Obama and other future Administrations. The fact is that supply-side economics was a partial con job from the get-go. Granted, from the 80% marginal tax rate that existed in the U.S. and the U.K. into the late 60s and 70s, lower taxes do incentivize productive investment and entrepreneurial risk-taking. But below 40% or so, it just pads the pockets of the rich and destabilizes the country's financial balance sheet. Bill Clinton's magical surpluses were really due to ephemeral taxes on leverage-based capital gains that in turn were due to the secular decline of inflation and interest rates that at some point had to bottom. We are reaping the consequences of that long period of overconsumption and undersavings encouraged by the belief that lower and lower taxes would cure all.

The current annual deficit of $1.5 trillion does not even address the "pig in the python," baby boomer, demographic squeeze on resources that looms straight ahead. Private think tanks such as The Blackstone Group and even studies by government agencies, such as the Congressional Budget Office, promise that Federal spending for Social Security, Medicare, and Medicaid will collectively increase by 6% of GDP over the next 20 years, leading to even larger deficits unless taxes are increased proportionately. Collectively these three programs represent an approximate $40 trillion liability that will have to be paid. If not, you can add that present value figure to the current $10 trillion deficit and reach a 300% of GDP figure - a number that resembles Latin American economies such as Argentina and Brazil over the past century.

So the rather conservative U.S. government debt ratio shown in Table 1 will likely be anything but in less than a decade's time. The immediate question is who is going to buy all of this debt? Estimates suggest gross Treasury issuance of up to $3 trillion this calendar year and net offerings close to $2 trillion - almost four times last year's supply. Prior to 2009, it was enough to count on the recycling of the U.S. trade/current account deficit to fund Treasury borrowing requirements. Now, however, with that amount approximating only $500 billion, it is obvious that the Chinese and other surplus nations cannot fund the deficit even if they were fully on board - which they are not. Someone else has got to write checks for up to $1.5 trillion additional Treasury notes and bonds. Well, you've got the banks and even individual investors to sponge up some of the excess, but a huge, difficult to estimate marginal supply will have to be bought. The concern is that this can be accomplished in only two ways - both of which have serious consequences for U.S. and global financial markets. The first and most recent development is the steepening of the U.S. Treasury yield curve and the rise of intermediate and long-term bond yields. While the Treasury can easily afford the higher interest expense in the short term, the pressure it puts on mortgage and corporate rates represents a serious threat to the fragile "greenshoots" recovery now underway. Secondly, the buyer of last resort in recent months has become the Federal Reserve, with its publically announced and near daily purchases of Treasuries and Agencies at a $400 billion annual rate. That in combination with a buy ticket for over $1 trillion of Agency mortgages has been the primary reason why capital markets - both corporate bonds and stocks - are behaving so well. But the Fed must tread carefully here. These purchases result in an expansion of the Fed's balance sheet, which ultimately could have inflationary implications. In turn, nervous holders of dollar obligations are beginning to look for diversification in other currencies, selling Treasury bonds in the process.

The obvious solution to both dollar weakness and higher yields is to move quickly towards a more balanced budget once a sustained recovery is assured, but don't count on the former or the latter. It is probable that trillion-dollar deficits are here to stay because any recovery is likely to reflect "new normal" GDP growth rates of 1%-2% not 3%+ as we used to have. Staying rich in this future world will require strategies that reflect this altered vision of global economic growth and delevered financial markets. Bond investors should therefore confine maturities to the front end of yield curves where continuing low yields and downside price protection is more probable. Holders of dollars should diversify their own baskets before central banks and sovereign wealth funds ultimately do the same. All investors should expect considerably lower rates of return than what they grew accustomed to only a few years ago. Staying rich in the "new normal" may not require investors to resemble Balzac as much as Will Rogers, who opined in the early 30s that he wasn't as much concerned about the return on his money as the return of his money.

I want to emphasize that we will get through all this, one way or another. Some paths will make it easier than others. But it is very important that you understand what the options are, and build a game plan to deal with them. Over the next few months, I will spend some writing time going into some ideas.

Eastern Europe, Maine and Tulsa

For the next month I will actually be home, then in mid-July off to London and I think Eastern Europe. I am reading through some old International Living issues to help me decide where to actually go. For those with an interest in living in another country, or just like to dream, you should check it out. It is a lot of inexpensive fun. To learn more click here: https://www.web-purchases.com/ILV/LILVK5E1/landing.html

Then Maine in August with my youngest son, and of course Tulsa for Amanda's wedding August 22.

As noted above, I am a little out of sorts, but expect to be back in full swing soon. Have a great week.

Your hoping we can at least Muddle Through analyst,

John Mauldin

This Way There Be Dragons

John Mauldin — Sat, 30 May 2009 04:02:58 GMT

This Way Be Dragons
A Housing Update
More Prime Foreclosures In Our Future
Are We Paying Too Much for Health Care?
Naples, London, and Home for June

In fantasy novels the intrepid heroes come across a sign saying "This Way Be Dragons." Of course, they venture on, facing calamity and death, but such is the nature of fantasy novels. We live in a very real world, and if we don't turn around there will be some very nasty dragons in our future. This week we look at three possible paths we can lead the world down. We then review a number of charts and data on the housing market.

If you just read the headlines on this week's data, you could be forgiven for assuming the worst is over -- not. And then finally we look at some rather stark comparative data on the health-care systems of the US, Canada, and Great Britain. Everyone knows the US pays way more in terms of GDP than the latter two countries. Are we getting our money's worth? There is a lot to cover, and I hope to finish this on a flight to Naples, so let's jump right in.

This Way Be Dragons

More and more we read about the growing concern over $1-trillion-dollar deficits. Stanford professor John Taylor (creator of the famous Taylor Rule) jumped into the debate with a rather alarming op-ed in the Financial Times this week, echoing much of what I wrote last week, but with some real insights into what trillion-dollar deficits mean. Quoting:

"I believe the risk posed by this debt is systemic and could do more damage to the economy than the recent financial crisis. To understand the size of the risk, take a look at the numbers that Standard and Poor's considers. The deficit in 2019 is expected by the CBO [congressional Budget Office] to be $1,200bn (€859bn, £754bn). Income tax revenues are expected to be about $2,000bn that year, so a permanent 60 per cent across-the-board tax increase would be required to balance the budget. Clearly this will not and should not happen. So how else can debt service payments be brought down as a share of GDP?

"Inflation will do it. But how much? To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling of prices. That 100 per cent increase would make nominal GDP twice as high and thus cut the debt-to-GDP ratio in half, back to 41 from 82 per cent. A 100 per cent increase in the price level means about 10 per cent inflation for 10 years. But it would not be that smooth -- probably more like the great inflation of the late 1960s and 1970s with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession."

You can read the rest at (http://www.ft.com/cms/s/0/71520770-4a2c-11de-8e7e-00144feabdc0.html?nclick_check=1)

While Obama gives lip service to cutting the deficit in half, his actual budget increases it over the next 10 years. As I have been writing for some time, this is a very dangerous path. And it is one that the bond market seems to be concerned about, as interest rates are rising, even on mortgages that the Federal Reserve is buying in massive quantities in its effort to hold down rates and stimulate the housing market.

"The good news," Taylor concludes, "is that it is not too late. There is time to wake up, to make a mid-course correction, to get back on track. Many blame the rating agencies for not telling us about systemic risks in the private sector that lead to this crisis. Let us not ignore them when they try to tell us about the risks in the government sector that will lead to the next one."

Taylor is right that the massive tax increases necessary to fund these deficits and programs should not happen. But it is not clear to me that they won't. A Democratic Congress is talking of adopting John McCain's plan to tax health-care benefits. While this would be a tax on the middle class (on everyone) that Obama said he would not do, he is clearly willing to sign a bill that has such a tax.

The administration is starting to float trial balloons about a new VAT, or value-added tax. Many of my non-US readers will be familiar with VAT taxes, especially in Europe. A combination of a VAT and taxing health-care benefits would raise enough to get us to a deficit of "only" a few hundred billion. Take away the Iraq war and you get even closer. You can make an economic case that a VAT tax would be preferable to an income tax.

However, the administration is not talking about a substitute but an additional tax. There is momentum in the heavily Democrat-controlled Congress for large new health-care programs. While there is resistance to large deficits on the part of a few moderate Democrats, there is a chance they could be brought on board with a tax or a series of new taxes that would offer the potential to pay for the new programs. (Even though everyone knows that the cost overruns on new health-care benefits will be much larger than estimated.)

As much as it grieves me to say it, a tax on health-care benefits or a VAT tax large enough to hold the proposed deficits to something under 3% of GDP would be preferable to running decade-long trillion-dollar deficits, which would destroy the US economy and the dollar and do severe damage to the world economy. (For the record, I am assuming the Bush tax cuts are history.)

But while a large tax increase would keep the economy from crisis and collapse, it is not without very serious consequences. It will put a serious crimp in economic growth. It will lock in European growth rates and European-like unemployment rates. And we will be using those tax increases to fund new spending and will still not have solved the future problems with Social Security and Medicare, which are going to require massive increases in spending in another 5-7 years. Which of course means that either a cut in benefits or another round of growth-crippling tax hikes is down the pike.

A third path would be to simply go ahead and raise taxes on the rich, say no to increased spending on programs until we can afford them, hold the line on any new spending, and see if we can reintroduce the gradual budget control that was the result of the stand-off (and to some extent cooperation) between Gingrich and Clinton.

I put about a 5% probability on the third scenario happening. Better than the chances of a snowball in hell, but not much. The first disaster scenario is about a 35% probability, which is quite scary. If we do choose such a path, then short the dollar, buy gold, and invest abroad. It will be a very tricky and difficult environment.

I assign a 60% probability to the middle path. Maybe it's my basically optimistic nature and I am simply being naive, but I am hopeful that cooler heads will prevail and we will not run continual massive deficits larger than the growth of GDP. While that means rather large tax increases, since the current leadership wants to create massive new health-care entitlements and will do so, I would rather have to simply overcome higher taxes in my business rather than deal with a collapse of the dollar, high unemployment, high interest rates, and an extremely sluggish economy.

Each scenario will create a different investment environment. Ironically, the middle scenario could be good for the dollar over the long term. But it will be hell on corporate profits from US sources. Given the above, it seems like a 95% chance that we should start looking at investing a significant percentage outside of the US and Europe. Think Canada, Australia, Asia (not Japan), Brazil, South Africa, etc.

Normally, politics does not have all that much of an impact on the stock market. As an example, both Democrats and Republicans can take credit for the '90s, but it was really the dynamic of the free market that worked in spite of government. Same for the Bush years. While the tax cuts did help, it was the free market and increasing leverage that were the dominating factors.

This time it will be different. The choices we make as to how to fund, or not fund, the increases in spending that are our clear and sad destiny, will have a major impact on not just the US but the world economy. As US consumers have been a major part of the growth of the developing world, and especially Asia (China), a slowing of consumption in the US will mean a very slow recovery for the rest of the world. It will happen, but the choices made by politicians this year will have many unintended consequences. Just as deciding we would take a major part of the corn crop and turn it into expensive ethanol raised the price of tortillas in Mexico, raising taxes in the US will mean lower global consumer spending and trade. It is a very tangled web we weave.

A Housing Update

If you read the headlines the last few days you would think that the housing market has turned. Mostly they read something like "Home Sales Rise 0.3%," and of course the reflexive bulls started talking about green shoots and a bottom in housing. And while someday we will actually have a bottom in housing, it will not be this month. It has been awhile since we have looked at the housing market, and it is time to review.

First. Of course home sales rose. It is April. Look at the graph below. It is the time of the year when home sales rise. And 0.3%? Really? The margin of error is close to plus or minus 10% or so, so 0.3% is a meaningless number. It will be revised. Who knows which way? I don't. (I am on the plane so I cannot access the exact margin of error, but 10% is not that far off.)

My main thesis since 2006 has been that the housing market was in a bubble that would burst. We built something like an extra 3 million homes over trend growth, and those homes are going to have to be absorbed in the normal way, through growth of population and the economy. We "need" about 1 million new homes a year to take care of population growth and demand. Further, we have cut off home availability to buyers who are in the subprime category, whereas during the boom you simply had to have a pulse, even a lying pulse, to get a home for which you did not have a chance of actually paying the mortgage.

The earliest we see a real bottom to housing is late 2010 or 2011. By real bottom I am talking about housing values in general being to rise (assuming we do not visit scenario one and have significant inflation.) There is nothing that can be done about that. We have to work through the excess capacity. (More later on that below.)

We had the Case-Shiller home price data come out this week. Home prices are still in free fall. They are down almost 19% year over year and 32% from their 2006 highs (see chart below). If we get back to the long-term price growth trend, we would see another average 10% drop; and as prices tend to overshoot on the upside and the downside, in some markets they could fall even further.

Yet there is hope that we will not see a fall below trend. Housing in many areas is starting to once again become affordable (see chart from Moody's below) to more and more Americans and even first-time home buyers. The cure for the housing crisis is actually lower prices, as that brings more and more potential home buyers into the market. While housing sales are still quite depressed, what are selling are homes in foreclosure, as buyers perceive that there are bargains. And they are right.

On the negative side, the supply of homes available for sale is again rising, as more and more foreclosures come onto the market. And as we will see, this foreclosure trend is going to slow down soon. (Thanks to Greg Weldon at www.weldononline.com for the chart.)

Notice in the above chart that the supply of homes for sale is over ten months. But that average can be misleading. If you are in Florida, I read recently that in many areas it is over 40 months. And that is for homes that can be financed with government-sponsored "conforming loans," typically up to $719,000. But what if your home cost more than that? National Association of Realtors chief economist Lawrence Yun said that the supply of existing homes for sale over $750,000 has reached a forty-month supply.

Diana Olick, the very on-top-of-it CNBC real estate reporter, had the following to say (emphasis mine).

"That's going to mean a new phase of the current housing recession. So far we've seen the 'correction' of a boom market that was driven by faulty, exotic loan products, investors looking to make a quick buck, and average Americans using their homes as ATMs. Now the losses are being driven by traditional economic factors and by sweeping price drops across the nation.

"Yesterday Fitch ratings estimated that up to 75 percent of the modifications now being done through the administration's Making Home Affordable program will re-default in six months to a year. I'm not talking about the old modifications, which were largely repayment plans that could actually raise monthly payments. I'm talking about the new mods, which lower monthly payments to 31 percent of a person's income. I couldn't understand Fitch's reasoning, so I called them.

"Diane Pendley, managing director at Fitch, said the problem is not on that "front-end" ratio, but on the back end, which is all of the borrowers other debt (credit cards, car loans, student loans, etc.). She said that in talking with servicers, she's hearing other debt is so high that most of today's troubled borrowers cannot afford any loan payment at all, even at a very modest debt-to-income ratio. 'Just getting the house payment done doesn't mean their lifestyle is sustainable,' she said.

"Another problem is that with home prices continuing to fall, more and more borrowers, who are essentially just renting their mortgages now because they will never see any home equity, are walking away. Even if the mortgage payment is low, the property taxes and home maintenance costs are padding that payment, and without an upside to the investment, there's simply no reason to pay. Suffice it to say, the foreclosure crisis, on the high and low ends, is not getting any better."

And it gets worse.

More Prime Foreclosures In Our Future

The Mortgage Bankers Association noted that a record 12%, or 1 in 8 homeowners, in the US are now behind on their payments or in foreclosure. 10.6% of the mortgages in Florida are now somewhere in the process of actual foreclosure. (My seatmate here on the flight says the prices on the condos where he lives are now back to 1998 levels. It would be scary, he said, if you had to sell. There are new developments that only have 10% actual occupancy, as the bulk of the condos were bought for speculation. Now those 10% of buyers are having to shoulder all the fees for upkeep. Nobody will buy, because the upkeep costs can be more than the mortgage. It is a vicious cycle.)

In Nevada foreclosures are 7.8%, Arizona 5.6%, and California 5.2%. 25% of subprime loans are now in foreclosure, 14% of FHA (government, taxpayer-guaranteed) loans and a growing 6% of all prime loans are now in foreclosure. (Note: the seasonal adjustments may overstate the actual numbers, as we are in new territory in terms of actual foreclosures.) Quoting from the MBA press release:

"In looking at these numbers, it is important to focus on what has changed as well what continue to be the key drivers of foreclosures. What has changed is the shifting of the problem somewhat away from the subprime and option ARM/Alt-A loans to the prime fixed-rate loans. The foreclosure rate on prime fixed-rate loans has doubled in the last year, and, for the first time since the rapid growth of subprime lending, prime fixed-rate loans now represent the largest share of new foreclosures. In addition, almost half of the overall increase in foreclosure starts we saw in the first quarter was due to the increase in prime fixed-rate loans." (emphasis mine)

How could so many prime loans be in foreclosure? These were people with good credit and jobs. The answer is the very deep and lengthy recession, coupled with high and rising unemployment. The number of foreclosures will not abate until unemployment starts to fall. And even optimistic forecasts assume unemployment will keep rising into 2010. As I have written for a long time, I think it is quite likely that we will see unemployment rise to over 10%. When I first wrote that a few years ago, many called me just another doom and gloom guy. Now, many think I am Pollyanna. Such is the life of those who believe in Muddle Through.

For those who think the end of the recession will be like all past recessions, the problems in the housing market should make for serious concern. As we will see on Monday in my Outside the Box, the average homeowner with a mortgage has very little, if any, equity. There is little room for home equity withdrawals -- if banks were lending. And recent data shows a very serious and un-American-like drop in credit card borrowing. US consumers are retrenching, and global trade figures echo that.

We are in for a slow, Muddle Through recovery, with the real potential to slip back into recession when the tax increases hit. Stay tuned.

Are We Paying Too Much for Health Care?

I want to pass on this quick note from Dennis Gartman's eponymous letter. It should give all of those who favor a nationalized healthcare system pause, before they jump right in. Quoting Dennis:

"Canada is a wonderful place to have a nasty gash on one's forehead stitched, or to break one's nose in a game of pick-up baseball; but have cancer, or need eye surgery, or want an MRI, and the business of medicine in Canada and/or the UK breaks down badly in favour of medical care here in the US. For example... and we wish to thank The Investor's Business Daily for the data noted here this morning...

"... here in the US men and women survived cancer at an average of just a bit better than 65%. In England only 46% survive. In the US, 93% of those diagnosed with diabetes receive treatment within six months; in Canada only 43% do, and in the UK only 15% do! For those seniors needing a hip replacement and getting one within six months, 15% get it done in the UK; 43% get it done in Canada ... and in the US 90% do! For those waiting to see a medical specialist, 23% of those in the US get in within four weeks, while 57% in Canada have not yet done so, and in the UK 60% are still waiting after four weeks.

"When it comes to proper medical equipment, in the US there are 71 MRI or CT scanners available per million people. In Canada there are but 18, and in the UK there are only 14! Ah, but the best figure of all is this: 11.7% of those 'seniors' in the US with 'low incomes' say they are in excellent health, which in and of itself sounds rather low ... rather disconcerting ... and an indictment of the system itself, doesn't it? But in Canada only 5.8% do!

"Yessiree bob, ya' jus' gotta' luv that collectivized, socialized medical care! Let's all go break a collective arm and enjoy the benefits of socialized medicine in the Commonwealth! (Canada) ... but heaven help you if you've got something really, really wrong. If that's the case, you'll be running south to the border faster than you can reach a specialist anywhere in Canada; of that we are certain."

Do we pay too much for health care here in the US? Everyone says yes. And there is a lot of waste (and waist) in the system. But if you are the person who needs treatment, maybe the answer is "not really." If you can't get the medical help you need when you need it, maybe the fact that it is theoretically free doesn't mean anything.

As an aside, I have two friends who have had immediate family members diagnosed with Lou Gehrig's Disease. For all practical purposes, it is a death sentence. Yet one family was told (at a top-five cancer hospital) there could be a cure within a few years, or at least clinical trials. But just not now. Unfortunately, the prognosis is less than a year.

I can guarantee you, if that was me or my family, I would like to be able to make the decision whether to try a radical treatment. What's my downside if I die a little earlier? Shouldn't that be my choice?

And if I don't want some nameless bureaucrat dictating who gets to live or die in the name of his scientific system, why in God's name would I want a bureaucrat deciding to ration my access to health care? But that is what the majority in Congress are planning for our future. And bluntly, I find that far harder to swallow than my taxes going up.

Naples, London, and East Europe

I am literally in the taxi in Naples as I finish this letter (even for me, this is a first). I am supposed to go right into meetings when I arrive. Ground zero for the housing crisis. But it is still a pretty city. Hopefully I can get out and do a little power walking on the beach tomorrow. I am looking forward to being with good friend and fellow writer Gary Scott and business partner Steve Blumenthal, as well as my friends from Jyske Bank.

The schedule says I am home all of June. Then I am off to London in the middle of July for my partner Niels Jensen's 50^th birthday, and then a vacation to far Eastern Europe. Thanks to everyone who wrote with suggestions and offers to help.

School is just about over for youngest son Trey, and we have been spending a lot of time reviewing material for his finals (with some success!) But then you get a call from the vice principal. Seems there was a little trash talk and the other (bigger) kid hit first, and then ... "Really, Dad, it wasn't my fault. This is just so stupid." Well, you know how that goes. (Trey is fine.) After seven kids, I should get used to the regular surprises. Well, there is always next year to teach him how to avoid bullies. (Which of course Dad was soooo good at.)

It is time to hit the send button. We are pulling up to the resort. I have a good feeling about this summer. It will be busy (what else is new?), but I think it will be fun. Have a great first week of summer!

Your real life just keeps on coming at you analyst,

John Mauldin

The Paradox of Deficits

John Mauldin — Sat, 23 May 2009 20:44:50 GMT

Things That Go Bump in the Night
A Trillion Dollars as Far as the Eye Can See
The Global Recession Gets Worse
Where Will the Money Come From?
The Paradox of Deficits
Naples, London, and Eastern Europe

From ghoulies and ghosties

And long-leggedy beasties

And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

There is something that is bumping around in my worry closet. The bond market is not behaving as if there is deflation in our future, and the dollar is getting weaker. Unemployment keeps rising, but most of all, the US government deficit looks to be spinning out of control. This week we look at all of this and take a tour around the world to see what is happening. There is a lot of interesting material to cover.

But first, I am proud to announce that thanks to your donations the net proceeds from the Richard Russell Tribute Dinner totaled $17,000! A donation was made in that amount to the Autism Society of America, San Diego County Chapter, in Richard Russell's name.

The evening was captured in both video and photographs, and we would like to share those with you. We have put together a DVD that captures all the wonderful moments, including tributes from Richard's longtime friends and family, an entertaining skit by Richard's daughter Daria, and another touching tribute by Richard's daughter Betsy. Perhaps the best speech, however, came from Richard himself -- which is of course included on the video. For those who could not attend in person, we have already made copies of the video and will mail it to you as soon as you order it. The cost is $29.95, and that includes shipping. You may order as many copies as you like.

To order the video, please visit: http://www.johnmauldin.com/russell-tribute-dvd.html

The photographs were placed on Shutterfly, an online gallery where you may view them and choose the ones you would like to order. We have created a web page specifically for these photos. To access that page, please use this link: http://richardrusselltributedinner.shutterfly.com or you can link from the page above. Now, let's jump right into the letter.

A Trillion Dollars as Far as the Eye Can See

As of this week, total US debt is $11.3 trillion and rising rapidly. The Obama Administration projects that to rise another $1.85 trillion in 2009 (13% of GDP) and yet another $1.4 trillion in 2010. The Congressional Budget Office projects almost $10 trillion in additional debt from 2010 through 2019. Just last January the 2009 deficit was estimated at "only" $1.2 trillion. Things have gone downhill fast.

But there is reason to be concerned about those estimates, too. The CBO assumes a rather robust recovery in 2010, with growth springing back to 3.8% and then up to 4.5% in 2011. Interestingly, they project unemployment of 8.8% for this year (we are already at 8.9% and rising every month) and that it will rise to 9% next year. It will be a strange recovery indeed where the economy is roaring along at 4% and unemployment isn't falling. (You can see their spreadsheets and all the details if you take your blood pressure medicine first, at www.cbo.gov.)

Just a few quick thoughts. This year the proposed administration plan is to borrow 50% of every dollar spent. The CBO projects than nominal GDP will grow by about 50% over the next 10 years (which is historically reasonable), but also that revenues will double, which suggests massive tax increases in relation to GDP. Interestingly, the International Monetary Fund says growth next year will be tepid at best (more below). The deficit in 2010 is almost 10% of GDP. The average proposed deficit is almost a $1 trillion average for the next ten years. Ten years from now, the deficit is projected to be $1.2 trillion. And that is if government costs do not go up and inflation only averages 1.1% for the next six years.

The Global Recession Gets Worse

Let's take a quick trip around the world. In the first quarter, the German economy fell by 14%, Japan by 15%, Mexico by 21%, and England was down almost 8%.

Global trade is simply collapsing. The chart below is the ugliest it has ever been. Chinese exports are down 41%, Japanese exports down 38%, Germany's down by 32%, and so on. (chart courtesy of www.variantperception.com )

Let me quote from the very interesting study the team at Variant Perception did.

"As we have repeatedly said, Spain is set for a long, painful deflation that will manifest itself via a spectacularly high unemployment level, a real estate collapse and general banking insolvencies. Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That's almost 50% of Spanish GDP. Most of these loans will go bad.

"Spanish banks are now facing a very bleak outlook. Spain's unemployment rate reached over 17% last month; there are now four million unemployed Spaniards and over one million families with not a single person employed in the family. Spain and Ireland had the worst housing bubbles in the world and now Spain has as many unsold homes as the US, even though the US is about six times bigger.

"Why are Spanish banks not insolvent? Spanish banks are not marking their real estate loans to market. We've often wondered how it is that our thesis for Spanish real estate and industrial collapse has not created more victims. The answer is simple according to an article in Expansion, the Spanish equivalent of the Financial Times, from the 19th of April titled 'Spanish banks control half of all real estate appraisals.' You can't make this stuff up. We haven't even begun to see the worst in Spain yet."

European banks are in far worse shape than their US counterparts. That is because they utilize far more leverage, on an average about 30 times leverage. How can that be, in what is supposed to be a conservative industry?

"European banks were only restricted on the basis of risk-weighted assets, unlike the US where it is the total leverage ratio that matters, so most European banks bought assets that were rated by Moody's and S&P, who couldn't rate their way out of a paper bag, and for anything that wasn't highly rated, they bought credit default swaps or guarantees from AIG and MBIA. Because of that European banks were able to lever up a lot more than their US counterparties. Given the much higher leverage levels and general worsening of collateral values, we think that all the shoes in Europe have not dropped."

European banks have assets of about 330% of their GDP, compared to US banking assets, which are about 50%. They have over $700 billion in loans to Asian businesses (which are watching their exports collapse) and $1.3 trillion in loans to Eastern Europe, which is in a very serious recession, and so many of those loans are simply not going to be worth anything. Simply put, there is going to be a need for massive amounts of money to bail out European banks, or we'll watch their economies simply implode.

Where is the money for the bailouts going to come from? Germany? That will be a tough sell politically in a country that is in a much worse recession than the US. How do you tell your citizens you need to bail out banks in other countries with their tax dollars? Italian and Austrian banks are going to need a lot of capital, more than their governments can pay. It is going to be a very tough problem.

Governments around the world are responding to the global recession by running massive deficits. In addition to the US, the UK, Japan, Russia, Spain, and Ireland are all running deficits of over 10%.

And, as in the case of the US, these are not going to be one-time deficits. The IMF predicts that England will shrink again next year and the recovery in the US will be modest at best. The US economy is expected to grow by 0.2% (far from the optimistic projections of various US government agencies), the 16-nation eurozone will eke out a modest gain of 0.1%, and the Group of Seven (G7) leading industrial economies will, as a whole, only grow by 0.2 percent. They project that Japan's economy will stagnate next year.

Where Will the Money Come From?

And now let's look at what is bumping in my worry closet. The world is going to have to fund multiple trillions in debt over the next several years. Pick a number. I think $5 trillion sounds about right. $3 trillion is in the cards for the US alone, if current projections are right.

Just exactly where is that money going to come from? The US trade deficit is now down to under $350 billion a year. The Fed can monetize a trillion. Maybe. Look at the yield curve on US government debt below (Bloomberg). US savings are going to go up, but where is the incentive to buy ten-year debt at 3.5%? Four-year debt under 2% doesn't do much for your savings growth. Even with monetization and the Chinese buying our debt with the dollars we send them, that still leaves the bond market about $1.5 trillion short, give or take $100 billion.

The world is deleveraging. Debt is being drawn down. Securitization of various types of debt has seriously slowed. Banks are cutting back on lending. Home prices are dropping all over the world. Commercial real estate is rolling over, and banks all over the world are exposed. "Recession turns malls into ghost towns" is the headline in today's Wall Street Journal. Personal savings are rising and retail sales are flat to down. Unemployment is rising.

All this should be massively deflationary. Interest rates should be falling or at least not rising. But a funny thing is happening. In the past two months, the yield on the ten-year bond has risen by 1%. It has moved 0.38% or almost "4 big handles" in just two weeks. Look at the chart below. What is happening?

According to Merrill Lynch, the size of the world bond market is estimated to be approximately $67 trillion, with the shares of US, Euroland, and Japanese securities each representing less than 50 percent of this total. (PIMCO)

England has been put on negative watch for its debt rating. Bill Gross said yesterday that it is not unthinkable that the US could lose its AAA rating. I think the bond market is looking at the mountain of debt that will have to be somehow sold and wondering where such a colossal sum will come from. Where do you find $10 trillion in the next ten years for US debt?

And that is just for US government debt. $5 trillion for new global debt in the next two years? In a deleveraged world? How much will the other countries need? What about money needed for businesses and mortgages and credit cards and so on?

If you add $10 trillion to the current $11.3 trillion (including Social Security trust funds, etc.), that totals $21 trillion in 2019. Let's be generous and suggest that interest rates will only be an average of 5%. That would be an interest-rate expense of over $1 trillion. That is 25% of projected revenues and 20% of expected expenses. And that assumes you have nominal growth of over 4% for the next ten years. If growth is less, tax revenues will be less. It also assumes massive tax increases from carbon credits.

The Paradox of Deficits

I think the bond market is looking a few years down the road and saying that $1-trillion deficits are simply not capable of being financed. And if the debt is monetized, then inflation is going to become a very serious issue.

When you run deficits that are 4-6-8% or more than nominal GDP, at some point things simply back up. Can we ride along for a few years? Certainly. Japan is getting ready to see its debt-to-GDP ratio rise to almost 200%. But everybody can't do it all at once.

Call it the Paradox of Deficits. We have been running a large trade deficit in the US for years, because the people (China, Japan, and the Middle East) who wanted to sell us "stuff" were kind enough to turn around and invest the money in our bonds. This in turn created Greenspan's conundrum, as it helped keep down US (and global) interest rates. Combine that with a massive increase in leverage, a few bubbles, and we now arrive at a true crisis.

Deficits are not necessarily a bad thing if kept in check and restraint is shown. But everyone cannot run deficits at the same time. If we don't buy $700 billion in goods, then that money cannot be recycled back to our debt. It is that simple.

(Sidebar: And now, China and Brazil are moving to do their trades in their own currencies rather than dollars. Very smart on their part.)

Europe, Japan, and the US cannot try to borrow $5 trillion in the next two years without a serious distortion of the bond market, not to mention the entire economic landscape.

I have long thought that "crunch time," the end game, would show up around 2013-14. But I never in my wildest imaginings thought we could run an almost $2 trillion deficit. That crazy guy on the corner telling us "The end is nigh"? He may be right.

Long before we get to 2015, let alone 2019, I think the bond markets will have called a halt to $1 trillion deficits. There will be a real crisis. The deficits will not be funded at anywhere close to an interest rate that will not break the budget. Taxes will get raised beyond what they were in the Clinton years. And Obama's budget makes some very optimistic judgments about how much will be saved in medical costs, as if no one has tried to rein in medical costs before. The crisis may come much sooner if his universal health-care bill is passed as proposed without offsetting cuts somewhere else.

Watch the bond market. Rates should be going down, not up. The bond market is telling us the deficit simply can't be financed down the road. Now, maybe a few cool heads in the Democratic Party will prevail in the US Senate and the deficits will be brought under control. (The Republicans have so far seemed as clueless as they are impotent.) We could (theoretically) run $400 billion deficits for a very long time, as GDP would be growing somewhat faster.

It would be best to run budget surpluses, but the game does not end if there are reasonable deficits. It ends with deficits that cannot be funded except by monetization. And that will tank the dollar, except against all the other countries that are monetizing their debt.

I am increasingly inclined to think that as the world comes out of its current malaise – and it will – US investors should think more globally with their investment portfolios. That is something we will explore over the coming year. But that's enough for today.

Naples, London, and Eastern Europe

Next Friday I go to London to speak at a conference for my friends at Jyske Bank. International investing expert Gary Scott will be there, as well as my friend and business associate Steve Blumenthal. It should still be possible to attend, if you would like. You can see more at www.jgam.com. And then, in theory, I will be home all of June.

The plan now is for me to return to London on July 15^th. I will co-host CNBC London Squawk Box on July 17^th, see clients, and then be with London business partner Niels Jensen for his 50^th birthday party on the 18^th. (And here's wishing him a speedy recovery from his back surgery last week!)

And then I am actually going to take a vacation. I am slowly trying to expand the list of countries I have been to. This year I am thinking of venturing further into Eastern Europe. Romania and Bulgaria are on the top of the list, and perhaps Slovenia? I would love to hear from readers in those countries, or from others who have visited them. I will have about 12 days and want to be able to see the sights and relax as well.

Then I come back, go to Maine with young son Trey for our annual get together with all the guys at the Shadow Fed fishing trip run by David Kotok, and get back in time for daughter Amanda's wedding on the 22nd. It is going to be a full, fun summer.

And speaking of Trey, he turns 15 on Wednesday. He is the last of my seven in the house. The rest are all out and (more or less) on their own. But then I get three new grandkids between now and the end of the year, so the next generation is starting.

These are interesting and serious times we find ourselves in, but we should all try and remember to enjoy life as much as possible. I am grateful that I am so busy, and count it as a blessing when so many are not. Have a great Memorial Day, and take a few moments to remember those who have sacrificed so that we can be free.

Your looking forward to summer analyst,

John Mauldin

Faith-Based Economics

John Mauldin — Sat, 16 May 2009 03:19:31 GMT

Can I Have Some More of that Data, Please?
The Fault, Dear Brutus, is Not in Our Stars
Faith-Based Economics
Is Unemployment a Lagging or a Leading Indicator?
An Unsustainable Trend in Debt
Some Thoughts on the Health Care Problem

Why does government data need to be revised so often? Is it conspiracy, as some claim, or is it methodology? And if it is methodology that leads to faulty data, then why not change the methodology? Is unemployment a lagging indicator, as conventional wisdom suggests? We look again at the underlying assumptions to suggest that things are not always the same. And finally, we look at unsustainable trends, fiscal deficits, and health care -- there is a connection.

But first, a quick note about the latest "Conversations with John Mauldin" that I just did with Don Coxe and Gary Shilling. These two esteemed analysts have different views on whether commodity prices will rise or fall, and are not afraid to make their views known. I edited the final transcript today, and I can tell you that even though I was "at the table" I learned a lot reading it the second time. If you want to understand the nature of what is a very central debate, this is a must-read. This was a VERY lively debate. Most of my friends know that I am not shy, but it was hard to get a word in edgewise as these guys went at it. It was great fun to watch.

And if you have not yet subscribed, you can go back and listen to my Conversation with Chris Whalen and Rick Lashley on the banking crisis, and see if you can figure out what motivated the Manhattan district attorney's office to call me asking for clarification. Plus the quintessential piece with Lacy Hunt and Ed Easterling on the fundamentals of the current economic crisis, which many subscribers said was worth the price of an annual subscription. And then there is the Conversation I did with Nouriel Roubini. It is all there for you.

The new Conversation will be posted early next week. Subscribers will get an email notifying you when it is up. Also, George Friedman of Stratfor and I are going to start doing a regular quarterly Conversation that will be a separate product, but if you subscribe today you will get it as part of the regular service for a year.

Right now, we are offering a subscription for $109, $90 off the regular $199 price. To learn more, you can click here and subscribe, if you haven't already. Insert code JM75 for this special offer. You can enter that code on the final screen of the subscription process.

Note: When George and I record that first piece sometime in the next few weeks, the price will rise to $129 a year, so you should act now. As we add more features like the one with George, current subscribers will simply get the new services, but the price for a new subscription will rise. New subscribers will however get access to the previous Conversations, at least for now.

Can I Have Some More of that Data, Please?

One of my regular reads is the blog The Big Picture. They featured a short piece by Michael Panzner this week. He put together some rather interesting data and then asked a question, which gives me an opportunity for discussing government data. Let's see what he had to say, and then I will make my comments.

"Many market-watchers claim that U.S. economic statistics are increasingly being revised downward in subsequent periods, suggesting that the figures initially being reported by Washington are "puffed up," so to speak, most likely for political purposes.

"Well, I went back and had a look at the differences between the reported and revised data for various series, including monthly retail sales, nonfarm payrolls, industrial production, and durable goods orders, to try and figure out if the cynics are right.

"Using data from Bloomberg, I calculated whether the revised data for each month was lower than the first-cut estimate. Then I tabulated 12-month running totals for each series to see if there has been some sort of systematic bias (in other words, whether the pattern of monthly downward revisions was trending higher instead of undulating up and down).

"To make the comparisons easier, I subtracted the 12-month tally as of May 2002 (an arbitrarily chosen date) from the monthly totals for all four economic series so that the starting point for each would be the same — zero.

"Based on a quick read of a graph of the data (see below), it does seem as though the pattern of negative revisions has been trending higher lately, especially during the past year or so, suggesting that the cynics may be on to something.

"That said, I am not a statistician, and the results may be nothing more than "noise." There is also the possibility that my methodology is lacking (because, for example, the margins-of-error for each month's data are relatively large, or because of certain quirks that crop up when an economy is in transition). Still, you gotta wonder..."

Actually, Mike (can I call you Mike?) your last thought is the correct one: "or because of certain quirks that crop up when an economy is in transition."

Go back to 2003-04. Notice that the numbers of downward revisions in non-farm payrolls are negative in your graph? Remember all the talk back then about the "jobless recovery"? We can now look back and see there were a lot of jobs being created. They just did not show up in the early statistics. And look at the opposite reaction in industrial production: here they revised strongly downward for a the better part of two years, yet it turned out there was a production boom going on.

Was all this a conspiracy on the part of the Bush administration to make things look worse than they actually were? Hardly seems like rational political behavior.

The "problem" comes from the methodology. There is no exact data for any of those statistics. They have to get as much data as they can and then make estimates. Part of the process of estimation uses previous trends. It is as if we were using past performance of a mutual fund or stock to project future returns. Even though we look at the past performance, we should know that past performance is not indicative of future results. Just look at some of the top-performing value-oriented mutual funds in the recent bear market, like superstar Bill Miller's Legg Mason Value Trust fund (LMVTX), the after-fee returns of which had beaten the S&P 500 index for 15 consecutive years, from 1991 through 2005. It did rather poorly last year, even in comparison with the S&P, which was horrid. Past performance is interesting, but it can disappoint. And sometimes rather viciously.

Now, just as saying that a fund on average will produce a 10% return does not mean that it will yield 10% every year, neither do government statistics work that way. While the methodology for each series of data is different, they all are more or less trend-following. They take past relationships in the data they can gather and use them to estimate current numbers. And -- this is important -- on average and over longer periods of time, they are pretty accurate.

They will revise the data many times over the coming years, getting closer and closer to the actual numbers. For instance, I can't remember exactly when, but it was several years later that we learned that we were already in a recession in the third quarter of 2000, at the very time most economists were calling for a robust economic future! (Except for your humble analyst, who was predicting a recession, and had been for some time because of the inverted yield curve, but that's another story.)

But in the short run, at economic transitions they are going to get it wrong, because the backward-looking data is mean-reverting. But how else would you do it? One of the keys to economic transitions is to look at the direction of the revisions. Recently, the revisions have all been negative. Things are actually getting worse than the initial data suggested. And during the last recovery the data kept getting revised upward, especially six months and one year later.

The Fault, Dear Brutus, is Not in Our Stars

Look again at the very useful chart above (great work, wish I had thought of it!). Non-farm payrolls, which for some odd reason everyone pays attention to, is especially wrong at the turns. Anyone trading on non-farm payroll data deserves the losses they will get.

One of the reasons that non-farm payrolls are so often revised is that the Bureau of Labor Statistics (BLS) is forced to estimate the number of new businesses being created each month that are simply under the radar screen of government statisticians. This number is called the birth/death ratio. You could not create a useful payroll number without this estimate, yet it is simply a wild-eyed guess based on past trends, which by definition we know will change at economic turning points.

Further, almost no one pays attention to the fine print in the data, which talks about margin of error. The statisticians clearly understand the limits of their data, even if the public does not. Often, the margin of error is larger than the number being given, so that a positive number may actually turn out to be negative, and vice versa, when viewed from a few years out.

As Cassius said in Julius Caesar, "The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings."

Faith-Based Economics

Should we cast aspersions on the data creators? I rather think not. The various government statistics creators are doing their best to give us information that, over time, will be useful. Some is more useful than others in real time. Some has large time lags before it is accurate. To expect the BLS or the Commerce Department to have accurate current data is expecting them to know the future. The very people who are the most critical would never presume to be accurate about the prices of stocks six months out (or even one month), on a consistent basis. Yet that is the kind of prescience they want from government statisticians.

Do you really want data from government sources that makes assumptions about economic recoveries and recessions? That is the job of independent economists, and they generally do it pretty badly. There is no need for the government to compound the errors.

Again, repeating myself, anyone who trades on government statistics as being anywhere close to accurate in real time deserves any losses they get. They are at best a foggy window through which we peer into the future. Taken together, and with some seasoning of time, they can be rather useful; but to pin hopes of a recovery or a bull-market run on one week's data is hazardous to one's wealth.

Reading and watching all the analysts and economists who "see" recovery in one set of data or another makes me wonder what sort of faith-based economics they actually practice. Just as it requires faith to believe in God, it also requires a lot of faith to believe in forecasts made on a single month's set of data, or based on past performance.

Are you interested in finding a real green shoot? Let's look for a quarter when the economic data keeps getting revised upward, two and three months out. That will signal a real recovery. As long as the data is being revised downward, the economy is "having issues," as my kids would say.

Quick sidebar to those who keep asking: Yes, I think we have seen the worst of the economic data, as far as GDP goes. But that does not mean we don't have further negative quarters in our future. I just don't think they will be a negative 6 like they have been the last two quarters. And we may even see a quarter this year with a positive number. But take it with a grain of salt when the usual suspects declare the end of the recession. Look into the data that produces the numbers. As Gary Shilling points out, eight of the last eleven recessions have had a positive quarter, only to see more negative quarters follow. GDP numbers are quirky. But here's to hoping for a real recovery when we do see the next positive number.

Is Unemployment a Lagging or a Leading Indicator?

There is a very interesting animated graphic done by Chris Wilson at Slate.com (http://www.slate.com/id/2216238/). It shows the progression of unemployment by US county over the last two years. I reproduce the beginning and ending stages of the graph for you below, and apologize to those of you who are reading this in black and white, as it will not be as dramatic. But if you watch the entire series, it shows how rapid the deterioration in unemployment has been. (It takes about ten seconds.) The first graph shows that there 2.6 million jobs had been created in 2006. The last one shows that job losses were 5 million through March and, if we add in April and estimates for May, it will be close to 6 million. Again, the actual animation is dramatic, and made my daughter go "Ouch!"

It's been 50 years since we have seen unemployment drop as rapidly as it has in the current recession. Given that we have a much smaller percentage of manufacturing jobs now, that volatility is breathtaking. Look at the data since 1930 from the St. Louis Fed:

The typical pundit keeps telling us unemployment is a lagging indicator, and that the recovery will be well under way before it shows up in the job numbers. Therefore, you should buy what they are selling, because the recovery is on its way. But that may not be the case this time. One of my favorite reads, when I get to see it, is the economic analysis from Bridgewater. They are among the best thinkers anywhere, and everyone who follows them gives them a great deal of credence. This is what they wrote about unemployment being a lagging indicator last month:

"Normally, labor markets lag the economy because incremental spending transactions are financed via debt, stimulated by interest rate cuts. But as long as credit remains frozen, spending will require income, and income comes from jobs. And debt service payments are made out of income. Therefore, in a deleveraging environment job growth becomes an important leading, causal indicator of demand and other economic conditions.

"... The bounce in the economy and the stabilization in markets reflect government actions that are big enough to impact near-term growth rates, but are not sufficiently directed at the root problem of excessive indebtedness to produce permanent healing. The deterioration in employment markets will continue because companies' profit margins are so deeply damaged that a little bounce in growth won't do much to alter their need to cut costs. This deterioration in labor markets will undermine demand and continue to pressure loan losses, which will keep the pressure on the banks and elevate the cost of capital for tentative borrowers, inhibiting credit expansion."

This again illustrates the problem of using past performance to project future results. You have to look at the underlying conditions in order to get a real comparison, and we have not seen a deleveraging recession in the US for 80 years. Using the past data in today's world is statistical masturbation: it may make you feel good, but it is not producing anything really useful, and may be harmful to your portfolio.

An Unsustainable Trend in Debt

This week, the federal government published two important reports on long-term budgetary trends. They both show that we are on an unsustainable path that will almost certainly result in massively higher taxes. By 2016 we will have to fund Social Security out of general revenues, as the surplus we now have will be gone. And there are no trust funds. They are a myth. It as if I wrote myself a check for $2 trillion and then declared I was worth $2 trillion. The money is just not there. Social Security makes Bernie Madoff look like a small-time crook.

And Medicare is in far worse shape. For those with the stomach, you can read Bruce Bartlett's analysis at http://www.forbes.com/2009/05/14/taxes-social-security-opinions-columnists-medicare.html. He estimates that taxes will have to go up by 81% if we are to pay the obligations as they now stand.

Now that is unsustainable. It won't happen. And as the saying goes, if something is unsustainable, at some point it will stop. No getting around it. Long before we get there, change you will not like will be forced on the US.

The following headline caught my eye: "Obama Says US Long-Term Debt Load is 'Unsustainable.'" Yet they announced a $1.8 trillion deficit, which is really going to be at least $2 trillion, and are getting ready to pass health-care programs that will mean at least a trillion in deficits for as long as one can project.

How will they pay for it? Even getting rid of the Bush tax cuts will only produce a few hundred billion a year, which is nowhere near enough. They project much lower medical costs in the future, because they assume they are going to figure out ways to cut costs and make medical care more efficient. As if no one has ever tried that.

Yes, there are some savings on the margin; but the only way you really cut costs is to ration health care, especially health care in the last year of life, which is about 30% of health-care expenses. That is going to be very tough in the US. But when faced with a real budget crisis, the choices are going to be stark. And that crisis is coming if we do not control spending.

You cannot propose massive increases in spending without either creating crushing debt that the markets will simply not allow, pushing interest rates much higher and really slowing growth and hurting the economy. It is a simple fact that you cannot increase the debt-to-GDP ratio without limit.

We found the limit on personal and corporate debt this past year. We pushed the limits until the system crashed. And now the US government wants to basically do the same thing. They are planning to see where the limits on government debt-to-GDP will be. Unless cooler and more rational heads in the Democratic Party prevail, this is not going to be pretty. Sometime in the middle of the next decade we will hit the wall, and it will make the current crisis pale in comparison.

The only way to solve the problem is to grow GDP more rapidly than debt, and for that to happen you have to have policies which are shaped for the growth of the economy or massive savings by consumers. And right now we have neither. Cap and trade is hugely anti-growth. So are high corporate taxes, and Obama is proposing to effectively raise corporate taxes by closing loopholes for income earned outside the US. Much better would be to lower the overall corporate level to a competitive world rate and then require the offshore income to be taxed. A lower rate would actually increase tax revenues.

Looming protectionism worldwide is a problem. (See the article at http://www.msnbc.msn.com/id/30758018.) Towns in Ontario, Canada with a population totalling 500,000 have effectively barred US contractors from doing business with them, in retaliation for job losses stemming from US protectionism in the stimulus plan. That movement is spreading. A US steel mill with 600 union jobs will have to close down because its owners are not US-based, and thus it is not technically a US supplier. They are losing jobs to US-owned mills -- but those are US jobs. The insanity goes on and on. As I have written for many years, the one thing that really gets me worried is protectionism. That can make this very significant recession into a depression quicker than you can imagine. Bad ideas have bad consequences.

All in all, we face some very difficult decisions, not just in the US but all over the developed world. Ironically, the less developed nations will have fewer problems and on a relative basis will likely grow much faster than the developed world. But, multi-trillion-dollar deficits and massive new programs are not the right answer.

Obama is right: the debt load is unsustainable. Let's hope he will do more than talk, and show some budget restraint.

Woody Brock has given me permission to pass on to you his recent notes on this very topic of what we have to do to get out of this crisis. It will soon be an Outside the Box. Read it. It is a very sobering and thought-provoking piece.

Some Thoughts on the Health Care Problem

Now, some positive news. This week I visited the Cleveland Clinic and went through their Executive Health Program (more on that below). I got to visit for several hours with my doctor, Michael Roizen, of YOU: The Owner's Manual fame (not to mention all his subsequent books). They have now sold over 20 million copies, and I highly recommend them.

I have long been a student of medical trends, and long-time readers know that I think the next really big boom will be in the biotech world. I asked Mike what three things he thought would have the biggest impact in the next five years in medicine. What he said gave me hope, because he thinks there may be some advances in medicine that could help solve some of the basic health issues we all face, and at the same time give us some relief from the high and rising costs of medical care. I was aware of most of the research, but did not know that we were as close as it appears we actually are.

Briefly, he feels there are three developments in late-stage trials that could have major impacts. The first is the development of sirtuin, which so far seems to be delaying the effects of diabetes but also seems to work for a host of diseases that are inflammatory in nature (including many heart-related issues). It essentially delays the symptoms for 30-40 years. While the current trials are for very specific diseases, he thinks sirtuin will have a wide applicability and that it could be huge, as inflammation is the cause of a number of diseases. This could prolong useful life and forestall a number of debilitating conditions.

Second, there is a late-stage-three trial due out soon that promises to increase muscle mass. I have been reading about such developments, but was not aware that something might be available within a few years. This promises to help people stay active a lot longer than currently possible, which will be a good thing if we are going to live longer.

And finally, there is a study and trial which shows that DHA may delay the onset of Alzheimer's disease, which eats up a significant portion of US medical budgets.

I recently spent time with a research doctor at the University of California Irvine who believes that muscular dystrophy and other brain/nerve-related diseases may be conquered within five years.

We may just get lucky. Instead of high and rising medical expenses that we cannot pay for without bankrupting the country, we may be able to reduce our medical bill by staying healthier and living longer.

Everybody should be like my personal hero, Richard Russell. I hope to be writing as well as he does when I am 85. With some luck, I might just make it.

Let me quickly recommend to my readers that they get serious annual physicals. At the Cleveland Clinic this week I saw seven doctors in one and a half days, and went through some serious poking and prodding. The program was tailored to my needs, as it is different for every person. You see professionals who are geared to your physical challenges. They make all the arrangements, and a staff person walks you into see the doctors, who are on very tight schedules.

The advantage of the Cleveland Clinic is that they are very oriented toward helping you not get sick in the first place. I am turning 60 this year, and Iwant to be active for a very long time. You have to be proactive.

As an aside, I had a colonoscopy. I was really dreading it, but it is one of those things you need to do. As it turns out, it was nowhere near as bad as I thought, and they basically gave me a drug which allowed me to relax and only experience a little discomfort. ("You are going to feel really relaxed in about 30 seconds.")

You can learn more at www.clevelandclinic.org/executivehealth. Whether it is there or somewhere else, get a serious physical. I want you to be reading me in 25 years as much as I want to be writing.

It is time to hit the send button. I will close by wishing you a very healthy week.

Your really an optimist at heart analyst,

John Mauldin

Green Shoots or Dandelion Weeds?

John Mauldin — Sat, 09 May 2009 04:43:00 GMT

A Few Thoughts on Recessions
Are the Green Shoots Really Dandelion Weeds?
Is That a Leaky Bucket?
Frugality Is Back in Vogue
Where Will the Jobs Come From?
Cleveland, New York, and Mother's Day

Go to Google. Type in "green shoots." In about a 10^th of a second you will find 28,900,000 references. Scrolling through a few pages, you find a lot of references to the beginning of the end of the recession. Today we look at some data to see if we can indeed see the end. Most readers will be surprised to know that the number of people employed in the US went up (!) in April. Yet so did the unemployment rate. Is that green shoot just another dandelion weed in our economic garden?

We'll jump into that and more, but first let me quickly mention the new subscription service that we began offering this year, called "Conversations with John Mauldin." One of my "secrets" is that I have a very powerful rolodex (or, for the younger crowd, my contacts list). In this new project, each month I call up one or two of my special contacts in the investment and economic world and hold a conversation with them about the important topics of the day -- where the US and global economies are going, how we should be investing, what opportunities and pitfalls are out there, etc. Some will be names you recognize, and others will be names you will want to know. You get to listen in, download to your computer, or read a transcript -- whichever you prefer.

The reviews from subscribers have been more than excellent. Over the top, actually. You can read some of them at the website below.

I just recorded a Conversation with Donald Coxe and Gary Shilling. Both men are among my favorite analysts, and have been remarkably right with their calls for a long time. However, their views on how commodity prices will develop over the next few years differ considerably. Mischievously, I thought it would be fun to get them together. Neither are shy or retiring men, and both can articulate their views very well, thank you. The conversation turned into a lively debate, one in which I did not get to say as much as I do in a normal Conversation. I think subscribers will find it one of the best we have done. I certainly came away with a lot to think about.

The Conversation will be posted next week. Subscribers will get an email notifying you when it is up. Also, George Friedman of Stratfor and I are going to start doing a regular quarterly Conversation that will be a separate product, but if you subscribe today you will get it as part of the regular service for a year.

Right now, we are offering a subscription for $109, $90 off the regular $199 price. To learn more You can click here and subscribe, if you haven't already. Insert code JM75 for this special offer. You can enter that code on the final screen of the subscription process.

Note: When George and I record that first piece sometime in the next few weeks, the price will rise to $129 a year, so you should act now. As we add more features like the one with George, current subscribers will simply get the new service, but the price for a new subscription will rise. Also, new subscribers will get access to the previous Conversations, for now.

Thanks, and now let's jump into the letter.

Are the Green Shoots Really Dandelion Weeds?

When the employment numbers come out, my usual routine is to go the Bureau of Labor Statistics website and peruse the actual tables (www.bls.gov). I was rather surprised to see that the actual number of people employed in the US rose by 120,000. That has certainly not been the trend for a rather long time.

So, are things back on track? Is the recession just about over? Is that a green shoot? I don't think so.

First, there are actually two surveys done by the BLS. One is the household survey, where they call up a fixed number of homes each month and ask about the employment situation in the household and then take that data and extrapolate it for the economy as a whole. So, while the number of employed rose, the number of unemployed rose a lot faster, by 563,000 to 13.7 million. In addition, there are 2.1 million who are "marginally attached" to the workforce. These individuals wanted and were available for work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.

According to the survey, headline unemployment rose 0.4% to 8.9%, the highest level since 1983. But if you count those who are working part-time but want full-time work, as well as the "marginally attached," the unemployment rate (called the U-6 rate) is an ugly 15.8%.

For whatever reason, the markets were happy that the headline number of the other BLS survey, the establishment survey of lost jobs, was "only" 539,000, down from a negatively revised 699,000 in March. At least, the thinking was, the numbers were not getting worse, though it is hard for me to be encouraged by half a million lost jobs. That may not be the worst of it, however, since 66,000 jobs were temporary workers hired for the 2010 census, and the BLS estimated that the birth-death ratio added 226,000 jobs as a result of new business creation. Really? This will mean that there will likely be a major revision downward at some future point. The number will likely be well over 600,000 in the final analysis.

Further, it is likely that we will see at least another 1.0-1.5 million lost jobs over the rest of the year, taking unemployment very close to 10%. As an aside, the Treasury used an unemployment rate of 9.5% in their stress test of the banks, which suggests the test was not all that stressful. And, showing further weakness, there were 66,000 fewer temporary jobs. If there was really a nascent recovery, you would see a rise in temporary workers.

Average wages rose by a mere 3.2% on an annual basis, and by just 0.1% for the month, and the average work week was at an all-time record low of 33.2 hours. In nearly any inflation scenario, rising wages play an important part. This suggests that inflation is not in our near future.

Is That a Leaky Bucket?

Let's play a thought game. Picture the economy as a leaky bucket, maybe not as bad as the one below, but leaking nevertheless.

We have put holes in the bucket of our economy, and the "water," or GDP, is leaking out. We are going to settle at some new lower level of GDP and consumer spending. At some point, we can fix the holes and begin the process of increasing the level of the water. Typically, this happens relatively quickly.

However, a recent study showed that recessions that come as a result of or in conjunction with a financial crisis take a lot longer to recover from. The study looked at 122 recessions, of which 15 were associated with financial crises.

The research, published as Chapter 3 in the April 2009 World Economic Outlook (WEO) of the International Monetary Fund, finds that recessions that are either associated with financial crises or that are highly synchronized worldwide have historically been longer and deeper, and featured weak recoveries (see chart). The combination of these two features -- a rare phenomenon in the postwar period -- resulted in even costlier recessions, which lasted almost two years.

"In addition to the current global recessionary cycle, there were three other episodes of highly synchronized recessions: 1975, 1980, and 1992. These recessions were on average longer and deeper. Distinct from other episodes, the recoveries from these recessions feature much weaker export growth, especially if the United States is also in recession.

"A perfect storm? Recessions that are associated with both financial crises and global downturns have been unusually severe and long lasting. Since 1960, there have been only six recessions out of the 122 in the sample that fit this description: Finland (1990), France (1992), Germany (1980), Greece (1992), Italy (1992), and Sweden (1990). On average, these recessions lasted some two years, were unusually severe, and featured weaker-than-average recoveries." (IMF)

In addition, I would suggest that the current recession is unlike any in the study, in that the habits of the American consumer are changing right before our eyes. Instead of spending and borrowing with little or no savings, people are now reducing their borrowing and increasing their savings. Savings are now 4% of income and are likely to rise to 7-8% or more in the next few years, as consumers see the need to repair their balance sheets and retirement funds.

Frugality Is Back in Vogue

While Wal-Mart and other low-cost retailer sales are up, Saks and other high-end retailers are down by as much as 30%. There is a new frugality in vogue. That new hole in the bucket? It is the damaged psyche of the American consumer. Consumer spending is going to fall, and when it does find that new level it is going to grow more slowly than in the past.

And that, gentle reader, is why the recovery is going to be a long slow Muddle Through. This recession will end, as all recessions eventually do. We will see a positive number, maybe as early as the 4^th quarter. Employment should turn back up, albeit slowly, after that.

Typically, in a recession jobs are lost because sales slow and production is not needed. When sales recover, so do jobs.

But we are permanently destroying jobs in this recession, all up and down the food chain and in numerous industries. There will be fewer cars made, for a long time. Less demand for financial service jobs. Housing construction will be a long time recovering, well into 2011 or 2012.

And commercial real estate? General Growth, the largest operator of malls, with 166, filed for bankruptcy protection and in a very controversial move took all 166 malls into bankruptcy as well. General Growth was the largest issuer of Commercial Mortgage-Backed Securities (CMBS), which is how the great majority of commercial mortgages are created. The lenders thought they had direct access to the cash flow of the malls. Some of those malls are quite profitable. Cue the lawyers.

If this rather aggressive move is allowed to stand up in court, it could do serious damage to the whole commercial real estate industry, which is already in upheaval, and throw new construction projects into serious difficulty. And less construction means fewer jobs.

Where Will the Jobs Come From?

As the water in our bucket seeks a new economic level, there are simply going to be fewer jobs to make "stuff," as we consume less. We can't rely on many of the old jobs and industries to come back in short order, as has been the case in the past. In order for new jobs to be created, we are going to have to create new businesses and expand current ones.

The vast majority of new job creation in the US is by small businesses and entrepreneurs. Yet today small business faces a tough environment. Banks have tighter lending policies. Venture capital is tough to find. Competition in a shrinking economy is brutal.

And the Obama administration wants to raise taxes on small businesses by raising taxes on the "rich." 75% of those rich he targets are small businesses who need capital in order to grow, but are having trouble getting it from banks.

Sure, entrepreneurs will do what they have to do, and higher marginal tax rates will typically not keep them from working as hard as possible to make their businesses successful. If the tax rates of the large majority of businessmen and women go back to the pre-Bush level, it will not make us close our businesses, but it will cut down on the capital we have available to expand. It will slow down economic growth and hinder job creation. There is just no getting around that fact.

There is a reason that high-tax states have higher unemployment rates and lower job growth. Taxes have consequences for economic growth.

The sad reality is that it is going to take a long time to get back to acceptable employment levels in the US. It now takes an average of over 21 weeks to find a new job, a new record. Stories from friends in the financial services business are particularly difficult, as there are many very highly qualified people for every job that comes available. And it is not going to get better any time soon.

How could we add 120,000 new jobs while unemployment is going up? Because the number of people looking for jobs is growing far faster, as more and more young people come into the market place and couples now find they both must look for a job. And that is a trend that is going to continue.

So many bullish analysts talk about the second derivative of growth, by which they mean that we are slowing our descent into recession. But it is not the second derivative that is important. What is important is that the first derivative, actual growth, return. Until that time, unemployment will continue to rise, which is going to put pressure on incomes and consumer spending, and thus corporate profits.

Profits in the first quarter, with nearly 90% of companies reporting, are down over 50% from last year and are 18% less than estimates. Yes, inventories are down, but so is final demand from consumers and businesses. There is a reason that GM and Chrysler are shutting down for two months this summer. That will percolate throughout the economy.

As the realization that the economy is not due for a robust recovery sinks in, I think the chances for another serious bear market test of the stock market lows will become increasingly high. As David Rosenberg said in his final memo from Merrill Lynch (and good luck to him in his new position, where I hope we all still get to read his very solid analysis!), if a few weeks ago someone had said you could sell all your stocks 40% higher, most of you would have hit that bid.

Now that price has in fact been bid. Do you want to gamble on a renewed bull run in the face of a continually shrinking economy? I suggest you give it some serious thought, or at least put in some very real stop-loss protection.

Cleveland, New York, and Mother's Day

I thought I was staying home in May. Well, plans change. I am going to the Cleveland Clinic on Monday for a full physical with Dr. Mike Roizen (YOU: The Owner's Manual, etc.) which I have postponed for too long. This is an excellent program. I will give you a report next week.

Then on June 3^rd I will be in New York for a very special conference hosted by my friends at The Big Picture. The conference is called "Capitalism after Crisis -- A look at Banking, Hedge Funds, and Media during the Recession ... and Beyond." It is an all-day affair on June 3, 2009 at the New York Athletic Club. There is a great line-up of speakers -- like Dylan Ratigan, Nassim Taleb, Doug Kass, Barry Ritholtz, Chris Whalen, and Josh Rosner -- and your humble analyst will do the closing keynote address. The conference is $895, but my readers get a special deal of $695 if they use this link: https://secure.pnmi.com/bigpicture/?source=mauldin

Much of the family will gather for Mother's Day. My mother will be 92 in August. She is bionic, with two new knees and two new hips. Mother was in the WACs in World War II and went to Germany, where she met my father. She did not have an easy life, as Dad was an alcoholic for most of his life, but she stayed with him. She has always had a positive attitude. We almost lost her this last year, when she went into the hospital for minor surgery and ended up getting a very deadly stomach virus. She was actually giving my brother her last requests one night, as they thought she might not make it through the night -- but she did. I come from hardy stock.

And speaking of mothers, Tiffani is coming along and is now two months pregnant. I get the blow-by-blow narrative each day in the office. It does bring back memories. Enjoy your weekend; I certainly intend to enjoy mine. The Mavericks are in the playoffs, although so far Denver is eating our lunch. And Star Trek is out. I am a huge Trekkie. It will be a fun next few days.

Your can't wait to see Star Trek analyst,

John Mauldin

Sell in May and Go Away

John Mauldin — Sat, 02 May 2009 04:18:00 GMT

Sell in May and Go Away?
The End of the Recession?
Is the US Consumer Back?
A Dangerous End Game
A Few Thoughts on Swine Flu

The old adage that one should "sell in May and walk away" has been around for years. I mentioned that bromide about this time last year, urging readers to head for the sidelines if they had not already done so. I was also suggesting a strategic retreat in August of 2006 (after which the markets went up 20% before plummeting). In this week's letter we look at the actual data and offer up a fresh viewpoint. Then we turn our eyes to the recent GDP numbers, which were awful, though many took comfort in the apparent rise in consumer spending. Are Americans back to their old ways? It will make for an interesting letter.

Sell in May and Go Away?

My friend and South African business partner Prieur du Plessis recently updated a chart on monthly stock market returns since 1950. It clearly shows that the November through April periods have on average been superior to the May through October half of the year. (To read his very interesting blog you can go to http://www.investmentpostcards.com/)

And the difference is quite significant. As Prieur notes, the "good" six-month period shows an average return of 7.9%, while the "bad" six-month period only shows a return of 2.5%. Of course, selling creates taxable events, which can hurt your returns.

Plus, you never know when the markets are going to go down and when they will be up. There can be a lot of variance from year to year. For instance, in 2007 the markets were up during the summer by 4.52% and down during the "good" period by -9.62%, which is opposite the average pattern. Of course, the markets did go down by 30% after May 1 last year and down another 5% since then. That is what bears markets can do.

Which caused me to wonder. The last 59 years have seen two significant secular bull markets (roughly 1950-1966 and 1982-1999) and two secular bear markets (1966-1982 and 2000-??? -- the one we are in now). I wondered if the pattern changed during the bear cycles, so I shot a late-night note off to Prieur and came in the next morning and had my answer.

It made a significant difference. May through October in secular bear cycles has been ugly. Look at this graph:

And just for fun, let's look at the monthly numbers since the present secular bear market began in 2000. So far, this has been a lot worse than the 1966-82 cycle, although we have not yet had the recovery phase from the current doldrums, which will likely make the overall numbers look better in 4-5 years.

As noted above, these graphs simply give us past trends and not an absolute forecast. But they do provide food for thought. There are times when you should be cautious and times when you should throw caution to the wind. I think this is the former. While some pundits are talking about green shoots and the second derivative of growth, this economy may be worse than their rosy forecasts of the end of the recession, as we will see in a few paragraphs.

The End of the Recession?

Let's revisit 2000 and 2006. The yield curve was inverted in the late summer and early fall of both years. By that I mean that short-term yields were higher than long-term yields. When that happens for longer than 90 days, a recession has always followed within 12 months. (I wrote numerous e-letters on the topic. You can go to the website and search for "Mishkin," one of the authors of a Fed paper on the yield curve.) I wrote in this letter on both occasions that it was time to get out of the market, as the stock market drops an average of 43% during a recession.

There is a YouTube of me on CNBC in August of 2006 on Larry Kudlow's show. I was forecasting a recession in 2007 based on the inverted yield curve. And if there was going to be a recession, I reasoned, then a bear market would follow. Larry and John Rutledge basically noted that "this time it's different," because the reasons for the inverted yield curve were different. And the market did rise another 20%+ for over 12 months.

There was a recession, but it did not come until 15 months later, in late 2007. The yield curve was right in forecasting a recession, but the timing was different this cycle. If you had gotten out in August of 2006, you were not terribly happy 12 months later; but today you are still way ahead, plus the gains on your bonds and alternatives.

On October 5 of 2007 I wrote about what I saw coming as a "Slow Motion Recession." I was more convinced than ever we were either in a recession or soon would be. As it turned out, we were. But at the time there was a lot of criticism from a lot of analysts. Christopher Amberger did a particularly scathing piece (which was at least witty) on YouTube on October 10, suggesting that the concept of a recession was nonsensical and there were still plenty of opportunities in the market. (Oh, and buy his newsletter to find out what they are). http://www.youtube.com/watch?v=UjAK0s9I8vA The market topped two days later.

The point is that it is more important to get the general direction right than to be right on the specifics. In August of 2006 I was seeing a modest recession in the future. As time went on, I became increasingly bearish. But whether it was to be a mild recession or a major one, the advice would have been the same. You do not want to get caught long the market before a recession.

Today, there are those who say the stock market will start rising six months before the economy does. And maybe it will. I don't know. The predisposition of this market is down. Valuations are not at a level that has spawned major bull markets in the past. At the beginning of real bull markets, volume is strong and rising. Now it is weak (modest at best) and shows no real sign of becoming strong, especially going into summer.

Further, this rally has all the earmarks of a major short squeeze. Regulators have recently (and correctly) been enforcing short selling rules that require stock to be delivered and settled on short trades. This may be a one-time event. When the short squeeze is over, the buying will stop and the market will drop. Remember, it takes buying and lot of it to move a market up but only a lack of buying to create a bear market.

Corporate earnings are likely to go even lower, as consumer spending is likely to get weaker in the coming months. Capacity utilization is at its lowest point since they began tracking it. The National Federation of Business says a recent survey shows none of the responders plans to raise prices, which is not a sign of business strength.

Banks are not yet lending, and the past quarter's positive performance was mostly accounting gimmicks. Citigroup, for instance, said they made $1.6 billion. They did this by booking a one-time gain of $2.7 billion, because the value of Citigroup bonds have fallen (!), giving them the theoretical possibility of buying back their debt at a discount. And with consumer and credit card loans showing more weakness, Citi decided to REDUCE its loan loss reserves, allowing it to show another $1.3 billion in profit. And then there was the profit of $400 million from the new mark-to-market rules, which allowed them to produce a profit on "impaired assets." Without all these games, there would have been a loss of $2.8 billion.

Maybe this time it's different. But when I survey the economic landscape, I see lots of opportunity for disappointments and missed targets. And bear market rallies are killed by disappointments and missed expectations.

To be long this market going into summer you need to be brave or have very serious stops on your portfolio. I think the possibility of missed expectations at the end of the second quarter is high. It could be ugly.

Is the US Consumer Back?

The headlines told us that even as the economy fell an annualized 6% in the first quarter, consumer spending rose by 2%. Given that consumer savings climbed to 4.2%, unemployment rose, and income was down, how did consumer spending rise? To get the real picture, you have to dig into the numbers. (Thanks to 82-year-old, long-time reader Paul Miller for doing the slicing and dicing of the data at his excellent blog http://musingsbymiller.wordpress.com/.)

First, the headline numbers are inflation-adjusted. Consumer spending in actual dollars rose $28 billion. But since prices went down (deflation), the "real" or after-inflation/deflation number shows up in the headlines as $44 billion.

But where prices went down makes the real difference. Gasoline and other energy costs were down $50 billion, allowing consumers to spend on other items. Over the last two quarters energy costs are down almost $200 billion from the second and third quarters, making a huge difference. But now the "tax cut" from energy is largely gone, as prices have stabilized.

Paul notes, "But ... now ... the gasoline tax cut has dissipated, and coming to the rescue are the Obama administration's tax cuts. In fact, the cuts began to be felt in the first quarter. Personal income declined modestly in the first quarter, by $60 billion, or a 2% annual rate. But personal taxes were down by $193.5 billion, some part of which was the result of the tax cuts, so that disposable income rose at a 5% annual rate. Putting taxes and lower gasoline prices together gave consumers $143.5 billion more to spend or save than they would otherwise have had, which accounted for the rather amazing performance of consumption in the face of immense job losses."

And going further into the GDP numbers, there is an interesting statistic. Imports fell more than exports, mainly due to oil. The net trade deficit was only about $26 billion last month. Falling prices in imports, and especially oil, actually added about 3% annualized to the GDP number. Without that boost, the number would have been far more ugly.

That being said, we are very likely to see better numbers in the future, and maybe even a positive one in the 4^th quarter. But a large part of that will be statistical. For instance, housing construction is now down to 2.5% (or thereabouts) of GDP. Drops in housing construction have contributed almost a negative 1% a quarter for the last year. Even if housing construction goes down another 10-20%, it is becoming a very small piece of the puzzle and is not likely to be a big drag on future GDP.

Inventories, though, have been a large drag on the economy for the last two quarters. While we could see inventories drop somewhat this quarter, as the ISM manufacturing number is still significantly negative, they will probably not drop a lot more in the third and fourth quarters.

There are more stimuli and tax cuts on the way, and they will start to have an effect, as individuals will have more disposable income, whether to pay down debt, save, or spend.

But that positive will be balanced by rising unemployment, likely to hit 10% or more by the end of the year. If you count those who are part-time workers wanting full-time work or who are discouraged workers, unemployment is over 15% today.

A Dangerous End Game

The Fed and the Obama administration are playing a dangerous game. The Fed is going to print trillions of dollars to forestall deflation and try to re-ignite the economy. But for a variety of reasons we will go into next week, a real, sustainable recovery may be a few years away. What happens when the market start balking at high and unsustainable national deficits? What happens when inflation (finally) does return? Can the Fed remain independent and take back the money it is printing in the face of what will likely be a tepid recovery? And if they don't, what happens to the dollar?

Next year, we will be entering what will certainly be the most dangerous era in my lifetime for the US economy. It is not clear what will happen. There are a lot of paths that can be taken, though some are more likely than others. For those who are convinced that high inflation and a falling dollar are absolutely, unequivocally in the future I have just one word: Japan.

Yes, there are differences, but there are a lot of similarities. While I think the most likely outcome is a long Muddle Through recovery, the likelihood of a lost decade of deflation a la Japan is a very real potential outcome. And the possibility of stagflation and a seriously impaired dollar is also quite real.

Investors, businessmen, and entrepreneurs need to be as nimble as possible. A free market will figure out what paths to take, and I am still optimistic about the long term. But we have some very dangerous times in front of us, and we need to be realistic.

And before I close, let me make a few comments about the Chrysler and GM issues. I tell my kids all the time that actions have consequences. If I hold senior secured debt of a company and the government tells me I have to take less than unsecured junior debtors, I am not going to be happy. I may have been dumb to make the loans in the first place, but I did it under a very specific contract and the rule of law.

If the Obama administration arbitrarily changes those rules to favor a political class (unions), then that is going to have a chilling effect on future lending to all corporations. As an aside, they are spending $12 billion to save 54,000 Chrysler jobs (at $22,000 per job). With 600,000 jobs a month being lost, why are these 54,000 jobs more special than those of the rest of the unemployed, who get a fraction of that amount in unemployment benefits?

Actions have consequences. The lenders who are forcing the Chrysler deal into bankruptcy court are not all "predatory hedge funds." They are mutual funds, pension funds, and other financial firms with small stakeholders as their investors.

Cerberus, the hedge fund that originally bought Chrysler, deserves to lose their money. They made a bad investment. But those who lent money deserve to be treated in accordance with the contracts they signed.

Demonizing investors and businessmen is hardly helpful. They are precisely the people we need to help get this economy moving. Governments don't create true job growth, businesspeople do, and mostly small businesses. I am not certain why small business owners, the job creation engine of the country, should see their taxes raised in order to protect bond holders of automobile companies or banks, or for union jobs to be preserved in companies that are clearly not competitive. But that is just my final thought late at night, before I hit the send button.

OK, one more thought. If Chrysler couldn't figure out how to make efficient cars from their partnership with Daimler-Benz, are they now going to become viable through a partnership with Fiat, which has been on the verge of bankruptcy for the last decade? Really? GM paid $2 billion in penalties to Fiat in 2005 so as to not be forced to buy them. And Fiat gets 20% for no cash?

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

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

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

A Few Thoughts on Swine Flu

Intellectually, I know that flu is something that we live with every year. According to the Centers for Disease Control, seasonal flu infects between 15 and 60 million Americans each year (5% to 20%), hospitalizes about 200,000, and kills about 36,000. That comes out to over 800 hospitalizations and over 250 deaths each day during flu season.

Worldwide deaths from "regular" flu are between 250,000 to 500,000 a year. In the last SARS virus "epidemic" in 2003, there were around 8,000 deaths worldwide but none in the US.

Swine flu has been diagnosed 160 times in ten countries, plus several hundred more in Mexico. The toll is almost sure to rise a great deal, but will it reach the level of normal, everyday flu? I hope not, and I rather doubt it, at least based on the recent SARS scare.

But that is all an intellectual, distanced, nuanced concept. The real world is a little different. This morning I went to wake up my son to get ready to take him to school. For a real change, he was already up. He had been throwing up, he had a sore throat, and his head was warm. We finally found the thermometer and took his temperature. It was 100, and 20 minutes later had risen a degree.

We got into the car and went to the local "Doc-in-the Box." (For non-US readers, that is a local private-care clinic that will take walk-up patients without an appointment.) After a few tests, which they can now do in a few minutes, they determined it was not flu or strep throat. It was just some bug he had come down with that needed a course of antibiotics. We got the medicine and went home.

On the way back I asked him if he was worried about whether he had swine flu. The day before, his school had cancelled a field trip, and a local large school district (Fort Worth) had simply closed for a week after one diagnosed case.

"Yeah, Dad, I was worried a little. Glad it's not the flu." And Dad was, too. Statistics, whether financial or medical, become meaningless when it's personal.

Have a great week, and stay healthy!

Your planning to enjoy his May through October analyst,

John Mauldin

Back to the Future Recession

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

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

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

MV=PQ

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

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

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

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

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

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

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

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

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

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

Financial Innovation: The Round Trip

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

2010-11: Back to the Future Recession

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

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

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

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

The Fed at the Crossroads

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

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

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

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

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

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

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

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

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

How Did We Get It So Wrong?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Trend Is Not Your Friend When It Ends

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

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

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

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

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

Orlando, Naples, Cleveland, and Grandkids

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

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

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

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

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

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

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

Your almost ready to be a grandfather analyst,

John Mauldin

The Trend May Not Be Your Friend

John Mauldin — Sat, 18 Apr 2009 04:43:54 GMT

Thoughts on the Continuing Crisis
Dressing Like an Economist
The Trend Is Your Friend Until the End of the Trend
What Is Money?
MV=PQ
Newport Beach, Orlando, and Home

Two weeks ago I presented my thoughts on the current economic situation at my 6^th Annual Strategic Investment Conference in La Jolla (co-hosted with Altegris Investments). The speech was well-received, at least to judge from the comment forms. So this week and next, we are going to revisit that talk (with a few edits). Let's start with a little set-up to explain the first few paragraphs.

My speech was Saturday morning. On Friday, I wore a nice grey suit with a Leonardo tie. For those who know about Leonardo's, they are "statement" ties. I should note that Tiffani picked the tie out for me about ten years ago and persuaded me to wear it. It took some getting used to. It is 16 silk-screened colors, bright blues and pinks and grays, the central feature of which is a very vivid parrot. It is not subdued.

When my good friend George Friedman of Stratfor gave his speech on Friday, he commented rather derisively about my taste in ties, which got him a few laughs. This did not bother me too much since, while George is a brilliant geopolitical analyst, his sense of sartorial style is not exactly top-drawer. So now, let's jump into the speech.

Dressing Like an Economist

Three years ago I was here at our third conference, and my daughter Tiffani came to me in the middle of the conference and said with a very serious face, "Dad, we've got to have a talk." Oops, we have to have a talk? This was her "You've done something wrong" face. But I didn't know what I had done. Had I been speaking with my zipper down? Was something I said wrong? So I said, "Well, let's go talk right now." And she says. "No, we can do this when you get home." And I said "No, now."

So we go to another room, and I ask, "What's wrong?" And she says, "Dad, the partners wanted me to come and talk with you." Oh God, I think, what is it?

Now, Art Laffer (he of the napkin and Laffer Curve fame) had spoken earlier at that conference. If any of you have ever seen Art speak, Art dresses to the nines. He gave a speech with which I did not agree. It was brilliantly delivered, but he was just wrong. But he looked really good being wrong.

So Tiffani says, "Dad, the partners want me to talk with you. You dress like an economist. You are supposed to be a guru. We've got to get you some new clothes." And it was true, I had not bought many new clothes for years.

So this is my guru suit. Somebody at least has some sartorial taste -- Tiffani and others picked it out. You can see the evidence of true style and taste by the way she dresses, can't you? And she picked out the tie, too. (And I should point out that the one person in George's family with outstanding taste, his wife and partner Meredith, liked the tie as well.)

Thoughts on the Continuing Crisis

Ok, with that out of the way, let's talk about some of my thoughts on the continuing crisis.

This cartoon is pretty much where we are right now. The consumer is shell-shocked. That pot of gold has now become just a pot. The 401k's are now 201k's. People are trying to figure out how to go forward. Let's go back and get some sense on how we got here and what the landscape looks like and what I think the future will look like.

By the way, I started writing this speech at 1 o'clock yesterday because everyone else was saying what I was going to say, so my friend Kerri helped me create this PowerPoint yesterday. I'm making two classic mistakes that every speaker should never make, and they are: number one, if you are not a morning person, you should never speak first thing in the morning, but I had to trade places with Dennis Gartman; and number two, you should never make a speech to your most important audience that you haven't made somewhere already. So we'll see how it goes, but you guys are all my closest friends, okay? So cut me some slack.

In the beginning there were banks, and the banks were without form or regulation. That lack of regulation begat panics. You had the panic of 1807, then the 1827 panic and Andrew Jackson got rid of the Bank of the US. Then you had the panic of 1873 and the panic of 1907 And over time, the powers that be, not wanting to have any more panics, created first the Federal Reserve and then the FDIC. After World War II, there were basically no more worries about bank deposits. The FDIC covered them, and we entered a new era of "stability." This did not repeal the business cycle and prevent recessions, but it did stop major bank runs and banking panics. We can clearly have financial crises, but they will be different than those of the Depression.

The Trend Is Your Friend Until the End of the Trend

Stability, though, as we were taught by Hyman Minsky, leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits, because we human beings learned to trade and invest by dodging lions and chasing antelopes on the African savannah. We now chase momentum and dodge bear markets. We are hard-wired to look around at our circumstances and predict trends far into the future.

We take the current trend and we project it forever. But the one thing we know about trends is that they are eventually going to end. The trend is only your friend until it ends. Trends are notoriously fickle. That stability breeds instability. Calvin Coolidge said in early 1929 that "In the domestic field, there is tranquility and contentment and the highest record of prosperity in years." The trend ended. "Apres moi, le deluge."

Now, so what happened in 1929, after this era of stability? The bubble burst and the stock market crashed.

By the way, I thought one of the great headlines in the papers from those days was, "The deluge of panic selling overwhelms the market. 19 million shares changed hands." 19 million shares changing hands caused the crash in 1929! That's about a minute today. Okay, before the Great Depression, Coolidge was telling us, at the end of his presidency, that everything was cool, and then we got Hoovered. They tried to balance the budget, and they didn't really provide any stimulus. We got Smoot-Hawley. Given the massive implosion of capital and the closing of banks, there clearly was not enough growth in the money supply. Government and the Fed just did a lot of wrong things.

So at the height of the Depression, in 1933, as Roosevelt was coming into his first term, we had 25% total unemployment; 37% (!) of non-farm workers were unemployed; 4004 banks had failed; $3.6 billion in deposits was lost. That's like trillions in dog years, okay? At least in 2009 dog years. You end up with bread lines, and the stock market just keeps going down, down, down (with a few marvelous bear-market rallies – maybe like what we are seeing today?).

Roosevelt comes along and we get the New Deal. He applied massive stimulus. By the way, his stimulus hired people. He put them to work building parks and the Tennessee Valley Authority. They were building a lot of infrastructure. He didn't put it into Democratic wish lists and permanent wealth transfers and welfare and special-interest agendas to increase the overall budget beyond what we could ever hope to actually pay for (without even more radical tax increases), which the Obama Administration is clearly doing. We'll get to the effectiveness of current policies in a moment.

Then let's look at what he did in 1937. With the economy somewhat on the mend, he tried to balance the budget, raise taxes, reduce deficit spending. And what happened? We had another deep recession and unemployment jumped back up to 20%. It was hard to pull that stimulus back out. And it's particularly dangerous to raise taxes in a weak economy.

Most of the people in this room are old enough to remember the Blue Screen of Death. Remember, you would be typing along on your computer and all of a sudden you would get this screen, saying, "You have an impossible error." (Okay, what's an "impossible" error? Clearly something happened that was possible.)

And the only thing you could do was just unplug the thing. You couldn't even turn it off -- you just had to unplug the computer. It was the Blue Screen of Death. Well, that is kind of what World War II was for the world. We unplugged the world economy, and then we started from a new base. We hit the reset button. We were at lows everywhere in the world; places were in a mess. So we began to grow from there. The bebt supercycle started. For all the recessions and bear markets, a new stability ensued, and debt and leverage began to grow.

We'll revisit that point in a moment. We are doing just what I do in my regular e-letter: I'm going to take three or four ideas, and at the end I'm going to try and tie them all together. Let's see how successful I am.

What Is Money?

Let's talk about what money is. For some people it's M-1 or M-2, and they worry that the money supply is growing too much. For some people it's gold; gold is the only real currency. I think those ideas each have their place, and there's some truths to them, but they focus us on the wrong thing.

It's a bit misleading to talk about money supply, because what money really is is roughly $2 trillion of cash and then $50 trillion in credit. Because what do the banks do? They take deposits in and then they borrow money to leverage them up. I take my credit card and I spend with it. I borrow against a house. I have an asset that rises, and I borrow against it.

We have two trillion dollars of actual cash propping up $50 trillion in credit. If we all decided to settle and pay off everything, we couldn't do it because there is not enough cash. There would be massive asset deflation. We, as a nation, are levered 25 to 1, or we were. Now, that $50 trillion is in a real sense the money supply because that is what we are all pretending is real money. I lend you money and you pretend you are going to pay me back. Then you pretend he [pointing at another attendee] is not going to call your debt for cash, and we are all going to keep the system going. Because if we all try to pay each other back at once, we are all collectively -- and this is a technical economic term -- screwed.

So we keep the system going. Now, where are we today? We are at the Great Deleveraging. We are seeing massive losses and destruction of assets, on a scale that is unprecedented. There was massive destruction of assets during the Great Depression, which caused a lot of problems, and we are seeing the same thing today. We are watching trillions simply being poofed (another technical economics term – which will drive my poor Chinese translator crazy!). We are watching people pay down their credit lines, which is one way of saying the supply of money and credit is shrinking.

This is not just in the US, but all over the world. Because when you start adding European cash-to-credit, and Japanese cash-to-credit, and Indonesian and Chinese cash-to-credit, it becomes multiple tens of trillions, and we are watching a goodly portion of that credit be vaporized. So we -- individuals and businesses -- are trying to find that $2 trillion in real cash and get some of it to pay down our debts. We are reducing that massive leveraged money supply down to some smaller number. We are hitting the Blue Screen of Death. We don't know what it is going to reset to, but we have permanently seared the psyche of the American consumer, and it is going to get reset to some lower number, about which I will speculate in a minute.

Now to give you some idea of how important credit was in our recent period of economic growth – and I keep using this slide, but it is an important slide because it shows you what would have happened in the economy without mortgage equity withdrawals. The red lines are what GDP would have been without MEWs. Notice that in 2001 and 2002 we would have had negative GDP for two years, that's 24 months. It would have been as long as or longer than the current recession. Not quite as deep, because we had the Bush stimulus and Bush tax cuts at the time. The Bush tax cuts were very important in keeping the economy rolling over in 2001 and 2002.

But notice that the recovery for the next four years would have been under 1%. We would have had under 1% GDP for four years running, without mortgage equity withdrawals, without people being able to spend more. That doesn't even count the leverage we increased on our auto loans, on credit cards -- you saw the two charts that Louie [Gave] and Martin [Barnes] used yesterday about the growth of credit, and we are now seeing it in reverse. Do you think George Bush would have stood even a small chance of being reelected without mortgage equity withdrawals?

Quarter 1-2006 we had $223 billion in mortgage equity withdrawals. Quarter 2-2008 it was $9.5 billion. Is it any wonder we were in recession by 2008? By the third and fourth quarters there was no money to keep the treadmill going That $50 trillion in credit was shrinking fast. We were imploding it. Further -- just as a little throwaway slide -- if you look at 2010 and 2011, we are getting ready for another huge wave of mortgage resets.

Now, we've gone through the last wave and we saw what happened; it created a lot of foreclosures. We are not out of the woods yet. It is going to be 2012 before we sell enough houses to really get back to reasonable levels, because we had 3.5 million excess homes at the top. We absorb about a million a year, it takes 3 years, that's kind of the math.

[Skipping some attempts at humor that you had to be there to get] ... By the way, this AIG thing and the bonuses, that's so bogus. I mean, the 40 people that created the problem were gone, they go to 40 other people and say, stick around because we've got to have somebody who actually knows what these things are to try and unwind it, and we'll give you a bonus. Some of them worked for a dollar against getting that bonus, and now we've told the world that a contract isn't a contract in the US of A, for a lousy 160 million dollars. No bank is going to want to play with the US again, because you don't want to be hauled up in front of Barney Frank.

MV=PQ

Okay, when you become a central banker, you are taken into a back room and they do a DNA change on you. You are henceforth and forever physically incapable of allowing deflation on your watch. It becomes the first and foremost thought on your mind: "Deflation, we can't have it." So let's move along to the next point, and then I'm going to tie them all together.

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

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

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

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

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

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

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

Side point: what happens if the $300 billion they put in the system comes back to the Fed's books because banks don't put it into the LIBOR market because they are worried about credit risks? If that happens, it does absolutely nothing for the money supply. Okay? It's like, goes here, goes back there -- it doesn't help us. If the Fed creates money which is simply deposited back with the Fed, then there is effectively no money creation. We are still faced with deflation. The Fed has got to somehow get it into the financial system. They've got to figure out how to create some movement.

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

(This is about as good a break point as I can find in the speech, so we will end here and take it up again next week.)

One note from today's data on deflation. The headline in the Wall Street Journal says China grew at 6.1% last quarter. That doesn't sound bad. But what was not in the story is that nominal growth was just 3.7%. The other 2.4% was because of deflation. To get real (after-inflation) growth you subtract inflation and/or add deflation. Growth in China is slowing down more than the headlines suggest.

Newport Beach, Orlando, and Home

I am writing this somewhere over Canada as I fly back from London. I always try and stay up on the way back so I can get on local time quickly, although I did not get enough sleep this trip. I will need to catch up this weekend. It will be good to be home.

This Thursday Tiffani and I leave for Newport Beach to attend Rob Arnott's annual conference. Each spring Research Affiliates brings together a rather special group of analysts and money managers to work through current economic issues. Harry Markowitz, Burton Malkiel, Mohammed El-Erian, Paul McCulley, and Peter Bernstein are just a few of the luminaries who will be there. I think Rob invites me for comic relief. And just like Jeremiah, he always serves some mighty fine wine (a few of you will get that).

Sunday I get back and then leave Monday to go Orlando to speak at the national Chartered Financial Analysts conference. My assigned topic will be the "state of the union" for alternative investments. If you are attending, you might want to drop into the session, as it will be at the very least provocative and for a few people rather controversial. I think the whole industry is at a crossroads, and we are going to see some real changes in the coming years.

And then? I am home for awhile. I told my London partner Niels Jensen that I would show up for his 50^th birthday party in mid-July, and maybe try to take a vacation then. And Amanda gets married in Tulsa in August. And of course the annual Maine fishing trip in early August. Oh, and Freedom Fest is penciled in for July 11, in Vegas. But not much travel in May and June, at least not yet.

Copenhagen and London were a whirlwind this week. I ended up getting asked to do CNBC Europe for about 30 minutes on a wide range of topics. I really like their Squawkbox crew. And it was good to spend time with the team at Absolute Return Partners. We had some very thought-provoking client meetings.

There is a lot of change getting ready to happen in my business, and I am grateful that it all seems to be for the good. I will be making a few announcements over the next few months that I am quite excited about. There are a lot of people in the finance world (and the world in general) that are really struggling, and I appreciate the support of my clients, my partners, and you, gentle reader. You are why I write this letter. Well, maybe you and my one million other closest friends -- but we both know it is really for you.

It's time to hit the send button, get my bags, drive home, get a good meal, and find my own bed. Have a great week!

Your happy to be home analyst,

John Mauldin

Is That Recovery We See?

John Mauldin — Sat, 11 Apr 2009 03:08:20 GMT

Is That Recovery We See?
Those Wild and Crazy Analysts
The Shadow Inventory of Homes
Commercial Real Estate Starts a Long, Slow Slide
P/E Ratios Go Negative!
The Effect of Earnings Surprises
Corporate Earnings and Recovery in Recessions
The Implosion in Social Security
Copenhagen, London, Newport Beach, etc.

The market, we keep hearing and reading, is telling us that there is recovery around the corner. And pundits point to data that seems to suggest the worst is behind us. The leading economic indicators, while still down significantly, seem to be in the process of bottoming. There is a large amount of stimulus in the pipeline. Mark-to-market has been modified. Housing seems to be finding a bottom, if you look at the rise in sales from January. And so on.

In this week's letter, we look at what past recoveries have looked like in terms of corporate earnings; and we look at the continued slide in earnings on the S&P 500, which has a negative price-to-earnings ratio looming in future months (yes, that is not a typo, we have an unprecedented earnings multiple). We take a peek at housing and foreclosures. There is just so much bad news out there (like continued unemployment) that it just has to get better, doesn't it? This should make for an interesting letter.

Is That Recovery We See?

This week the market seemed to like financial stocks and was buoyed on news that Pulte Homes would buy Centex to create the largest US homebuilder. And with banks having some room to adjust their writedowns as mark-to-market is modified, the market saw significant increases in the financial sector. Everywhere I keep hearing the old saw that the market predicts a recovery about six months out, so won't we see a recovery in the fourth quarter of 2009?

If you look at earnings estimates for 2009, that is what is suggested. Bloomberg reports that profits at S&P 500 companies probably fell 38% on average in the first quarter. The stretch of quarterly declines is the longest since at least the Great Depression, data compiled by S&P and Bloomberg show.

Earnings may drop 31% in the second quarter and 18% in the next before gaining 74% in the last three months of the year, analysts predict. Banks are projected to account for all of the rebound in the final quarter. Without financial companies, the gain turns into a 5% decline, the data show.

The above estimates are based on operating earnings, not as-reported earnings. Long-time readers know that operating earnings are actually earnings before interest and Bad Stuff. As-reported earnings are what companies actually report on their tax reports, and as a gauge of profitability they are much more reliable. Before the mid-'90s the difference between operating and as-reported earnings was typically quite small. Then companies found they could play the market if they played games with their operating earnings.

Operating earnings typically do not take into account one-time, nonrecurring events. The number of items which get classified as "nonrecurring" has mushroomed to the point where projected operating earnings for 2009 are more than double the estimates of as-reported earnings. Operating earnings for 2008 were almost three times actual, or as-reported, earnings. We certainly seem to have entered an era of really bad one-time events, which just keep on coming and coming. As recently as 2006, there was less than a 10% difference between the two. In some quarters it was only 5%. A far cry from today's 100%-plus.

Those Wild and Crazy Analysts

Analysts, who as a group have been egregiously bad at predicting earnings of financial stocks for the last two years, would have us believe they are due for a large rise in the 4^th quarter. Let's visit those assumptions for a few minutes.

They contend that much of the bad news in the subprime-loan and housing market has been written off. And one would have to admit that a lot has been; and with the relaxation of mark-to-market, there may indeed be some truth to that suggestion. But there are still some issues that remain for housing. Take a look at the graph below. (Not sure where it is from, as it was sent to me, but I have seen the same data elsewhere.) Notice that monthly mortgage-rate resets declined markedly in 2009 from 2008, but are expected to rise again in 2010 and 2011. There is still some heartburn in the mortgage market.

The Shadow Inventory of Homes

And foreclosures keep climbing, though some point to that fact that they seem to be leveling off. However, a strange thing is happening. We are seeing what is being called a "shadow inventory" of foreclosed homes.

"We believe there are in the neighborhood of 600,000 properties nationwide that banks have repossessed but not put on the market," said Rick Sharga, vice president of RealtyTrac, which compiles nationwide statistics on foreclosures. "California probably represents 80,000 of those homes. It could be disastrous if the banks suddenly flooded the market with those distressed properties. You'd have further depreciation and carnage." (San Francisco Chronicle)

A Realty Trac survey found that only 30% of foreclosures were listed for sale in real estate listings like the MLS (Multiple Listing Service). Add in homes that people would like to sell but simply can't find buyers for, and must either hold or rent, and the unsold inventory numbers that are public are likely far below actual available homes.

Might some homes in foreclosure be held off the market because banks eventually want to negotiate with the homeowner? Possibly, but other surveys show that anywhere from 30-40% of homes in the foreclosure process in many areas are actually already vacant. There is no one with whom to negotiate.

Typically a foreclosed home sells within a few weeks, as banks take the first "reasonable" offer. But it normally takes about three months from foreclosure to when the home is put on the market -- it takes a few months to get a home ready. But surveys show it is taking a lot longer now, and many homes have not made it onto the market, even as more homes are being foreclosed each month.

The Chronicle suggests several factors may be at work. First, there is the "pig-in-the-python" problem. There are just so many homes that it is hard to get them onto the market and sold. Normally there are about 160,000 homes a year in foreclosure sales. We are now seeing 80,000 a month, or six times normal levels, and rising.

Second, lenders could be deferring sales to put off having to acknowledge the actual extent of their losses. "With banks in the stress they're in, I don't think they're anxious to show losses in assets on their balance sheets," one observer said.

Finally, banks may not want to flood the market with foreclosures, driving prices down even more. They are simply managing their assets so as to recover the most capital they can.

Given that the graph above says there will be more mortgage misery as large numbers of mortgages reset in the next two years, and given the unknowable nature of the losses, it is somewhat optimistic to think financial profits will rise by 74% in the fourth quarter. But it gets worse.

Commercial Real Estate Starts a Long, Slow Slide

We are now starting to see some real deterioration in traditional bank lending. Delinquencies on home equity loans are rising rapidly. The American Banking Association released a composite index of eight different types of consumer loans, and the delinquency rate on this 35-year-old composite jumped to a record high of 3.22%.

The above reflects 4^th-quarter data. As unemployment is up 2% since then and is rising, it is more than reasonable to assume that we will see another record rise in delinquencies this quarter. With unemployment headed to over 10% and maybe 11% from today's 8.5%, delinquencies are likely to continue to rise for the entire year.

David Rosenberg reports that "The National Federation of Independent Business found in a poll that 28% of small firms said they had a line of credit or credit card limit cut back in the second half of last year; 69% stated they are facing worse terms. A new FICO study found that 11% of US consumers -- 22 million people -- have had their credit lines cut or accounts closed even though they have been paying their bills on time and retain a solid rating." This is certainly not good news for those who expect a positive 4^th quarter. Cutting credit to small business, the engine of job growth in the US, is hardly a prescription for a growing economy.

Commercial mortgages are in trouble. S&P has warned they may cut ratings on $97 billion in commercial-mortgage asset-backed debt. The country's 10 biggest banks have $327.6 billion in commercial mortgages, according to regulatory filings. A projected tripling in the default rate would result in losses of about 7% of total unpaid balances, according to estimates from analysts at research firm Reis Inc. (Bloomberg)

I think, given the track record of the analysts who project a 74% rise in earnings for financial stocks in the 4^th quarter of this year, that we should remain a tad skeptical. And speaking of earnings, let's go to the S&P web site and see how things are progressing.

But first, let's look at just how badly analysts blew it in estimating 2008 earnings. In the table below we see that as recently as October 15 they were estimating AS-REPORTED earnings to be $54, down from $92 when I first saw the 2008 estimates. There were only two months to go in 2008. So, what are the actual 2008 earnings? Down to $14.88!!!

Not exactly a record to inspire confidence. So, how are we doing in 2009? We see the same pattern. There is a clear deterioration in earnings estimates. Yet, even with the ever lower estimates, they are still projecting nearly a doubling from 2008. Care to make a wager as to what the estimates will look like in a few quarters? Think we will see earnings rise?

P/E Ratios Go Negative!

When we last visited the S&P web site a few weeks ago, the P/E ratio for the quarter ending September 30 was around 181. I must confess that when I looked at it today, as jaded as I am, I was shocked. You can see the numbers for yourself at http://www2.standardandpoors.com/spf/xls/index/SP500EPSEST.XLS?GXHC_gx_session_id_=5350992f205e73e4&.

The P/E ratio for the end of the second quarter is 1944 (not a typo). The losses of the 4^th quarter wipe out almost all earnings for the 12 months ending June 30. But by the end of the 3^rd quarter, the estimated P/E ratio has dropped to a (negative) -467. That has never happened. We have never seen negative earnings over a 12-month period since WWII. (I don't have data for the Depression era.)

Then as the negative earnings of the 4^th quarter of 2008 drop off, we see the estimated P/E ratio rise back to 30, which is quite high. However, if actual earnings come in lower, as I think they will, the P/E ratio will rise and/or the market will fall as negative earnings surprises just keep on coming.

The Effect of Earnings Surprises

As William Hester of Hussman Funds writes in a recent article, the rise and fall of the stock market closely correlates with earnings surprises. Look at the following chart. (You can see the whole article at http://www.hussmanfunds.com/rsi/econsurprises.htm. I highly recommend it.)

As Hester writes, "To track the trends in economic performance, we keep an ongoing tally of how data is announced relative to expectations -- a method of analysis originally inspired by Bridgewater Advisors . Economic data that surpasses expectations gets added to a 3-month running total. Data that comes in weaker than expected gets subtracted. A rising line means that economic data is generally coming in above expectations, while a falling line means that the data has disappointed. A descending line could be the result of an economy that is not expanding as quickly as economists predict or -- like in 2008 -- it could be the result of an economy that is contracting at a faster rate than expected.

"... Much of the excitement in the stock market -- at least that is related to the current performance of the economy -- seems to be centered on an economy that is performing less badly than expected. The risks here seem to be that if the trends in data surprises change, so could investors' attitudes toward stocks that are currently overbought on a number of measures.

"... If the high correlation between stock prices and data surprises holds, the recent rally in stocks might be tested. Even if the economy has bottomed, it's very likely that the eventual recovery will prove to be uneven, causing the flow of positive surprises to be uneven. During these periods, the risks to stocks will be greatest when the market is overbought and investors have priced in high expectations of positive data surprises continuing."

The projections of many market analysts assume that we will have something that will look like a normal recovery. I have objected that that could be a very bad assumption, since we are not having a normal recession. This is already a very lengthy recession, and is just going to get longer. As I will note below, there are reasons to think we could see a mild recovery late this year, only to dip back into recession next year.

Corporate Earnings and Recovery in Recessions

Next, let's look at a very interesting chart sent to me by one of my readers, Chad Starliper of Rather and Kittrell in Knoxville, Tennessee. It shows all the cumulative drops in earnings from major peaks, along with the recovery paths. What is interesting is the divergence between the pre- and post-WWII periods. Our experience since 1945 is one of rather quick recoveries, averaging about 3-4 years until earnings rise above the old highs.

The thicker black line shows a drop of 69.2% from peak earnings since 2007. Prior to World War II, it took 12-20 years for earnings to recover. Earnings are still dropping. As I will point out in the next few e-letters, we live in a world (not just the US) that is in a deep recession. There is massive deleveraging and deflation. The recovery is going to be quite slow, and that portends a slow recovery in earnings, which suggests protracted churning in the stock market. (By the way, for those of you who print out this letter, the next graph will be hard to read if it is not in color.)

Even ignoring the disastrous 4^th quarter of 2008, what if earnings drop by 80% or more, which is quite possible? That means they have to rise by 400% to get back to new highs. That could take some time. Even if they could rise at an unlikely 24% a year, it would take six years to see new highs. Look at what a mountain corporate earnings must climb.

Consumers are retrenching, and savings rates are likely to rise for at least 3-4 years, back to 7% or more, leaving consumer spending not at 70% of US GDP but closer to 63%. That will be a rather large adjustment, and will mean that a lot of productive capacity will have to be closed or allowed to lie in disuse for a long time. We just built too many strip malls and car factories and restaurants. It is going to take some adjustments.

Further, the Democratic Congress and the Obama administration are going to enact the largest tax increase in history in 2010, just as the economy is barely recovering. The Bush tax cuts go away, because the Republicans could not make them permanent when they had the chance. We are going to pay for that with a likely dip back into a recession in 2010, or at the very least a prolonged weak economy.

The Implosion in Social Security

And then there is the last piece of data I want to bring to your attention, which is the most troubling of all. Everyone knows that the government spends the Social Security surpluses on current needs, "borrowing" the money and putting it into a "Social Security Trust Fund," which is basically just US debt we owe to the trust fund. In other words, there is no trust fund with anything other than paper debt. It is accounting legerdemain.

Everyone assumed that the real problem would come sometime later next decade, when there would no longer be surpluses. In 2008, the Congressional Budget Office (CBO) projected there would be $703 billion in surpluses from 2009-18. Recently, the CBO has revised those estimates downward. It now projects surpluses to be only $83 billion. Here is a table that was sent to me from a blog by Chris Martensen. (http://www.chrismartenson.com)

Writes Chris, "In the projections for the table above, the CBO has assumed no cost of living adjustments (COLAs) in 2010, 2011, or 2012 and a return to economic growth next year. If either of those assumptions proves wrong, the table above gets smoked to the downside."

Losing $700 billion (and likely a lot more) out of your budget projections is a huge blow to the US taxpayer. That money is going to have to be borrowed, or spending reduced. But the plans are for huge increases in spending.

In one of the great ironies, the Democrats and the Obama administration are going to have to deal with the Social Security crisis, and soon. Bush tried to do so, and he got torpedoed from both sides of the aisle. Politicians just do not want to be seen doing anything to SS. Given the massive, multi-trillion-dollar deficits that are projected, the US is going to face some difficulty in borrowing to meet those deficits in the not-too-distant future. Is it 3 years? 4? 5? No one can say for certain, but that day is coming and it now appears much closer.

Let's say that US consumers do save 7%. That's almost a trillion a year. The trade deficit dropped to $26 billion last month, as imports continued to drop. That's another $300 billion that foreign central banks could recycle. The Fed could print a few trillion here or there without really pushing up inflation in today's deflationary world.

But there is a limit to continued $2-trillion deficits without the appreciable rise in interest rates that will be needed to attract buyers of Treasury bonds, which of course would increase interest-rate payments on the national debt, while also crowding out corporate and personal borrowing. This is not going to end well, and the end game is getting a lot closer.

All in all, the next few years are going to be a very difficult environment for corporate earnings. To think we are headed back to the halcyon years of 2004-06 is not very realistic. And if you expect a major bull market to develop in this climate, you are not paying attention.

The original question was "Is that recovery we see?" I think the answer is no.

Copenhagen, London, Newport Beach, etc.

Last week's Strategic Investment Conference was the best we have ever had. Many attendees said it was the best investment conference they had ever attended. We are transcribing speeches and will make some of them available over time.

The Richard Russell Tribute Dinner was a great success. We had video crews there as well as photographers, and intend to allow those who wish they could have been there to see part of the evening. It was a very emotional evening, and I want to thank the roughly 450 people who came from all over the world just to pay tribute to one of the true wonders of the investment-writing world.

I leave Monday evening for Copenhagen, where I will meet with Tom Fischer of Jyske Bank, and then day-long, back-to-back board meetings with Niels Jensen of Absolute Return Partners, and back to London Wednesday night for more meetings.

I get back Friday in time to write the letter, then off the next Thursday to Orange County, where I will attend Rob Arnott's annual conference. More on that later. Back on Sunday, and then out Monday to the Charter Financial Analyst conference in Orlando, where I speak on the "state of the union" of the alternative investment world. Then I am home for awhile, and gladly.

We had 300 people in for the Strategic Investment Conference, and the staff of my partners and co-hosts, Altegris Investments, did a magnificent job making everything go smoothly. There were so many friends there, the only disappointment was that I did not have all the time I wanted to meet with everyone. It was like drinking from a fire hose for three days, but it was fun.

It's time to hit the send button, as all my kids are in town and most of us are going to have some dinner and then see the Dallas Mavericks play. Brunch on Easter, of course, with family and friends, and then the final day of the Masters to round out a perfect weekend. I have been watching some of it on ESPN, and seeing Augusta on high-definition TV is truly spectacular.

I hope your weekend will be as good as mine. Spend time with family and friends if you can. That time is an investment that will pay dividends forever, and doesn't run up the national debt. Well, a little bit, if you have to buy the tickets and pay for brunch for about 16. But that's what Dads are for.

Your starting to think about the end game more analyst,

John Mauldin

Deep Inside the Dow

John Mauldin — Sat, 04 Apr 2009 02:27:00 GMT

What About the Original Dow 30 Stocks?
Adding and Subtracting Value
The Original Dow 30 Components
A Few Thoughts from Richard Russell
How to Succeed at Writing
Conversations on Banks
Copenhagen, London and Orange County, etc.

Tonight (Saturday) some 450 people will come together in San Diego to honor Richard Russell, who has been writing the Dow Theory Letter for over 50 years. In that spirit, in today's letter we are going to look deep inside the Dow, back to its very roots. The Dow is a price-weighted index as opposed to a cap-weighted index. Does that make a difference in performance? Specifically, does it affect how the Dow has performed since it was expanded to 30 names in 1928? There are some real surprises we have found, and I think you will find this letter very interesting.

What About the Original Dow Jones 30 Stocks?

The Dow Industrials was expanded to 30 names from 20 on October 1 of 1928. Today, only nine names of the original 30 remain in the Dow. The committee at Dow Jones has replaced the other names as the companies grew out of favor, were merged into other stocks, were considered too small, or the committee felt that other companies better represented the industrial prowess of the US economy.

For instance, in November of 1999, Goodyear and Chevron were removed in order to allow Microsoft and Intel to join the Dow 30, where the two tech giants proceeded to rise handily the next few quarters. However, it has not been that pretty since the end of 2000, with both stocks down approximately 60% from their entry price, and much further from their peak price. Chevron proceeded to move up some 60% in price after it was removed, at which point Chevron was inserted back into the Dow 30 on February 19, 2008, where it is now down about 15%. Not a good run for the selection committee.

But it is not all bad. If you look at the deletions and additions, you find some interesting timing issues. Some additions were excellent in terms of performance. Some avoided later bankruptcies.

Thinking about the Dow, I wondered how much the committee had helped or hurt the Dow performance over the last 80 years. What if we went back to the original 30 stocks and simply bought them and held them until today? Good, bad or indifferent, what would the results be?

I asked that question to good friend Rob Arnott of Research Affiliates. It turns out that he and Jeremy Siegel (of Wharton and Stocks for the Long Run fame) were corresponding over that very same question about the S&P 500. Rob helpfully sent my question on to one of his top research associates, Ms. Feifei Li, who spent a lot of time and effort to get me several large spreadsheets, some of which are over 800 pages long. The rest of this letter is based on her research, some very helpful comments, and observations by Rob, with some homework by me. Any wrong conclusions are all mine.

So, the question of the day: would you have been better off investing in the index, or buying the 30 stocks and holding them? Further, would it make any difference if you price-weighted them or equal-weighted them (explanations below)? What about inflation? And how does that compare to the S&P 500?

And before you answer, remember that one stock, Bethlehem Steel, went bankrupt. You would be stuck with Chrysler, which was removed in 1979 for IBM, which itself had been taken out in 1939 for AT&T. There have been 55 changes in the components of the Dow over the last 80 years. Some of the original 30, listed below, we would all recognize. But our kids might not remember Victor Talking Machines or Nash Kelvinator (Nash Auto).

(Sidebar: As a country, we let LOTS of auto companies fail over the decades. My Dad worked at Nash Auto in Wisconsin during the Depression because he could play baseball for their semi-pro team. Remember Rambler or Studebaker? But now we obsess about keeping an auto industry and union jobs.)

The Original Dow 30 Components

The following companies are the original members of the Dow 30 on October 1, 1928:

Allied Chemical, American Can, American Smelting, American Sugar, American Tobacco B, Atlantic Refining, Bethlehem Steel, Chrysler, General Electric Company, General Motors Corporation, General Railway Signal, Goodrich, International Harvester, International Nickel, Mack Truck, Nash Motors, North American, Paramount Publix, Postum Incorporated, Radio Corporation of America, Sears Roebuck & Company , Standard Oil (N.J.), Texas Company, Texas Gulf Sulphur, Union Carbide, U.S. Steel, Victor Talking Machine, Westinghouse Electric, Woolworth, and Wright Aeronautical.

Almost immediately the Dow 30 changed, as Radio Corporation of America bought Victor Talking Machines in January of 1929. Since RCA was already in the Dow, they added National Cash Register instead. Over time, US Steel became Marathon Oil. The remains of what was once mighty Woolworth are now Footlocker. Westinghouse is CBS. So, there have been some changes over time, leaving us only nine of the original Dow 30 still in the index.

For the insatiably curious, you can go to http://www.dogsofthedow.com/djdelete.htm and find a trove of data, including the additions and deletions over time.

Before we get into the actual data, a little about methodology. There is some subjectivity here. For instance, RCA was bought by GE in 1985. We did not then double-weight GE; we simply had one less component in our model. When Bethlehem Steel went bankrupt, that took away another component. While some stocks have clear trails all the way up until December of 2008, like Woolworth/Footlocker, others were taken private. We made our best effort to rationalize the data with the real world.

Adding and Subtracting Value

Now, the rather stark conclusion. As Rob noted to me in the email he sent with the data, "If Dow Jones hadn't tinkered with the index, the 30 companies would have merged or failed their way down to just 9 survivors. Of the 21 companies in the original 30 that are now gone, 20 disappeared through M&A, some were replaced by successor firms and others not, and only one (Bethlehem Steel) failed outright. But this no-fiddling index would have topped out at just over 30,000 in October 2007 and would have finished 2008 at 14,600. Ugly decline, but not as ugly as a level of 8776 [now down to 7300 as I type this]. This compounds out to a 0.7% per year greater return than the actual Dow 30 results. The difference comes from dropping companies when they're out of favor, and trading at deep discounts, only to replace them with popular large-cap, high-multiple newcomers."

Like Intel and Microsoft, as a prime example. And in the graph below, there was an almost immediate difference between the returns as RCA bought Victor, as mentioned above. But RCA was already in the Dow, so we did not double down on RCA but simply rebalanced with one less component for our 30.

The graph below is going to be hard to read for those who print it out in black and white, but I will try and talk you through it.

We track the original Dow 30 equal-weighted, the original Dow 30 using the Dow price-weighting methodology, and the S&P cap-weighted, for comparison. Also the Dow Total Return Index, the Dow price-only (no dividends), and the Dow 30 Real Price Index, or inflation-adjusted.

So, looking at the lines from the bottom and going up. First, let's see how you would have done on an inflation-adjusted basis with just the actual Dow 30. It's not pretty. The price-only inflation-adjusted index returns for the last 80 years are only a mediocre 1.4%! The price level of the Dow 30 is currently less than twice that of its August 1929 peak, net of inflation. Sadly, we last saw the 1929 peak level as recently as October of 1992. That means that an investor in the Dow 30, in August 1929, would have pocketed only the dividends, with no real price appreciation, for some 63 years.

Rob couldn't resist writing Jeremy, "Net of taxes on the dividends and cap gains taxation on the inflation "gains," the real after-tax return would have been awfully skinny. Jeremy, I hope you'll forgive me for saying so, but that's a 'Long Run' indeed!"

The next line is the Dow 30 price-only index (without dividends). That gives us a 4.6% annual average return. The next line up is the Dow 30 total returns, including dividends, which is 8.9%; this shows how important dividends are to the total return of the Dow. And with dividends now fairly skinny and being cut almost monthly by some component or other, we are left to wonder what total return will be over the next few years.

Next, we find that the S&P 500 cap-weighted index outperforms the Dow by about 0.2% annually, for a total return of 9.1%. Not much difference there.

Now we come to the interesting part. The next-to-the-top line is the original Dow 30, using a price-weighted index, just like the current Dow 30 uses. The only changes in the next 80 years are companies getting bought or dying. That "Original 30" gives us an annual return of 9.6%. Just 0.7% a year, so you might think, not much difference. But if you start with $100 and compound it for 80 years, that 0.7% becomes a quite large differential. With the Dow 30, your $100 would have grown to $96,993 as of December 2008, but the Original 30 would have grown to $161,603.

And there is an even bigger differential if you simply equal-weight the components rather than use a price-weighting methodology. Your $100 grows at a 10.4% clip and becomes $272,554, or almost three times the actual Dow 30. This is probably due to the fact that, whenever a change was necessary, it would be natural to add one of the more popular and respected large-cap growth stocks that wasn't already on the list. It's hard to earn a "risk premium" on assets that are not seen as having much risk!

What accounts for the difference? There were 34 changes in Dow components in the first five years. Many were dropped and then added back in. It was a VERY fluid index. There were two changes in 1939. IBM was dropped for AT&T, and Nash Kelvinator was again dropped for United Technologies. (NK was dropped the first time in 1930, only to be added back in 1932.) But, most of our Original 30 survived the Depression, so the Original 30 was largely unchanged during those tumultuous years.

Then, from 1939 there were no changes until 1956, when International Paper was added, followed by four changes in 1959. There were only three changes in the late 1970s and five in the '80s, but since then there have been 17 changes. The past two decades hardly qualify for buy and hold.

And we may see more changes. Anyone care to speculate on when General Motors gets replaced? Can you have a bankrupt component of the Dow, which typically removes a stock below $10? GM is now at $2, which is basically a call option on the Obama administration not completely wiping out shareholders in a bankruptcy. GE was down to $5.89 before rebounding today to $10.89. Could you really replace GE?

Can we find some nuggets of investing wisdom here? I think the thing that stands out most to me is how the slight difference of value over growth builds up over time, which is what a number of other studies show. This goes along with my numerous exhortations that the valuations you start with when you invest in stocks have a great influence on the long-term returns.

A market-cap-weighted index will tend to perform better than a price-weighted index over time, again because of the value orientation of the cap weighting. But equal weighting or, better yet, weighting and indexing according to valuation fundamentals like price to earnings, price to sales, price to book, etc. is even better. We don't have time to delve back into the research on fundamental indexes, but the letters I have written on it are in my archives at http://www.investorsinsight.com/.

A Few Thoughts from Richard Russell

As noted above, well over 400 guests will honor Richard Russell this weekend for 50 years of writing the incomparable Dow Theory Letters. A lot of people ask him how can they succeed as writers. He recently made some comments which I thought I would pass on, because they are so right. Also, he gives us a few fascinating moments, looking back over his career.

But first, let me thank the following firms and people for their generous support of this evening as sponsors, which will allow us to make a donation in Richard's name to his favorite charity, the Autism Foundation in San Diego:

Matthew Connors of ProFunds (www.profunds.com)

Ian McAvity of Deliberations

Bill Bonner, founder of Agora and editor of The Daily Reckoning (www.dailyreckoning.com )

Monex (www.monex.com)

Frank Trotter of Everbank (www.everbank.com)

Martin Zweig

Robert Prechter (http://www.elliottwave.com/)

And now, let's turn to Richard:

"I've been in this business a l-o-o-o-n-g time, and I've known a lot of great people, mostly through their subscriptions. Stanley Kubrick, the genius movie producer and director, was a subscriber for many years. Stan was a gold man, and we used to correspond. Stanley would tear off a piece of yellow paper and write notes to me. He invited me to visit his studio, 30 miles outside of London. When I visited England years ago, damn it, I completely forgot to visit him, a mistake I've always regretted.

"Marlon Brando's dad was a subscriber for years. I had met his Marlon while he was shooting On the Waterfront. I exchanged services with the great Hamilton Bolton, genius writer for The Bank Credit Analyst. Marty Zweig is a good friend of mine, and when Marty retired I took over his advisory -- this was years ago, and I still have many of Marty's subscribers on the books. I knew Garfield Drew, the original interpreter of the odd lots. I also knew E. George Schaefer, who authored his famous Dow Theory Trader advisory during the 1940s through the '70s. George used to run four-page ads in Barron's.

"John Magee was a friend of mine. John had a sign posted on his wall. It said, 'Don't tell me what to buy, tell me WHEN to buy it.' Bob Bleiberg, the brilliant editor of Barron's, was my friend and mentor. Bob was responsible for popularizing technical analysis of stock trends. General Marion Cooper was a subscriber. Coop invented the concept of King Kong and he produced the original movie. Coop was also adjutant general to Claire Chennault of the famous Flying Tigers, in Asia. The Tigers, with their outdated P-40s (painted like sharks), played hell with the Japanese off China.

"I'm very friendly with that fabulous pair, the gifted Aden sisters. I count Jim Grant (Interest Rate Observer) as a good friend (Jim is probably the best writer in the business). Then there's Robert Prechter of Elliott Wave fame (I originally urged Bob to go into business, and he's built up a wide following since). A few years ago, I took over Julian Snyder's business when Julie wanted to retire. I still talk with my old buddy Joey Granville. Other old-timers I keep in touch with are Jim Dines and Mister International -- the one and only Sir Harry Schultz.

"I guess my strangest subscriber was a priest who worked in a leper colony in West Africa. I never could figure out why he was interested in the stock market. The Bank of China was a subscriber; I don't know whether they still are. Many Arab organizations are subscribers. I used to say that I was the only Jew who the Arab big-wigs really listened to. Paul Penner, CEO of Agnico-Eagle, was a good friend of mine. Paul devoted his life to that gold mine, which is now one of the leading gold mines in Canada.

"The tireless, peripatetic John Mauldin is a good friend, and how John gets it all done (he has a million readers for his famous column) is a mystery to me.

"And it goes on and on. I did find that the stock market and finance was a totally democratic business. On Wall Street they don't give a damn who you are or what color or religion you are -- they only care about whether you know anything, which I believe is one of the best things about the money business.

How to Succeed at Writing

"I've been asked a thousand times, 'What's the secret of success in the advisory business?'

(1) You've got to be an obsessive nut to start with.

(2) You have to be able to write in a way that people understand and like to read.

(3) You can't come across as a phony who knows it all. Readers know that nobody knows it all.

(4) It helps if you have a long life and don't want to retire.

(5) You need a wife who can put up with a husband whose head is full of the markets 24 hours, day and night.

(6) Woody Allen said the 90% of success in life is just showing up. If you can show up for the markets 250 days a year, you're ready to start an advisory service (but I wouldn't wish this business on my worst enemy -- it's the closest thing to absolute madness. No wonder nobody else has lasted in the business 50 years).

(7) This is a lonely business. So be prepared. Need a friend? Get a dog. Need two friends? Get two dogs.

(8) One last thing -- you must have thick skin, because no matter what you write, some subscriber will send an e-mail calling you a moron or brain-damaged, and the scary thing is, that makes you think, because they may be right."

Conversations on Banks

This week I recorded a special conversation with Chris Whalen and Rich Lashley, two of the real experts on the US banking system. I learned a lot and found it a fascinating time. The Conversation will be up for subscribers the early part of next week. We will send you a notice. If you would like to know more about Conservations with John Mauldin, you can go to https://www.johnmauldin.com/newsletters2.html. The regular price for a yearly subscription is $199, but you can subscribe now for $109 and still get access to the previous timely Conversation with Ed Easterling and Lacy Hunt, as well as one with Nouriel Roubini. Don't wait, as I am sure my staff will only keep raising the price. To find out more, just click on the link and put in code JM75, which will give you the discounted price.

And for organizations that would like to purchase a discounted multiple subscription for all their brokers or partners, just drop Tiffani a note at conversations@2000wave.com and she will get back to you.

Copenhagen, London and Orange County, etc.

I will report at some point on the fascinating afternoon I had with Dr. Hans Keirstead, a professor at the University of California, Irvine, and one of the leading stem cell researchers in the world. We are on the cusp of amazing changes in medicine. Real therapies for numerous major killers like MS and spinal cord injuries are around the corner. It was a very upbeat session.

Today, I am in La Jolla for my Strategic Investment Conference, co-hosted with my partners Altegris Investments. I will be talking on how I see the global economy shaping up over the next few years. Eventually, that talk will make it into this weekly letter. Saturday night is the Richard Russell Tribute Dinner. Then home for a week. Easter weekend, all seven kids will be home. Then the following week I go to Copenhagen for a board meeting; and I will be in London, Thursday April 16 to meet with my European partners, Absolute Return Partners, and clients. The next weekend I go back to California for a conference sponsored by Rob Arnott, and then the next week I'll be a day or so in Orlando, where I'll speak at the CFA conference on the state of the alternative investment industry.

At the end of May (29-31), I will be in Naples, where I will be doing a seminar with Jyske Global Asset Management and Gary Scott. You can see more at www.jgam.com.

A quick note: There has been a lot of writing on mark-to-market. There were a few bloggers who said I was wrong (some rather rudely) about the mark-to-market changes that were coming. I hope by now they see they were wrong and have edited their remarks. And for a sense of what the mark-to-market controversy is all about, I suggest you look at this video presentation by Barry Habib of Mortgage Market Guide. Barry was on top of the issue months ago as the source of a lot of problems. It is done in a way that everyone can understand. http://www.mortgagesuccesssource.com/go/markmarket/index.html

This is a fun weekend. Almost 300 clients and friends are at my sold-out conference in La Jolla. And because of the Russell dinner, so many writers and publishers are here as well. And my business partners from around the world. And Tiffani is her usual well-dressed self. She rarely buys new clothes, but for whatever reason she goes all out for this weekend, and her attire is now subject to oohs and aahs, and she has a reputation to live up to. Dad is proud.

Have a great week, and find a few friends, at least over the phone, to share some time with. It is about the healthiest thing you can do.

Your ready to listen and learn this weekend analyst,

John Mauldin

Why Bother With Bonds?

John Mauldin — Sat, 28 Mar 2009 13:32:00 GMT

Why Bother With Bonds?
So Then, Bonds for the Long Run?
P/E Ratios at 200? Really?
Mark-to-Market Slip Slides Away
Housing Sales Improve? Not Hardly
La Jolla, Copenhagen, London, etc.

Investors, we are told, demand a risk premium for investing in stocks rather than bonds. Without that extra return, why invest in risky stocks if you can get guaranteed returns in bonds? This week we look at a brilliantly done paper examining whether or not investors have gotten better returns from stocks over the really long run and not just the last ten years, when stocks have wandered in the wilderness. This will not sit well with the buy and hope crowd, but the data is what the data is. Then we look at how bulls are spinning bad news into good and, if we have time, look at how you should analyze GDP numbers. Are we really down 6%? (Short answer: no.) It should make for a very interesting letter.

And for the last time, let me remind you of the Richard Russell Tribute Dinner this Saturday, April 4 in San Diego. We have had over 400 of Richard's fans (I guess you could say we are all groupies) sign up. A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. You are going to be able to rub shoulders with some very famous analysts and writers. If you are a fellow writer, you should make plans to attend or send me a note that I can put in the tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven't, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don't procrastinate. I wouldn't want any of you to miss out on this tribute. I look forward to sharing the evening with all of you. I am really looking forward to that evening.

Why Bother With Bonds?

If stocks outperform bonds by as much as 5% over the long run then, for our truly long-term money, why should we bother with bonds? Why not just ignore the volatility and collect the increased risk premium from stocks? That is the message of those who believe in "Stocks for the Long Run" and also from those who want you to invest in their long-only mutual fund or managed account program. Indeed, it is always a good day to buy their fund.

One of my favorite analysts is my really good friend Rob Arnott. Rob is Chairman of Research Affiliates, out of Newport Beach, California, a research house which is responsible for the Fundamental Indexes which are breaking out everywhere (and which I have written about in past letters), as well as the only outside manager that PIMCO uses, for his asset allocation abilities. He has won so many industry awards and honors that I won't take the time to mention them. In short, Rob is brilliant.

He recently sent me a research paper that will be published next month in the Journal of Indexes, entitled "Bonds: Why Bother?" The publisher of the journal, Jim Wiandt, has graciously allowed me to review it for you prior to it actually being sent out. The entire article will be available when the Journal of Indexes goes to print in late April, at www.journalofindexes.com. Qualified financial professionals can also get a free subscription there to pick up the print copy. There is some very interesting research at the website. But let's look at a small portion of the essay. I am reducing 17 pages down to a few, so there is a lot more meat than I can cover here, but I will try and hit a few things that really struck me.

It is written into our investment truisms that investors expect their stock investments to outpace their bond investments over really long periods of time. Rob notes, and I confirm, that there are many places where investors are told that stocks have about a 5% risk premium over bonds.

By "risk premium," we mean the forward-looking expected returns of stocks over bonds. As noted above, if you do not think stocks will outperform bonds by some reasonable margin, then you should invest in bonds. That "reasonable margin" is called the risk premium, about which there is some considerable and heated debate.

Most people would consider 40 years to be the "long run." So, it is rather disconcerting, or shocking as Rob puts it, to find that not only have stocks not outperformed bonds for the last 40 plus years, but there has actually been a small negative risk premium.

In a footnote, Rob gets off a great shot, pointing out that the 5% risk premium seen in a lot of sales pitches is at best unreliable and is probably little more than an urban legend of the finance community.

How bad is it? Starting at any time from 1980 up to 2008, an investor in 20-year treasuries, rolling them over every year, beats the S&P 500 through January 2009! Even worse, going back 40 years to 1969, the 20-year bond investors still win, although by a marginal amount. And that is with a very bad bond market in the '70s.

Let's go back to the really long run. Starting in 1802, we find that stocks have beat bonds by about 2.5%, which, compounding over two centuries, is a huge differential. But there were some periods just like the recent past where stocks did in fact not beat bonds.

Look at the following chart. It shows the cumulative relative performance of stocks over bonds for the last 207 years. What it shows is that early in the 19^th century there was a period of 68 years where bonds outperformed stocks, another similar 20-year period corresponding with the Great Depression, and then the recent episode of 1968-2009.

In fact, note that stocks only marginally beat bonds for over 90 years in the 19^th century. (Remember, this is not a graph of stock returns, but of how well stocks did or did not do against bonds. A chart of actual stock returns looks much, much better.

Bill Bernstein notes that in the last century, from 1901-2000, stocks rose 9.89% before inflation and 6.45% after. Bonds paid an average of 4.85% but only 1.57% after inflation, giving a real yield difference of almost 5%. In the 19^th century the real (inflation-adjusted) difference between stocks and bonds was only about 1.5%.

In the late '90s, stock bulls would point out that there was no 30-year period where stocks did not beat bonds in the 20^th century. The 19^th century for them was meaningless, as the stock market then was small, and we were now in a modern world.

But what we had was a stock market bubble, just like in 1929, which convinced people of the superiority of stocks. And then we had the crash. Also, from 1932 to 2000 stocks beat bonds rather handily, again convincing investors that stocks were almost riskless compared to bonds. But in the aftermath of the bubble, yields on stocks dropped to 1%, compared to 6% in bonds. If you assumed that investors wanted a 5% risk premium, then that means they were expecting to get a compound 10% going forward from stocks. Instead, they have seen their long-term stock portfolios collapse anywhere from 40-70%, depending on which index you use.

So what is the actual risk premium? Rob Arnott and Peter Bernstein wrote a paper in 2002 about that very point. Their conclusion was that the risk premium seems to be 2.5%. Arnott writes:

"My point in exploring this extended stock market history is to demonstrate that the widely accepted notion of a reliable 5% equity risk premium is a myth. Over this full

207-year span, the average stock market yield and the average bond yield have been nearly identical. The 2.5 percentage point difference in returns had two sources: inflation averaging 1.5 percent trimmed the real returns available on bonds, while real earnings and dividend growth averaging 1.0 percent boosted the real returns on stocks. Today, the yields are again nearly identical. Does that mean that we should expect history's 2.5 percentage point excess return or the five percent premium that most investors expect?

"As Peter Bernstein and I suggested in 2002, it's hard to construct a scenario which delivers a five percent risk premium for stocks, relative to Treasury bonds, except from the troughs of a deep depression, unless we make some rather aggressive assumptions. This remains true to this day."

One other quick point from this paper. Just as capitalization-weighted indexes will tend to emphasize the larger stocks, many bond indexes have the same problem, in that they will overweight large bond issuers. At one point in 2001, Argentina was 20% of the Emerging Market Bond Index, simply because they issued too many bonds. If you bought the index, you had large losses. The same with the recent high-yield index which had 12% devoted to GM and Ford. In general, I do not like bond index funds, and this is just one more reason to eschew them.

So Then, Bonds for the Long Run?

Let me be clear here. I am not saying you should put your portfolio in 20-year bonds, or that I even expect 20-year bonds to outperform stocks over the next 20 years. Far from it! The lesson here is to be very careful of geeks bearing charts and graphs (it will be a challenge for my Chinese translator to translate that pun!). Very often, they are designed with biases within them that may not even be apparent to the person who created them.

Professor and Nobel Laureate Paul Samuelson in late 1998 was quoted as saying, a bit sadly, "I have students of mine - PhDs - going around the country telling people it's a sure thing to be 100% invested in equities, if only you will sit out the temporary declines. It makes me cringe."

When someone tells you that stocks always beat bonds, or that stocks go up in the long run, they have not done their homework. At best, they are parroting bad research that makes their case, or they are simply trying to sell you something.

As I point out over and over, the long-run, 20-year returns you will get on your stock portfolios are VERY highly correlated with the valuations of the stock market at the time you invest. That is one reason why I contend that you can roughly time the stock market.

Valuations matter, as I wrote for many chapters in Bull's Eye Investing, where I suggested in 2003 that we were in a long-term secular bear market and that stocks would be a difficult place to be in the coming decade, based on valuations. I looked foolish in 2006 and most of 2007. Pundits on TV talked about a new bull market. But valuations were at nosebleed levels. And now?

I have been doing a lot of interviews with the press, with them wanting to know if I think this is the start of a new bull market. There are a lot of pundits on TV and in the press who think so. I also notice that many of them run mutual funds or long-only investment programs. What are they going to do, go on TV and say, "Sell my fund"? And get to keep their jobs?

Am I accusing them of being insincere? Maybe a few of them, but most have a built-in bias that points them to the positive news that would make their fund (finally!) perform. And believe me, I can empathize. It is part of the human condition. But you just need to keep that in mind when you are thinking about investing in a new fund, or rethinking your own portfolio.

P/E Ratios at 200? Really?

Just for fun, when I was interviewing with the New York Times today, I went to the S&P web site and looked at the earnings for the S&P 500. It's ugly. The as-reported loss for the S&P 500 for the 4^th quarter was $23.16 a share. This is the first reported quarterly loss in history. That almost wipes out the expected earnings for the next three quarters. For the trailing 12 months the P/E ratio, as of the end of the second quarter, is 199.97. Close enough to 200 for government work.

But it gets worse. The expected P/E ratio for the end of the third quarter is (drum roll, please) 258! However, taking the loss of the fourth quarter off the trailing returns allows us to get back to an estimated P/E of 23 by the end of 2009. The problem is that you have to believe the estimates, which I have shown are repeatedly being lowered each quarter, and which I expect to be lowered by at least another 25% in the coming months.

Now, much of that loss is coming from the financials, which showed staggering write-offs of $101 billion, $28 billion coming from (no surprise) AIG alone. Sales across the board are down almost 9%, with 290 companies reporting lower sales.

This quarter the estimated consensus GDP is somewhere between down 5% to down 7%. Last quarter we were down an annualized 6.3%. That would be two ugly quarters back to back. It is hard to believe earnings for nonfinancial companies are going to be all that much better.

Side note: The economy did not contract at 6.3% in the 4^th quarter. That is an annualized number. The quarter actually contracted at about 1.6%. If we go a whole year with a 6% contraction, that would be truly horrendous. We would blow right on through 10% unemployment. While it is possible, we should start to see somewhat better numbers in the second half of the year, although I still think they will be negative.

Mark-to-Market Slip Slides Away

But it is quite possible that the financial stocks see an improvement in earnings this quarter. The US Financial Accounting Standards Board (FASB) changed the mark-to-market rules last week, which many (including your humble analyst) thought was needed. First, they suspended the mark-to-market rules for assets in distressed markets. Second, they widened the definition of "temporary" impairments of troubled assets, which will "allow banks to write up the value of some troubled assets if these have been hit by falling markets without (yet) suffering any significant credit losses." (www.gavekal.com)

Here's the important part. The board decided to make the new changes effective immediately, prior to full board approval on April 2.

As my friend Charles Gave noted, this will allow banks to write up their paper, and it happens before Treasury Secretary Tim Geithner starts putting taxpayer money at risk. Expect to see a pop in valuations. It will be interesting to see if Citi and B of A post profits this quarter.

(I should note that the International Accounting Standards Board sent out a scathing press release. I guess from that we should assume that European banks will not be so fortunate as their US counterparts.)

In theory, as I understand it, the information will still be there, but the way it will be recorded will not be reflected in the profit and loss statement. I understand that this is a very controversial proposal, and I expect many readers will disagree. The key is whether or not the information is available to investors and how the proposals are put into actual practice. If there is abuse, and regulators should be all over this, then the old rules must quickly go back into place.

This could put some strength back into financials, at least until the commercial mortgage and credit card problems start having to be written off. At the least, it could make for another solid rise in the stock market until we start to get what I expect to be very bad 1^st and 2^nd quarter earnings.

Housing Sales Improve? Not Hardly

I opened the Wall Street Journal and read that new home sales were up in February. Bloomberg reported that sales were "unexpectedly" up by 4.7%. I was intrigued, so I went to the data. As it turns out, sales were down 41% year over year, but up slightly from January.

But if you look at the data series, there was nothing unexpected about it. For years on end, February sales are up over January. It seems we like to buy homes in the spring and summer and then sales fall off in the fall and winter. It is a very seasonal thing. If you use the seasonally adjusted numbers, you find sales were down 2.9% instead of up 4.7%. But the media reports the positive number. Interestingly, they report the seasonally adjusted numbers for initial claims, which have been a lot better than the actual numbers. Not that they are looking to just report positive news, you understand.

Plus, as my friend Barry Ritholtz points out, the 4.7% rise was "plus or minus 18.3%". That means sales could have risen as much as 23% or dropped 13%. We won't know for awhile until we get real numbers and not estimates. Hanging your outlook for the economy or the housing market on one-month estimates is an exercise in futility, and could come back to embarrass you.

But that brings up my final point tonight, and that is how data gets revised by the various government agencies. Typically with these government statistics, you get a preliminary number, which is a guess based on past trends, and then as time goes along that data is revised. In recessions like we are in now the revisions are almost always negative.

There is no conspiracy here. The people who work in the government offices have to create a model to make estimates. Each data series, whether new home sales, employment, or durable goods sales, etc., has its own unique sets of characteristics. The estimates are based on past historical performance. There is really no other way to do it.

So, past performance in a recession suggests higher estimates than what really happens. Then, the numbers in the following months are revised downward as actual numbers are obtained. But the estimates in the current months are still too high. That makes the comparisons generally favorable, at least for one month. And the media and the bulls leap all over the "data," and some silly economist goes on TV or in the press and says something like, "This is a sign that things are stabilizing." It drives me nuts.

Ignore month-to-month estimated data. The key thing to look for is the direction of the revisions. If they are down, as they have been for over a year, then that is a bad sign. Further, one month's estimates are just noise. Look at the year-over-year numbers. When the direction of the revisions is positive and the year-over-year numbers are starting to stabilize, then we will know things are starting to turn around.

La Jolla, Copenhagen, London, etc.

April is a travel month. Next week I am going to a presentation in Irvine on the state of stem cell research, which I must admit fascinates me. Then I'm in La Jolla for my Strategic Investment conference, co-hosted with my partners Altegris Investments. Then home for a week. Easter weekend, all seven kids will be home. Then the next week I go to Copenhagen for a board meeting; and I will be in London, Thursday April 16 to meet with my European partners, Absolute Return Partners, and clients. The next weekend I go back to California for a conference, and then the next week I'll be a day or so in Orlando, where I'll speak at the CFA conference on the state of the alternative investment industry.

While I'm in London, I need to drop by and buy a pint for David Stevenson, a columnist for the Financial Times. Seems that he was asking his readers for nominations for best financial websites. For whatever reason, he decided I deserved a special award: "Best online commentator goes to US analyst John Mauldin, whose weekly letters at www.frontlinethoughts.com are required reading for all the big City-based bears I encounter." It's nice to be appreciated.

At the end of May (29-31), I will be in Naples, where I will be doing a seminar with Jyske Global Asset Management and Gary Scott. I will try to line up a web site where you can see whether you would like to attend.

It's after midnight and time to hit the send button. The day simply vanished on me, although I did get to the gym, at least. I am working hard, but somebody turned the dial down on my metabolism.

Have a great weekend. It is spring in the northern hemisphere, and the azaleas in Texas are awesome this year. Make sure you stop and enjoy nature a little this spring (or fall, for you blokes Down Under).

Your getting more skeptical of data as I get older analyst,

John Mauldin

Solving the Housing Crisis

John Mauldin — Sat, 21 Mar 2009 21:05:00 GMT

Solving the Housing Crisis
Housing Could Drop Another 20% in Pricing
Buy A Home, Get a Green Card
A Real Stimulus Package
Las Vegas, La Jolla, and the OC

This last Tuesday the Wall Street Journal published an op-ed by my friend Gary Shilling and Richard LeFrak. They offer a simple solution for the housing crisis: give foreigners who will come to the US and buy a home resident status (green cards). This is a very important proposal and one that deserves national attention and action. Gary was kind enough to send me two lengthier white papers offering more facts. In this week's letter we are going to look at this proposal in more detail than the small space that an op-ed can offer. And while this letter will be somewhat controversial in some circles, I ask that you read it through, giving me the time to make the case. I will also add a few thoughts as to why this could not only help solve the housing crisis, but help put the nation back into growth mode.

Long-time readers know that I have been growing more and more bearish of late. I have been writing for a long time that we are in for a long period of slow Muddle Through growth as the twin crises of the housing bubble and credit bubbles require time to heal. Today we look at a serious proposal for cutting the time to healing for at least one of those bubbles (housing), and at least keep the other (credit) from getting worse. This is the most serious idea I have seen that could actually make a real positive contribution to the economy and help put us back on a growth path.

I will post Gary's papers and a link to the actual op-ed piece for those who want to do further research, but let me make one point at the beginning that he did not emphasize: the US is already allowing roughly 1 million immigrants a year into the country (which for a variety of reasons I and most serious economists of all stripes believe is a very good thing). We are suggesting that we simply change the nature of what constitutes the conditions for acceptance, so as to jump start the housing industry and the economy. We are not suggesting additional immigrants, although nothing would be wrong with that. I will also post a link for you to send this e-letter to your congressmen and senators.

Let me put up front a few benefits of a program that would allow legal status to immigrants buying a home. Housing values would stabilize and in many cases rise. The massive losses because of bad loans that are being subsidized by US taxpayers would be stemmed, saving many hundreds of billions, if not a trillion or more dollars. The excess inventory of homes would quickly disappear and the millions of jobs that were lost as home construction fell into a deep depression would come back. If housing values rise, many families would be able to refinance their homes at lower rates and have more income left over after paying their mortgages. $12 billion in commissions would end up in real estate agents' pockets, helping a very battered and bruised group. Hundreds of billions will flow into local businesses, as these new immigrants will need to furnish their homes. This could mean as much as a half trillion dollars in sorely needed stimulus in the next few years, without one penny of taxpayer money and actually adding taxes back to governments from local to national. And we are not bringing in 1 million foreigners, we are attracting 1 million mostly middle-class new Americans, which, if we are smart in how we do this, will result in more jobs for all Americans. So let's jump right in and look at the details.

Housing Could Drop Another 20% in Pricing

Let's review the situation as it will be if we do nothing. Shilling shows that we built 6.7 million more homes in this country between 1996-2005 than the normal trend would have projected, partially because we underbuilt the decade before that. New housing starts average about 1.5 million in normal times but have fallen to 500,000 recently, and could fall further as unemployment rises and demand declines. Even so, Shilling estimates that we still have about 2.4 million excess homes.

This compares rather well with estimates by independent analyst John Burns, which I cited in the e-letter early last year. What they both agree on is that it will take at least until 2012 to work through this excess inventory, and that assumes that foreclosures do not increase as housing prices drop.

Excess supply of anything means lower and continuously falling prices, and that has certainly been the case in housing. Here is what Shilling writes:

"We believe that if nothing is done to eliminate surplus housing, prices will fall another 20% between now and the end of 2010 for a total peak-to-trough decline of 37% (Chart 1 below). The resulting further negative effects on the economy will be devastating. At that point, almost 25 million homeowners, or almost half the 51 million total with mortgages, will be underwater… That's also a third of the 75 million total homeowners, with the remaining 24 million owning their houses free and clear. It would take a little over $1 trillion to reduce their mortgages to the value of their houses, compared to $449 billion for the almost 14 million currently underwater."

This is not inconsistent with similar projections by other acknowledged experts and independent analysts like John Burns and Professor Robert Shiller of Yale. If nothing happens to stimulate buying, there is a great deal more pain ahead for American homeowners.

For the great majority of Americans, their homes represent the largest portion of their assets. This is particularly true of Americans of more modest means, who have been hit the hardest. Watching their single biggest assert drop another 20% will be devastating and for many will mean they will not be able to retire as they had planned. More Americans own homes (68%) than own stocks (50%). This helps explain a recent poll which shows more Americans are worried about house prices than about the decline in stock prices.

Falling home prices means that consumers have to save more for retirement, which results in lower consumer spending, which translates into lost jobs and more homeowners coming under stress -- a vicious spiral that is increasing unemployment. Realistic estimates of unemployment rising to over 10% within the year abound.

Two years ago I and a few others foresaw the current housing crisis (and an accompanying credit crisis), predicting a protracted recession and a slow, multi-year Muddle Through recovery. Sadly, I was right about the housing crisis. Without some intervention, there is little to suggest that the prediction of a long, protracted recovery will not come true.

Lowering rates, as is being discussed in various circles, will help homeowners who can make their payments, but it does nothing to really bite into excessive inventory. Until we reduce the inventory, housing prices in many neighborhoods all across America are going to continue to come under pressure. And as Barry Habib points out, while the Fed may be lowering rates for securitized packages of loans, those low rates are not available to the average home buyer. The cost of packaging and securitization adds considerable cost.

Shilling discusses the "traditional" options for reducing home inventories, but in the end there is no real solution other than time, or massive amounts (read trillions) in taxpayer money being given to homeowners, which will be very unpopular, as homeowners who were responsible and are paying their mortgages would get no benefits. Waiting another two and a half years for the excessive inventory to sell will keep this country in a very slow or no-growth economy, and devastate the wealth of millions of homeowners.

But there is a solution. There are millions of foreigners throughout the world who would like to come to live in the US. In 2006, there were 1.1 million immigrants allowed into the US, some 63% of whom were allowed in simply because they already had relatives here. Only 13% of visas were granted to people because of their skills. While allowing relatives of current residents to come to the US may be a humane and reasonable policy, it does nothing to assure they bring more than that relationship to help them make their way in the US.

Buy A Home, Get a Green Card

What if we changed the rules for a few years? Starting as soon as possible, we should allow anyone to come into the country who would buy a home. They would be given a temporary visa which would become permanent if they had no problems after, say, five years.

While Gary proposes that they be allowed to borrow against the value of their homes, I lean toward suggesting that initially we take those who buy their homes outright (with a few exceptions). That means they have enough capital to purchase a home to begin with, which probably means they are educated and have skills. In fact, if they have enough cash to buy a home, that means they would have more actual savings than most US citizens. We would be attracting future citizens with the capital to invest in job-creating businesses and/or who have useful skills to assist in the recovery of the US economy.

Of course, there should be some rules that go along with this proposal. Background checks and references should be required. The home could not be rented for a period of time (at least two years), to help reduce the supply of available housing, and could not be resold for at least two years unless another home was purchased. There should be a minimal price, which could be somewhat different for various regions, but $100,000 would seem to be a good minimum for most areas, with higher minimums in certain areas.

The immigrant should demonstrate the ability to support himself and his family for a period of time (at least one year, preferably two), including the purchase of health insurance. Cash or letters of credit or other guaranteed commitments would be required. Only immediate family members (spouse and children) would be allowed to come with the immigrant. Cousins and siblings must buy their own homes. The permanent visa should be contingent on not having gone on welfare or public assistance at any time in the past five years. We are trying to solve a housing problem, not looking to create others.

I would make an exception in having 100% financing for immigrants with advanced degrees or special skills, especially those who did their schooling in the United States. If the US is to remain competitive in an increasingly technological world, we need more scientists and engineers. But getting permission to stay is becoming increasingly difficult. We are seeing a brain drain of those who would like to stay and create new jobs and technologies (and buy houses) here in the US. Shilling and Le Frak write:

"The authors of this report believe that a number of people have given up waiting for those visas or don't want to put up with the hassle and are leaving the country. This "brain drain" is unfortunate since many of these foreigners are highly productive. In 2006, foreign nationals residing in the U.S. were named as inventors or co-inventors on 25.6% of the 42,019 international patent applications filed from this country, up from 7.6% in 1998. Studies of the authorship of academic papers show the same trend.

"U.S. educational institutions are considered the best in the world by many and are magnets for foreign students, especially at the graduate level. Many of them are inclined to settle and work in this country after completing their studies, if they can obtain permanent resident status.

"The Council of Graduate Schools survey revealed that in the fall of 2007, 241,095 non-U.S. citizens were enrolled in graduate programs. Technological progress and the productivity it generates depends on people educated in biological sciences, engineering and physical sciences, but only 16% of U.S. citizen graduate enrollment was in these three disciplines. In contrast, 55% of total non-U.S. citizen enrollment was in those fields. Conversely, 53% of graduate enrollment by Americans was in education, business and health sciences while those three fields accounted for only 24% of foreign graduate students."

(There is a great deal more background detail in the second white paper. See link below.)

Much can be learned from similar programs already in place in immigrant-hungry countries such as Canada, Australia, and New Zealand. The United Kingdom has recently added new programs. Many countries realize that in the coming years there is going to be increasing competition for the best and brightest of the world. Again, there are more details in the white papers, but let's turn to the effects that would result from such a program.

A Real Stimulus Package

First, upon Congressional approval, it would almost immediately stop the seemingly inexorable slide in house prices, as initial demand would be significant. Let's assume one million new immigrants would buy homes. At an average price of almost $200,000, that would be $200 billion injected into the economy. And each of those homes has to be furnished, food has to be bought, clothing will be needed, local taxes will be paid. Airplane tickets to research potential areas, hotels needed during the interim period, and other related expenditures would add up. Over two years, this could easily be another $100 billion.

Couple 1 million new buyers with current US demand, and the excess inventory would be worked through within a year, and possibly faster. This puts a floor under the housing market, and home values could once again to begin to rise in line with a growing economy.

Such a program would have a salutary effect on the value of the dollar, as not only the initial purchases of homes and materials would need to be converted to dollars, but it is likely that immigrants would bring even more capital into the country.

By stemming the fall of home values, it would decrease the likelihood of foreclosures and help homeowners get refinancing at lower rates. Refinancing now is difficult because most lenders want a substantial slice of equity to go along with any new mortgage. If your home value has dropped 20% and is likely to fall another 20%, it is hard to have enough equity to qualify for a new mortgage. Stopping the fall in prices is critically important; and maybe if prices rise in some areas, homeowners will be able to refinance at better rates, giving them more cash each month to save or spend.

As I have written in previous letters, the psyche of the American consumer is permanently scarred. We are on our way back to a savings rates that will look more like 1987 than 2007, when it was almost zero. Just a few decades ago, we saved 7-10%. Consumer spending was only 64% of US GDP in 1987. It was 71% in 2007. It is on its way back to that lower level.

Lower consumer spending will be a drag on growth for years. But bringing in 1 million already middle-class new immigrant families will help make up for a lot of that reduced spending. If you can spend $200,000 on a home, you are likely skilled at something and well-educated. You will find a job, or create one, as many immigrants do, and then you will add to our total consumer spending.

If you are a real estate agent, you should love this proposal, as it would result in an additional $12 billion in commissions.

If you are a home builder, what a great way to reduce inventory and get back to the conditions where there is a demand for your product. This would help put back to work those who have lost their jobs in the home construction collapse. Home Depot and Lowe's and local stores? It would help them to increase sales, which leads to more jobs.

We are on the cusp of the Baby Boomers beginning a huge wave of retirement, both in the US and elsewhere in the developed world. There is going to be a need for skilled workers to replace those Boomers, as well to provide services to the retirees. Further, the promised Social Security and Medicare expenditures are going to start increasing at a significant rate. We are going to need immigrants to help pay for those benefits. Given the controversy over immigration, we will look back with some irony in ten years when we find we are in a serious competition with other nations to attract skilled immigrants. We should start now. I think the concept is, let's not waste a good crisis.

Let's look at some of the potential critics of this proposal. I was on Yahoo Tech Ticker yesterday talking about this, and got a few irate emails and phone calls.

"Why," I was asked, "do I hate American workers? Isn't there enough unemployment? Why do we need more immigrants taking American jobs?" And there was considerable angst about illegal immigrants.

First, I am suggesting we transform the already existing legal immigrant flow, which is going to happen anyway, into a form which helps us solve a major crisis. I am not talking about adding another 1 million immigrants on top of the current legal inflow. Just change the nature of that inflow until the excess housing inventory is settled, and then we can go back to the current program, if that is what is wanted (more on that below).

Second, I am not suggesting we bring in or condone illegal immigrants. That is another issue altogether, for another debate at another time.

If we do nothing, unemployment is going to rise to at least 10%. That is certainly not good for the American worker. Home values are going to continue to fall. That is certainly not good for the American worker. The economy is likely to be stagnant for an extended period of time, which means job growth in a Muddle Through recovery will be slow and stagnant. That is not good for the American worker.

Hundreds of billions more of taxpayer dollars will have to go to banks to keep them solvent as falling home prices and increasing unemployment increase foreclosures. That is not good for the American worker and taxpayer.

And further, I am not talking about bringing 1 million foreigners to this country. I am talking about bringing 1 million future Americans, who want to work hard and live the American dream.

Let me say a few words to those who are opposed to immigration -- and I have heard from you. With few exceptions, US citizens reading this have an immigrant in their genealogies. Some of mine go back to the 1600s. Some of mine were not exactly considered welcome. "No Irish and Dogs allowed" read the signs. But immigrants and their children have been the driver for growth in this country for generations. It is hard-working immigrants who leave their homes for the dream of being Americans that have been the backbone of the building of the nation -- the hewers and shapers, if you will.

It is precisely that melting pot of human diversity that is the strength of the American idea. Each new wave of immigrants has been viewed with trepidation or scorn, yet within one generation they have become American. And in turn, their children's children forget that their forebears had to deal with discrimination.

America -- the US -- is not so much a country as it is an idea, the idea that anyone, regardless of race or religion or gender, can come here and with hard work and determination make their own way. Some end up owning the local deli, and some end up founding Google. Some 25% of Silicon Valley start-ups, I am told, are by immigrants, creating jobs at the bleeding edge of technology. They see the US as a land of opportunity. That is why so many want to come and that is why we can attract a new generation of affluent, self-reliant immigrants who can help us solve a problem that we created.

I can see no downside to changing our immigration policy for a few years. We solve the housing crisis, stabilize home values, brings hundreds of billions in stimulus to the US, and with no taxpayer outlay. For a short time, we substitute one class of immigrant for another, to solve a serious crisis. It is not a matter of immigrants or no immigrants, just which immigrants

So which do you want? 10% unemployment and a decade of lower home values and increasing foreclosures, with a slow, Muddle Through, jobless recovery, or a stable housing market and home construction back to trend?

If you agree with me, I suggest you contact your Congressman. You can go to http://www.visi.com/juan/congress/ (selected at random from many such sites) and type in your address and get the name of your congressperson and senators. Just tell them you like this idea, and cut and paste the link where you read this into the letter. And tell them to get into gear! I would like to point out that this proposal is not Republican or Democrat, it is just common sense. I hope we can get broad bipartisan support.

The link to the Wall Street Journal editorial is: http://online.wsj.com/article/SB123725421857750565.html

The links to the white papers are:

http://www.investorsinsight.com/samples/Housing_Whitepaper_1.pdf
http://www.investorsinsight.com/samples/Housing_Whitepaper_2.pdf

Las Vegas, La Jolla and the OC

I expect I will get a few new readers from this letter. Normally, at the end of my regular weekly letter, I make a few personal comments. I write this free weekly letter to my 1 million closest friends, and you can add yourself to the list at http://www.investorsinsight.com. You can find out more about me at www.johnmauldin.com.

Parts of this letter have been written in New York and Dallas, and as I write this I am on a flight to Las Vegas to speak at a conference on natural resources. I am sure the recent Fed actions will be at the center of conversation. There is not enough space now to comment on that; but I did do a few segments on Yahoo Tech Ticker (one of which evidently made the Yahoo home page), which you can listen to at the following links.

Links to the Yahoo segments:

D.C. to America: You Can't Handle the Truth
http://bit.ly/10rUiF

Plan to Solve Crisis: Let Immigrants Buy Houses 2
http://bit.ly/W0XLq

Fed Strategy: Spread Economic Pain Over Multiple Years
http://bit.ly/wgGjA

I will be in La Jolla for my annual Strategic Investment Conference in two weeks, as well as hosting the Richard Russell Tribute Dinner. The dinner is shaping up to be a big event, with hundreds of attendees and many of the brightest lights in the investment writing world present to honor Richard for 50 years of brilliant commentary.

I really enjoyed my trip to NYC. I had a great steak dinner with Art Cashin, everybody's favorite commentator on CNBC. Breakfast with Tom Romero and then a meeting with Jim Cramer, who I found to be very personable and genuinely likeable. Meetings in the afternoon with business partner Steve Blumenthal, then breakfast the next day with Barry Ritholtz, Yahoo at the NASDAQ, and then a speech at noon, back on the last flight and up writing -- and then this plane, which I hope ends up in Las Vegas.

In addition to being with old friends Doug Casey and David Galland (and their posse), I intend to see the inside of the gym and spa. I need it. Tiffani has been gone for two weeks, working on our book, and will get back on Monday; and the new chapter I was supposed to have for her has disappeared in a reboot from this laptop. I am quite distressed, but evidently the book gods decided it needed a major rewrite.

Have a great week, and find a few friends and share some laughs and your adult beverage of choice.

Ok, the computer crashed again, and this letter is going out on Saturday rather Friday night. But I did get to see the Jersey Boys (The Story and Music of Frankie Valli and The Four Seasons) here in Vegas last night. One of the best shows I have seen in years. See it when it comes near you.

And if you are in Las Vegas, eat at Wolfgang Puck's new place, called Cut. One of the best pieces of steak I have inhaled in years. And now it really is time to hit the send button and go attend the conference.

Your wondering if we can actually get some action analyst,

John Mauldin

The Swiss Start Their Engines

John Mauldin — Sat, 14 Mar 2009 14:03:26 GMT

Where Have My Earnings Gone?
The Land of the Setting Sun
The Swiss Start Their Engines
My One True Nightmare
New York, Vegas, and Happy Birthday, Tiffani

This week we look at the Land of the Rising Sun. Japan is going through major upheavals, and they will have consequences all over the world. And what are those wild and crazy Swiss central bankers up to? It's time for another round of competitive devaluation. And of course I have to look at the recent Barron's cover story, about how stocks are cheap. There's a lot to cover.

But first, and quickly, I just wanted to take a moment and remind you to sign up for the Richard Russell Tribute Dinner, all set for Saturday, April 4 at the Manchester Grand Hyatt in San Diego - if you haven't already. This is sure to be an extraordinary evening honoring a great friend and associate of mine, and yours as well. I do hope that you can join us for a night of memories, laughs, and good fun with fellow admirers and long-time readers of Richard's Dow Theory Letter. The room is filling up and there will be a very large crowd.

A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. You are going to be able to rub shoulders with some very famous analysts and writers. If you are a fellow writer, you should make plans to attend or send me a note that I can put in a tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven't, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don't procrastinate. I wouldn't want any of you to miss out on this tribute. I look forward to sharing the evening with all of you.

Where Have My Earnings Gone?

Barron's probably jinxed the stock market by stating why they think the Dow won't fall to 5000, although we do have what I hope is the start of a nice bear market rally. Part of their reasoning is that stocks are cheap. They assign a price to earnings (P/E) ratio of a lowly 13, based upon 2009 estimated earnings of $51 in operating profits, which they suggest is historically low. And I agree that 13 is toward the low end and would represent a good long-term buying opportunity - if indeed it was 13.

Actually, if you want to get really bullish, go to S&P's web site and look at their estimated earnings for 2009. They calculate a P/E of 10.89 on 2009 estimated operating earnings.

As I have written over the years, the long-term P/E studies all use "as-reported" earnings, or earnings that are reported on tax returns. Operating earnings are of the EBBS variety, or Earnings Before Bad Stuff (or whatever you want to designate as the BS component). Companies like to tell us to ignore all those "one-time" writedowns, which seem to happen a lot more than once these days.

Going back a few decades, operating and as-reported earnings were very closely aligned. That relationship began to change in the mid-'90s, as management wanted to make a more bullish case, which certainly helped with their stock options. And the difference between operating and as-reported earnings is now wider than ever.

The difference between estimates for 2009 operating and as-reported earnings is almost exactly 100%. Which means that analysts are projecting there is going to be a lot of Bad Stuff in 2009 to be written down. The table below is a cut and paste from the S&P web site, where they calculate the earnings for the S&P 500. Notice the difference between the P/E ratios for operating and as-reported earnings. The latter P/E is based on the previous 12 months and used Thursday's price, so if you calculate it today it would be slightly higher.

Did you notice the as-reported estimated earnings P/E for the quarter ending September 30, 2009? In the 20 years of data on the web site, the highest it ever got to was 46, in the last recession. That P/E of 181 is because of the negative earnings for the 4^th quarter of 2008. Of course, this assumes that earnings estimates don't keep being revised downward, which is not a safe assumption. They have been revised downward every quarter for almost two years. Seemingly, past projections are not indicative of future results.

Now, to be fair, using the extremely bad earnings of the recent past as a one-time metric is not altogether indicative either. Robert Shiller of Yale uses ten-year average earnings to smooth out the business cycle, and this would give you a P/E of about 13.

My good friend Ed Easterling uses a different methodology to project earnings, involving the historical relationship between GDP and P/E ratios. This is based upon the historical fact that earnings more or less rise at the level of GDP plus inflation. This is a mean-reverting chart, as earnings cannot grow faster than GDP for too long, and also acknowledges that rough patches like the one we are in now will not last, and earnings will rebound. Using his methodology we end up with a P/E just south of 13.

So, I know a lot of you have stayed in the market the whole time it has been falling and are now wondering what to do. If you have a ten-year time horizon you probably can buy here and do OK. But I wouldn't. I think this market is going to have more problems as we confront the real possibility that we will get some really poor earnings for the first and second quarters. The economy is simply weak, and that weakness is hitting more and more companies. From exporting companies to the big international firms, a global slowdown is hitting almost everyone. Even hospitals are being challenged. We could see a real bear market rally lure investors back in, just to crush their hopes this summer.

Markets go from high valuations to low valuations and back again over long periods of time. I believe that we have a long time to go in the current secular bear cycle. As I have written for years, this one began in 2000 and could last until the middle of the next decade. While we will see a "bottom" in stock prices at some point, maybe even this year, we have a long way to go to get to a really low P/E ratio.

Big secular bull markets happen when P/E ratios drop below 10 (and even lower). That acts just like winding a spring. When it is let loose, it explodes for a very long time. There is another bull market in front of us. I would rather be patient and rely on an absolute-return style of investing for now. If I miss the first part of this run, so be it. I see more risk than reward in this latest run-up.

The Land of the Setting Sun

Japan has been in a malaise for 20 years. And just when it looked like the country might turn around, the bottom has seemingly fallen out. Japan's economy shrank a slightly revised 3.2% in the last quarter of last year, confirming the sharpest contraction since the oil crisis in 1974, and economists warn of further contraction in the next two quarters.

The Japanese economy, mired in its worst recession since World War II, is forecast to shrink a further 2.5% in the first quarter of this year and another 0.4% in the second quarter, a Reuters poll shows.

But if you look at the underlying data, it's even worse. Let's turn to a recent letter from my good friend and favorite data maven, Greg Weldon. (www.weldononline.com)

Japanese exports have fallen 54% in the last 6 months, an average of $40 billion a month, or down over a quarter of a trillion dollars. Greg notes that past 6-month changes in exports in Japan were hardly ever up or down more than a trillion yen. This is four times that level, about 4 trillion yen. To get a visual view, look at the graph below. That is called falling off a cliff.

The decline in exports is about 45% year over year. Japan is one of the countries that has run a very large trade surplus, allowing them to buy lots of dollars and lend a great deal of money. Their banks have been an engine for growth worldwide, but especially in Asia. And the graph below shows that trade surplus turning into a large trade deficit of 952 billion yen, or somewhere over 9 billion dollars.

To give that some perspective, the US trade deficit came in today and was "only" $36 billion, the lowest level in six years, mainly due to lower oil prices, as our exports have been shrinking as well (more on that below). The US economy is roughly three times the size of Japan's (and Japan is the world's second largest economy); so $9 billion is no small sum of money, relatively speaking.

(Quick note - while looking for that number on the web, I came across this tidbit in the China Daily. They project that the GDP of China will surpass Japan's next year.)

Inventory-to-shipping ratios in Japan are rising by over 50%, as industrial production is down more than 10% and likely to fall much further. Japanese auto exports are down 63% in just four months. Auto exports have literally fallen off a cliff, as inventories have doubled.

No surprise, Japan is promising even more government support programs, and aid to industries of all sorts. This from a government that has over 140% of debt to GDP, about twice that of the US. And their rapidly rising credit default swap rate is not helping. Who would have thought of Japan as a credit risk? Three years ago, almost no one. Now, rates are 30 times higher.

Japan's economy is driven by exports. And those exports were crushed as the yen rose in buying power and Japan's exports became less competitive in the last quarter, with calls for intervention to bring the yen back to a level where their industries can be more competitive. Look at the chart below of the Japanese yen versus the US dollar. (The moving average is 90 days.)

Note that less than two years ago the yen was over 124 to the dollar, and fell last quarter to below 87, and has risen back to 98 today. Think about the Japanese auto manufacturer. Two years ago he could sell his car in the US (or wherever) for $30,000 and get 3,750,000 yen. Today, that $30k only gets him a little under 3,000,000 yen. Think his costs dropped 20%? Think he can raise prices 25%?

If you sell machinery, you are competing with companies, countries, and currencies all over the world. If your currency rises, you are less competitive, or your profits have to fall.

Japan has problems, and not just in manufacturing. The population of the country is now literally shrinking, as they have the highest proportion of elderly people and the lowest proportion of children. By 2050, 70% of the labor force will have disappeared. While Toyota is the world's largest car company, auto sales in Japan peaked 18 years ago. Supermarket sales have fallen every year for the last 11 years. This is a country in a long-term decline, with massive debt. While there is still a lot of economic power there, it is not the country of the future. Unless they figure out how to grow their population, it will be a long slow slide.

The Swiss Start Their Engines

About five years ago Greg Weldon (mentioned above), a big NASCAR fan, introduced the idea of a competitive devaluation raceway among Asian countries trying to make sure they could compete against each other to produce "stuff" for the US consumer, with each "car" drafting the other as they went around the turns, trying to get a competitive advantage by manipulating their currencies.

Today, I heard a new engine roar, one that I have never heard before. It is a deep-throated and powerful new entry into the devaluation race, and one that will have large ramifications for world trade. Gentle reader, this is huge, and we visited Japan first to give you some idea of the problems all over the world, for indeed we could have picked any number of countries and told as sad a tale.

But who would have picked Switzerland? Yet we read this morning, "The Swiss franc posted its biggest weekly decline against the euro since 1999 after the country's central bank sold the currency to halt a 7.6 percent appreciation in the past six months.

"The franc was also near the lowest level versus the dollar in three months after the Swiss National Bank's (SNB) first solo intervention in foreign-exchange markets since 1992. The SNB also said yesterday it will buy corporate bonds as it cut the benchmark three-month Libor target rate to 0.25% from 0.5% to revive the economy."

This is tectonic. It is a game changer. First, they did it before the upcoming G-20 meeting. They clearly felt they could not wait. And they moved the currency big-time. Look at the chart below of the Swiss franc against the euro. The far right bar jumped 7 big "handles" in a few hours. (A handle is trader talk for a unit of movement.) Currency markets have been violent of late, but this is huge. Currencies are supposed to move at a glacial pace, not by 4-5% in a day!

The Swiss economy will slump by as much as 3% this year, the most since at least 1975, the central bank said yesterday. Price pressures evaporated in recent months as oil prices sank, the franc strengthened, and domestic demand dropped. Prices will probably decline this year and inflation will be "very close to zero" in 2010 and 2011, the SNB said. The franc's appreciation made Swiss products less competitive in Europe and the US, where deepening recessions were already curbing demand. (Bloomberg)

The story goes on to talk about numerous Swiss businesses that simply were not competitive with the rise in the value of the franc against the euro. With their economy slumping, with deflation knocking at their door, they clearly felt the need to act. Note they plan to buy corporate bonds to inject money into their economy. The Swiss, being frugal, don't have that many bonds, so the central bank may have some trouble finding enough to stimulate their economy - thus they are clearly prepared to use the currency tool in the cabinet to help stimulate their economy.

The last time a G-10 nation intervened in its currency was in 2003 when Japan tried, and oddly failed, as their currency had risen about 6% a year later. That caused me to write back then that their central bank established a new level of central bank ineffectiveness, because they could not figure out how to destroy their own currency, even when they wanted to.

The point is that such interventions by major developed countries are rare. Whatever their reasons, the Swiss have opened Pandora's box. Do Senators Schumer and Graham now start talking about that major currency manipulator, Switzerland, and start to introduce bills to punish them? Will Secretary Geithner come before a Congressional committee and call the Swiss currency manipulators? If not, then how do we deal with China?

Because China can now say, with some justification, that if the Swiss can manipulate their currency to make themselves more competitive, then why is it wrong for us? And how long do you think it will be until Japan tries once again to push the yen lower, with its export industries in tatters? And Korea? Taiwan?

You can almost hear the announcement over the loudspeakers: "Gentlemen, start your engines!"

My One True Nightmare

Let's be clear. As bad as things are, and they will probably get worse, I am a believer in free markets and the ability of people to figure out their own paths. And it is 300,000,000 people in the US and billions worldwide, each acting in their own interest, that will bring us back to a growing global economy.

But there is one thing that worries me above all else. For over six years I have been writing that the one thing that could truly derail the world economy is protectionism. Nothing would be more deleterious in today's global economy.

And that brings us to this stark note I read today on Bloomberg. It sent chills down my spine: "American exports have slumped at a 44% annual pace in the most recent six months of data, with imports shrinking 51%, probably the most since the Great Depression, according to Morgan Stanley analysts. The figures may add to pressure on the Obama administration to rework international agreements and include protections for US workers and the environment."

The US steel industry is planning to bring anti-dumping charges against foreign steel. India just raised steel tariffs. It seems like every day I read that someone somewhere is calling for their particular industry to be protected, bailed out, or subsidized. And it is not just the US. It is happening all over the world.

Right now, it is just small amounts and nothing that will rock the system. But these things can get a life of their own. If the Swiss can move to take their currency lower, then there will be a score of countries that will ask why they shouldn't be allowed to do the same. And the one currency they all want to be lower against? The dollar. Even though our economy is in shambles and consumer spending is falling, it is still a huge spending machine. And every export-growth-led country wants a piece of it.

We are getting ready to run a huge, $3-trillion deficit, and the Fed is going to print a lot of money and inject it into the economy. There is real reason to worry about the strength of the dollar. And yet, the dollar is the weakest currency except for all the others. As much as we in the US worry about the fall of the dollar, it could rise over the coming year.

That is going to put a lot of pressure from a lot of sources on President Obama, who ran as a populist. Here is hoping that his advisors steer him away from starting a round of trade protectionism that could beggar the world, just as Smoot-Hawley did 75 years ago. This bears watching closely.

New York, Vegas, and Happy Birthday, Tiffani

I will be in New York next week for a few days, and hope to have dinner with Art Cashin. I have a lot of meetings scheduled. Details are firming up. Then it's Doug Casey's "Crisis & Opportunity Summit," March 20-22 in Las Vegas, where I get to be the resident bull! Click to learn more about the Summit.

I will then go to La Jolla for my own Strategic Investment Conference, April 2-4. It is sold out; but as I mentioned at the top of the letter, you can still get tickets to the Richard Russell Tribute Dinner.

And today, Tiffani, my oldest daughter and business partner, is 32. She is holed up in the wilds of Kentucky working on our book. It is hard for me to express how great it is to be working with her. As all my partners know, she really does run the business, letting me do what I do and giving me the time to research and write to you.

And just to brag a little, here is a picture of my four girls. Dad is very lucky. And maybe this is just a little reason I remain so optimistic in spite of everything.

Time to hit the send button. Have a great week, and remember that we will all get through this together. That is what friends are for.

Your ready for some down time analyst,

John Mauldin