Mauldin cont..
The world is in a synchronous recession. What country is going to kick-
start the buying which propels inventories back to boom-time levels? The US
will have to lead, of course. But we will be doing so with much lower
profits. That is NOT a proper environment for an explosion in inventory
rebuilding.
Further, simply because most past recession have had sharp recoveries does
not mean we will have one this time.
Richebacher makes some very good points in that regard. He refers us to a
watershed 1993 study by the Federal Reserve of New York in their Summer
Quarterly Review. (I read Richebacher precisely because he finds studies
like this one. He may be an unrepentant bear, but he does very good
research.) The study shows that "V" shaped recoveries are always
characterized by sharp increases in housing and business equipment
investment. Increases in consumer spending lags the recovery. This is to be
expected, I think, as unemployment is also a lagging factor and consumer
spending and employment are closely tied together.
How can we have an explosion in residential building from levels that are
already very high? Usually, housing drops off significantly during a
recession. It did not do so this time. At the best, it seems to me, the
most we can hope for is for this current level to be maintained for the
year. The increased costs of mortgages, which are tied to the 10 year US
bond, will serve as a further drag on new housing. Applications for re-
financing is down 50% over the last month, and that will hurt new home
sales as well.
The more likely scenario is for the housing market to continue its recent
softening. Housing prices are down, as are new starts. I don't think we see
a real drop-off, except in certain areas affected by higher than usual
unemployment. In short, this is not an area which will stimulate a "V" or
even a "U"!
(Long term, I am a fan of housing stocks and the industry in general, as
demographics and the American love of a home are forces just too powerful
to ignore.)
Business investment, the other major component in the study, is a direct
function of rising business profits. As noted above, I don't see an
explosion in profits either. So no help here.
One other significant component in past recoveries was the high growth in
real disposable income. But these came as a result of significant increases
in corporate profits. Again, not likely this time.
Muddle, Muddle, Toil and Trouble
But is it all that bad? Are we looking at a repeat of the deflationary
1930's and the Great Depression? I think the likelihood of that is only
slightly higher than that we will see a "Super-V" recovery. My "Gripping
Hand" analysis is that we muddle through. The differences between 1930 and
now (or 1990 Japan and the US today) are significant. Here's why.
First and foremost, we are a market economy of the first order. US
entrepreneurs will do what they have always done and adjust. Betting
against American business is a losing proposition. While I do not believe
in a "New Economy," the Old Economy principles work just fine, thank you.
Contrasting the ability of US businesses, financial institutions or
individuals to adjust in 1930 and today just falls short of realistic
analogies.
That is not to diminish the very real problems we face. It is not a case of
onward and upward. It is much more likely merely onward.
Secondly, there are pockets of real growth opportunities. While some
technology will suffer, new technologies are in the wings which will offer
significant growth potential. Biotechnology could explode. While much of
the rest of the world is in a recession and seems determined to destroy
their currencies, a strong dollar will allow us to buy productive foreign
assets at fire sale prices. That may not add to bottom lines this year, but
will make a difference in years to come.
There are still large amounts of willing investment capital for promising
new ventures. Risk investors have not faded into the woodwork. A good sign
is that silly dot.com ventures are not getting money which means that the
new venture capital is being employed in pursuits which have a reasonable
chance of success.
Finally, much of the economy is stable. While the banks and financial
institutions are going to have to write off a lot of debt this year, they
have the balance sheets to do so, unlike Japanese banks. Healthcare seems
highly unlikely to fade. While the automotive sector may be weaker than
usual, it will not go away. Unfortunately, government is likely to expand.
We still need food and clothes and basic items. This just does not appear
to me to be the environment for a lengthy, multi-year recession.
I should also point out that much of my "recovery scenario" is based upon
the fact that the last half of 2001 was so very bad. We are coming off two
really bad quarters. It is always easier to leap over a one foot hurdle,
especially when you are jogging and not running.
Next year, I think GDP grows less than 1%, if at all. Corporate profits
will show some growth in the second half, but overall growth will be in the
small single digits if we see any. We may "technically" be out of recession
in the second quarter by a smidgen (a technical economic term), but it
won't feel like the return of the boom days.
If anything, my thought is that the "recovery" is more of an "L". If you
look very closely at the "L", you will see the line at the bottom rising
slightly at the end. (At least it is if you use a serif faced type like
Garamond.) This is a slower version of the 1990-91 recovery. Also, it will
not lead to a 9 year boom.
This is in keeping with my views on the longer stock and economic cycle. We
are entering a 10-15 year period of slower than trend growth. This will
just be the first of the recessions we see in this decade. I am going to
put together a compilation of parts of half-a-dozen letters dealing with
economic cycles and post the entire report on the web within two months. I
promise.
Back at the Federal Reserve Ranch
Is Greenspan likely to sit back and watch deflation wash over our soil? I
will admit that if the Fed sits back and does nothing, the likelihood of a
serious deflationary recession becomes likely. But they will not sit and do
nothing. They will continue to do what they have been doing, and that is
pump the money supply like crazy.
If the money supply was growing at this rate in 1985, gold would be at
$2,000 overnight. Today it can barely get to $280. Inflation would be
raging in the teens. As mentioned above, it is almost gone.
In fact, the best evidence for deflation is that the Fed can pump the money
supply with so little consequence in prices. Where is the money going? Why
isn't it showing up as inflation?
As mentioned in past letters and above, debt destruction, a tighter lending
policy at banks and a lower velocity of money have partially offset the
money supply growth.
Plus, there is serious concern that the Fed is re-creating the stock market
bubble. This Son-of-Bubble is not just a passing concern of bears, but even
the normally staid Bank Credit Analyst. Just as the major money supply
increase by the Fed in response to the Asian Crisis and Y2K is widely
credited with creating the NASDAQ Bubble, there is concern that we are
seeing the same phenomena.
In 2001, I used the analogy of a boxing match between History and Greenspan
We have always had a recession one year after the appearance of a negative
yield curve. Greenspan was fighting History with his rate cuts, and I bet
on History. It was an uneven fight with Greenspan fighting out of his
weight class.
Now Greenspan is fighting deflation. That is an opponent more suited to his
strengths. He has a printing press and a demonstrated will to use it.
Will he win? Most likely. What round will he win in? Though it will be a
late round TKO, I think we are already in the middle rounds.
And thus we have the real wild card in the prediction scenario. Can
Greenspan create money faster than the world can destroy it? In theory, yes
he can.
As Bill Bonner recently wrote, the Fed has a plan, but they have no clue.
Inflation comes back in our future. The real question is when, and to be
very honest, I must tell you I have no clue either. Zip. Nada. None
whatsoever. This is new territory for the Fed. You have many countries of
the world intent upon making the dollar as strong as possible. You have a
European Central Bank with no idea or focus who seems willing to go
wherever the winds take it. You have paper assets disappearing (like
Argentine bonds and other debt) at a prodigious rate and no end in sight.
You have a market that is seriously over-valued by historic standards.
Print too much and they bring back inflation, high interest rates and a
falling dollar, which would tank a budding, albeit tepid, recovery. Can you
spell stagflation?
Print too little and you get real deflation, which would scare the markets
out of their optimism, and would be a self-fulfilling prophecy for a major
slow-down in the economy.
So, what do they do? They watch the NAPM index, (name change: now the ISM
index), which finally turned back up yesterday. They look at capacity
utilization, debt defaults and a dozen other items and try to fine-tune the
economy back to 1-2% inflation, a somewhat weaker dollar and slow and
steady growth.
I do not expect inflation to come roaring back but my expectation is based
upon the ability of the Fed to not over-work their printing press.
They will not raise interest rates at all until late in 2002, if at all,
unless inflation comes roaring back. I think the likelihood is that the Fed
funds rate is lower or flat at the middle of the year, and probably stays
there for the rest of the year. They will use the money supply to try and
boost the economy and slow it down if necessary before they play the
interest rate game.
Predictions:
The US Stock Market:
Last year, going into a recession, it was a lay-up to predict the markets
would close lower for the second straight year. This year, I feel like I am
shooting from 3-point range.
History has never - not once-- been kind on a long term basis to investors
who invest at the level of P/E ratios we are at today. Short term? Can you
spell m-o-m-e-n-t-u-m? If it feels like a bubble and quacks like a bubble
maybe it is a bubble.
On the other hand, the Fed is pumping money into the economy and it is not
going into higher prices for anything except stocks. How long can this
mechanism work? The market can be irrational for a long time. Earnings are
not likely to rise by 25% from 2001, which implies that at today's level
the trailing P/E next year would be at least 30 if the market merely stayed
where it is.
This is a market once again priced for perfection, and I don't see how
anything can be perfect in 2002.
I think we should see a test of the market lows sometime this winter/early
spring, on a pattern somewhat like 2000. Then will come the bounce. After
that? It depends on a lot of factors, especially Fed money creation, which
are just unknowable. How will the market react to flat earnings? Will they
patiently wait at current levels for profits to catch up? Will they finally
go somewhere else? But where?
Major bull markets do not begin when people are this optimistic about the
markets. I think it is likely we work a trading range for the year.
Earnings disappointments may be offset by Fed money creation. The broad
indexes (DJIA and S&P 500) should end up within 5% of where we started, and
technology indexes (NASDAQ) will end up down, as they will disappoint on
the earnings fronts and are now priced for a powerful earnings rebound.
Long time readers know that I am waiting for my "Three Amigos" (The NAPM
index, capacity utilization and junk bonds) to turn positive to signal a
return to the stock market. They are trying to get us there. When we do, I
would suggest long-term investors and clients avoid most large cap stocks
and stick with true small and mid-cap value stocks and funds.
Bank Credit Analyst is suggesting that the coming year is one in which
market timing will work, which is an unusual posture for them. They think
that we are entering a period like 1966 to 1972 where there were numerous
market moves of 15-30% up and down. Those of you who are traders should
have a lot of opportunities for profits.
The World Equity Markets
As usual, there will be a mix of results, but 90%+ of the world's markets
are down this year in terms of the dollar. With a world recession picking
up steam, it seems hard to figure out how that will change. There will be
the usual outstanding markets, but do you really want to gamble on Russia
or Finland or Romania? Stay away, at least for the first half of the year,
until the dollar can start to get weaker.
The Bond Market
This is the one I blew in 2001. While predicting lower short-term rates was
a no-brainer, I (and most of the world, including Alan Greenspan) expected
long term rates to go down in 2001 as we entered recession. We end almost
where we began, with a wild ride down, up and down again. My recommended
leveraged long term bond fund is down about 2% for the year (American
Century Target 2025: BTTRX).
For 2002, let's see if I can do better. Short term rates should rise
slightly at the end of the year, unless we start getting real inflation
signals. Long term rates should drop in the first half of the year, as
inflation is increasingly seen as not a problem.
After that? I will have to wait until the middle of the year to make even a
reasonable guess. I hate to be wishy-washy, and am not afraid to state my
opinion. It is just that I do not have one after the middle of the year.
Currencies
As correctly predicted during the last year, once again I think the dollar
will rise against Asian currencies and I think it will end up flat with the
Euro. The Euro may be a special case, however, and we will have to look at
the inflation picture in the middle of the year. If inflation stays benign,
there will not be all that much movement. If US inflation comes back, you
could see the Euro jump rapidly, as the perception of a fumbling European
Central Bank which is not concerned about economic growth changes to that
of a bank which is rightly worried about inflation.
Europe is between a rock and a hard place. Asian currencies will drop
against the euro as rapidly as they do the dollar. That puts the same
profit pressure on them. If they also see a 10-15% rise in the euro against
the dollar, they are even further behind the curve. They are also entering
recession and do not need to create more problems for their corporations.
Oil
I predicted lower oil prices last year. I also thought they would come down
faster than they did due to OPEC cheating. Will the cheating develop this
year?
Much of the rest of the world will still be mired in recession. This is not
an environment in which oil makes a dramatic move up. If OPEC can get
cooperation from Russia and keep a handle on cheating from some of its cash
strapped members, you could see a slight rise to the mid-20's. If not, oil
will stay in the recent trading range.
Gold
If you are Japanese or Asian, gold is already in a major bull market.
Except for a few currencies, much of the world perceives a gold bull
market.
It is hard to be a gold bull (in dollar terms) when I think deflation is
the dominant factor. Couple that with central bank selling every time gold
rises above $300 and it is even harder to get excited.
Gold will rise someday, probably when the dollar falls. But if all the
crises we have seen in the world cannot get even a whimper of a bounce from
gold, then I look elsewhere for my investment excitement. I continue to
recommend a small percentage (less than 5%) in gold as a defensive play.
Looking Forward
This year we will be looking at the data on a weekly basis to tell us when
the economy is ready to turn (I think it is close, even though it will take
two quarters to egt back into the black), when and if inflation is coming
back, and when it is time to get into junk bonds (in anticipation of a 40-
50%+ run over 3 years). I will also start to recommend some dividend paying
stocks and other income plays when the time is right. I will continue to
review the works of Greg Weldon, Bank Credit Analyst and the dozens of
economic publications I review each week, trying to keep you up on the ever
turbulent markets.
Next week, we will look at the issues surrounding consumer and business
credit. Is it time for a Day of Reckoning, or not an issue?
For my New Year's resolutions, I will make the same two I made last year,
since they are still unused. I will lose weight and I will write a book on
hedge funds. I will be posting chapters on the web site as they are done
for comments. I will finish it in the first half of the year. This year I
will really do both.
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Let me wish you a Happy and Prosperous New Year. This is the time we all
make investment plans for the next year. May this be the year your
investments work as well as your plans and goals.
Your Planning to Have His Best Year Ever Analyst,
John Mauldin
John@2000wave.com |
