Puzzle Me This, Mr. Market
The Three Amigos, Once Again
Nuclear Waste or Corporate Bonds?
Muddle Through Reigns
Bear Market Rally
Inflation-Deflation Debate
By John Mauldin
I confess. I like jig-saw puzzles. My bride indulges this quaint
past time by buying me a new puzzle from time to time. This last
month, I must have done something bad, however, as she purchased a
particularly fiendish puzzle, where too many pieces look the same.
It is proving quite the challenge.
I bring this personal anecdote up, because the recent economic news
is in somewhat the same vein. Trying to develop useful themes from
the recent spate of very interesting statistics is quite
troublesome. Is this chart or that article a piece of the bearish
landscape or does it fit into the bullish blue sky? Let's review and
see if we can get a picture that makes sense.
The Three Amigos, Once Again
First, let's take a look at my Three Amigos. I use these as they
give us a good view of the economy. First, the ISM index (Institute
for Supply Management) is a measure of economic activity in the
manufacturing sector, which grew for the sixth consecutive month in
July. The overall economy grew for the ninth consecutive month, say
the nation's supply executives in the latest report.
That's the good news. The bad news is that it dropped significantly
from June. An index number above 50% shows growth. The index was
only 50.5% in July, a decrease of 5.7% when compared to 56.2%
reported in June. New Orders Index declined from 60.8% in June to
50.4% in July. Almost every category and sub-category was down.
This is really bad, isn't it? Maybe, but if you look at the serious
decline in inventories, you can find some distinct hope. The large
growth in the first quarter of this year was almost entirely
attributable to businesses re-stocking very low inventories. Some
would argue, and with some credibility, that we are going to soon
see another such growth spurt as businesses have let inventories get
too low.
Then we go to the Three Amigo of capacity utilization, or how much
of our potential production capacity is actually being used?
Anything above 80% is considered good. The index rose 0.1% in July,
to a very anemic 76.1%. One year ago, in what was supposed to be a
recession, it was at 76.7%.
Capacity utilization is important, because it gives us some real
hints about inflation and the direction of corporate profits. If
there is excess capacity, then companies have difficulty raising
prices. This holds down inflation and also means profits are going
to be lower.
As a part of this index, industrial production is up. Not
surprisingly, business equipment and construction material was down,
but bringing up the average was a solid increase in consumer goods.
Retail consumer spending held up well in June and July, posting a 1%
gain. This is not surprising when you consider that economist Brian
Wesbury tells us "real disposable personal income has risen 9.4% at
an annual rate over the last six months, suggesting a well-
positioned consumer, especially with the labor market showing
improvement."
(I might note that I was not included in that survey, as back-to-
school time does not increase real disposable personal income at the
Mauldin house.)
Gary Halbert tells us, "Yet despite all the negative predictions,
consumer spending just continues to RISE. The latest data from the
US Bureau of Economic Analysis shows that consumer spending has
increased EVERY QUARTER BUT ONE since the beginning of 1999. Only
in the 3Q of 2001 - mostly before 911 - did consumer spending fall
in any quarterly reporting period. Even in the 4Q of 2001, just
after 911, consumer spending increased. In fact, it has accelerated
sharply higher ever since 911.
"We know that consumer spending accounts for at least two-thirds of
GDP.
So, if consumer spending continues to rise, the economy is NOT going
into a serious recession."
Balancing the positive reports above were anecdotal reports from
Wal-Mart, Radio Shack and other retail firms suggesting consumers
are spending less in August.
Unemployment claims improved slightly, although overall levels
remain high. Consensus forecasts are that we will be in the 6% range
for a long time. The Financial Times of London recently published
an article suggesting that the increase in unemployment since 2000
has resulted in the economy growing at 3-4% below capacity. They
consider this to be a serious precursor and cause of deflation, and
predicted that the US would be at zero inflation by 2004.
Nuclear Waste or Corporate Bonds?
And finally, we look at the most volatile of the Three Amigos - high
yield bonds. They have been worse than junk bonds of late. Nuclear
Waste bonds would be a better epitaph. But yesterday, the best high
yield bond timer I know, Steve Blumenthal of CGM, moved back into
high yield bonds, having been appropriately on the sidelines in cash
for months, as junk bonds have dropped in price this summer along
with the serious concerns in accounting.
The yields on high yield bond funds are quite high on a historical
basis relative to government bonds. Has the rubber band of junk bond
prices been stretched too far, and thus ready to snap back? This
market will bear close watching over the next few months.
Capital spending by corporate America remains weak. Investment grade
lending by banks dropped alarmingly in July, to a comatose $3.8
billion in the last week of the month. This was not a result of
banks being unwilling to lend, but businesses simply not coming to
the table to ask for money. In the last three weeks, however,
lending has ratcheted up to a weekly $15 billion, the highest number
in months.
Car sales have been good. Existing home sales are dropping rather
rapidly, but are still at historically high levels. Mortgage rates
are very low, yet new housing starts have dropped.
Finally, the Philadelphia Federal Reserve compiles a monthly Blue
chip Economic report. The economists surveyed said that this year
the economy will expand 2.3%, compared with last year's 0.3% rise,
according to the survey. The estimate is lower than the 2.7%
forecast in last month's survey, and far down from the robust 3.5%
predicted earlier this year.
2.3% doesn't seem all that bad, until you realize that the first
quarter grew at 5.0% and the second quarter was 1.1%. I interpret
this to mean they expect growth of 1.6% for the rest of the year to
get us to an average of 2.3%. Since this group qualifies as
certified, unrepentant optimists, and have been wrong for years to
the downside, that does not bode well for the rest of the year.
Muddle Through Reigns
It's not all bad; it's certainly not all good. I admit to a certain
amount of discomfort when the Blue Chip report seemingly agrees with
my view that we are in a slow growth, Muddle Through Economy. These
guys have been so wrong for so long that it does seriously make me
ask myself, "Am I being too optimistic?"
Maybe, though, having been wrong throughout this entire turn of the
economy, they are beginning to adjust their models. Then again, an
economist for whom I have the utmost respect, Martin Barnes of Bank
Credit Analyst, notes that many of his indicators show the potential
for increased stress. His index of leading economic indicators is
turning down, as is the more widely published ECRI leading economic
index. The BCA Financial Stress Index is turning up, which is not
good.
BCA is widely followed, and is quite influential. I went to their
August letter looking for some good news, as Martin can usually find
some positive points. Frankly, this was the most negative BCA I have
read in years. I found little comfort for a bullish perspective.
While every economist wants to make you think they are independent,
there are very few who really are. They tend to run in herds, just
like mutual fund managers. They follow the few leaders who have
demonstrated an ability to sense the future of the markets. Martin
Barnes is a lead dog in the world of economists. This month's BCA
report may have influenced a number of economists in the Philly Fed
survey to be more sanguine.
On that theme, Comstock Partners tell us "The economy continues to
look shaky, with a majority of recently reported indicators showing
either weakness or anemic growth. These include the Philadelphia Fed
Index, consumer sentiment, small business confidence, real earnings,
the ECRI leading indicator, the ISI surveys, layoff announcements,
real earnings, First Call earnings estimates, chain store sales,
personal bankruptcy filings and industrial production."
All in all, we are growing slower than I thought we would at the
beginning of this year, even in a Muddle Through world. While I
predicted 2-3% for the year, I did not think we would see most of
the growth in the first quarter. I do not like the feel of this
recent slowing. We are growing so slowly that any serious shock to
the system could push us into recession.
Bear Market Rally
We have had a nice summer rally in the stock markets, as I predicted
we would. Whether it is over or not, I have absolutely no way of
knowing. Frankly, I hope not. Long term I do not think we have come
close to the lows of this secular bear market, but getting there too
quickly would cause serious problems to the economy.
As many readers know, I am writing on a book called Absolute
Returns. I have finished the first draft of the chapters which show
why we are in and will be in a Secular Bear Market for a long time,
which I will publish as a "White Paper" next week. I am now working
on a chapter showing why earnings growth will be muted this decade.
That should be ready within another week as well.
The historical evidence is quite strong that we will see several
more severe market drops, followed by bear market rallies, over the
next few years. The biggest financial bubble in the history of the
world will not end in a few years. It will take a long time to
unwind. I will give you the web address for these reports next week.
In the meantime, I would invite you to ponder this thought. We are
still at a Price to Earnings ratio on the S&P 500 of 35. If the
recent July lows were the bottom of the bear cycle, it would be at a
higher P/E ratio than at any bull market top with the exception of
the recent bubble. Earnings growth for the near term is going to be
much lower than analysts are predicting, as the rules for growth in
a deflationary environment where world wide capacity utilization is
quite low will be turned on their head. Analysts will have to change
the way they make predictions.
When we hit the next recession, whether next year to 2-3 years from
now, earnings will come under even more pressure. Investors are
going to be less willing to look several years into the future for
earnings to come up to par. The time horizon leash will grow
shorter, and P/E multiples will drop. That is why I state that this
secular bear market will be long in duration.
We may indeed see a significant rally in 2003 if the economy does
catch traction and being to grow at 3% or more. But earnings in a
deflationary world will not grow as fast as they have in the past.
Today we read Germany is in outright year over year deflation. So is
Japan and China. Even Italy has seen its inflation rate drop to 2%,
an unthinkable level a few years ago!
This deflation tidal wave is rolling over the world. It is coming to
our shores. As I wrote last week, we do not have to experience a
deflationary recession or even depression. There are policies which
could prevent this. I hope our leaders act accordingly.
One thing which could help is the current discussion of getting rid
of the corporate tax on dividends. If somehow the Republicans could
get control of the Senate, and actually pass such a tax cut, it
would be a big boost to the economy and certain segments of the
stock market.
I would become a raging bull for those companies which are cash
machines and elect to distribute dividends. Dividends in a low
inflation, low interest rate world would be king. It would focus
corporate management on actual cash earnings, and work to lower
overall corporate debt, which has doubled in just the last five
years, to $3.9 trillion. This would be a solid boost to the economy,
and would go a long way to get us out of this slow growth economy.
Inflation-Deflation Debate
Many of you wrote to ask me what I thought of the article my good
friend Dr. Gary North wrote last week entitled: "Repeat After Me:
There is No Deflation." Why is he saying there is inflation, when I
keep talking about deflation?
Part of the reason is simple to explain. Let me quote him. "The most
accurate indicator of American price changes, in my opinion, is the
median consumer price index." This weighted statistic is a creature
of the Cleveland Federal Reserve Bank.
In my opinion, this is one of the least meaningful measures of
inflation. All inflation indexes have a bias. This one is biased to
overstate inflation. I know the problems with the CPI. I use it
because it is widely followed. But other, less well know stats like
the GDP deflator, the PPI index, etc. all show inflation is slowing.
While none are perfect, my sense, when looking at all the various
measures, is that the real direction is towards less inflation, and
has been for years.
On that note, and a final comment, let me talk about the rise in
health care costs. Yes, these costs are rising. But much of the rise
is because there is just so much more for which to bill. 10 years
ago, my mother would have been an invalid. Today, she is bionic,
with two new knees and a new hip, plus sundry other parts and
medicines. These cost money.
My laser eye surgery cost me $4,000 4 years ago. Today, the surgery
is half that, and I see advertisements for 25% of that cost. More
and more people are getting this elective surgery, and it is a
growing market. It adds to overall health care costs, but is this
inflationary?
When I get my annual check-up today, they look at so much more than
they did even a few years ago. Yes, it costs more. But do I want
them to look at only the same things they did 5 years ago?
Health care costs are going to become an ever-growing part of our
personal and national budgets. They are going to rise. I am not sure
that the rise is entirely due to inflation, as much to increased
availability of new procedures. As my body starts to creak a little
more each year, I find that to be a good thing.
******************
This week has flown by too fast, with not enough done. I had a
major computer crash, and had to call in the computer fairy to
sprinkle pixie dust on my almost brand new Sony Vaio to get back up.
We are still trying to get back to normal. The bad news is we do not
know what caused the problem. I hate that. For those of you who have
asked for information on my management services or other pertinent
questions, I am behind, but intend to catch up this weekend. Thanks
for your patience.
Your running so fast his shadow is complaining analyst,
John Mauldin
John@2000wave.com
Copyright 2002 John Mauldin. All Rights Reserved
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