John Mauldin's Outside the Box : Economic Forecast

The Uncomfortable Dance Between V'ers and U'ers

John Mauldin — Tue, 10 Nov 2009 04:04:59 GMT

"Why" many ask, "is the stock market going up when the bond market is telling us the recovery will be tepid? Isn't there a disconnect?" And the answer is that there is, and this week good friend and fishing buddy Paul McCulley of PIMCO fame discusses that very topic with his usual insight and wit. He poses the conundrum that those expecting a "V" shaped recovery have pushed risk assets up quite high, and that the real risk to their position is that they in fact get a "V" shaped recovery. And yet, they could go higher and into bubble territory.

For the policy wonks among you, I offer a link to a recent paper by the Cleveland Fed, which suggests that the Fed could hold rates lower for far longer than we would think normal. Which makes What Paul writes even more important to understand. http://www.clevelandfed.org/research/commentary/2009/0809.cfm

I think you will find this a very interesting read. Meanwhile, I am off to Philadelphia where a team from Dallas was treated very well last night. I hope I get the same warm reception. And then to Orlando and back to Dallas. Have a great week.

Your just trying to puzzle it all out analyst,

John Mauldin, Editor
Outside the Box

The Uncomfortable Dance Between V'ers and U'ers

by Paul McCulley

Around the world, in investment committee meetings and on trading floors (and at the Fed!), one question dominates discussion and debate:

How can it be that risk assets, notably common stocks, have been roaring ahead, presumably discounting a robust V-shaped economic recovery, while Treasury bonds are holding their own with a bull flattening bias, presumably rejecting the V-shaped hypothesis, instead discounting a U-shaped recovery as the base case, with a W-shaped outcome the dominant risk case?

One of these markets is wrong, it is commonly argued; the only question is which one. In the longer run, we here at PIMCO certainly agree, siding with the U-shaped camp. But that does not necessarily mean that one of the markets must necessarily capitulate to the other in the months immediately ahead. And the unifying explanation is simple: The Fed is committed to maintaining "exceptionally low levels of the Federal funds rate for an extended period." The Fed is also openly committed to being extraordinarily careful in reducing its elevated balance sheet, implying that a very elevated level of excess reserves/liquidity will be sloshing through the financial system for a long time.

To be sure, the Fed has been communicating repeatedly, with academic flourish, the technical details of its ability to eventually hike its policy rate, even with a bloated balance sheet and massive excess reserves:

Hiking, via its newly-granted powers of last fall, the interest rate it pays on excess reserves (IOER), which should act as a floor for the more visible Fed funds rate; and
Reducing excess reserves directly through massive reverse repurchases, including using tri-party repo arrangements, effectively augmenting the universe of counterparties beyond the capital-constrained primary dealers, to include liquidity flush end users.

But the Fed has also gone out of its way to communicate that discussions are about the "how" of its exit strategies, not a signal as to the "when," in the phraseology of the Financial Times' Krishna Guha. Thus, not only is the price of Fed liquidity set to hover near zero for an extended period, but the sheer volume of Fed-supplied liquidity is also likely to be flush for an extended period. In turn, as long as the Fed retains ownership of its longer-dated assets, sterilizing their liquidity effect via reverse repos, the Fed will remain not just the arbitrator of the Fed funds rate, but will also be a holder of market risk previously borne by the private market.

Thus, while rich risk asset prices can certainly be viewed as a consensus expectation for a strong recovery, such lofty valuations can also be viewed as a consensus expectation about the Fed's commitment to erring on the side of being too late, rather than too early, in starting a Fed funds tightening cycle. Indeed, one could actually be agnostic, even antagonistic, about a big-V recovery and still be favorably disposed to risk assets, in the short run. Historically, what pounds risk asset prices is either a recession or unexpected Fed tightening; or worse, both. Right now, it is hard to get wrapped around the axle about recession, since we've just had one, which might not even be over.

To be sure, the economy could have back-to-back recessions, as was the case in 1980 and 1981–1982. But that episode was associated with massive Fed tightening in 1979–1980, followed by massive easing in the middle months of 1980, followed by massive Fed tightening yet again, as Paul Volcker waged a two-step war against inflation. Presently, the Fed is openly declaring that it will maintain near-zero short rates for an "extended period," in the context of inflation below its implicit target.

Thus, as long as economic recovery appears underway, even if stoked primarily by (1) policy stimulus and (2) a turn in the inventory cycle, there is no urgent reason for investors to run from risk assets. Put differently, investors can be agnostic about (3) the strength of private demand growth until the one-off forces supporting growth exhaust themselves, as long as they don't have fear of Fed tightening.

In turn, a bull flattening bias of the Treasury curve, with longer-dated rates falling toward the near-zero Fed policy rate, can be viewed as a consensus view that the level of the output/unemployment gap plumbed during the recession is so great that disinflationary forces in goods and services prices, and perhaps even more important, wages, will be in train, even if growth surprises on the upside. Accordingly, Treasury players, like their equity brethren, need not fear the Fed, as there is no economic rationale for an early turn to a tightening process.

Thus, both rich risk markets and the lofty Treasury market can be viewed as rational in their own spheres, even if they are seemingly irrational when compared to each other. The tie that binds them, that allows them to co-exist, need not be a common view regarding the prospective strength of the recovery, but rather a common view as to the Fed's friendly intent and reaction function.

But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so?

All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening).

To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es.

Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.

The Efficient Market Hypothesis in Retreat
But such discomfort is likely to be an enduring fact of life on the journey to the New Normal. Recall, a core tenet of "fundamental analysis" is the efficient market hypothesis, which presupposes that rational investors will, given time, always pull nominal – and real – values back toward their "fundamentally justified" levels. Yes, there will be noise in real time, the hypothesis allows, but it also holds that neither irrational gloom nor irrational exuberance will go to extremes: momentum players will, in the end, always be trumped by value players, before momentum players have done any great harm. Market failures, capitalism's equivalent of estrangement in families, are simply assumed away. They are not supposed to happen; therefore, they won't.

But they do. Such was the case with the Forward Minsky Journey¹ that unfolded alongside the Great Moderation for twenty-five years after the recession that ended in 1982. Ever-increasing private sector leverage was applied on the presumption that the Great Moderation was a perpetual motion machine, rather than an epoch that would eventually implode on its own debt-deflationary pathologies, as Minsky envisaged. Nominal asset prices, notably property, became bubbly-unmoored from "fundamental" value, yet both borrowers and lenders were willing to "validate" those unmoored levels with legally binding nominal debt obligations – hedge debt units followed by speculative debt units followed by Ponzi debt units.

It all blew up, of course, with not just trillions of net worth destroyed, but also the wisdom of religious belief in the efficient market hypothesis. Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.

Behavioral Economics and Finance in Ascendency
In contrast, the insights of behavioral economics and finance are very much in ascendency. This personally brings me great satisfaction, as both of my macroeconomic heroes, John Maynard Keynes and Hyman Minsky, were quintessentially behavioral economists, starting with the proposition that developing a theory as to how the world does work is much more productive than developing a theory as to how the world should work. That's not to suggest that there is not room for both types of theorizing. Indeed, one without the other is silliness, and both Keynes and Minsky did both.

And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold.

This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds.

In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.

And how do we deal with it? As Keynes explained in Chapter 12 of the General Theory, we deal with it by falling back on convention, or rules of thumb. In his words:

"Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice?

In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely.

The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities.

We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.

Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence.

Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual."

Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.

But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.

The way out of that lacuna was for (1) the fiscal authority to step into the breech and borrow money from the newly risk-averse, putting it to work to recapitalize the banking system and on Main Street in support of aggregate demand; and for (2) the monetary authority to drive the interest rate on money to zero and promise to hold it there for an extended period, making holding cash very painful while reducing uncertainty, re-exciting investors' risk appetite.

Bottom Line
Fiscal and monetary authorities around the world have done exactly that over the last year, and since April, in the words of the G-20, it has "worked." Well, at least on Wall Street, where risk appetite is in full bloom. Whether or not that renewed risk appetite finds its way to Main Street is the key question beyond the immediate horizon.

We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.

Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.

¹"The Shadow Banking System and Hyman Minsky's Economic Journey", Global Central Bank Focus, May 2009

Debt and Deflation

John Mauldin — Mon, 13 Jul 2009 19:37:49 GMT

There is a reason I call this column Outside the Box. I try to get material that forces us to think outside our normal comfort zones and challenges our common assumptions. I have made the comment more than once that is it unusual for two major bubbles to burst and for the conversation to be all about rising inflation and not a serious problem with deflation.

As Niels Jensen pointed out last week, the most important question that an investor can ask is whether we are in for deflation or inflation. And this week we read a well reasoned piece on deflation. This is one of the more important essays I have sent out. You need to set aside some time to absorb this one.

Van Hoisington and Dr. Lacy Hunt give us a few thoughts on why they think it is deflation that will ultimately be the problem and not inflation we are dealing with today. This week's letter requires you to think, but it will be worth the effort.

And let me quote a few sentences in the middle of this letter about taxes which you need to think about.

"Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth."

"The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3."

Now, if you put all of the various inputs together, Hoisington and Hunt show that theory suggests we will soon be dealing with deflation. It's counter-intuitive to what we hear today, which is why the Bank for International Settlements used the stagflation word in a recent report. The transition that is coming will not be comfortable....

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook
Second Quarter 2009

DEBT ACTS AS A BRAKE ON THE MONETARY ENGINE

One of the more common beliefs about the operation of the U.S. economy is that a massive increase in the Fed's balance sheet will automatically lead to a quick and substantial rise in inflation. An inflationary surge of this type must work either through the banking system or through non-bank institutions that act like banks which are often called "shadow banks". The process toward inflation in both cases is a necessary increasing cycle of borrowing and lending. As of today, that private market mechanism has been acting as a brake on the normal functioning of the monetary engine.

For example, total commercial bank loans have declined over the past 1, 3, 6, and 9 month intervals. Also, recent readings on bank credit plus commercial paper have registered record rates of decline (Chart 1). The FDIC has closed a record 52 banks thus far this year, and numerous other banks are on life support. The "shadow banks" are in even worse shape. Over 300 mortgage entities have failed, and Fannie Mae and Freddie Mac are in federal receivership. Foreclosures and delinquencies on mortgages are continuing to rise, indicating that the banks and their non-bank competitors face additional pressures to re- trench, not expand. Thus far in this unusual business cycle, excessive debt and falling asset prices have conspired to render the best efforts of the Fed impotent. The 100% plus expansion in the Fed's balance sheet (monetary base) has done nothing to rekindle borrowing and lending or revive even the smallest spark of inflation. What is clear is that as long as private market factors in the monetary/credit 1creation process are shrinking, as they are now, the risk for the economy is deflation, not inflation.

THE COMPLEX MONETARY CHAIN

The link between Fed actions and the economy is far more indirect and complex than the simple conclusion that Federal asset growth equals inflation. The price level and, in fact, real GDP are determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. Or, in economic parlance, for an increase in the Fed's balance sheet to boost the price level, the following conditions must be met:

The money multiplier must be flat or rising;
The velocity of money must be flat or rising; and
The AS or supply curve must be upward sloping.

The economy and price changes are moving downward because none of these conditions are currently being met; nor, in our judgment, are they likely to be met in the foreseeable future.

Aggregate demand (AD) is planned expenditures for GDP. As defined by the equation of exchange, GDP equals M2 multiplied by the velocity of money (V). M2 equals the monetary base (MB) multiplied by the money multiplier (m). Professors Brunner and Meltzer proved that m is determined by the currency, time, and Treasury deposit ratios, as well as the excess reserve ratio. The money multiplier moves inversely with the currency, Treasury deposit ratios, and excess reserve ratios and positively with the time deposit ratio. For example, if those ratios rise on balance, then m will decline. By algebraic substitution AD(GDP) = MB*V*m. In our present case, the massive increase in the Fed's balance sheet has created a sharp surge in excess reserves, and thus m has fallen.

Obviously the preceding paragraph is as clear as mud. It is included to provide mathematical proof of the complex connection between monetary actions and real world results. The practical and straightforward fact is that GDP has declined in the face of a surge in M2 growth. The labor market equivalent of GDP (aggregate hours worked) has declined at a record rate over the last 18 months, the entire span of the recession (Chart 2). That is, the monetary surge was totally offset by other factors; thus, the recession deepened and inflation was nonexistent.

The conventional wisdom is that the massive increase in excess reserves might eventually be used to make loans and reverse the economic contraction now underway, or that the velocity of money might increase. First, there is a very good explanation for the surge in excess reserves. The Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). If this is the amount needed for transaction purposes, then this "high powered" money is not available for making loans and investments.

Second, velocity (V), or the turnover of money in the economy, is far more likely to fall than to rise. This is because V tends to fall when financial innovation reverses downward. As this process continues excess leverage will eventually diminish and together they will lead V lower. This process has already begun in the household sector.

In addition, the Fed needs an upward sloping supply curve to get the economic ball rolling. Today we estimate that the AS curve is flat. The reason it is in this perfectly elastic shape, rather than upward sloping, is that we have substantial excess labor and other productive resources. For example, in June the work week was at a record low while the U6 unemployment rate was at an all time high of 16.5%. No wonder wages are deflating. Further, industry capacity utilization was at a four decade low at 68.3%, while manufacturing capacity was at a six decade low for the longer running series at 65.0%. Indeed, when excess resources are extreme, the AS curve is likely to be not only horizontal, but shifting outward, meaning that prices will be lower at any level of aggregate demand or GDP. Thus, even if Fed actions could shift the aggregate demand curve outward, which it cannot do under present circumstances, inflation would still be a long way down the road. Thus, theory and current evidence clearly point to deflation as the overwhelming economic risk.

A FISCAL POLICY DRAG

Over the next four years, the ratio of U.S. government debt will rise to somewhere between 71% and 80% of GDP, up from 41% at the end of 2008. The 71% figure, which is from the CBO, is probably understated. The CBO figures do not include the debt of Fannie Mae and Freddie Mac (now owned by the U.S. government), and their economic forecasts are probably too optimistic. None of these projections have incorporated the proposed health care bill which would raise the debt ratio considerably. This substantial increase in government spending far exceeds projected rising revenue sources such as the large marginal tax increase that has been suggested by the reversal in 2010 of the 2001 and 2003 tax reductions.

While the federal deficit is expanding, state and local government spending is being reduced and taxes have increased. It is highly unusual that state and local expenditures have actually decreased in current dollars in the past two quarters and, in real terms, spending is lower than a year ago. This is because state and local governments generally do not have the flexibility to incur deficits, yet they face potential deficits of about $121 billion for fiscal 2010. The Center for Budget and Policy Priorities indicates that thus far this year 23 states have imposed tax increases, with another 13 considering them. This is in addition to the ten states that imposed higher taxes or other revenue boosters in late 2007 or 2008. Therefore, the apparent thrust of federal policy is stimulus, while state and local policy is contractionary.

Interestingly, the term "federal stimulus spending" is an oxymoron. Many assume that the act of sending checks from the federal government sector to the private sector helps the economy through so-called spending multipliers. Multipliers take into consideration the second, third, fourth, etc. round effects from an initial change. Thus, multipliers capture the unintended consequences of policy actions. Although the initial spending objectives may be well intended, the ultimate outcome becomes convoluted. Over the past several years, multipliers have been intensively examined by leading economic scholars. Robert Barro of Harvard University calculates in Macroeconomics a Modern Approach (Thomson/Southwestern, 2008, p. 307) that the government expenditure multiplier from 1955 to 2006 was negative .01, not statistically different from 0. The highly respected Italian econometrician Roberto Perotti of Universita' Bocconi and the Centre for Capital Economic Policy Research has also done extensive work on this subject while visiting the fiscal policy division of the ECB. In October 2004, in his Estimating the Effects of Fiscal Policy in OECD Countries, Perotti calculates that the U.S. expenditure multiplier is also close to 0. Thus Barro and Perotti are saying that each $1 increase in government spending reduces private spending by about $1, with no net benefit to GDP. All that is left is a higher level of government debt creating slower economic growth. There may be intermittent periods when government spending will lift the economy, but offsetting episodes will follow. The best available empirical research suggests that the current federal policy of expanding spending will retard, not improve, the performance of business conditions. In addition to spending multipliers, however, there are also tax multipliers.

The most extensive research on tax multipliers is found in a paper written at the University of California Berkeley entitled The Macroeconomic Effects of Tax Changes: Estimates Based on a new Measure of Fiscal Shocks, by Christina D. and David H. Romer (March 2007). (Christina Romer now chairs the president's Council of Economic Advisors). This study found that the tax multiplier is 3, meaning that each dollar rise in taxes will reduce private spending by $3.

Presently, the federal government is increasing spending that in the end may actually retard economic activity, and is also proposing tax increases that will further restrain private sector growth. This policy mix is the same approach that failed in the U.S. from 1929 to 1941 and also failed in Japan over the past two decades, a subject we addressed in our April letter. In other words, fiscal policy is executing a program that is 180 degrees opposite from what it should be to stimulate the economy. How is it possible to get an inflationary cocktail out of deflationary ingredients?

BUSINESS CYCLE IMPLICATIONS FOR EQUITIES

The preferred way to answer the business cycle question of expansion versus contraction is to examine the four variables most integral to the economy's performance: employment, production, personal income, and sales. For these variables to be consistent over time, the income and sales must be adjusted for inflation and personal income must exclude government transfer payments.

Recessions end when the National Bureau of Economic Research (NBER), the official arbiter of such matters, says they end. But sometimes economic conditions suggest that the NBER miscalculated. Economic recovery occurs when these four indicators turn higher at about the same time. If the NBER's cycle turning dates are aligned with these four indicators they have validity. Regardless of the NBER's opinion, if the four indicators are not rising, a normal recovery will not occur. This seemingly esoteric point has important implications for the stock market.

In all the recessions from 1967 to 1999, the NBER aligns its recession ending dates very well with the unified recovery in income, production, employment and sales (Charts 3 & 4). However, for the 2000-2001 recession the NBER call date for the recovery did not line up with these four coincident indicators. Although the recession officially ended in November 2001, employment and income had not turned higher. In fact, they did not trough until March and August 2003 recording lags of 16 and 21 months, respectively. Thus, the economy was only in a partial recovery, a situation that had huge stock market implications.

The S&P 500 Stock Price Index troughed prior to the end of all the NBER defined recessions from 1967 through 1999, in concert with the four key economic variables (Chart 3 & 4). However, in 2001 the S&P bottomed 15 months after the end of the NBER defined recession yet one and six months before the cyclical troughs in income and employment, respectively. In other words, stock prices anticipated the complete, not partial, recovery of these pillars of economic growth. Although all four of these indicators are still falling, the critical event for the financial markets will be when all four finally turn higher. If a complete recovery of these four variables is still far in the future, then the current gains in the stock market cannot be sustained, just as rallies were not sustained in 2001.

DEBT DEFLATION AND BONDS

Total U.S. debt as a percent of GDP surged to 375% in the first quarter, a new post 1870 record, and well above the 360% average for 2008. Therefore, the economy became more leveraged even as the recession progressed. An over- leveraged economy is one prone to deflation and stagnant growth. This is evident in the path the Japanese took after their stock and real estate bubbles began to implode in 1989. At that time Japanese debt as a percent of GDP was 269% (Chart 5). This percentage actually continued to move higher until 1998 when it peaked at 345%, below the current level in the U.S. While the Japanese increased leverage for nine years after the bubble highs, neither highly inflated stock and real estate prices nor economic performance could be sustained as debt repayment became more burdensome.

Contrary to many evaluations of Japan's problems, traditional monetary policy was actually working. This is evidenced by the enlarged Japanese debt ratio in the early years after 1989 which was not merely due to increased government debt. Private debt as a percent of GDP also rose from 219% in 1989 to its peak of 274% in 1996. However, private debt as a percent of GDP turned down in 1997 as government debt absorbed a rising proportion of Japan's credit resources. The greater private debt load, from 1989 to 1996, as well as the massive increase in the government debt from 1989 to the present, coincided with two lost decades, not with prosperity. This template of increasing debt, combined with decreasing asset values, is a warning to investors of the efficacy of our current fiscal and monetary postures.

The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

Investments in long term Treasury securities are motivated by inflationary expectations. If fixed income investors believe inflation is headed lower, they will invest in long-dated securities, while they will invest in Treasury bills, or inflation protected securities if they believe inflation is headed higher. In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios. However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event. The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

Thoughts on the Market Rebound

John Mauldin — Mon, 13 Apr 2009 19:20:50 GMT

This week we will look at two shorter essays for this edition of Outside the Box. The first is some thoughtful words by Tom Au on whether or not we have put in a true bottom for the market. I particularly want you to read his thoughts on what earnings will look like going forward, and whether we can get back to the highs in corporate earnings we saw in 2006.

Tom is the executive vice-president of R. W. Wentworth, a contributor to Real Money at www.thestreet.com and the author of "A Modern Approach to Graham and Dodd Investing"

In last Friday's letter I mentioned an article by William Hester, CFA, who is the Senior Financial Analyst at the Hussman Funds. (www.hussmanfunds.com) While I quoted a few paragraphs from his essay, on reflection I think I will re-produce it below, as this is a very important concept. I have written in past letters and in Bull's Eye Investing about how powerful a driver earnings surprises can be (both positive and negative). Powerful bear and bull markets develop when there are numerous surprises in the same direction, re-enforcing market psychology.

So, read Hester's essay with the knowledge of what Au writes about earnings. I think the two make a very powerful, thought-provoking concept. And I am off to Europe.

John Mauldin, Editor
Outside the Box

Watch Out For the Second Leg of the Downturn

by Tom Au

Do you think that the crash is over, as certain former bears do? This question arises as we have breached the first downside target, of Dow 7000, based on my proprietary investment value model, that was first published in thestreet.com October 24, 2007. It was less a forecast than an evaluation. The Dow has now vindicated this model by reaching "fair value," as one would expect from a simple definition. Does that represent a base for a new bull market? Or is it just one more stop to the nether regions?

To understand my model, note that a stock can be analyzed as a combination of a bond plus a call option. My proprietary investment value metric for a stock is book value plus ten times dividends. That is a Ben Graham like construct that treats stocks almost like bonds, and gives no effect to growth over and above the pro rata return from the reinvestment of retained earnings. On the other hand, many investors prize stocks, particularly tech stocks, for their "optionality," the hypothetical ability to generate "positive surprises" over and above what economic theory would support. At bottom, the belief in the new economy was a belief in "optionality," that random positive events that occur from time to time, and did so with particular frequency in the 1990s, will become a recurring fixture of the economic landscape.

But such a process can also work in reverse, as it has recently. We are now experiencing what my colleague Robert Marcin calls the Great Unwind. A turbocharged economy is most likely to become "unstuck" when the conditions that initially favored it no longer exist. When this happens, an economy can grow as much below trend as it was formerly above trend, a fact that is likely to be reflected in the financial markets. History is not very encouraging on this score. In past downturns, such as those of 1932 and 1974, the Dow troughed at one half of my investment value metric, reflecting then-prevailing investor beliefs for negative optionality; that the economy will be worse than normal economic forces would dictate. With investment value at 7000 (actually a rounded version of 6600) on the Dow, half of that would be 3300. And during the 1930s, this metric actually fell, meaning that the "ultimate" low could be half of a number lower than 6600.

So having completed a first downleg, the market is now working on a second one. And this would be fully reflective of economic forces. For instance, financial earnings used to represent some 40% earnings (if you count the financing arms of some old line "industrial" companies such as General Electric and General Motors). Thus, they made up $32 of what used to be normalized S& P earnings of $80. But most of those financial earnings have disappeared. That, by itself, would take the S&P earnings into the $50s.. But how many of those non-financial earnings (of $48) were tied to the finance bubbles such as the homebuilding and the "housing ATM?" At least 10%, or around $5, and that is being conservative. Thus, normalized S&P earnings are likely to be no more $50 a share, if that.

The problem comes at payback time. For instance, much of the borrowing was tied to the housing market, on the bogus theory that houses could be made twice as valuable (as a multiple of rent) as they were for all of American history if prices could be kept on steady incline. The problem was that valuations collapsed when house prices fell, or even failed to rise, bringing down the market with it. To make up the shortfall, the U.S. economy now has to consume less than it produces, for a time. But the formerly virtuous circle became a vicious circle when falling prices (and consumption) led to falling production in a self-reinforcing process of the kind best described by George Soros in the Alchemy of Finance. This is a process called underabsorption, which in its strongest form, is called disintermediation. When a major part of the economy becomes "unstuck, the rest of it doesn't merely go into retrograde. It has to fall apart also to keep pace.

But I can live with $50 trough earnings, say many. And at historical multiple of 14-16 times trough earnings, the S&P should stop its downside in the 700-800 range. But the point is, they're not trough earnings, they are the "new normal." And in the current "slow" (zero or worse) growth environment, a trough P/E of 6-8 times earnings is more likely. Put another way, we are about to get the worst of all worlds; below trend earnings, below trend growth from a depressed base, and below trend P/E, after having gotten the best of all worlds, astronomical P/Es on above-trend and rapidly growing earnings, about a decade ago. Warren Buffett now agrees, saying that we will get "almost the worst of all possible worlds…"

The bears-turned-bulls have taken the latter stance because the market now reflects at least a severe recession. One such commentator likened the recent market to 1938-1939, and feels that the latter represents a bottom. But the 1930s bottom was 1932, not 1939, which is to say that the market probably has further to fall. Having correctly dodged the "overvaluation" bullet earlier, the new bulls pin their hopes on the prospect that the current market represents everything bad short of the 1930s Depression. Unlike us, they aren't willing to grasp the nettle that the current crisis will likely be as bad as anything including the Great Depression.

A Stock Market Rebound Closely Linked with Economic Data Surprises

by William Hester, CFA - April, 2009

There are several ways to interpret the economic data in March, most of which came in above what economists were expecting. Some analysts concluded that the worst is over for the economy, and a rebound is ahead. Others suggested that the economy is still contracting, but at a slower rate for now. In any case, economists have overestimated the economy's rate of contraction lately. The rebound in the stock market has been at least partially fueled by economic data that consistently came in better than expected last month. Some part of this rally is likely relying on the continuation of these "positive" surprises.

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. In the first graph, and the others below, I've isolated only the data that measures the growth in the economy, leaving out measures that track the rate of inflation and sentiment. The first chart below shows the surprise line for growth-related economic data since last August, just prior to the passing of the Emergency Economic Stabilization Act, from which the first version of the TARP was born.

There's nothing quite like pointing out how bad a shape the economy is in to get people acting like the economy is in bad shape. During the early part of last summer the economy was actually holding up better then what was generally expected. But during the final quarter of last year, the economic surprise line (in blue) collapsed. Data persistently came in below expectations, which created the steepest drop in the line tracking economic performance versus expectations in the available data.

The red line in the graph above tracks the S&P 500 Index and it shows that stocks have recently closely tracked the trend in data surprises. The market fell along with the deteriorating surprise line last year, rallied slightly prior to improved news in December, and then rolled over again as the news weakened versus expectations in late January. In March the market rebounded along with a more pronounced persistence in favorable economic news versus expectations.

The data released in March was better (or less negative) than expected on a number of fronts. The slowdown in spending eased, there was temporary relief in the new and existing homes sales data, and sentiment measures mostly halted their steep decent of recent months. But while much of the data was surprising relative to expectations, it's difficult to point to any piece of data that was surprisingly strong (outside of some of the volatile data series like, for example, durable goods). New homes sold at an annual rate of 337 thousand versus 300 thousand (and a peak of 1.4 million). GDP was revised to -6.3 percent versus an estimate of -6.6 percent.

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 investor's attitudes toward stocks that are currently overbought on a number of measures.

There are a couple of reasons why the trend in the rate of data surprises could change. The first is that trends in economic surprises are very prone to reversals. The chart below shows a longer-term picture of the changes in the trends in economic data surprises. The one thing that stands out looking at the graph is that the trends in surprises often reverse abruptly. When the estimates of economists fall behind in an expanding economy - underestimating its strength - expectations are adjusted upward. These estimates eventually become too optimistic. The same can be said of an economy that is contracting more quickly than expected. And the data shows that the more pronounced their forecast errors – the more abruptly economists begin to overestimate the economy's recent trend.

Another reason why the economic news may begin to disappoint at some point is that recoveries rarely proceed smoothly. The trends in month-to-month and quarter-to-quarter data tend to lurch forward and backward as the economy regains its footing (and at times, like in 1982, the economy can fall right back into recession).

One recent example of this was in 2002, which is shown in the graph below. The trends in economic data versus expectations were persistently better than expected from late 2001 as the economy emerged from recession that year through late spring of 2002. The S&P 500 surged by more than 20% from its 2001 low as the economy began to regain its footing and offer up positive data surprises. But by the summer of 2002 the rebound proved not robust enough when compared with economist's expectations, and the surprise line rolled over. With stocks not yet at valuation levels that were attractive to investors, the S&P plunged along with the data surprise line.

It's important to note that this was during a period where the economy was, in hindsight, no longer in recession, and where there were many measures that showed the economy was growing again. But the market was still tripped up at least partly because expectations had moved ahead of the economic recovery. The bear market remained unfinished, and stocks fell to new lows. This may turn out to be an important risk over the next couple of months. The economic data is certain to be uneven, which in turn may cause investors to begin to question whether an economic recovery is really at hand. Risks will likely be higher at points where the market is overbought.

Investors tend to punish economic disappointments much more strongly during bear markets than during bull markets. The graph below, which shows the S&P 500 and the surprise line from 1998 to 2002, highlights this tendency.

Although it's just a portion of one cycle – the late stages of an expansion and a mild recession, it's worth noting how stocks performed in response to economic data surprises. In the last part of the 1990's bull market, a rising economic data surprise line mostly fueled rallies. Data worse than expected weighed on performance – often causing shallow declines like in 1998 and late 1999. Conversely, during the 2000-2002 bear market, disappointing economic data coincided with steep declines in equity prices, while positive surprises usually eased the market's deterioration.

These trends were also evident during the market's advance from 2003 through 2007, but were somewhat less dependable. During that period, the trends in the surprise data were shorter and more variable than the market's slow, persistent advance. Since last summer, the correlation between the two has tightened considerably. In fact, the correlation between the S&P 500 and the data surprise line has climbed above .80, implying that investors are keeping a close eye on how data comes in relative to expectations.

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.

Foundations of Crisis

John Mauldin — Tue, 30 Dec 2008 00:58:10 GMT

This week I have a special Outside the Box for you. My long-time friend Doug Casey wrote a very prescient piece back in 1997. He has updated it somewhat for today's times. The critical part is a summary of the work of Richard Strauss and (friend) John Howe and their book The Fourth Turning, which I consider one of the more important and prescient (that word again) books of the last 25 years. (Amazon.com). It should still be read today. It is seminal to understanding the times we live in.

Doug summarized the book and makes some observations based on that understanding, many of which turned out to be true and some of which may well be in out future. I think you will find this to be very useful and enlightening if you are not familiar with their work, and a great review if you are.

Doug is chairman of Casey Research, author of numerous best-sellers over the last 25 years, raconteur and a certified expert in resources stocks. If you are investing in natural resources stocks, energy or gold without reading Doug and his team at Casey Research, you are missing the boat. They have a special offer for readers of Outside the Box. You can learn more about it here.

Here's wishing you a very happy and prosperous New Year.

John Mauldin, Editor
Outside the Box

Foundations of Crisis

By Doug Casey, Chairman, Casey Research, LLC.

Everybody wants predictions. The following article does a little better than that, in that I wrote it back in November of 1997, outlining several theories of history, and pointing to a logical way of anticipating what will likely happen to the world at large over the next generation.

As you will read, the methodology I relied upon for anticipating the events that are now unfolding -- 11 years later -- were actually quite accurate, confirming, in my mind at least, that now is a time to be very cautious in your personal and financial affairs.

The article is unaltered in its text from the original, though I have added some current commentary in bold italics.

Doug Casey
December 16, 2008

"Don't know much about the Middle Ages, look at the pictures an' I turn the pages. Don' know much about no rise and fall, don' know much 'bout nothin' at all" "Wonderful World," Sam Cooke.

The lyrics quoted above probably describe the average American's knowledge of history about as well as any academic study. Not only don't they know anything about it, and think it's irrelevant, but what they do know is inaccurate and slanted. And they must not think very much about the future either if the amount of consumer debt out there, mostly accumulating at 18% interest, is any indication.

One point of studying history is that it gives you an indication of what's likely to happen now, if you can find an appropriate analog in the past. This is a tricky business because as you look at factors contributing to a trend, it's not easy to determine which ones are really important. Making that determination is a judgment call, and everyone's judgment is colored by his worldview, or Weltanschauung as the Germans would have it.

Let me briefly spell out my Weltanschauung so you can more accurately determine how it compares with your own, and how it may be influencing my interpretation of the future.

I'm intensely optimistic about the long-term future. It seems to me a lock cinch that the advance of technology alone -- and nanotechnology in particular -- will result in a future of incredible abundance and prosperity, and that alone will solve most of the problems that plague us. Space migration, intelligence increase, and life extension will be commonplace realities. These things, plus the growth of both knowledge and its accessibility and the concomitant rise of the individual from the group, will constantly diminish politics as an element of life. The future will be much better than anything visualized on Star Trek, and will arrive much sooner. That's the good news.

The bad news is that within the longest trend in history, the ascent of man, there is plenty of room for setbacks, and much of history is a case of two steps forward and one back. My gloomy short-term outlook, and my reasons for maintaining it, is recounted here monthly. Whether it's right or wrong, from an investor's point of view, the short term is more relevant than the long term. Notwithstanding Warren Buffett's great success in going for the long term, Keynes was right when he said that in the long run we're all dead. History shows that goes for civilizations as well as people. The problem is that our civilization is probably just now on the cusp of the long term.

Hari Seldon: Where Are You When We Need You?
Isaac Asimov's classic Foundation trilogy centers around a scientist, Hari Seldon, who invents a science called psychohistory, which allows the fairly accurate prediction of broad trends in society going for centuries into the future. Seldon lives on Trantor, the planetary capital of a galactic empire; the entire planet is covered with a high-tech version of Washington, D.C., devoted to nothing but taxing and regulating the rest of the galaxy. Seldon forecasts that the empire will collapse and Trantor turn into a gigantic ghost town. And of course that's what happens, because it's a novel, and that makes for a good story. It's a good story because it's credible, and it's credible because people know nothing lasts forever, and there is a cyclicality to everything; birth, youth, maturity, senescence, and death. These stages are shared by everything in the material world, whether it's a person, a city, a civilization, or a galaxy. It's just a question of time and scale.

From that point of view everyone knows the future, i.e., we all know that everything eventually dies. But we'd like a bit more precision on the timing of their lifecycles. Some gurus believe, or appear to believe, they can actually predict the details of the future; I consider them knaves. People who actually do believe them should be considered fools. That said -- Nostradamus, astrology, channeling, tea leaf reading, and the like aside -- I do think the best indicator of what will likely happen in the future is what has happened in the past. That may seem like an obvious statement, but it's not. There have traditionally been three ways of looking at the problem; call them theories of history.

Oldest is what might be termed a chaotic view, which presumes mankind doesn't have any ultimate destination but is wafted on the wings of Fortune or hangs by the thread of Fate. Subject to the arbitrary will of the gods, whether it's the Old Testament's Yahweh, or Homer's Zeus, the future is unpredictable, and prophecy or an oracle gives you as good a read as anything else. I discount this theory heavily.

A second ancient view is that everything is cyclical, and therefore somewhat predictable. History may be viewed like a giant sine wave that's possibly headed somewhere, but the direction is unknown. Or history is really a circle, constantly repeating itself, much like the four seasons of the year. There's a lot of wisdom to the cyclical view.

The third view sees history as a linear sequence, one that's actually headed somewhere. That view holds a special appeal for followers of evangelically oriented religions, particularly Christians (many of whose beliefs have an apocalyptic tinge) and Marxists (who were, until lately, given heart by the "scientific" inevitability their views would prevail). The linear view ties in with the idea of Progress, that (more or less) every day and in every way, things are getting better and better -- although there's also a subculture populated mostly by deep ecology, animal rights, and anti-technology types who believe things are headed to hell in a hand-basket. But they all believe we're headed somewhere in a more-or-less straight line. There can be a lot of truth to the linear view, certainly if you look at the technological progress of mankind over the past 10,000 years, and this view prevails today.

My own view is a synthesis of the cyclical and linear theories. I see history evolving towards an incredibly bright future, but cyclically suffering setbacks, cyclically repeating the same patterns along the way. To me history looks like a spiral, heading off in a specific direction, but always covering the same ground in a different way with each revolution.

That's one reason The Fourth Turning, (Broadway Books, NY, 1997) by William Strauss and Neil Howe got my attention; we're all drawn to those who see at least part of reality the way we do. The book is an extrapolation of their last work, Generations, and notwithstanding its literary faults, is simply brilliant. I've never met Howe, but did have lunch with Strauss once about five years ago. The way I see it, although they're both conservatives, neither of them has any particular economic, political, or social philosophy, and they're not trying to grind an ax. Their books are a value-free look at U.S. history, and their conclusions are more credible as a result.

Their basic hypothesis is one I suspect Hari Seldon would recognize, and my thoughts are built on the research Strauss and Howe have done over the years. I suggest you get a copy of The Fourth Turning while it's still in the stores. That's also true for my own Crisis Investing for the Rest of the '90s, which has several chapters on related subject matter, and Arthur Herman's just-released The Idea of Decline in the West, which also bears on the subject. With 50,000 new books published every year, very few stay available for more than a few months. If something has appeal, you should buy it now, because it may be hard to come by when you have the chance to get into it. (Of course, I was wrong on that point -- websites such as Amazon and Alibris.com now make it easy to pick up many older books.)

Generations
Generational conflict has been recognized since ancient times. The twist here is the discovery of several things that have previously eluded observers. One is that the well- known conflict between fathers and sons is only half the story; there aren't just two generational types that alternate (e.g., liberal and conservative), but four. The reason for looking at it this way is that a human life can be conveniently divided into four stages: Childhood, Young Adulthood, Midlife, and Elderhood. Throughout all of history, a long life might be considered to be 80 to 100 years, with each of the four stages equaling a quarter of it.

Just as each person's life holds four stages of about 20 years each, each generation comprehends a group of people born over about 20 years. Members of a particular generation tend to share values and ways of looking at the world not only because their parents also shared a set of views (which the kids are reacting to), but because every new generation experiences a new set of events in a way unique to them. They hear the same music, see the same events, are exposed to the same books. Members of a generation share a collective persona. There appear to be four distinct archetypal personae that recur throughout American history. And throughout world history as well, although that's a bit beyond what I hope to explore here.

It also seems, throughout history, that there are periodic crises. About once every century, or about when each of the four generational types has run its course, a cataclysmic event occurs. It generally takes the form of a major war, and it generally catalyzes a whole new epoch for society.

The four mature generations alive today each represent an archetype. Let's review them from the oldest now living, to the youngest.

Hero Archetype
The "GI" generation, born between 1901 and 1924, includes basically all living people in their mid-70s and older. They grew up and came of age in the midst of the most traumatic years in human history: the 1930s and '40s. This was a time of catastrophic financial and economic collapse, world war, political dictatorship, genocide, and virulent ideology, among other unpleasant things; a period of intense turmoil. The times required them to be civic minded, optimistic, regular guys who could be counted on to do the right thing, fit in, and see that everybody got a square deal. As a consequence of what they've been through, they tend to be indulgent parents. As kids they're "good"; as adults they're selfless, constructive, and communitarian. Hero archetypes encounter a Crisis environment in Young Adulthood; assuming they survive it, the odds are the rest of their lives will be lived in growing economic prosperity, leading to a leisurely retirement.

Artist Archetype
Meanwhile, another generation was being born at the height of the Crisis -- something that seems to occur roughly every 80-100 years -- from 1925-42. This generation, the "Silent," watched these titanic events happen but were too young to take part in them. They were relegated to being protected, while trying to be helpful in the limited ways available to them. They're overprotected as children, when they might be characterized as "placid"; they tend to underprotect their own children as a reaction. As adults they're sensitive, well-liked, sentimental, and caring.

Prophet Archetype
Next came the group we call the "Boomers," born from 1943 to 1960. This was the first generation born after the Crisis was over, and they grew up in an environment where their parents (mostly GIs and early cohort Silents) felt obligated to protect them from all the trauma of the preceding years and were desirous of giving them all the things they never had. As kids they're seen as "spirited." Later in life, they tend to be narcissistic, presumptuous, self-righteous, and ruthless. Born after a Crisis, their Childhood years coincide with a rebirth of society, and their Elderhood coincides with another Crisis. More on them below.

Nomad Archetype
The fourth generational type is represented by today's "Generation X," born 1961-81, during what might be called an Awakening period when the Boomers were in the limelight. As a consequence, they were overlooked and a bit abandoned. Their reputation as kids can be summed up as "bad." They're oriented toward survival, which is partially a result of their being underprotected as children. When they become parents, they react and become overprotective. They tend to be savvy, practical, tough, and amoral.

The kids born between 1982 and perhaps 2002 should be another Hero archetype. My own experience with them is that they're shaping up that way. Represented by clean-cut, straight-arrow Power Rangers. Quite a reaction to the sewer-dwelling Mutant Ninja Turtles that were analogs for the previous generation. They're "'can do" kids, programmed to do the right thing in a smoke-free, drug-free, eco-sensitive, politically correct world. Like all Hero types, they respect their elders, do what they're told without much questioning authority. That's just the type of person you want to have fighting a war for you, and that's probably just what they'll wind up doing. Just like the last Hero types, the GIs. (Iraq was first. Iran next? Or will it be Saudi Arabia?)

It's risky to characterize everyone born in a certain time frame as sharing a persona; after all, people are individuals, not ants or atoms, each like the other. But it's really no different than characterizing people by the country they're from. There's no question in my mind that people share characteristics by virtue of the milieu in which they live, and that's true of time as well as geography. Take a look at the people you know by age groups, and see if they don't roughly fit the brief descriptions.

The interesting thing is that through about 400 years of American history, it's possible to see these generational types repeating themselves. It's not an accident. The characteristics of each type shape the next generation, as well as current events. And events leave a further imprint on all of them.

Making an Example of the Boomers
Just as every generation has its own persona, the character of each generation evolves as it moves through life. The Boomers are perhaps the most relevant example of this. First they were Mouseketeers and Beaver Cleaver clones. Who could have guessed they would mutate into Hippies and even Yippies as they reached Young Adulthood, reacting against everything they'd grown up with, everything their parents worked so hard to give them.

They came of age during a period that might be called an Awakening, and it's recurred on schedule five times so far in American history. Awakenings are times of religious and moral ferment, when the youth tend to challenge prevailing cultural values pretty much across the board. Young adults were into New Age things this time around, in the 1960s and '70s. At the time it seemed utterly shocking and completely new, but that was only because nobody then alive had seen the previous Utopian Awakening in the 1830s and '40s, the Pietist Awakening of the 1740s and '50s, the Puritan Awakening of the 1630s and '40s, or the Protestant Reformation of the 1530s and '40s.

Like all the generations before them that grew up in similar times, they eventually put away the things of their youth. But who guessed that their next mutation would be into Yuppies, whose motto was not "Peace and Love" or "Revolution for the Hell of It," but "Shop Till You Drop" and "He Who Dies with the Most Toys Wins" as they moved into midlife.

But even now the acquisitive mania that characterized the '80s is ebbing, now that the first cohorts of Boomers are crossing over 50. You can already see the signs of their next stage of evolution, in the judgmental behavior of people like William Bennett (George Bush) and Dan Quayle (Ann Coulter) on the "right," and Al Gore and Hillary Clinton on the "left." They did sex, drugs, and rock 'n' roll in the '60s. They believe they've fought the war of good against evil in both Vietnam and the segregated lunch counters of the South. They know they were the first generation to have traveled widely thanks to the jet, to have been brought up by television, and had the telephone as a given. They've been there, done that, and now that they're getting older, they're going to make sure that everyone else benefits from their wisdom -- like it or not.

The Boomers are an archetypal Prophet generation, a type born after a secular crisis, just in time to create another one. Get the image of a grim elder, with a well-defined vision of what's right and wrong, calling down wrath, and laying down the law for a troubled nation in chaotic times. That's the type of person who tends to lead countries into wars, as well as through them. Interestingly, the Boomers in America have their counterparts abroad today, especially in China, where they grew up during the Cultural Revolution. Two ideologically driven, righteous groups running two such powerful and alien cultures is almost a guaranteed formula for a millennial-sized crisis. Which should appear, coincidentally, sometime shortly after the millennium. (We're right on schedule.)

So What's Next?
The real watersheds in history, crises that make or break a civilization, occur roughly every 100 years. The most recent ones in American history that will resonate without looking up the facts in a reference book are the Revolution, circa 1782; the Civil War, circa 1863; and WW II, circa 1943. We've had other wars, and they were traumatic enough; that's the nature of war. But the War of 1812, Mexican, Spanish, World War I, Korean, and Vietnam wars had nothing to do with the country's survival as an entity, as a civilization. They were optional wars, sport fighting, if you will, by comparison. Wars that occur at a secular Crisis, a "Fourth Turning" to Strauss and Howe, when a Prophet generation is acting as elder statesmen, with Nomads as operational commanders, and Heroes as front line soldiers tend to be total wars that have an ideological underpinning. They're life-and-death struggles not just for the individual participants, but for the civilization as a whole.

That major wars occur at such long remove from each other probably isn't an accident. Really catastrophic wars, from at least the days of Troy on down, have usually been the Great Events that resound through living memory. The Great Event of a century forms the thought and character of everyone alive when it happens, influencing them relative to the stage of life they're in at the time. Perhaps that's why a people will collectively do its best to avoid a repeat, at least while there's anyone still alive who saw the last crisis.

(It's been said that war is a force that gives life meaning. And I think that's true, although it's perverse that the most destructive and idiotic activity that it's possible to engage in would just have to be the most important. Maybe, after the orgy of self-indulgence and conspicuous consumption that has characterized the past couple decades, Americans collectively feel they need to prove something. There has to be some rationale for the current war hysteria other than pure stupidity...)

In any event, the way the current generations line up relative to historical analogs, an excellent case can be made the U.S. is approaching another time of secular crisis, a Fourth Turning, with an expected due date of 2005 -- seven years from now -- plus or minus a few years in either direction. The Stamp Acts catalyzed the American Revolution, the election of Lincoln catalyzed the Civil War, the Crash of '29 catalyzed the Depression/WW II era. What might precipitate the elements now floating in solution? The answer is, practically any random event that's sufficiently traumatic. Any of the theses of current disaster/action novels and movies will do nicely. Perhaps the accidental or intentional release of a super plague vector. The crashing of an airliner into the Capitol during a joint session. (Close, but not quite.) An all-out assault on the IRS computers by an armed group -- or perhaps the computers just melting down due to the Year 2000 Problem. Perhaps a financial disaster that cascades into the Greater Depression. In any of these, or a hundred other scenarios, the federal government would almost certainly act precipitously and with a heavy hand, which would bring on a whole other set of consequences.

(In the historical context, 9/11 will be viewed as the opening kick-off for the coming Crisis... and the messianic overreaction of Bush and his cronies as the catalyst for turning things from bad to worse. It may be that Hurricane Katrina, for instance, a completely accidental event, may be blamed for providing a pin to burst the financial bubble -- which would be a pity, since the neocons could then blame it, not themselves.)

There's no way of telling where the Crisis will lead, or how it will end. That's going to depend not only on exactly who's in control, but what they do, whom they're up against, and a hundred other variables we can't even anticipate. One thing that seems certain is that real crisis brings out strong (although not necessarily wise) leadership. Because of its age and size, it will come from the Boomer generation, and it will be in the mold of Roosevelt or Lincoln -- both very dangerous precedents. The Boomers in Elderhood will be dogmatic, harsh, puritanical, and quite willing to burn down the barn in order to destroy whatever rats they see. Admix that attitude to a time resembling the Revolution, the Civil War, or WW II, overlain with today's ethnic strife, urbanization, financial overextension, and powerful, compact new weaponry in the hands of foreign fanatics out to teach the Great Satan a lesson, and it's a real witch's brew.

If things evolve over the next decade as they did in past analogs, it will be a very un-mellow time indeed. That's assuming things end well, and there's no guarantee they will, as many foreign countries have discovered throughout history. We've been uniquely blessed.

What to Do
Strauss and Howe aren't financial types, and their advice is nebulous along those lines. To sum it up, their suggestion is to learn to swim with the tide by not hoping the current good times last forever; the chances of the good times are coming to an end now. They'd also advise not sticking your head up above the crowd, something that is always very risky when times are in turmoil; remember what happened to Japanese-Americans during the last crisis. They suggest that there will likely be a resurgence of nationalism, much as was the case during past crises. It won't be a good time to be a maverick in the U.S., a thought that makes places like Argentina and New Zealand look even more appealing.

(I bought property in both places shortly after this was written, and have been rewarded with a quadruple in both instances -- considerably better than would have been the case in the U.S.).

Strauss and Howe suggest you look to diversify in all things, so everything won't go bad at once. Brace for the collapse of public support mechanisms. Set your roots with your family, because people you can rely on will be at a premium. Heed emerging community norms, bond with like-minded people, and return to basic, classic virtues. This is sound advice any time, but critical if you're rigging for heavy weather.

Assuming you wanted to stay in the U.S., you'd rather be on some land near a small town, and far away from a major city. You'd want to be self-sufficient in as many ways as possible -- freeze-dried food. etc. Perhaps Howard Ruff will make a comeback with advice like that, which seems quaint today. But then I'm nothing if not a contrarian.

(In hindsight, the original article could have been a bit more specific -- other than the suggestions about Argentina and New Zealand. Personally, I believe that unassailable wealth is the best protection against global crisis. For it to be unassailable, your wealth must be at once substantial, free from threat of confiscation, divorced from the whims of the masses, and located in a country or currency that has a good risk/reward profile. Unfortunately, the U.S. doesn't make the cut.

In the first instance, the single best way to build wealth now, while there is still time to do so, is in carefully selected gold and other resource stocks. In order for it to be free from the threat of confiscation, at least some part of your wealth needs to reside in a country where you don't. To state the obvious, I would be very cautious about traditional stocks and bonds until we see how things shake out. Rather, get positioned in gold and silver stocks now, ahead of the curve, then sell out for a big profit to the panicking masses and move an increasing percentage of your wealth into tangibles such as gold, silver, and maybe, as part of a diversified portfolio, real estate in especially attractive areas -- but only after the bubble has decisively burst.)

A Parting Parable
In case you have any doubts, I buy the theory outlined above and its many ramifications that there isn't room to explore here. It really is scary to think that we could again experience a real Crisis with a capital C; I'm not talking about just a bear market in stocks. If it happens, I promise you stocks and mutual funds will be about the farthest things from most people's minds.

At the same time, there's no point in feeling terrorized. This stuff has been going on since the dawn of history. So let me leave you with a parable. I could appropriately quote Ecclesiastes (To every thing there is a season, and a time to every purpose under heaven: a time to be born, and a time to die, a time to plant, and a time to pluck up that which is planted, etc., etc.). But everyone knows that reference. Let me rather give you John O'Hara. At the beginning of O'Hara's novel Appointment in Samara, he tells a brief parable, which I'll summarize:

There was a merchant in Baghdad who went to the market with his servant. There they saw Death, who stared at the servant in what seemed a threatening way. Later the servant said "Master, lend me a horse. I shall ride to Samara, and there Death will not find me." The merchant did so, then returned to the market, where he again saw Death, whom he approached and asked why he had stared at his servant in such a threatening way. Death responded, "I wasn't threatening him. I was just very surprised to see him here in Baghdad, since I have an appointment with him in Samara later this afternoon."

(Strange, the location for the proverb, in that this was well before the current war).

Dow 5,000 Redux

John Mauldin — Mon, 08 Dec 2008 16:13:37 GMT

What is fair value for stocks? Are they now cheap? You can certainly make that argument by comparing valuations based on past performance. But repeat after me, "Past performance is not indicative of future returns." The investment climate of today is almost certainly going to be quite different than that of the 80's and 90's. Thus, to expect stocks to repeat the performance of the last bull market in a climate of government intervention, deleveraging and increased regulations may not be realistic?

This week Bill Gross, the Managing Director of PIMCO (and one of my favorite analysts) moves away from his familiar neighborhood of bonds and offers a few thoughts on stock market valuations. This is not a lengthy read, but it is one you might want to read twice, as the concepts are important. And not just for stocks but for investments of all types. I trust you will enjoy this week's Outside the Box.

John Mauldin, Editor
Outside the Box

Dow 5,000 Redux

By William H. Gross
Managing Director PIMCO

Here I go again! Gosh it was only six years ago that I cemented my place in stock market history by predicting that the Dow would fall from 8,500 to 5,000, instead of going up to 14,000 where it peaked in October of 2007. Well, I could use the standard set of excuses: 1) No one else saw it coming, 2) I was misinterpreted, and taken out of context, 3) I was tired, overworked, and had family problems, or 4) I had just come out of rehab. But these days what really works is a full confession. I mean, like, uh, it was totally my fault and I take full responsibility. The fact is I was only off by 9,000 points. That's my story, and I'm stickin' to it.

Well, fools rush in. This time though I'm definitely older and maybe a little bit wiser. No magic number, nor a specific target date from the Swami of the Dow. This one will be more conceptual, but still present a "take" that you can criticize or damn with faint praise. And no, despite the title, it doesn't imply that the stock market is headed to 5,000 and that I was always right or just a little bit early. It only suggests that I'm readdressing the critical topic of equity valuation – that mysterious fragile flower where price is part perception, part valuation, and part hope or lack thereof. Press on, Swami.

Let me first announce a fundamental premise with which I think all rational investors would agree: I believe in stocks for the long run – but only if purchased at the right price. That statement packs a real punch. It says that capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy's growth and its share of after-tax corporate profits within it. Acknowledging the above, let's look at a few basic standards of valuation that historically have stood the test of time, to see if at least the price is right.

One of them is what is known as the "Q" ratio, or the value of the stock market relative to the replacement cost of net assets. The basic logic behind "Q" is that capitalism works. If the "Q" is above 1.0, then the market is valuing a company at more than it costs to reproduce it; stock prices should fall. If it is below 1.0, then stocks are undervalued because new businesses can't be created at as cheap a price as they can be bought in the open market. In the short run, this ratio is volatile as shown below but it tends to be mean reverting, which is critical. As long as capitalism is a going concern, "Q" should mean revert to 1.0. If so, then oh, oh what a "Q"! Today's Q ratio has almost never been lower and certainly not since WWII, implying extreme undervaluation, as seen in Chart 1.

Another long-term standard of valuation comes from the good ol‘ P/E ratio, where earnings per share, or E, is compared as a function of P, or price. Chart 2, going all the way back to 1871, shows the same relatively massive undervaluation, not only in the U.S. but elsewhere. This has been a global bear market. Yet here one should be careful. The sage of rationality, Yale's Robert Shiller, cautions us to look at earnings on an historical 10-year moving average to remove adverse or fortuitous cyclicality. When measured on this basis, P/E's are cheap but less so, slightly below their mean average for the past century.

Professor Shiller may be on to something, although even his 10-year approach may not be enough to adjust for our future economy and its functioning within the context of a delevering as opposed to a levering financial system. Recent Investment Outlooks and indeed, discussions in PIMCO's Investment Committee and Secular Forums for the past several years have pointed to the necessity to view current changes as not only non-cyclical, but non-secular. They are, in fact, likely to be transgenerational. We will not go back to what we have known and gotten used to. It's like comparing Newton and Einstein: both were right but their rules governed entirely different domains. We are now morphing towards a world where the government fist is being substituted for the invisible hand, where regulation trumps Wild West capitalism, and where corporate profits are no longer a function of leverage, cheap financing and the rather mindless ability to make a deal with other people's money. Welcome to a new universe stock market investors! In this rather "sheepish" as opposed to "brave" new world, here are some considerations that may affect Q ratios, P/E's, and ultimately stock prices for years to come:

Corporate profits have been positively affected for at least the past several decades by several trends that appear to be reversing. Leverage and gearing ratios – the ability of companies to make money by making paper – are coming down, not going up. In addition, the availability of cheap financing – absent government's checkbook – will likely not return. Narrow yield spreads and low real corporate interest rates are gone. Last, but not least, the historical declines of corporate tax rates, shown graphically in Chart 3, will not likely continue downward in a Democratically-dominated Washington.
Globalization's salutary growth rate of recent years may now be stunted. While public pronouncements from almost all major economies affirm the necessity for increased trade and policy coordination, and avoiding the destructive tendencies of one-off currency devaluations as a local remedy for global problems, investors should not bank on the free trade mentality of recent years to support historic growth rates. Already we are seeing separate ad hoc policy responses with very little cooperation. Not only does the EU's approach differ from that of the U.S., but France is in many ways an odd man out within its own community. Asia is legitimately suspicious of any U.S. endorsed approach given the failure of America's capitalistic model.
Animal spirits, and with them the entrepreneurial dynamism of risk-taking has likely experienced a body blow. Not only have dancers on the financed-based dance floor been shown the exit à la Chuck Prince, but those that remain have been publicly chastened and handcuffed. Golden parachutes, options, executive compensation and bonuses themselves are now at risk. Care to climb to the throne of this new world? Well, yes, egos will always dominate, but the rules will be changed and hormone levels lowered.
The benevolent fist of government is imperative and inevitable, but it will come at a cost. The champion of free enterprise, Ronald Reagan, knew that growth of the private sector was in no small way dependent on deregulation and the lowering of tax rates. Now that those trends have necessarily come to an end, no rational investors should expect innovation and productivity to be unaffected. Profit and earnings per share growth will suffer.

My transgenerational stock market outlook is this: stocks are cheap when valued within the context of a financed-based economy once dominated by leverage, cheap financing, and even lower corporate tax rates. That world, however, is in our past not our future. More regulation, lower leverage, higher taxes, and a lack of entrepreneurial testosterone are what we must get used to – that and a government checkbook that allows for healing, but crowds the private sector into an awkward and less productive corner. Dow 5,000? We don't have to go there if current domestic and global policies are focused on asset price support and eventual recapitalization of lending institutions. But 14,000 is a stretch as well. One only has to recognize that roughly 20% of bank capital is now owned by the U.S. government and that a near proportionate share of profits will flow in that direction as well. Better to own corporate bonds than corporate stocks, but that's a story for another Investment Outlook.

William H. Gross
Managing Director

Your thinking we will see even better valuations analyst,

John Mauldin

The Stock Market is Not in Uncharted Territory

John Mauldin — Mon, 17 Nov 2008 23:07:31 GMT

This week we visit some very thoughtful analysis by an old friend of Outside the Box, Dr. John Hussman of the Hussman Funds (http://www.hussmanfunds.com/index.html). Is it 1932? Are we in a Depression? Where is the bottom? John gives us a very balanced view and actually offers some positive insight on the markets. There may be light ahead.

(Note: there is a chart from Ned Davis Research that is, as John notes, not to be distributed further. I did call Ned Davis Research and they graciously gave me permission to use it as well.) Have a great week, and enjoy some positive thoughts below.

John Mauldin, Editor
Outside the Box

The Stock Market is Not in "Uncharted Territory"

By John Hussman, PH.D.

One of the fallacies about the recent financial turbulence is that the markets are in "uncharted territory" and that there are no historical precedents for the volatility, panic, or economic uncertainty that we've observed. To make statements like this is to admit that one has not examined historical evidence prior to the 1990's. The fact is that we've observed similar panics throughout market history. This decline has been deeper and more rapid than most, but that is largely a reflection of the rich valuation and overbought condition that characterized the market in 2007 (see the July 16, 2007 comment - A Who's Who of Awful Times to Invest).

If we seriously deem it necessary to talk about the Great Depression, fine. Even the Great Depression can be adequately used as a precedent for current conditions provided that one recognizes that the market's valuation during the Depression didn't fall to the levels we currently observe until 1931 when the rate of unemployment was already 15%. Sure, if U.S. unemployment is headed to 25%, as it did in the Great Depression, then stock prices might fall in half even from here, as they did by 1932. But this is important - even if stock prices were to fall further, it would not be because of earnings losses that would permanently impair the fundamental value of U.S. companies. Rather, if further losses emerge, it will be because of increases in risk premiums that will be associated with extremely high subsequent returns. Indeed, even though unemployment shot to 25% in 1932, the S&P 500 more than doubled in the year following the 1932 Depression low, and tripled off of that low within less than three years.

The handful of historical instances when stocks fell to 7 times prior record earnings were also points that were accompanied by 15-25% unemployment, 12% yields on commercial paper (as at the 1974 lows), or 15% Treasury yields (as at the 1982 lows). Similar data is unlikely in this instance - and even if conditions deteriorate to that point, it will involve months and months of ebb and flow in the economic reports. We can be virtually certain that stocks would experience enormous rallies, not simply continuous decline, while the evidence accumulates. Meanwhile, it is notable that data that measure investor panic, such as risk-premiums and intra-day market volatility, already match historical extremes (1932, 1974, 1982, and 2002) - points where stock prices were not far from their lows even though negative economic news persisted for a longer period.

The chart below (reprinted by permission and not to be distributed further) is from Ned Davis Research. Note the points at which similar spikes in volatility and credit spreads occurred. None of this provides assurance about very near-term risks (very short term fluctuations can be obscured by monthly charts like this), but it underscores that similar panics have typically been associated with washed-out market lows, and in any event, should further reinforce that this decline is not particularly "uncharted."

That's not to say that I believe stocks have "hit their lows." We always have to allow for the market to move significantly and unexpectedly, and there is plausible downside risk from here. Our activity as investors is not to try to identify tops and bottoms - it is to constantly align our exposure to risk in proportion to the return that we can expect from that risk, given prevailing evidence.

If I was confident that the market's downside risk was tightly limited, I would remove our hedges. Instead, the Strategic Growth continues to hold a put option defenses against 70-80% of the holdings at about the 850 level on the S&P 500. Above that level, we are accepting a good deal of day-to-day market fluctuations. Below that level (which is something of a line in the sand for us since it represents the October lows), our option defenses can be expected to increasingly mute the impact of any further market losses. I don't anticipate lowering those strikes in the event that market losses continue, at least until we observe fresh evidence of improved market internals. That said, in the event of a substantial further decline, I do expect to very gradually reduce the percentage of the Fund's holdings that are hedged.

In short, with stocks both undervalued and oversold, it is appropriate to accept a modest amount of market risk and a good sensitivity to "local" fluctuations, but we remain hedged to defend against any major and unexpected deterioration.

Investors can get a good understanding of market history by examining a great deal of data, or by living through a lot of market cycles and learning something along the way. Only investors who have done neither believe that current conditions are "uncharted territory." Veterans like Warren Buffett and Jeremy Grantham have a good handle on both historical data, and on the concept that stocks are a claim to a very long-term stream of future cash flows. They recognize that even wiping out a year or two of earnings does no major damage to the intrinsic value of companies with good balance sheets and strong competitive positions. Most importantly, these guys never changed their standards of value even when other investors were bubbling and gurgling about a new era of productivity where knowledge-based companies would make the business cycle obsolete, and where profit margins would never mean-revert. They knew to ignore the reckless optimism then, because they understood that stocks were claims on a very long-term stream of cash flows. They know to ignore the paralyzing fear now, because they still understand that stocks are a claim on a very long-term stream of cash flows.

No thoughtful investor "calls a bottom" in the markets. Stocks are undervalued here, but they could decline further. Economic conditions are poor, but may be over or under-reflected in stock prices. Investors will find out over time, and the ebb-and-flow of information is slow enough to allow very large market fluctuations in the meantime. Current market conditions are extremely compressed, to the extent that the market could soar by 30% even in the context of an ongoing bear market. At the same time, investors remain skittish, and we should allow for fresh weakness into next year or perhaps a wide and prolonged trading range. We continue to have something of a line-in-the-sand at the October lows, which is largely where our index put option strikes are positioned. We'll alter that as the evidence changes.

Price Fluctuations, Support Levels, and Valuation in Bear Markets

If we seriously need to talk about the Great Depression (I personally believe that it is an outrageously dire comparison), we should recognize that even during that prolonged decline, it rarely made sense to sell into a major break of a previous low, because investors invariably had a chance to sell on a later recovery to the prior level of support. Below is a chart of the Dow Jones Industrial Average during the Depression. Even if one hung on after the enormous rally of nearly 50% that followed the initial 1929 low, the market's initial break of that low (the first horizontal bar) was followed several months later by a rebound to that prior level of support. The break of the second intermediate low of early 1931 (the second horizontal bar) was followed by a rebound later in the year to that same level. Third break, same story.

It is a typical market dynamic to have massive rallies toward prior levels of support, even within ongoing market declines. Once valuations are favorable, that tendency is even stronger, even in a weakening economy. Only the final panic decline of a bear market offers investors virtually no chance to get out on rebounds, but it is precisely that final decline that is recovered almost immediately in the subsequent bull market.

It's possible we've already seen the final panic of the current "bear market," though we certainly wouldn't remove our hedges on that expectation. Given the slim prospects for an economic recovery in the near future, my impression is that regardless of what happens over the very near term, we'll observe an additional spate of weakness (possibly from higher levels) early next year as investors give up their remaining patience and decide -as they often do near the end of a bear market - that there's no way that the market or economy can recover, and that there is no "catalyst" that is capable of driving stocks higher.

Even if the U.S. economy experiences a much deeper recession, I believe that the 1000-1100 level on the S&P represents a reasonable estimate of "fair value" for the S&P 500. That estimate is somewhat conservative since I am adjusting for the fact that earnings in recent years have been based on very wide profit margins, but could be too conservative given that long-term interest rates are very low. Long-duration instruments like stocks should not be priced off of short-duration instruments like 10-year Treasury bonds, or even 30-year Treasuries, so low interest rates shouldn't make investors recklessly optimistic about their valuation estimates. In any event, I do believe that current levels represent value from the standpoint of long-term investment prospects.

As for extreme and less likely benchmarks, the 780 level on the S&P 500 would represent a 50% loss from the market's peak, and would put the market in the lowest 20% of all historical valuations. I would expect heavy demand from value-conscious investors about that level if the market was to decline further, and a decline below that level could be expected to reverse back toward 780 fairly quickly. Further down, but very unlikely at this point from my perspective, the 700 level on the S&P 500 would represent the lowest 10% of historical valuations, 625 would put the market in the lowest 5% of valuations, and anywhere at 600 or below would put the market in the lowest 1% of historical valuations. I don't expect to see such a level, but there it is. Note that these estimates are unaffected by how low earnings might go next quarter or next year. Stocks are not a claim on next quarter's or next year's earnings - they are a claim on an indefinite stream of future cash flows.

Recent market conditions seem like they have no precedent only because so many investment professionals know only the data they've lived through. If one actually examines market data from the Great Depression, 1907, and other less extreme panics, one realizes how much the recent decline has already discounted potential economic negatives. At this point, further declines in stock prices simply increase the long-term returns that investors can expect over time. We can't rule out the possibility that investors could get more frightened, or that they might abandon their stocks at prices that would offer extremely high long-term returns to the buyers. It is important to establish exposure slowly, but long-term investors who ignore attractive valuations are not investors at all.

As I repeatedly noted when valuations were rich, gains in an overvalued market are generally not retained over the full market cycle. Likewise, weakness in an undervalued market tends to be temporary and impermanent. This distinction is essential. The main damage that investors can do to their financial security at this point would come from selling into steep but impermanent declines. Even in ongoing bear markets, once valuations become favorable, declines through prior levels of support are typically followed by advances back to that support. Remember that if and when things look frightening.

It is also important for investors to separate near-term earnings risks from long-term valuations. Earnings are more volatile than stock prices, and year-over-year fluctuations in earnings are not correlated at all with year-over-year fluctuations in stock prices. It is only over the long-term, when we examine stock prices versus the smooth trend of normalized earnings across multiple business cycles, that earnings really matter.

Again, if the market cleanly breaks the October lows, our investment position will become less sensitive to market fluctuations because that is where our put option strikes are largely set, but valuations have already improved beyond the point that would justify a full hedge against 100% of our holdings.

Market Climate

As of last week, the Market Climate for stocks was characterized by moderately favorable valuations and unfavorable but extremely compressed market action. The initial improvements we observed in market action a couple of weeks ago are now more tentative, and the market is only slightly above the level where we would lose that early favorable evidence (which is, not surprisingly, why we have set our option strikes at that same level). If the October lows hold well, we may very well observe a scorching advance in the range of 20-30% as investors re-evaluate the extent to which the market's decline has discounted the probable negatives. A significant break of the October lows could prompt "weak" holders to abandon stocks, which would create a need for a sufficient discount for "strong" holders (mainly value-conscious investors) to purchase those shares. Again, my impression is that in the event of a clear break of October's lows, 780 on the S&P 500 would most probably be where value-conscious investors would exhibit very strong demand.

As a side note, do your best to filter out comments like "investors are moving out of stocks and into ..." or "investors are selling into this decline" or "investors are buying into this rally." On balance, investors do not sell shares, and they don't buy shares. Every share purchased is a share sold. The only question is what price movement is required to prompt a buyer and a seller to trade with each other. No money will come off the sidelines into stocks. No money will come out of stocks and onto the sidelines. All such talk is non-equilibrium idiocy. Keep in mind that the "market" consists of different traders with a variety of time-horizons, risk-tolerances, and analytical methods (e.g. technical, report-driven, value-conscious). It is helpful to think in terms of which group of individuals is likely to do what, and when. It is equally important to know which group of investors you belong to. As the old saying goes, if you're at a poker table and you don't know who the patsy is, you're the patsy.

Your hoping we do get a major rally analyst,

John Mauldin

Two Little-Noted Features Of The Markets And The Economy

John Mauldin — Mon, 03 Nov 2008 21:11:50 GMT

This week I have a very special Outside the Box for you. Peter Bernstein is recognized as one of the more brilliant and insightful analysts of our times. At 89, he has been writing prescient material longer than most of us "young guys" (I am 59, and hope I am still writing at 89, or even able to write!) have been even marginally in the markets. His Economics and Portfolio Strategy Letter is read by the true cognoscenti of the investment world.

He has given me permission to reproduce his latest letter in which he offers two insights. Rather than give you some teaser copy, why don't you just jump in a read. And trust me, anything that Peter writes is worth reading more than a few times.

For those interested, you can learn more about Peter and subscribe to his letter at www.peterlbernsteininc.com.

John Mauldin, Editor
Outside the Box

Two Little-Noted Features Of The Markets And The Economy

By Peter Bernstein

This issue analyzes two significant aspects of the current environment, one financial and one from the real economy. Neither of these subjects has received the attention it deserves, yet both have important stories to tell. The financial discussion raises tantalizing questions about investor rationality. The comments about the real sector consider current conditions in the labor market and their implications for equity price/earnings ratios in the years ahead.

The Financial Side First

The following discussion includes a personal anecdote which may be familiar to some readers. Nevertheless, we repeat it here because it is essential to my argument.

These events occurred during 1958, when I had been a practicing investment counsel for seven years. The economy had peaked out late in 1957 and was heading into recession at the turn of the year. By the second quarter of 1958, real GDP was declining at a shocking annual rate of 10.4% (due mostly to slashes in business investment). The recession came to an end during the final quarter of 1958, but this episode's sharp decline and brief duration were not its most important characteristics. The historical significance lies elsewhere.

During this recession, the rate of inflation continued to be positive, on both a quarter-to-quarter basis and figuring year-over-year. Indeed, during the steepest part of the decline in real GDP in the second quarter of the year, the CPI was rising at an annual rate of 3.2%, not far from the 3.4% rate at the business cycle peak in 1957:4. Rising inflation during a recession was unprecedented. Weak business conditions in the past had always been associated with deflation, not inflation. During the preceding recession of 1954, the price level had been essentially flat and then declined from 1954:3 through 1955:3.

These extraordinary events had an even more extraordinary echo in the capital markets. In the second quarter of 1958, the dividend yield on stocks was 3.9% and the yield on 10-year Treasuries was 2.9%. Three months later, dividend yields were down to 3.5% while Treasuries had climbed to match them at 3.5%. The next three months made history, as stock prices kept rising and pushed the dividend yield down to 3.3% while bond prices kept falling and drove the bond yield up to 3.8%. As the graph on page 2 demonstrates, this, too, was unprecedented. The two yields had come close in the past but had always backed away at the critical moment. In 1958, they reversed their historical positions and have never looked back.

When this inversion occurred, my two older partners assured me it was an anomaly. The markets would soon be set to rights, with dividends once again yielding more than bonds. That was the relationship ordained by Heaven, after all, because stocks were riskier than bonds and should have the higher yield. Well, as I always tell this story, I am still waiting for the anomaly to be corrected.

As investors pondered this upside-down yield spread after 1958, two explanations (rationalizations?) began to circulate. First, the vigorous recovery from the 1958 recession had demonstrated that investors could finally put to rest the widely-held expectation of an imminent return of the Great Depression. Truly, a New Era had dawned. Second, as a corollary of the first, the notion of growth stock investing was beginning to take hold. My own article, "Growth Companies versus Growth Stocks," which had appeared in the Harvard Business Review in 1956, had attracted widespread attention - it put my name on the map for the first time. In addition, T. Rowe Price's case for growth stock investing was finally gaining respectability. Growth justified dividend yields below bond yields, because the dividend flow could increase over time while bonds were a fixed-income investment.

As I recount this story today, I am beginning to wonder whether my older partners might have had something on their side after all. The graph on page 3 shows the anomaly is now closer to reversing itself than at any time since 1960-1962 when - as at present - 10-year Treasury bonds were yielding less than 4%.¹

In the unlikely event that the difficulties the economy is facing at this moment are about to melt away, stocks will probably continue yielding less than bonds. On the other hand, if the this deteriorating financial and economic environment persists, or if conditions should become even more alarming, stock prices will fall further and Treasury bond prices will continue to rise. Then a thunderbolt would strike: my partners' forecast of an anomaly in 1958 would turn out to be valid as dividend yields revert to tradition and rise above bond yields. A fifty-year relationship would be thrown into reverse.

In that case, where was the anomaly - in 1958 or in 2008? Are there in fact any rules to define the basic relationship between bond yields and dividend yields? We see no clear answer to these questions.

A profound philosophical dilemma is present here. The yield inversion in the spring of 1958 taught me a lesson I have never forgotten: anything can happen. Just because a relationship had held since the beginning of time is no reason to believe it would also hold until the end of time. Black swans lurk behind every shadow, and we should always be prepared for unimaginable outcomes - unknown unknowns. My older partners may have been mistaken for half a century when they confronted an unknown unknown in 1958, but even a time span of fifty years was no guarantee they were going to be mistaken unto eternity. I, for one, shall not be surprised if the inversion is reversed in the near future, nor shall I expect that reversion to last into the indefinite future.

The graph above provides additional evidence to demonstrate the risks of naively extrapolating the patterns of the past. Consider the correlation between the two variables.

To many observers, the long-running positive correlation between bond yields and dividend yields from 1970 to 1999 has defined the fundamental and enduring relationship between these two variables. This pattern appeals to commonsense, and its consistency over thirty years has given it authority. The coefficient of correlation from 1970 to 1999 was a powerful +76.7%, with a fat t-statistic of 13.0 on the independent variable. With a relationship that potent, why not extrapolate the positive correlation between asset class returns?

Well, there was good reason not to extrapolate. Note that the correlation had been negative from 1954 to 1969, with an impressive coefficient of -58.8% and a significant t-statistic. As a result, people active in those years were totally taken by surprise when the correlation switched to positive after 1970, and with such remarkable consistency. But then that surprise was repeated at the other end. The arrival of a new century brought a switch back to a negative sign on the correlation coefficient, and the familiar lock-step process crumbled! From 2000 to the latest data for 2008, the coefficient of correlation has been an imposing -78.2%.

Now let us venture an explanation for these changes in the coefficient of correlation from positive to negative: inflation From 1954 to 1969, the average annual rate of inflation was 2.1% with a standard deviation of 1.5%. The period from 1970 to 1999 was entirely different, with an annual inflation rate that averaged 5.3% and a high standard deviation of 3.2%. Then matters settled back down again for the next eight years, with an average of 2.8% and a standard deviation of only 0.9%. Thus, the correlation between the two series has been high when inflation is high and volatile; the correlation has been low when inflation is low and steady. In other words, in order to predict the correlation between stock and bond yields, you need only predict inflation (that is if you are capable of making consistently accurate forecasts of inflation).

But even so, life is not that simple. The approach has a fundamental flaw, so fundamental that, at some point in the future, it must come to light and take over these relationships.

Dividends are variable over time and bond coupons are fixed from issuance to maturity. Therefore, the correlation in returns should be just the opposite of the relationship prevailing since 1954 - negative during inflationary episodes and positive when the price level is relatively stable. The risks of fixed-income securities under inflation needs no explanation, but dividends have been a firm long-term hedge against inflation. Dividends increased at just about the same rate as the price level from 1947 to 1956, after which they really took off. Indeed, during the worst of the Great Inflation from early 1973 to the peak in early 1980, the CPI rose at an annual rate of 9.2% and dividends increased at an annual rate of 9.0%. Today, dividends are forty times their 1947 level whereas the price level has risen "only" ten times.

Now look back at the upper graph covering the years from 1871 to 1959. The correlation was closest from 1871 to 1929, but those were years of low inflation or even deflation, except from the discovery of gold in South Africa in 1900 to the end of World War I. In other words, investors in the old days appear to have behaved more rationally than investors in the more sophisticated and theoretically aware era since 1954!

Differing generations of investors appear to have differing views on how bonds and stocks should behave as the environment changes. But the basic truth is simple. The correlation should be negative when inflation is high and positive when inflation is low.

Pain in the Real Economy

The graph below tells a grim tale. Until 1982, the rate of unemployment (unemployment as a percent of the civilian labor force) and the median duration of unemployment (in months) moved up and down together in almost lockstep. Since 1982, however, the duration of unemployment has increased dramatically relative to changes in the unemployment rate. It just so happens that 1982 was also the point at which the growth rate of real compensation began to lag significantly and persistently behind productivity - a condition we discussed at length in our issue of September 15 of this year.

These facts have high importance for investors at the present time. Congress has just passed a bill that "bails out Wall Street." The recent failures and mergers of investment banks have been accompanied by breath-taking bonuses to departing executives responsible for much of the mayhem they leave behind. Income inequality has risen steadily and ominously over the past fifteen to twenty years. Thousands of Americans are losing their homes to foreclosures

A new President and a new Congress will be installed in a few months, at which time both of the curves in this graph are likely to be even higher than they are at this writing. For how much longer will the great mass of Americans tolerate these trends? Regardless of how each of us may feel about these developments, the future direction of political leadership will aim to change the egregious imbalance between winners and losers.

Under these circumstances, and regardless of when the black clouds on the horizon finally begin to brighten, we would put low odds on a renewed bull market with ebullient price/earnings ratios and declining dividend yields. For a long time into the future, equity returns are likely to be muted.

Investor failure to understand the fundamental differences between bonds and stocks and the impact of inflation on those differences has elicited a large literature. The most important of these papers was written in 1979 by Franco Modigliani and Richard Cohn ("Inflation, Rational Valuation, and the Market," Financial Analysts Journal). See, also, Clifford Asness, "Fight the Fed Model: The Relationship between Future Returns and Stock and Bond Market Yields," Journal of Portfolio Management, Fall 2003. I am especially indebted to both of these papers for guidance in the arguments set forth above.

¹ At this writing, with stocks at 2.8% and bonds at 3.5%, the spread is the narrowest it has been since 1963.

oOo

"Economics & Portfolio Strategy" is copyrighted © 2008 by Peter L. Bernstein, Inc. NO PART OF THIS PUBLICATION MAY BE REPRODUCED OR TRANSMITTED IN ANY FORM OR MEDIUM WITHOUT RIOR WRITTEN PERMISSION FROM PETER L. BERNSTEIN, INC. Factual material is not guaranteed but is obtained from sources believed to be reliable.

Banking Crises Around The World

John Mauldin — Wed, 01 Oct 2008 16:45:11 GMT

Do government bailouts in times of banking crises work? Philippa Dunne & Doug Henwood of The Liscio Report highlight a major study of 42 fairly recent banking crises around the world. Result? Some types of government intervention works and some don't. One characteristic that is needed though is speed. Dithering, a la Japan, is a recipe for disaster. This is a brief summary of the report (to which they provide a link) and their conclusions as to the basic outlines of what the US should do. Given that Europe is already in the throws of its own bank crisis, and the rest of the world could experience problems, this should be useful reading. They also provide graphs of banking crises and comparisons with developed countries and the resulting market experience.

One major point? This is like the old Fram oil filter commercial line "Pay me now or pay me later." As this study points out, the tax payers and citizens of the US (and the world) are going to pay for this crisis in one way or another. Either a major recession (with high and persistent unemployment), reduced incomes and tax collections or a collective efforts to stabilize the banking system. The costs of inaction are much higher. It is not a matter of cost or no cost. We are going to have to pay in one form or another.

We cannot avoid the costs given where we are today. The time to avoid cost was years ago reigning in Freddie and Fannie and proper oversight of the mortgage industry. We (Congress) missed that opportunity. (Sadly, we are going to re-elect the very leadership to both parties largely responsible for the neglect. There is plenty of blame to go around. No amount of partisan finger pointing by Speaker Pelosi shifts that blame.) However, we can choose the form of the cost will be paid in. Personally, I prefer collective efforts to 10% or more unemployment and the risk of an extended recession and its costs. I know this is not pure free market theory, and sticks in the craw of many of my readers, but when many of my neighbors and friends will be unemployed and businesses are suffering theory will not make a very good meal. Congress must act now. This report is a good reminder of what has worked in the past.

My thanks to Philippa and Doug for allowing me to send this as a Special Outside the Box. You can see their work and blog at http://www.theliscioreport.com.

John Mauldin, Editor
Outside the Box

Banking Crises Around The World

The Liscio Report On the Economy
October 1, 2008

Having rejected Henry Paulson's rescue plan, it's not clear what Congress --or those in the broad population opposed to a "bailout"-- propose to do to keep the financial system from imploding. But a database of systemic banking crises recently assembled by IMF economists Luc Laevan and Fabian Valencia (www.imf.org/external/pubs/cat/longres.cfm?sk=22345.0) provides a useful map of how crises play out and what does and doesn't work.

Laevan and Valencia identify 124 systemic banking crises between 1970 and 2007, and assemble detailed information on 42 of them, representing 37 countries. (Some countries, like Argentina, appear multiple times.)

In almost every case, governments took active measures to mitigate the crisis, so there is no real test of whether rescue schemes actually work; no politician seems willing to face the consequences of letting the chips fall where they may. But the work of Laevan and Valencia does offer some guidance as to what works best.

Dithering Costs

One crucial lesson stands out: speed matters. This is obvious to anyone who followed Japan's dithering in the 1990s; standing aside and hoping the problem goes away is not a good idea. Relatedly, "forbearance" --regulatory indulgence, such as permitting insolvent banks to continue in business-- does not work, as has been established in earlier research. As the authors say, "The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance." This suggests that suspending mark-to-market requirements is not a good idea.

Since forbearance does not work, some sort of systemic restructuring is a key component of almost every banking crisis, meaning forced closures, mergers, and nationalizations. Shareholders frequently lose money in systemic restructuring, often lots of it, and are even forced to inject fresh capital. The creation of asset management companies to handle distressed assets is a frequent feature of restructurings, but they do not appear to be terribly successful. More successful are recapitalizations using public money (which can often be partly or even fully recouped through privatization after the crisis passes); recaps seem to result in smaller hits to GDP. But they're not cheap: they average 6% of GDP, which for the U.S. would be about $850 billion.

Total fiscal costs, net of eventual asset recoveries, average 13% of GDP (over $1.8 trillion for the U.S.); the average recovery of public outlays is around 18% of the gross outlay.

But those who don't want to spend that kind of taxpayer money should consider this: Laevan and Valencia find that "[t]here appears to be a negative correlation between output losses and fiscal costs, suggesting that the cost of a crisis is paid either through fiscal costs or larger output losses." And if the economy goes into the tank, government revenues take a big hit, so what's saved on the expenditure side could well be lost on the revenue side.

Oh, and about half the countries that have experienced crises have had some form of deposit insurance. So merely expanding the FDIC's coverage is not likely to do the trick --and, in any case, it's going to be hard to escape the huge expense of a systemic recapitalization, though using the FDIC might simplify the politics of the rescue.

(A note on the politics of the rescue: an ABC poll shows the public to be far more worried about the economic consequences of the bailout's defeat than Congress seems to be. There's not a lot of enthusiasm for what's seen as handing money over to Wall Street --but if properly structured and sold, say with more cost recovery prospects for the government, more relief for debtors, a rescue is not as unpopular as some would have it.)

Relevant Examples

Most of the countries in the Laevan/Valencia database are in the developing world, and are of questionable relevance to the U.S. But TLR has taken a closer look at four countries that offer more relevant models: Japan, Korea, Norway, and Sweden. Some major stats for the four and the U.S. are in the table at the end of the newsletter, and graphs of some important indicators are there as well.

Sweden, now widely seen as a model of swift, bold action, kept its ultimate fiscal costs relatively low --3.6% of GDP at first, almost all of which was recovered through stock and asset sales-- but was unable to avoid a deep recession. At the other end of the spectrum, Japan, the model of foot-dragging half-measures, saved no money through its procrastination; its fiscal outlay was 24% of GDP, almost none of which was recovered. And it was unable to avoid recession.

Note, though, that some of the worried talk surrounding the financial market impact of bank bailouts looks misplaced, at least on these models. Three years after the outbreak of crisis, inflation was lower and stock prices higher in all four countries, and government bond yields were lower in all but Japan. It's likely that the deflationary effects of a credit crunch outweigh the inflationary effects of debt finance.

Although the U.S. in 2007 had a lot in common with other countries on the brink of a banking crisis, one thing stands out: the depth of the current account deficit. Of the four comparison countries, only Korea comes close to the U.S. level of red ink. The unweighted average current account deficit of the 42 countries in the Laevan/Valencia database was 3.9% of GDP --compared with 6.2% for the U.S. That suggests that the U.S. has more to deal with than just resolving a banking crisis.

A Better Bailout

So, with the modified Paulson plan dead for now, what might a better bailout scheme look like in light of the Laevan/Valencia historical database?

First, it must be adopted quickly. Perhaps operating through the FDIC would be a way to accomplish that, though the FDIC will almost certainly need to have its coffers copiously refilled.

Second, forbearance would be a bad idea; it does no one any good not to face reality.

Third, purchasing bad assets and turning them over to an asset management corporation is not a promising strategy.

Fourth, recapitalizing the banks should be the heart of any policy; as the authors say, it should be selective, meaning supporting those institutions with hope of revival, and letting the terminal go down.

And fifth, targeted relief for distressed debtors, supported with public funds, has also shown success in earlier banking crises, and should be part of any rescue scheme in the U.S. as well.

Crises like this are manageable. They're expensive and painful to resolve, but even more expensive and painful when left to fester.

-- Philippa Dunne & Doug Henwood

Bailout Stats And Graphs

Haste Makes Waste

John Mauldin — Mon, 29 Sep 2008 21:48:06 GMT

The purpose of Outside the Box is to present views which cause us to think through our basic assumptions. This week our old friend Michael Lewitt of Hegemony Capital Management gives us a view as to why the bailout bill going down may not be as bad as I think it might. There is much we agree on, however. And part of our agreement is that a deeper recession is in our future. Let me be clear. Muddle Through is now at risk.

I have talked with my publisher, and for the next few weeks of The continuing Crisis, we are going to send more than one OTB per week, and I may also add some short commentary. These are extraordinary times, and I know a lot of you (as I can tell from phone and emails) are worried and are interested in analysis that is not biased with either a perma-bull or perma-bear stance. I will call it as I see it, as always, and forward you material from my best sources.

That being said, we will get through this, one way or another. Sanity and clarity will return, as it always does after times of crisis. I wish you the best in your situation.

John Mauldin, Editor
Outside the Box

Haste Makes Waste

by Michael E. Lewitt

"Examining the record of past research from the vantage of contemporary historiography, the historian of science may be tempted to exclaim that when paradigms change, the world itself changes with them. Led by a new paradigm, scientists adopt new instruments and look in new places. Even more important, during revolutions scientists see new and different things when looking with familiar instruments in places they have looked before. It is rather as if the professional community had been suddenly transported to another planet where familiar objects are seen in a different light and are joined by unfamiliar ones as well. Of course, nothing of quite that sort does occur: there is no geographical transplantation; outside the laboratory everyday affairs usually continue as before. Nevertheless, paradigm changes do cause scientists to see the world of their research-engagement differently. In so far as their only recourse to that world is through what they see and do, we may want to say that after a revolution scientists are responding to a different world."

Thomas S. Kuhn¹

The problem with trying to legislate in the middle of a revolution is that you aren't sure whether you are governing the world that is being destroyed or the one that is coming into being. There can be little question that the Wall Street that existed at the beginning of this year is no longer the industry that Congress is seeking to rescue from its own excesses. The financial world has been permanently altered by the collapse of the debt bubble that inexorably built up over the past three decades. Now Congress is trying to design a rescue plan for a world whose shape is highly contingent and unstable. Such an undertaking requires more than two weeks of work. Conventional thinking tells us that the government must do something to stabilize the markets immediately, and that doing something is better than doing nothing. Once again, conventional thinking is wrong. Congress would be much better advised to take the extra few days or week it would take to structure a plan that the world is going to have to live with for a very long time. As we were completing this newsletter, the House of Representatives voted down the emergency package and the financial markets are panicking. Such panic is unwarranted. The world should take a deep breath and consider whether defeat of a deeply flawed bill should be treated as a catastrophe or a rallying cry to develop a better plan that addressed the underlying issues that need to be fixed.

The Paulson Plan

HCM has been warning for years that all of the king's horses and all of the king's men wouldn't be able to put this mess back together again. It is now time for America to take the pain and figure out how to move forward. Any plan that is adopted must include a sufficient dose of strong medicine to prevent the culture of self-delusion and moral hazard that created the current crisis from further perpetuating itself. The purpose of the Paulson Plan has to be to rebuild confidence in the financial system. The manner in which the plan was presented and debated rendered that more difficult but hopefully not impossible. For any plan that fails to bring confidence back to the market will not work.

The great economic historian Charles Kindleberger wrote in his seminal study of financial crises, Manias, Panics, and Crashes, that, "[f]or historians each event is unique. Economics, however, maintains that forces in society and nature behave in repetitive ways. History is particular; economics is general."² This is a very important observation. While each financial crisis is unique in terms of its causes and the types of assets that it engulfs, the conditions that led to it are always driven by human irrationality and hubris. Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.

Recently, former New York Federal Reserve Governor Gerald Corrigan led a group of market experts that released a report entitled Containing Market Risk: The Road to Reform, The Report of CRMPG III (Corrigan III) (August 6, 2008). In that report, Mr. Corrigan and his colleagues wrote the following very wise words:

"The fact that financial excesses fundamentally grow out of human behavior is a sobering reality especially in an environment of intense competition between large integrated financial intermediaries which, on the upside of the cycle, fosters risk taking and on the downside, fosters risk aversion. It is this sobering reality that has, for centuries, given rise to universal recognition that finance and financial institutions must be subject to a higher degree of official oversight and regulation than is deemed necessary for virtually all other forms of commercial enterprise."

What is lacking from the public debate is a serious understanding of the difference between treating the symptoms of the crisis and trying to cure the disease. The disease is a total loss of confidence in the American model of debt-engorged free enterprise, and American economic and political leadership. The cure is regaining that confidence.

In his new book, economic consultant David M. Smick writes,

"the survival of the world financial system depends on an elaborate confidence game. The size of the financial markets, relative to the governments, has become so monstrously huge there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves cannot by edict restore order. They can only project to the markets a sense that they know what they're doing."³

What Henry Paulson and Ben Bernanke are desperately trying to explain to Congress is that America's leadership must immediately restore the world's confidence in American economic and political leadership. But the Paulson Plan was generated under impossible conditions. Were it to succeed, the best that could be expected at this point is a slow revival of the credit system. To hope for more is sheer folly. It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn't seen for decades. Frankly, HCM can't see any way that such a slowdown can be avoided, although HCM has some ideas on how to begin to work out of it. Moreover, if by some miracle it were to be avoided, it would merely delay the inevitable purging of the psychological and financial excesses that have been piling up in our economic system over the past thirty years. One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.

At one point during the bailout negotiations, Henry Paulson was seen genuflecting at the feet of House Speaker Nancy Pelosi, a fitting emblem of just how far the credibility of the Bush Administration has fallen.⁴ Earlier policy blunders are now haunting a lame-duck Administration. The Paulson Plan is being pushed with the same kind of urgency that pushed the U.S. to invade Iraq, and the President has no more weapons of mass destruction to sell. There are legitimate fears that anything approaching the Paulson Plan, like the Iraq War, will get quickly bogged down in the complexities and contingencies that will be encountered on the battlefield. Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all.

There is one practical problem that will plague the Paulson Plan and any plan that involves the government purchasing distressed assets from financial institutions. These assets are NOT(!!!) accurately valued on the books of financial institutions.⁵ Accordingly, these institutions are not in a position to sell them to the government at current fair market value. Any sales at current market value would inflict huge losses on these institutions. The alternative is for the government to grossly overpay for these assets, which would constitute a disguised capital infusion into these firms that would short-change the American taxpayer. This flaw in the plan is why members of Congress from both sides of the aisle insisted on some kind of profit-sharing structure that would compensate taxpayers in the event the government pays above-market prices for assets. HCM fears that very little of the $700 billion is going to be spent in the near future because of the reluctance of banks to part with assets at anywhere near their current value, and the government's reluctance to overpay for these assets.

HCM views the Paulson Plan as a matter of form over substance. The details of how the plan will work are ultimately less important than whether the plan succeeds in rebuilding market confidence. In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.

An Alternative Bailout Plan

A successful plan must address the following elements:

Confidence: It must restore market confidence by convincing both Wall Street and Main Street that the government will stand behind the mortgage obligations that are the weakest part of the financial system.
Time: It must provide time for financial institutions to earn profits that can be used to absorb future losses on bad mortgage paper. The primary way financial institutions make money is by borrowing money at one rate and lending it out at a higher rate. The cost of money for financial institutions must be lowered immediately.
Prevention: It must convince both the American people and the global community that the regulatory lapses that allowed this disaster to occur will not happen again, and that the system will be fairer in the future. This is closely tied to the issue of restoring confidence in the markets as well as in American economic and political leadership.

The government's plan must restore market confidence, give companies the time to heal their balance sheets, and prevent a recurrence of the most abject series of regulatory lapses in the history of Western financial markets. For the sake of contributing to the public debate, which will continue even after the initial plan is adopted by Congress, HCM suggests that the government move ahead with the following measures in an effort to restore order and stability to the global credit and financial markets:

The HCM Bailout Plan

The government should announce that it will effectively stand behind the U.S. financial system against failure through some sort of guarantee or insurance program. The government has already done this with respect to money market assets.
Mark-to-market accounting for financial institutions should be suspended for an indefinite period. Since nobody knows what these assets are worth, we should not drive the system into insolvency trying to place a value on assets that nobody is willing to purchase at the current time.
The Federal Reserve should reduce the overnight interest rate by 75 basis points immediately. This will allow financial institutions to begin to earn more on their assets, which will begin the process of rebuilding their balance sheets.
The Securities and Exchange Commission should announce the formation of a study group that will report back no later than December 31, 2008 on a comprehensive regime for regulating the credit default swap market.

As noted above, HCM is concerned that the plan to purchase mortgage assets from financial institutions will not produce the intended results because of the difficulty of reaching agreement on price without inflicting too much further damage on the sellers' balance sheets. That is why we favor a guarantee or insurance program rather than the Paulson proposal.

Will The Paulson Plan Work?

The American taxpayer is going to suffer economically whether the Paulson Plan, or some variation on it, is passed or not. HCM does not believe for a second that taxpayers will profit from this bailout as some prominent commentators are arguing. The assets that are clogging bank balance sheets are highly complex and illiquid, and the time required for them to return to any reasonable value will consume their recovery value in present value terms. Nonetheless, voices considered wiser than ours are touting the plan as a good deal for the American taxpayer.

Bill Gross of PIMCO, for example, has argued that taxpayers could profit from the $700 billion plan put forth by the Bush Administration. According to Barron's, Mr. Gross "estimates that the average price of distressed mortgage debt that will pass from troubled financial institutions to Treasury will be about 65 cents on the dollar, representing about a one third loss for the seller from face amount. Financed at 3% to 4% by the sale of Treasury debt, Treasury will be in a position to earn a positive carry, or yield spread, of at least 7% to 8% on the purchases, even after taking into account severe assumptions of default rates and foreclosure recoveries."⁶ Mr. Gross to his great credit has offered PIMCO's services to the government gratis in this endeavor (provided his competitors do the same). In PIMCO's hands, he argues, the government will get a fair deal for the assets it buys. "'The prices that Treasury will get will be somewhere between par, which of course might screw the taxpayer, and a fire sale price of, say, 20 cents on the dollar, which would likely bankrupt some weak institutions and defeat the purpose of the bailout.'"

We think Mr. Gross is unduly optimistic from a couple of standpoints. First, he appears to be assuming that virtually all of the assets that the government will be purchasing will be AAA-rated mortgage securities, since these are the only mortgage securities trading remotely close to 65 cents on the dollar today. Unfortunately, many of the securities that are weighing down the balance sheets of financial institutions carry lower ratings, and many AAA-rated tranches are trading at well below 65 cents on the dollar today. (We would note that the Federal Reserve had already agreed to take onto its balance sheet much lower rated collateral, including equities, in order to support these same financial institutions.) Current trading prices may be unduly depressed by speculative shorting of the ABX indices as well as crisis conditions in the marketplace, but by all accounts AAA-rated tranches of 2006 and 2007 vintage collateralized mortgage obligations are deeply distressed due to inordinately high levels of defaults in the underlying pools of mortgages. While current prices may reflect unrealistically pessimistic projections of future mortgage defaults, the fact remains today's prices are today's prices. If the government pays more for these securities, it will be giving the seller a windfall. Mr. Gross's scenario glosses over this dilemma, which lies at the heart of why the Paulson Plan is unlikely to yield rapid progress in moving troubled assets off bank balance sheets.

Second, we have yet to see the non-financial economy bear the full brunt of the collapse of the financial economy. Main Street is only starting to pay for the sins of Wall Street. The stock market remains in deep denial about the scope and depth of the economic slowdown this country is about to face. As the consequences of tighter credit seep into the mainstream of the American economy, there is every reason to expect that mortgage default rates will rise and home prices will continue to fall, further depressing the value of the mortgage securities that the government is supposed to be purchasing under the Paulson Plan. We wish we could share Mr. Gross's optimism, but we question whether deep in his heart he isn't trying to use his bully pulpit to talk up the market.

Japan Redux?

One of the tough questions that deserve to be asked in the wake of the U.S. government's bailout of the U.S. finance industry is whether American prosperity of the 1990s and 2000s was as illusory as Japanese prosperity of the 1980s? Just as Japan's prosperity was based on a rigged economic system constructed out of a cheap currency, cross-ownership of institutions and a nonmark-to-market accounting system, America's recent prosperity was also built on a cheap dollar, a non-mark-to-market accounting system, and an addiction to debt. While this comparison can be debated endlessly, and will likely be the subject of many scholarly articles and books, the real question is whether the United States will suffer anything like the "lost decade" that haunted Japan (actually, it has been almost two "lost decades"). There are significant differences between Japan and the United States (the most troubling, perhaps, being that Americans do not possess nearly the savings that the Japanese did entering their difficulties), but the question will gain more attention in the coming months.

While it is too soon to make any judgments that far into the future, America is certain to see very slow economic growth in the immediate future. The world's only superpower may see its first trillion dollar deficit within the next couple of years, although Washington will try to dress up the number to keep it under thirteen figures (an unlucky number in too many ways to count). That alone should be sufficient to knock down American hegemony a further peg or two. Such a deficit will contribute to a further debasement of the U.S. dollar against Asian currencies and the Swiss franc.

The primary reason why economic growth is going to be sluggish is that credit is going to be strictly rationed for the foreseeable future, which means that only the most creditworthy borrowers will be able to access capital at a reasonable cost. Companies that need capital will be the ones that find capital most difficult and expensive to access. This means that many companies will have to pay exorbitant rates to borrow, and many highly leveraged companies that have to borrow will be forced into bankruptcy or capital restructurings in order to do so. Many leveraged companies are already drawing down their revolving credit lines before their banks withdraw them. General Motors was the most prominent company to have done this recently, but HCM is seeing this occur throughout the corporate credit market.

American Oligarchy

One of the most discouraging parts of the debate over the Paulson Plan was the discussion about limiting executive compensation for those firms that might benefit from the plan. While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation. If troubled financial institutions are going to be run by individuals who would conduct themselves in such a manner, there isn't much hope that any plan is going to work. The mentality that led two of our best and brightest public officials to attempt to defend the kind of avaricious conduct that played a central role in the current crisis is something that must be changed if we are to avoid future market crises.⁷

This brings HCM to two related areas that need to be legislated immediately: financial institution leverage; and the taxation of highly compensated financial executives. There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it.

We do not believe it is presumptuous to state that the debate over whether Wall Street firms were too leveraged is over. The decision by Goldman Sachs and Morgan Stanley has decidedly ended the leveraged investment banking model that brought down Bear Stearns, Lehman Brothers and Merrill Lynch. The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets. Unfortunately, compensation schemes did not take into account the fact that adding leverage is far different than adding value (i.e. compensation schemes were not properly risk-adjusted). As a result, compensation structures for these executives were largely asymmetrical, particularly with respect to the portion of their pay that was distributed in cash. Multimillion dollar cash payments for profits earned in a single year were not subject to being repaid if losses in later years wiped out those earlier profits. Too much cash exited these firms each year in the form of compensation, significantly weakening their capital bases. Fortunately, a significant amount of compensation was also paid in stock, which did not weaken these firms' balance sheets but still failed to instill sufficient caution in management when it came to assuming balance sheet risk.

In addition to the gargantuan amounts of compensation being paid out, the taxes paid on these amounts continued to drop over recent years. This is a result not only of reduced taxes on capital gains and dividends, which are only good economic policy up to a point, but on tax deferral schemes and other aggressive tax stances taken by corporate, private equity and hedge fund executives to reduce their taxes to unconscionably low levels.⁸ Private equity managers, for example, are able to treat their "carried interests" as capital gains and pay taxes at only a 15% rate. Yet these earnings are no less the product of their labor than a teacher's or a policeman's earnings are a result of his or hers. Last year, several private equity billionaires actually had the gall to lobby on Capitol Hill to retain the 15 percent tax rate on their "carried earnings." These individuals argued that if their taxes were raised, they would no longer be willing to take the kinds of business risks that lead to new job formation and economic growth. Attempts to require these over-indulged [fill in the blank]⁹ to pay the same taxes on their income as ordinary Americans were derailed in what must go down as one of the most cynical lobbying efforts in history. It would be one thing if private equity firms were funding innovation and job creation, but in the last few years they have done little more than use cheap financing to engage in speculative transactions that generate fees for themselves and what are going to turn out to be at best mediocre returns for their investors.

Hedge fund managers play their own games. The most popular tax reduction technique among this crowd is the formation of offshore trusts that enable them to defer their management and performance fees for periods as long as ten years. A ten year deferral of taxes reduces the effective tax rate paid on these managers' already huge earnings to virtually zero on a present value basis while they continue to enjoy the ability to profit from investments in America's (once) free markets. This tax deferral scheme, which comes in a number of variations, further separates the interests of those hedge fund investors who are paying taxes on their income from those of managers who are not. (Of course, investors don't mind as long as they are making money. Investors never mind as long as they are making money. That's the problem.) As one memorable television commercial put it, "it's not what you earn, it's what you keep." And hedge fund managers have figured out how to keep virtually everything for themselves. Now that the bloom has come off the rose for many hedge fund strategies, investors are going to discover just how one-sided was the deal they made with their managers. Redemption requests from hedge funds are expected to reach epic levels this year, yet many investors are going to be greeted with the unhappy news that they can't get their money back right now (or anytime soon) because it is stuck in illiquid, hard-to-value investments. Others will be told that it would be unwise for their funds to liquidate positions to meet redemptions in the middle of a financial crisis, failing to be informed of the likelihood that many of these securities will most likely be worth less in the future.

Fairly taxing the upper 1/10 of 1 percent isn't going to plug the gaping U.S. budget deficit, but it will go a long way to returning a sense of fairness to a system that has lost its moral compass.

Footnotes:

1 Thomas S. Kuhn, The Structure of Scientific Revolutions (Chicago: University of Chicago Press, 1962), p. 111.

2 Charles Kindleberger, Manias, Panics and Crashes A History of Financial Crises (New York: Basic Books, 1989), p. 16. This book should be required reading in Congress.

3 David M. Smick, The World Is Curved (New York: Penguin Group (USA) Inc., 2008), p. 23. Not that we need more things to worry about, but Mr. Smick also makes a compelling case for why we should be concerned about China's future economic stability in the near future.

4 According to The New York Times, September 26, 2008 ("Day of Chaos Grips Washington; Fate of Bailout Plan Unresolved", p. A1)"n the Roosevelt Room after the session, the Treasury secretary, Henry M. Paulsen, Jr., literally bent on one knee as he pleaded with Nancy Pelosi, the House speaker, not to withdraw her party's support for the package over what Ms. Pelosi derided as a Republican betrayal." Nothing else has worked, so why not try this?

5 Although in fairness all the blame for this can't be placed on these institutions. There is currently no market for many of these assets and placing a value on them would be an arbitrary exercise. This is why mark-to-market accounting should be suspended for an indefinite period of time.

6 Barron's, September 29, 2008, "Making A Mint," p. 30.

7 There were unconfirmed media reports late last week that certain Wall Street firms were marketing products to hedge funds that were designed to avoid the restrictions on short selling that were imposed by the Securities and Exchange Commission. Whatever one thinks of the short-selling restrictions, which were far from optimal, the prospect of financial institutions trying to circumvent them suggests that even the biggest financial crisis since the Depression has been insufficient to instill good judgment into some of those in positions of responsibility on Wall Street. Anti-fraud rules are designed, among other things, to prevent individuals from doing indirectly what they can't do directly. Gaming the short-selling restrictions would be a perfect opportunity to teach somebody a lesson that there are things more important in this life than making money.

8 It would not seem unreasonable, particularly during a period when the government is going to be starved for revenue, to impose a higher capital gains tax of 20% or 25% at significantly higher levels of gain, so that a taxpayer would pay 15% on the first $1 or $2 million of gain and the higher rate on gains over that amount. In general, however, lower capital gains rates stimulate economic growth and should be maintained. Dividend tax rates should be maintained at very low levels since these earnings are already taxed once at the corporate level.

9 HCM always likes to identify cultural images that capture the spirit of the times. There is currently an exhibition of modern sculpture called "Beyond the Limits" being held in the gardens of Chatsworth House, home to the Duke and Duchess of Devonshire, in England. One of the works on display is entitled "Planet" by Marc Quinn; it is a giant white sculpture of a baby lying/floating on its side. "Planet," which belongs more to the category of stunt or spectacle than art, seems to be a perfect emblem of these private equity chieftains groveling for tax relief from our elected officials (although the baby is not sucking its thumb). To view "Planet" on-line, see www.chatsworth.org.

Observations on a Crisis

John Mauldin — Mon, 22 Sep 2008 15:32:01 GMT

This week we look at a very solid piece of analysis on the world economy from my friends and London business partners Niels Jensen and Jan Wilhelmsen of Absolute Return Partners (www.arpllp.com). I find it is quite useful to read the considered opinions of those from outside the US and particularly from people who have developed keen insight from years in the trenches. Niels and Jan are certainly in that category. The world economy is clearly out of balance and they point out where some of the opportunities and problems lie. I think you will find this edition of Outside the Box quite useful. If you care to, you can write them at info@arpllp.com.

From South Africa
John Mauldin, Editor
Outside the Box

Observations on a Crisis

The Absolute Return Letter
September 2008

"If a loose monetary policy and rapid asset price inflation were the route to economic prosperity, Argentina would be the richest country in the world by now."

Albert Edwards
Co-Head, Global Cross Asset Strategy
Societe Generale

August is my month off. Every year I go to Mallorca where my favourite pastime is the occasional glance at the sea whilst reading a good book. This year Peter Bernstein's 'Against the Gods' was top of the pile. Not that I hadn't read it before. But my last encounter goes back about ten years and I decided that it deserved a re-read. After all, the book is about risk management and few books deal with the subject of risk management better than this one.

I didn't spend many days on the island before I realised that Mallorca was not in its usual ebullient mood. Clearly the credit crunch had started to bite here as well. My friends on the island, most of whom are in the property business, confirmed my casual observation. The banks are tightening they said. Loans which could easily be obtained only six months ago were no longer available.

A few days later I ran into an article in the Daily Telegraph which illustrates the magnitude of the problem (see chart 1 below). Although this chart is based on U.S. data, the behaviour of banks around the world is broadly similar. It is clear that tightening lending standards are no longer a phenomenon exclusively linked to property loans. Consumer loans in general, and credit card loans in particular, are now subject to much closer scrutiny.

Chart 1: U.S. Lending Standards

Source: The Daily Telegraph

From my vantage point in the Serra de Tramuntana, I started to philosophise about the roots of the current predicament. How could it possibly go so wrong? Is the end in sight yet? What can we learn from this mess? These are obviously big questions, although the answer to the first question is pretty straightforward, the way I look at things. It all went so terribly wrong because of hubris combined with excessive use of leverage. It is funny how we always think that this time it is different. This time we really figured it out, or so we thought. However, the ever present invisible hand had other ideas.

In short, not just the United States but the entire world is dealing with the implications of a near perfect storm which has created havoc on three fronts - falling asset prices, a weakening capital base amongst financial institutions and high inflation. It is the interaction of these dynamics which explains the mess we are currently in, but it is also here we are likely to find the answers to our questions, so let's jump straight into things:

Observation # 1

It all began with housing and it will end with housing.

When U.S. home prices began to skid, the damage inflicted was swift and devastating. We know now that that the quality of many loans was poor, causing large write-offs across the industry. With house prices in the US and the UK still well above their long-term averages relative to disposable income (see chart 2 below), there is no reason to believe that they will not continue to fall for quite some time yet. The write-offs will spread from sub-prime to prime and to many other countries as well, a process which has, in fact, already begun. Two criteria must be met before property will start to appreciate in value again - house prices must reach (or fall below) their long term equilibrium values and the current overhang (see chart 1) must be dramatically reduced. All this will take time - years rather than months.

Chart 2: Current overvaluation of U.S. and U.K. homes

Source: GMO Quarterly Letter, July 2008

Observation# 2

Don't trust central banks to always do the right thing.

The Financial Times ran an interesting piece back in early August which pointed to the "collective action problem" - i.e. the fact that the right policy for each and every country does not necessarily add up to the right policy for the world¹. As is evident from chart 3 below, although most countries are currently challenged with significant inflationary pressures, the problem is much bigger in emerging economies than in the 'old world'.

Chart 3: Inflation - Targets and Actual

Source: Financial Times

There is no question that it would be good for the world, should Asian central banks revalue their currencies against both the dollar and the euro. And a great deal of inflationary pressure in Asia could be eliminated through rising exchange rates. Asian countries, on the other hand, insist on using their currencies to grow the economy at an accelerated pace by allowing local exchange rates to be perpetually undervalued. The Europeans and Americans call it cheating. The Asian say mind your own business. Until this attitude is changed, there is little chance of a globally coordinated exchange rate policy which would be to the benefit of everybody.

Observation # 3

Policy mistakes are likely to be repeated.

Talking about policy makers, back in 1991, when the Japanese property bubble finally burst, few investors imagined that it would take at least a couple of decades to work off the excesses which had accumulated after years of rising property prices. Some commentators have made the point that the overheating in the Japanese property market was much more severe than anything we have witnessed in the U.S. in recent years, but that is factually incorrect. As pointed out in The Economist last week (see chart 4), residential property prices have actually risen more in the U.S. during the boom years 2000-06 than Japanese property prices did during their boom years in the late 1980s.

Chart 4: The American versus the Japanese bubble

Source: The Economist

Likewise, as far as the monetary policy response is concerned, a case cannot be made that the Japanese were slow to respond to the crisis. If anything, the Bank of Japan reduced the cost of money more quickly than the Fed has done (see chart 4).

What worries me the most, though, is that the Americans, who were extremely critical of the Japanese approach back in the 1990s ("Let the weak banks go out of business" was the advice given by the libertarian Americans) are now at risk of making exactly the same mistake as the Japanese. A number of U.S. banks have capitulated over the past year, and both Fannie Mae and Freddie Mac are in pretty serious trouble at the moment. What do the Americans do? They spend tax payers' money to try and fix something which is unfixable, not at all dissimilar to the policy mistakes made in Japan 10-15 years ago. This could have quite severe implications for U.S. GDP growth for years to come.

Observation # 4

The golden era of investment banks is over.

For the past couple of decades investment banks have been operating like mega hedge funds. An ever larger part of profits has been derived from proprietary activities. I remember once, not that many years ago, when I worked for one of the largest investment banks, it was explained to me that the bank's gearing was around 40-45 times during the month. Then, every month, as we approached month-end, the gearing would be brought down to below 30 in order to satisfy the regulator. I would be surprised if this practice was not widespread, but I would be even more startled if this sort of activity has not been seriously curtailed in the current environment. As markets have frozen, investment banks have had to reconsider their business model.

Obviously, once a new equilibrium has been established, the de-leveraging induced selling will dry up and markets will stabilise. But the banks will be far less profitable. In fact, when you think about it, the historic high level of leverage in the investment banking industry is not the real story. What is truly disgraceful is that investment banks could only manage returns on equity of 15-25% with a balance sheet that was often leveraged to the sky.

Observation # 5

The final shoe hasn't dropped yet.

One of the most heated debates of recent months is whether the commodity bull market of the past year has been driven by economic fundamentals or it is just another case of greed caused by "a couple of handfuls of hedge funds" which seem to get blamed for pretty much everything these days.

Readers of the June 2008 Absolute Return Letter will know our take on it. There is no way that fundamental factors alone can explain the rise in oil prices we have experienced in 2008. That has always been our view and the rather steep drop in the price of oil since I wrote the June letter has only served to reinforce our beliefs that the oil price still has some way to go before the fundamental equilibrium price has been reached.

Despite some masterful attempts to convince us of the opposite, the global investment banks have failed miserably to persuade me that the commodity bull market is (mostly) based on fundamentals. To me, it still represents the last leg of the liquidity super cycle which has been in full vigour ever since Greenspan decided he couldn't distinguish a bubble from a mere bull market.

The first shoe that dropped came off the credit leg. Then the property shoe dropped to the ground rather ungracefully and, in recent months, the equity shoe has fallen off as well. Only the commodity shoe is still attached to the four legged beast and only just. What I find most interesting, though, is that the most vocal supporters of the notion that the bull market in commodities is driven by fundamental factors are the same investment banks which stand to lose the most, should commodity markets collapse (see chart). Case closed.

Chart 5: Investment banks' exposure to commodities

Source: The Economist

Observation # 6

Leverage is 'dead' but capital is not.

The global pool of capital continues to be quite strong, primarily driven by a continued rise in the global savings rate. Although American consumers have not yet discovered the need to save more, in other parts of the world, the penny has dropped, and the global savings rate (as a % of global GDP) is well over 20%. This will soften the impact of the crisis as these savings can be made available for new investments.

The question is whether investors around the world have the appetite for allocating this capital to where it is most needed - to re-capitalise the world's banks. As long as asset prices, and most importantly property prices, continue to fall, then investors will fear that we haven't seen the last of the big write-offs yet. And without a re-capitalisation of the large banks, the global economy will only fire on four of its eight cylinders; hence the absolute necessity for property prices to stabilise before we can realistically hope for better times.

Observation # 7

The end of the crisis looks further away than it did a year ago.

As pointed out by Larry Summers in a recent article in the FT², policy makers are still behind the curve, mostly as a result of the commodity-induced rise in inflation which has made it difficult for central banks around the world to stimulate economic growth through a reduction in interest rates.

This view is reinforced by an observation made by Joachim Fels in a recent research paper produced by Morgan Stanley³. Fels points out that real short term interest rates (which he defines as the policy rate minus consumer price inflation) are currently negative in 20 of the 36 countries in Morgan Stanley's research universe. Monetary policy is hence more accommodating than many investors realise - particularly in North America, Eastern and Central Europe and across Asia - and there is little room for the authorities to cut rates aggressively.

This brings me back to a point raised earlier. When banks struggle, the usual fix is a steeper yield curve. The simplest way to do this is through a reduction in short term rates. With the yield curve already quite steep in the U.S., the current environment should in principle be conducive to making lots of profit for U.S. banks. The fact that they don't, illustrates the extent of the current problems. Therefore do not expect a further reduction in the policy rate to fix the problem. We are dealing with a different kind of beast in this crisis. An accommodating Fed (or, for that matter, ECB or BoE) won't necessarily make the crisis go away!

Observation # 8

Traditional risk management has lost its way

Last but certainly not least, it has become crystal clear to me that the general approach to risk management has lost all credibility over the past twelve months. Paul McCulley of Pimco touched on the subject in the July 2008 issue of Global Central Bank Focus:

"[...] every levered financial institution - banks and shadow banks alike - decided individually that it was time to delever their balance sheets. At the individual level, that made perfect sense. At the collective level, however, it has given us the paradox of deleveraging: when we all try to do it at the same time, we actually do less of it, because we collectively create deflation in the assets from which leverage is being removed."

As I pointed out in the October 2007 Absolute Return Letter, the issue at heart is that returns in financial markets are not normally distributed, but the risk management tools which are used by pretty much everyone are based on the assumption that they are. In a brand new book authored by Cuno Pümpin and Maurice Pedergnana⁴ the authors make the following point:

"The tragedy of the worst financial crisis since the 1930s was enhanced by almost every investment bank, all rating agencies and all bank regulators using the same measurement and the same mathematical risk model for market evaluation of securities. This example shows how dangerous the use of the standard deviation based approach is. If most of the market participants make decisions based on the same risk control of a false distribution assumption, and oversimplified risk model, it could cause a complete failure of the system."

I believe this book is one of the most important new books out this year. Few investors understand risk better than Pümpin and Pedergnana. Unfortunately, the first edition is published only in German. However, the authors are keen to get it translated into English as quickly as possible. I will keep you posted.

Conclusion

With the global banking industry bleeding, with galloping inflation limiting the options of monetary authorities, with house prices showing no signs of recovery and with policy makers set to repeat the mistakes of the past, it is hardly surprising that we find it difficult to be bullish about the economic outlook.

The first stage of the credit crunch is now all but over. Forced liquidations are no longer an everyday occurrence and hence some sort of normality has returned to global markets. The big question going forward is how much damage has been inflicted on the real economy?

Over the summer, the world has gone from being quite sanguine about economic prospects to being very negative. However, the economic data points are all over the place: In Denmark, the leading financial newspaper ran with the following header yesterday: "The economy grows again - the recession has been cancelled."

You'd better get used to this sort of story. There will be several false dawns before we finally come through this crisis. And the recovery is still quite some way away. The consumer is in for another shock in a few months' time when the heating season kicks off again. We find it hard to believe in any sort of recovery until the spring of 2009 at the earliest.

On the other hand, if the economy does recover next spring, then the turnaround in global stock markets is not far away, as it usually leads the real economy by 6-9 months. Having said that, what would you rather own? Equities which currently trade at 15-20 times earnings or credit instruments trading at a fraction of that cost? Deutsche Bank has calculated that senior secured loans are now trading at an implied price earnings ratio of about 5 - less than a third of the cost of equities. There is no question that the real value is to be found in credit instruments. This is where most of the damage has been inflicted and it is where the big bargains are in today's market.

[1] "Shifting down the gears", The Financial Times, 6^th August 2008.

[2] "How to build a US recovery", The Financial Times, 7^th August, 2008.

[3] "Less than meets the eye", Morgan Stanley Global Economic Forum, 22^nd August, 2008.

[4] "Strategisches Investment Management - Wie Investoren nachhaltige Wertsteigerungen erzielen"

The Fall of Lehman and The Terrible Lessons of Bear Stearns

John Mauldin — Mon, 15 Sep 2008 21:17:34 GMT

The weekend has brought us events that can only be described in large, over-the-top terms. The Fed agreeing to take equity on its balance sheet? How bad can things really be? Clearly much worse than most people thought last Friday. Moral Hazard has been re-introduced as Lehman is allowed to go down. I will admit to being surprised. I thought Paulson and Bernanke would put it in the too big too fail category. I think they did the right thing by refusing taxpayer money for a bailout, but it is clearly going to roil the credit markets for weeks and months. It will be interesting to see how long it lasts.

I am in La Jolla today, working with my partners at Altegris, and looking over their shoulders while they monitor the performance of some of our managers. Interesting times. But I have had the time to read two short but very interesting commentaries on the current crisis. I will have more to say on Friday, but for now let's read old friends (to Outside the Box readers) Michael Lewitt of Hegemony Capital Management (www.hcmmarketletter.com) and Barry Ritholtz of Fusion IQ (www.fusioniqrank.com).

As I send this, credit default swaps spreads are simply blowing out. I have been writing about how we would see significant problems in the CDS markets for almost two years. This is something that you could see coming yet nothing was done. I know we are now in crisis, but let's hope that the authorities learn some lessons and put in place some sensible regulations of the CDS market soon. And for the love of Pete (insert your favorite expletive here) put these (more expletives) things on a regulated exchange.

And I agree with Michael below. This is not a time to try and catch a falling knife. That time will come, but not yet. And remember things will get better and we will get through this. As I just said to Barry, "We do live in interesting times."

John Mauldin, Editor
Outside the Box

The Fall of Lehman: How To Fix It - Part II

By Michael Lewitt

History has a funny way of humbling men. So do markets. Perhaps the most disturbing aspect of Lehman Brothers' fall is that it comes almost seven years to the day after 9-11. That day was supposed to teach us humility, and the fall of Lehman, coming six months after the collapse of Bear Stearns and coupled with Merrill Lynch's disappearance as an independent company, are the result of a complete lack of humility on the part of those executives charged with leading the world's most important purveyors of capital in the post-9-11 world. For all the talk of pulling together in the wake of the terrorist attacks that shook America to the core and that supposedly set our priorities straight, Wall Street rushed headlong back to its mindless pursuit of profits and speculation without consideration for the consequences of its actions. Now the chickens have come home to roost.

In April 2008, HCM published a controversial essay entitled "How To Fix It," in which we outlined our (unsolicited) recommendations for how to correct the excesses that led to the credit crisis that began in mid-2007 and brought us to this historic day. We are republishing that issue of the market letter by attachment for those who did not read it the first time. Our key recommendations, which seemed much more radical in April than they do today, were the following:

Improve financial industry regulation and replace substance over form in the regulation we have.
Place absolute leverage limitations on financial institutions at much lower levels than the 30:1 levels that led to this crisis.
Place an absolute limitation on hedge fund leverage.
Regulate Wall Street compensation by basing it on multiple years' performance, add clawbacks and high water marks, and limit cash compensation that is paid out and weakens these firms' balance sheets.
Tax private equity firms' carried interests at ordinary interest rates rather than capital gains rates and restrict private equity firms' ability to go public.
Outlaw off-balance sheet entities.
Reinstitute the uptick rule with respect to short selling.

Finally, we made the point that too much economic activity in the United States was aimed at speculation rather than production. For example, the equity markets are increasingly dominated by quantitative investment strategies that are driven by considerations that are totally divorced from considerations of fundamental value. At the same time, the credit markets are increasingly utilized to finance change-of-control transactions for private equity firms that are done simply because low cost financing is available, not because a project is going to add to the productive capacity or capital account of the nation. As we wrote in that April issue, "t some point, society has to figure out that the way an investor earns his money is even more important than the amount of money he makes. This is why human beings were vested with moral sentiments, so they could distinguish the quality of human conduct from the quantity of its results."

These changes cannot and will not be effected simply by legislative fiat. It is incumbent upon the gatekeepers of capital - the fiduciaries that make the decisions about allocating capital - to bring discipline to the system. This will require a rethinking of their priorities and a willingness to add to their investment calculus considerations that exceed their own narrow interests about short-term investment returns. Our system requires a new concept of fiduciary duty that encompasses systemic as well as single-firm interests, and that focuses to a greater degree on risk-adjusted returns than raw numerical returns. Obviously the forces that led to this weekend's events have been building for many years, and the changes needed to fix the system will not be made overnight. But we should not let this occasion pass to reflect on what has occurred.

Imagine You Are On the Deck of The Titanic (Because You Are)

It is clear to us that the Federal Reserve and United States Treasury are not underestimating the enormity of the crisis. Continuing to write checks to bail out the private sector would have been the wrong decision, but the fallout is going to be severe. The next domino to fall may be the insurance giant, American International Group, Inc. (AIG), which is facing credit rating downgrades that will force it to post more collateral (that it doesn't have )on a large volume of credit insurance contracts. AIG is a much larger systemic threat than Lehman Brothers ever was, so this situation is profoundly serious. In HCM's judgment, investors should not try to pick a bottom in today's or this week's market. The market is going to experience extraordinary volatility today and over the immediate future. Play the market at your own risk and only with money you can afford to lose. The indices are heading significantly lower, as we have previously forecast. Gold, short-term U.S. Treasuries, short-term Swiss and German government paper, the Swiss franc, and certain Asian currencies like the Singapore dollar are the safest places to park your cash for the moment. The U.S. dollar continues to be debased (less against the Euro, which remains compromised, than against Asian currencies and the Swiss franc), particularly by the startling and historic decision by the Federal Reserve to accept equity securities at its discount window. If nothing else, that decision alone suggests the enormity and depth of the crisis we are facing. We never thought we'd live to see the day that the American central bank would accept equity as collateral for loans. We have to admit that took us by surprise and made us very nervous.

The Terrible Lessons of Bear Stearns

Posted by Barry Ritholtz on Monday, September 15, 2008 | 07:09 AM
http://bigpicture.typepad.com/comments/2008/09/the-terrible-le.html

As Lehman Brothers (LEH) turns into a single digit financial midget on its way to zero, as Washington Mutual (WM) works its way towards a buck, as Wachovia (WB) drops more than 80% over a year, as Fannie Mae (FNM) and Freddie Mac (FRE) become divisions of the United States of America, and are now priced in pennies -- we need to reflect upon the ongoing lessons learned from all these interventions by Treasury, Congress and the Federal Reserve.

The lesson from the Bear Stearns' bailout -- $29 Billion in Federal Reserve bad paper guarantees -- are quite stark:

Go Big: Don't just risk your company, risk the entire world of Finance. Modest incompetence is insufficient -- if you merely destroy your own company, you won't get rescued. You have to threaten to bring down the entire global financial system. The fear and disruption caused by a Bear collapse is why it was saved. (AIG has the right idea on this)
If you cant Go Big, Go First: Had Lehman collapsed before Bear, then the same fear and loathing of the impact to the system might have worked to their advantage. But having been through this once before, the sting is somewhat lessened -- especially for a smaller, lets interconnected firm like LEH.
Threaten your counter-parties: Bear Stearns had about 9 trillion in its derivatives book, of which 40% was held by JPMorgan (JPM). Some people have argued that the Bear bailout was actually a preventative rescue of JPMorgan. Its a good strategy if your goal is a bailout -- risk bringing down someone much bigger than yourself.
Risk an important part of the economy: If your book of derivatives is limited to some obscure and irrelevant portion of the economy, you will not get saved. On the other hand, if Mortgages are important, credit cards and auto loans are too. Securitized widget inventory is not.
Balance Sheets Matter: Focus on the media, complain about short sellers, obsess about PR. These are the hallmarks of a failing strategy -- and a grand waste of time. Why? Its call insolvency. ALL THAT MATTERS IS THE FIRMS' BALANCE SHEET. Lehman's liabilities exceed its assets, and they are now toast. Merrill Lynch got a lot of the junk off of its books, and got a takeover at 70% premium to its closing price. And Credit Suisse, who dumped much of its bad paper many quarters ago, is in a better tactical position than most of its peers.
Unintended Consequences lurk everywhere: When the Fed opened up the liquidity spigots via its alphabet soup of lending facilities, the fear was of the inflationary impacts. But the bigger issue should have been Complacency. The Dick Fulds of the world said after Bear, these new facilities "put the liquidity issue to rest." Lehman got complacent once liquidity was no longer an issue -- perhaps they acted to slowly to resolve their insolvency issue in time.

Unfortunately, Moral Hazard has created terrible lessons in 2008 -- via Bear Stearns (BSC), Lehman (LEH), Fannie Mae (FNM) and Freddie Mac (FRE).

Your wishing I had not been so right analyst,

John Mauldin

Dead Men Walking

John Mauldin — Mon, 25 Aug 2008 21:15:00 GMT

Last Friday's letter was about the fact that it is not just Freddie and Fannie. There are other problems. The Weekend Edition and today's Wall Street Journal are filled with stories about the problems with Freddie and Fannie. The assumption in so many quarters is that they will soon need government assistance. The only questions seem to be when and in what form? Can this wait until a new president is in place? Congress is leaving town soon. Can it wait until the lame duck session?

As I have been writing for well over a year, the credit crisis is going to be deeper and take longer to correct than the main stream media and economists think. Losses at banks are going to be much larger, and they are going to bleed for a long time. That means we are going to see more banks failing.

Bennet Sedacca, who I quoted in last week's letter, sent out a new letter this morning, providing a list of stocks he thinks may also be in trouble, his "Dead Men Walking" list. He also notes several banks that will be the beneficiaries of the crisis as they gobble up weak competitors.

Caveat: I am not a stock guy, and can't comment on any of the specifics of what Bennet writes about, but I thought it is important for my readers to understand that this crisis is not going to be over when Freddie and Fannie are nationalized. There are still some whales out there left which are coming to the surface. Warning: this is not pleasant reading.

Bennet is the president of Atlantic Advisors in Winter Park, Florida.

John Mauldin, Editor
Outside the Box

Dead Men Walking

Dead Man Walking - Originally, a phrase in a poem by Thomas Hardy in 1909, but later in a work of non-fiction by Sister Helen Prejean, A Roman catholic nun and one of the Sisters of Saint Joseph of Medaille. Prejean later wrote 'Dead Man Walking', which became a hit movie in 1995. The title comes from the traditional exclamation "dead man walking, dead man walking here" used by prison guards as the condemned are led to their execution.

Death Row - A term that refers to the section of a prison that houses individuals awaiting execution. It is also used to refer to the state of awaiting execution, even in places where a special section does not exist. As of 2008, there were 3,263 prisoners awaiting execution in the United States.

The Last Mile - "I guess sometimes the past just catches up to you, whether you want it to or not. Usually death row is called 'The Last Mile'. We call ours 'The Green Mile'-the floor was the color of faded limes." - Tom Hanks as Paul Edgecomb in 'The Green Mile'.

Are There Corporations that are "Dead Men Walking"?

The title of this piece sums up how I feel about the current credit markets. When I first started in the industry in 1981 we were worried, but only about one company -the Chrysler Corporation. Prior to that, Continental Illinois was in the forefront. Later in my career, in 1998, it was Long Term Capital Management, the hedge fund founded by John Meriwether that captured our attention. Then we had Enron/WorldCom, and by early 2008 Bear Stearns became a worry and then a problem that needed fixing.

All of these events were isolated, dealt with, often with either direct assistance from Uncle Sam or an effort coordinated by our benevolent/socialist government financial authorities. Markets would become unnerved, fear would grow, and then the Government would step in to make sure that the systemic risk that had finally come to the surface didn't melt the entire planet.

But this is where it is "different this time". Not only is it different, I think it may be unprecedented in nature. When I look at my Bloomberg monitor each day that contains my 100 most important indices, companies, commodities, bonds, bond spreads, preferred shares, etc, I shudder. The reason I shudder is that my screen doesn't have just one "problem child". It looks like a screen that contains many "dead men walking".

The Failed Fannie Mae/Freddie Mac Experiment

I recently wrote a piece entitled The Tale of Two Markets, where I talked about the "Fannie Mae/Freddie Mac Experiment". That experiment has now clearly failed and a bailout/privatization/nationalization of Fannie and Freddie is now being planned. While I have been expecting nationalization for quite a while, I am intrigued along with my peers and colleagues as to why the bailout is taking so long to accomplish. This is where it gets interesting and dangerous from a systemic point of view. My hunch is that the reason for the delay is that the Treasury Department is "peeling back the onion" on Fannie/Freddie and finding out just how much of a mess the two of them are in.

At last count, Freddie had Level 3 Assets of $151 billion while Fannie had $65 billion, for a not-so-paltry sum of $216 billion. When Freddie announced their results a couple of quarters back, they disclosed that most of their Level 3 Assets were of the "sub-prime" variety (the type of assets that started the whole Credit Crisis in the first place). They are also littered with Alt-A mortgages and are leveraged to the hilt.

Just how bad is the news at Fannie/Freddie? On Friday morning, Moody's downgraded their outstanding preferred stock 5 notches from A1 to Baa3 (a slight gradation above junk) and their Bank Financial Strength Ratings (BSFR) to D+ from B- (one/half notch above D, which is reserved for companies in default). According to Moody's, "the downgrade of the BFSR reflects Moody's view that Fannie Mae and Freddie Mac's financial flexibility to manage potential volatility in its mortgage risk exposures is constricted.....in particular, given recent market movement, Moody's believe these companies currently have limited access to common and preferred equity capital at economically attractive terms." "Dead men walking" defined.

Moody's went on to say, "The GSE's more limited financial flexibility also restricts their ability to pursue their public mission of providing liquidity, stability and affordability to the US housing Market. Fannie Mae and Freddie Mac currently make up approximately 75% of the mortgage market in the US. A reduction in the capacity of these companies to support the US mortgage market could have significant repercussions for the US economy. In an effort to thwart broader economic effects, Moody's believes the likelihood of direct support from the United States Treasury has increased."

Let me put it this way. "We the people" are about to become owners in Fannie and Freddie, whether we like it or not. The capital markets have shut on them both as their stocks trade in the $2-5 range, down from the $70-80 level just a year ago. And the yield on the outstanding preferred shares hovers in the 18-23% range, quite the bargain if they keep paying, but also it is the market's way of saying "beware the value trap", as the preferred shares may pay another dividend or two, but that is about it.

When the Treasury peels back the onion, I believe they will find a hornet's nest. I think we will see an initial bailout of $100 billion or so, with 2/3-3/4 going to Fannie (as it is a larger organization). The scenario I foresee however, just as happened at Merrill Lynch, Lehman Brothers and Morgan Stanley, is that they came to the financing window expecting to have borrowed enough, but then find they have to keep coming back repeatedly until the buyers go away or until "We The People" have thrown at least $500 billion at Fannie/Freddie to get them back on their feet again. This will also likely take an Act of Congress to raise the Treasury's Debt ceiling quite dramatically.

I will now identify who might be the other "Dead Men Walking".

More Dead Men Walking-Is There a Pattern?

What strikes me the most about impaired companies, whether they are automakers, airline companies, banks, brokers or GSE's, is that they seem to sing the same tune, or have the same pattern of behavior. This is how I have attempted in the past to identify what would be in trouble in the future (whether that was just to avoid their stocks and bonds from the long side or to try to profit from their missteps on the short side). It is a pattern that is not terribly dissimilar from the emotion charts I like to focus on so much. In the graphic below, I will offer my "recipe for disaster" for a bank or brokerage firm. I would like this cycle to be called, "The Dead Man Walking Cycle".

The first tip-off or "tell" is when a company releases earnings or some sort of positive announcement and the stock falls. Another important tell is the credit spreads of the debt as the company begins to widen. Then, the company will usually announce that "all is well" and is so great that they will buy back stock and not "cut the common dividend". After this comes the "acceptance" phase and write-offs/write-downs are announced and then some Sovereign Wealth Fund or Private Equity firm will inject capital or that a company within the same group will buy a "strategic stake". After a brief pop in the stock and short covering rally, the stock begins to fall further and credit spreads begin to blow out and preferred shares get hammered. Then, uh-oh, more write-downs and more write-offs and yes, another capital raise and finally a dividend cut to 'preserve capital'.

Sound familiar yet...?

All of this goes on for quite some time, until your stock price is so low that you would have to issue so many shares in a secondary offering that you dilute your shareholder base until it is unrecognizable. With this new share offering your credit, while still rated investment grade, trades like junk, and your preferred shares rise to double digit yields. Further, the former strategic buyers, Sovereign Wealth Funds and Private Equity firms have taken such a beating that there are no further buyers.

Yet the write-downs and write-offs continue unmercifully as the economy slows and credit is all but cut off. Eventually, dividends go to zero and you are a "Dead Man Walking".

There are only a few things that can happen to the companies that are walking "The Green Mile". Either you make it to the electric chair (in the movie "The Green Mile" it was called "Old Sparky") and cease to exist or you are eventually forced into the arms of a better capitalized institution. Over time, I expect a bit of both but mostly of the latter.

Keep in mind that if too many are allowed into the arms of Big Sparky", it will have a systemic effect as all the institutions are so intertwined because when one group of institutions are forced to mark their bonds to market, others are forced to do the same, ending in an ugly daisy chain. I think the chain has formed and that many are about to "walk the mile".

In the end, perhaps years from now, many banks and brokers will be merged into an international list of "good banks" or "Live Men Walking". Who are the Live Men Walking? They are likely Bank of America, Bank of New York, JP Morgan Chase, Northern Trust, State Street, US Bancorp, ABN Amro, Deutsche Bank, BNP Paribas, Royal Bank of Scotland, Barclays, Allianz and a few others. The following cycle is how the cycle goes from good bank to 'Dead Man Walking'.

The "Dead Man Walking" Cycle

Who Are the Dead Men Walking?

Above, the cycle begins with denial, and ultimately ends up in despair. At first, the company denounces that anything is wrong, but Mr. Market has a way of sniffing out who is imitating Pinocchio. Ultimately, the company ends up in despair when they need/want to raise capital to just be able to function normally, but alas, they cannot because the window of opportunity to raise capital has shut.

Let's use Lehman Brothers as the poster child of this sort of behavior. I wrote a piece last week that singled out National City, Washington Mutual and Lehman Brothers. Before the credit crisis started, Lehman, at the time known for its savvy timing, suddenly came to market for $5 billion of long-term bonds when they didn't need capital-or did they know something was awry as I suspect? Last year, with the Credit Crisis in its infancy, Lehman announced a $100,000,000 stock buyback. The shares, as you would expect, popped on the news, but of course no stock was ever re-purchased. As the stock began to sell off, they kept saying that capital was not needed.

Then, on June 9, 2008 they sold 143,000,000 shares at $28 per share. As hedge fund manager David Einhorn said, "They've raised billions of dollars they said they didn't need to replace losses they said they didn't have." In between was an enormous preferred stock deal-75,900,000 shares at $25 per share at a rate of 7.95%. Those shares now change hands at $15 per share for a yield of 13.1%. Its pretty hard to turn a profit when your cost of capital is greater than 10%.

During this time, in January, the company actually raised its common dividend by 15% year-over-year. They have written off north of $8 billion since the Credit Crisis began and when they release earnings (or lack thereof) next month, estimates are for another round of $2-4 billion of write-downs. They have reportedly been trying to shop $40 billion of impaired real estate and they are mired in all sorts of Alt A, sub-prime, CMBS and CDO's and CLO's.

The best part is that they said they "shrank their balance sheet" when in fact they were sold to an "off balance sheet subsidiary" that they own part of. The bonds weren't sold, they were just "relocated". I sure wish I could do that when I make a mistake. And lets not forget that the Federal Reserve opened up the discount window to primary/dealers so that they could off-load a bunch of nuclear waste on to the Fed's balance sheet, which now looks like one big hedge fund in drag. And then the SEC temporarily changed short selling rules for 'the Group of 19' (the GSE's and Primary Dealers) for a few weeks, resulting in a short squeeze, but their shares still hobble along at recent lows.

On Friday, there was a rumor that the Korean Development Bank would buy Lehman, but again that turned out to be hogwash. And if they wanted to raise debt, like they say, "lotsa luck". Their bonds trade around +500 basis points to treasuries but my guess is that even if they could get deal done, they would have to come in the 10% range, again, uneconomic.

So now we have the recipe and an example for "Dead Men Walking":

Common stock too low to issue new shares.
Preferred stock yield too high to issue new shares economically.
Issuing debt is uneconomic.
More write-offs coming in days to come.
Business trends are awful.
Denial.

Now that we have identified the "poster child", let's find a few more... Or sadly, more than a few.

Zions Bancorp

Equity has traded down from $75 to $25.
Tried to issue a $200 million preferred stock offering at 9.5% but only was able to sell $47 million.
Their debt trades in the open market approximately 1,000 basis points above Treasuries, IF you can sell them, or 13 14%.
They are geographically in Utah, but spread out to Florida, Nevada and Arizona at the top of housing to take advantage of great opportunities.
They say they need $200-300 million capital. Good luck.
They maintained their common dividend.

KeyCorp

Common Stock has traded down from $40 to $11.
Preferred Stock trades at 13%.
Debt trades in the market at 10-11% dividend.
Cut dividend in half in July, still yields 6.5% even while they lose money.

Fifth Third Bank

Equity has traded down from $60 to $14.
There are no preferred issues outstanding.
Debt trades in 10-11% range if you can sell it.
Cut dividend by 75%.

Washington Mutual

Equity has traded from $40 to $3.
No preferred outstanding except convertible preferred.
Debt trades in the 20-25% range.
Cut the dividend to $0.01 per share in April.
Has admitted they will lose money for the next several years.

National City

Equity has traded from $40 to $5.
Preferred stock trades at 13-15%.
Sold a huge amount of shares at $5 per share in April.
Cut dividend to $0.01 per share in April.

Regions Financial

Equity down from $40 to $8.
Preferred Stock Trading at 10%.
Debt trades in the 10-11% range, if you can sell it.
Cut dividend by 75% in June.
Needs to raise $2 billion, according to Sanford Bernstein.

General Motor/GMAC

Equity has traded from $80 to $10.
Preferred stock trades in 18% area.
Short-term debt trades in 25-30% range.
Long-term debt trades in 17% range.
Eliminated common dividend in July.

Ford/Ford Motor Credit Co

Equity has traded from $60 to $4.
Preferred stock trades in 16-17% range.
Long term debt trades in the 18-20% range.
Eliminated common dividend in September.

Wachovia

Equity has traded from $60 to $14.
Issued a $3.5 billion "hybrid security" in February that now trades at 11%.
S&P has stated they cannot issue any more hybrids.
Sold 92,000,000 shars of a preferred stock in December at 8% that now trades $18 or 11%.
Cut common dividend twice since February to $.05 a share or 90%.
Debt trades at 9.5-10.5%.

CitiGroup

Equity has traded from 60 to 9.
Preferred Stock trades in 12% range.
Outstanding debt trades in 12-14% range.
Cut common dividend by 66%.
Sold 91,000,000 shares of common at $11 in April 2008.

Who are in the "Limping but Not Dead Man Walking Crowd"?

These companies would include those that may be 'too big to fail', have enough quality assets to sell, a franchise that is worth something to an acquirer or could just be broken up into pieces. They include:

Citi
Merrill Lynch
Morgan Stanley
Suntrust
Legg Mason
Capital One
AIG
MetLife
Prudential

Summary - This is NOT Shaping Up to be a Pretty Couple of Years

I am certain that I have missed a bunch of names on the "Dead man Walking List", but the pattern is rather easy to discern. As I stated early on, when we have one or two firms in trouble, we can deal with it. But when we add rising unemployment, explosive debt growth in recent years and non-performing assets to many hobbled financial institutions with trillions of dollars of exposure, it is hard not to be concerned.

For this reason, we remain cautious towards credit, expect a hard sell-off in stocks into 2010, consolidation in the financial services industry and some pain, like it or not. I am just not sure where the capital will come from to bail everyone out simultaneously. And even if the capital showed up, it would likely come at a cost that is uneconomic and would likely be dilutive for many years to come.

It is why we expect much lower than consensus earnings across the board and lower stock prices ahead. In the meantime, we sit with our historically cheap GNMA's at the widest spreads in 20 years and continue to add to that position. In the meantime we position our portfolios so that if we are wrong, the most we can lose is opportunity, not precious capital.

Your wishing it was not as bad as it is analyst,

John Mauldin

The Elusive Bottom

John Mauldin — Mon, 18 Aug 2008 21:26:05 GMT

In this weekend's Thoughts from the Frontlines, I quoted from part of a very thoughtful, right-on-target analysis by David A. Rosenberg entitled "The Elusive Bottom." Over the weekend, I decided that you should read the whole piece, as Rosenberg makes some very solid points about how the markets and the economy may play out over the next few years. He has a non-consensus viewpoint, but that is what I like for Outside the Box. In fact, I think this is one of the more thought-provoking pieces I have used in OTB for some time.

Rosenberg is the North American Economist for Merrill Lynch. They were gracious to give me permission to send this letter out on such a short notice, and I believe you will well served to take the time to think through his analysis. And rather than try and give you a quick summary, let's just jump right in.

John Mauldin, Editor
Outside the Box

The Elusive Bottom

Conference Call Notes
14 August 2008
David A. Rosenberg

We aren't past the halfway point of this recession

My sense is that we probably aren't even past the halfway point yet of this recession, the credit losses or the house price deflation. Looking at whether equities may have bottomed or not on an intermediate basis, maybe the recent action to the negative side was an important inflection. In terms of what I do, which is trying to tie the macro into the markets, I have a very tough time believing that we have reached anything close to a fundamental low, either in the S&P 500 or in the long-bond yield, for that matter.

300-point rallies in the Dow happen in bear markets

We're in a very confusing atmosphere. People didn't really know what to make of a 300-point rally in the Dow the other day, but my main message was that 300point rallies from the Dow don't happen in bull markets. In fact, they never happened in the bull market from October '02 to October '07, but it has happened 6 times in this bear market and happened 12 times in the last bear market. You don't get moves like that in bull markets. As Rich Bernstein has said time and again, "This is the hallmark of a recession and a hallmark of a bear market."

How can there be recession with GDP still positive?

We are at a crossroad in the economy. The 2Q GDP numbers recently came in at plus 1.9%. The details of the number left a little to be desired, but it was still a positive number. Turn on CNBC, and everybody says, "How can there possibly be a recession with GDP positive?"

Employment has been down seven months in a row

The very next day we got nonfarm payrolls. It prints down 51,000 and frankly, it doesn't matter whether it was below or above Wall Street expectations. The bottom line is that employment is down seven months in a row. In 60 years of sifting through the data here, that's never happened before without the economy being in a classic recession.

GDP is useful but it has its limitations

I think the point that has to be made as an economist talking to a group of portfolio managers or FAs or investors, it is important to convey to clients that there is a lot of noise out there. GDP is useful, but it has its limitations. First, GDP is going to get revised. We thought we had a plus 0.6 in the fourth quarter; all of a sudden, it's minus 0.2. Twenty percent of GDP is government. So, you really can't fully concentrate on GDP when a fifth of it is state, local and federal government, unless you're trading defense stocks.

You'll miss a lot of action waiting for GDP to go negative

More to the point, if you're waiting as an investor for GDP to actually turn negative, you're going to miss a lot of action along the way. I think the best example is to just go back to Japan. They had a real estate bubble that turned bust and they had their own credit contraction back in the early 1990s. Guess what; Japan didn't post its first back-to-back contraction of real GDP until the second half of 1993. By the time the back-to-back negative that people seem to be waiting for happened, the Nikkei had already plunged 50%, the 10-year JGB yield rallied 300 basis points, and the Bank of Japan had cut the overnight rate 500 basis points, which said a thing or two about the efficacy of using the traditional monetary policy response of cutting interest rates into a credit contraction (as we're now finding out here in the US).

Dating the recession is a very scientific process

The point is we can't make the assumption that we've avoided a recessionary condition in the economy, just because we have so far managed to avoid back-toback quarters of negative GDP. I'm just telling you as the economist that it is basically irrelevant. The only body that officially makes the call on the broad contours - when the recession started, when it ends, when the expansion starts, when it ends - is the National Bureau of Economic Research, the NBER. It's a very scientific process. It's not a gut check or a judgment call.

We should actually be welcoming the recession call

When they make the determination - it's very interesting, by the way - when they make the announcement that the recession began, when they actually date it for us, traditionally we're a month away from the recession actually ending. The announcement, in fact, is going to be a rather cathartic event, something we should actually welcome happening, but so far they are still taking their sweet time in making the proclamation.

Four factors used to determine recession

1) Employment

The NBER relies on four different variables. The first is employment. Now I've told you before; employment is down seven months in a row. Does employment go in the GDP? The answer is no. Is it correlated? Yes. Does it help grow the business cycle? Of course.

2) Industrial production

The next variable is industrial production. Does that go into GDP? The answer is no. Does it help grow the business cycle? The answer is yes. This is a number that comes from the Fed. The GDP comes from the Commerce Department. It's a very important variable.

3) Real personal income net government transfers

The next variable, the third one, is real personal income excluding government transfers. This metric is now down four months in a row. Does personal income go into GDP? The answer is no; of course, it doesn't. GDP is all about spending. Personal income goes into gross domestic income, which is another chart of the national accounts.

4) Real sales activity

The fourth variable and the only variable that actually feeds into GDP is real sales activity in manufacturing, retail and wholesale sectors.

Recession probably started in January

When I take a look at these four key indicators that define the broad contours of the business cycle, they all peaked and began to roll over sometime between October of last year and February of this year. I am convinced that when the NBER does make the final proclamation, it will tell us a that recession officially began in January. Of course, to any market person, this would make perfect sense, because of when the S&P 500 peaked. It did a double top into October, right when it usually does, before a recession begins.

This recession won't end before mid-2009, in our view

Now I'm just giving you the rearview mirror. What's most important to you folks is let's look through the front window and see when this recession is going to end. The tea leaves that I'm reading at this point in time show that this recession is not ending any time before the mid part of 2009, which would mean that, if you're looking for, not the Mary Ann Bartels intermediate bottoms, but the fundamental bottom, I don't think you can expect to see it before February or March of next year, if I'm correct on when this recession ends. Historically the S&P 500 troughs four months before the economy actually hits its bottom point.

Profit as a share of GDP was at unheard of levels

The next question, of course, is what levels are we talking about? Again, I'm going to take what I do, which is earnings, and then talk about the appropriate multiple. What is the appropriate multiple at the low in a recession? In terms of earnings, I think that we have to understand where we're coming from in this cycle. We're coming from a situation where, because of all the leverage in the system, profits in the share of GDP went into this recession and bear market at 14% of GDP, which is unheard of. That's never happened before. A lot of the reason why profits soared was because everybody turned to financials. There was this tremendous amount of leverage, and that accounted for half of just about everything in the cycle from GDP growth to employment to profits.

The profits share of GDP, again, as a proxy for margins, is now down to 12%. Think about that for a second. This terrible earnings recession so far has taken the share of profits from 14% down to 12%. The question is, if I'm right on a recession, where does the profit share of GDP go to at a recession trough? Well, consistently it goes to 7%.

We could get below $50 on operating earnings

Even the economists who are predicting a recession are going say, "Playing in a little recession, on average, troughs go down 25%." The problem this time is that we have to overlay the revenue decline that actually comes from a recession with a much more significant margin, considering the levels from which we headed into this bear market and recession. So when I'm talking about that historically, what's normal in a recession is that this profit share equals to 7% and we started at 14%, we are talking about a 25% decline in earnings. We can be talking about something closer to 50% peak to trough. The peak is $90 on a full-quarter trailing basis. It's not beyond the realm of possibilities that we get below $50 in operating earnings. The first call consensus numbers is $105 earnings for next year. I give the odds of that happening at exactly 0.0%.

There is a good chance we test the 2002 lows

Now, I'm not at $50 for next year. We're at $63 for operating EPS, but that means that the answer is no, I don't feel that we're too low on earnings. Usually you slap a historical trough multiple on in a recession. But typically, during a recession coupled with a credit crunch, the multiple bottoms at 12. You're at a 12 multiple with $63 in earnings and you're going to ask the question, "Are you talking about the possibility that we can actually test the ... 2002 lows?" And the answer is that it is certainly not outside the realm of the possible. I'm not making that forecast, but what I am telling you is that there is a good chance that that could happen.

We are in a secular bear market

With that being respectful to the fact, I believe we're in a secular bear market. I don't even think that's an opinion anymore. I think it's a stylized fact. If you saw it, Rich Bernstein put out his performance asset mix table. Out of all the asset classes, stocks, cash, bonds, commodities, the only one to have a negative inflation-adjusted return over the past 10 years is the S&P 500. So I think we have to be honest about this. If it's something like a 1929 and 1955 or 1966, 1982 type of secular bear market, I think this one actually started in 2000, it doesn't mean that you don't get cyclical bull markets along the way. We actually had a cyclical bull market in the context of a secular bear market that actually took the S&P to a new high. Of course, as I said before, half of that was unprecedented leverage, the stone process of unwinding.

I think that it is important now to recognize for our clients that we have a cyclical bear market being overlaid into a secular bear market. I think the message that we're trying to send is that there is a different investing style and strategy for every part of the business cycle. One part of the business cycle is all about adding ... data and risk to maximize your turns. Then there are times when it is all about preserving your capital and focusing on income, earnings, stability and dividend growth. I think that's where we have been, and I firmly believe that's where we will continue to be, at least over the course of the next 12 months.

Chapter 1 was the end of the res construction bubble

When I look at where we are in this book, and we continue to write chapters in this book and it is a book; this is an epic period. We are living through history. People will be writing about this in the future, no different than they wrote about the 1920s and the 1930s. Chapter one of the book was the end of the residential construction bubble, which I would tag as the first quarter of 2006, when housing started to peak and began to roll over at 2.3 million units. I continue to look back at that, 2.3 million units.

The natural level of demographic demand for housing in this country is annual demand of 1.45 million units. From 2003 until 2007, builders added on average nearly 2 million residential units per year, or 30% more, than the natural demand could absorb, because, of course, we were in a new paradigm. So the builders were building homes and condos as if we had the same demographics as the 1970s when the Boomers were buying their first refrigerator. This is a case of Global Crossing meeting D.R. Horton, and we are paying the price for that, even today.

Chapter two was the end of the home price bubble

Chapter two of the book was the end of the home-price bubble, and I would date that to the first quarter of 2007 when the Case-Shiller Index began to deflate year over year. Now, I want to make this point, and I want to make this point emphatically. Home prices in this country on average rose 20% per year for six years. That has never happened before. When you take a look at home prices in real terms, they're still more than 30% higher today than they were when this mania morphed into a bubble back in 2001. So to those people who are thinking that we're only 5% away from the low, I'd say I don't think so. Make no mistake that there is going to be more deflation in home prices ahead - I think significant deflation - just as Freddie Mac put us on notice yesterday.

Chapter three was the end of the credit cycle

The third chapter was the end of the credit cycle, which, again, I would tag at exactly a year ago. I think the way we have to look at this, and we're talking about how this affects our ability to navigate the portfolio and manage the macro forecast. This cycle saw the end of a 20-year secular credit expansion that went absolutely parabolic in the last 6 years and accounted for half the growth in just about every segment that's forecast.

Chapter four was the end of the employment cycle

This is very big stuff and it's taking on different forms. We have the end of the credit cycle as chapter three. Chapter four was the end of the employment cycle, which I discussed earlier, which started in December of 2007.

Chapter 5 is the first consumer recession since 1990-91

We're heading into chapter five, and chapter five is the onset of the first consumer recession since 1990-91. I would argue this could end up being very similar to that six-quarter consumer recession that we endured from 1973-75. There are differences, but there are similarities. A lot of people like to compare this to 199091, because of the real estate flavor and the credit crunch, but there is actually a lot more going on that compares it to 1975.

I was around in the 1980s, and I remember that it played out very similarly. What people called resilience and people called contained and people called decoupling were all very pleasant euphemisms for lags. That's what they are; they're lags. There are built-in lags. Housing peaked in 1988, rolled over, the credit crunch intensified in 1989 when RTC got into real action. Then 1990 ... two years after housing peaked, we had this very surprising consumer recession that caught even the Fed off guard.

The Four Horsemen

I wrote a report late last year titled The Four Horsemen. It was a regretful choice of words, because I kept on fielding questions as to whether or not I was, in fact, calling for the end of the world. I got to a point where my answer was "Just wait; it's going to get worse than that." In any event, who are the four horsemen? The four horsemen are credit contraction, deflation of both housing and equities, and that happened in the mid-1970s. Usually you'll get one or the other. To have both housing and equities deflate on the household balance sheet, we're talking about $30 trillion of assets. Half the assets on the household balance sheet are compressing dramatically right now. That last happened in the mid-1970s. We got credit contraction. We got deflation on the asset side of the household balance sheet that's forcing the savings rate higher. We have employment, which I mentioned before.

Of course, food and energy - and, again, not just energy, but energy and food - and food is a bigger deal. Food is 15% of the household budget; energy is 10%. That's a quarter of the household budget constrained by food and energy. Food is going to come down at a slower rate than energy will, but it's already too late.

Oil prices are going down because demand is going down

People are saying to me all the time, "Gee, aren't you going to turn more bullish with oil prices going down?" Well, oil prices are going down, because for the first time in this cycle it took $145 to break the back of the consumer. Quite amazing that it took that long, but it has happened. So we're seeing true demand destruction in energy at a rate we haven't seen in almost two decades.

It's something to get an oil price decline that's predicated on a new oil supply. I would keep that as a de facto exogenous tax cut; but when you're getting oil price declines because of recessionary pressures cutting into energy demand, it's no different than what happened in late 2000. That was the last time we had oil peel off as much as it is right now. I think it would have been a bit of a mistake for the economists at the end of 2000 to say, "Ah-ha, oil is coming down; I'm going to raise my 2001 GDP forecast." You have to take a look at the reason why oil is going down, and the reason is not because of supply. The reason is because consumer demand is starting to go down. Again, the last time you had food and energy deviating so much from the long-run norm was in the mid-1970s.

Cash flow drain to household sector is $800 billion

When I take a look at the four horsemen and I try to come up with a number, the number I'm trying to come up with is a cash flow number. What is the cash flow drain on the household sector from the four horsemen in the coming year? The answer is $800 billion. So Uncle Sam, give me six more of those tax stimulus plans. That is a huge number. It's equivalent to 12% of discretionary spending, which, by the way, is exactly the peak-to-trough decline in real consumer cyclical spending back in that 1973 to 1975 recession. The S&P 500 goes down peak to trough not by 20%, but more like 40%.

Three markers to turn us bullish

In terms of what are some of the markers that I'm weighing down to turn more bullish? I think this is very important. I look at not so much where am I going to be wrong, but looking at what are the things that will turn me more positive? There are three markers that I have laid down. The first marker is the personal savings rate. I have to see the personal savings rate go back to the pre-bubbles, normalized levels, which was 8%. I'm not talking about the Jurassic period here. I'm talking about where we were in the late 1980s and the early 1990s, before the last two bubbles. That's why I said plural.

We had a tech stock bubble followed very quickly by a housing bubble. This had tremendous implications for perceived net worth and perceived future asset growth of the household sector. It had monumental impact on how people spent their after-tax income. That's why we got to a point last year where briefly the savings rate got to negative for the first time since the 1920s. There was a belief system that we could retire on our assets, and now these assets are deflating and people's expectations of how they're going to retire is going to force that savings rate higher. That's going to be very disinflationary, by the way.

I think it's important to note that, in 2002, as the tech sector was deflating, Greenspan and Bernanke decided that it was a good idea to re-slate the housing stock as an antidote to the deflation in the tech capital stock. This is almost a piece of Mary Shelley's Frankenstein; we built the monster, now we have to tear it down. I don't know what else is left. We've had an equity bubble followed by a housing bubble, followed by a credit bubble. I don't think there are any more rabbits in the hat to create the next bubble, unless that bubble is going to be in Treasuries, and maybe that is, in fact, going to happen. It's pretty clear that the Fed is going to be concentrating a lot more in the future on non-traditional measures to ease monetary conditions, and not just cutting the Fed fund rate. Part of that may be reflating by expanding its balance sheet, which means that it's not just talk. The Fed is actually going to add to its balance sheet, and that's exactly what happened.

1) Need to see the savings rate go to eight percent

With the Bank of Japan and the operations they conducted back in the 1990s, this is just stuff to consider for the future. Let me just say that a savings rate of 8% would leave me feeling very good about the fact that we would have gone to a level of pent-up demand that would help us embark on the next bull market and economic expansion. That's going to take quite a bit of time. This is a process. This a process we're talking, even after the recession ends, that's going to be an elongated recovery, as there was in the early 1990s, after that asset cycle. Remember, the recession might have ended in November 2001, but that did not give you a "get out of jail free" card as an equity investor, and certainly the recovery was a good two years away, even if the recession technically ended at the end of 2001. I'm talking about the markers that will turn me bullish for the next cycle. An eight percent savings rate, to me, would be a very critical launching pad.

2) Months supply below eight months

What else? Well, I doubt that anything is really going to bottom, including the financials, until we're convinced that house prices have hit bottom. For that we have to look at the inventory to sales ratio, and there are different measures. There is the new inventory, which is a 10-month supply. There's the resale; that's 11-month supply. When I take a look at the Census Bureau data, which includes total vacant units for sale, single-family, condo, it's more like 17-month supply. We need to include everything, including foreclosed properties. I have to see that number sliced in half. I have to see it down below eight months supply before I'll be convinced home prices don't bottom, at least the second derivatives start to turn positive. I have to see that metric at the eight-month supply. I'm keeping a very close eye on it. That will make me feel a lot more comfortable with turning bullish for the next cycle.

3) Interest coverage ratio has to come down to 10.5%

The third and last marker comes down to the household balance sheet. What I'm referring to here is interest coverage in the household sector. We have a record debt-income ratio, but that's a stop-to-flow concept. I'm talking about interest coverage, how much are principal and interest payments from the record debt absorbing out of household income? It is 14.1%. It's at a near-record high. We have never been in a recession with this metric at this level. So, that means there are too many things that are levels we've never seen before. The whole thing about economic bottling is you run the rest of it based on the past, and there are so many things that we're entering into this thing that I've never seen before.

There is, I'd have to admit, a wide dispersion around the forecast I am providing. What I am really trying to do is put things into a certain perspective. What I know, being an economist, is that in some sense you're a glorified historian. So when I take a look at the chart of interest coverage in the household sector, what do I see? I see that after the recession of the early 1980s, this interest coverage ratio got down to 10.5% by 1982 and, voila, that was the touch-off point for a multi-year bull market and economic expansion.

Then we had the recession of the early 1990s, and what do you know? In 1992, interest coverage went down to 10.5% again. That was the launching pad for a multi-year bull market and economic expansion. We're 14.1% in this metric today. I know this historical record tells me that there is something about a 10.5% ratio that is a very cathartic event. The problem is that to get there from here would require the elimination of $2 trillion of household debt. So, maybe when NYU's Nouriel Roubini talks about that the total losses could be up to $2 trillion, maybe he's not talking through a paper bag.

Frugality is going to set in

As far as I know, there are only two ways to eliminate debt. You either walk away from it, which people obviously are doing, which is why we got these write-downs and these foreclosures, or you pay it down. I think people with a FICO score that they are concerned about are going to pay that down. That means that the savings rate is going to be forced higher. This, again, is going to be very, very disinflationary. It means that fashions are going to change. It means frugality is going to set in. We're going to be living in smaller houses, driving smaller cars and living more frugally. It's not going to be the end of the world; it's going to be a necessary process to truly embark on getting the balance sheets down to more comfortable levels so that we can actually embark on the next cycle.

Intense deleveraging in the banking sector

The whole thing about being an economist is that you're being requested to model behavior. What I found recently was three signs of significant changes in behavior. We obviously know of at least one investment bank that is taking aggressive action to sell assets and to deleverage. That's going to force a lot of action in other parts of the industry. What we're talking about here is intensified deleveraging in the banking sector.

Inventories cut by $62 billion despite tax stimulus

What else did we see? Well, those GDP numbers were just fascinating when you dig through them. Think about it for a second. How did businesses respond to the biggest tax stimulus of all time? They cut their inventory by $62 billion. Can you fathom that? Instead of boosting production as a result of the stimulus, they just allowed the stimulus to absorb past production. We already know that the inventory component went down another five points based on the July ISM number, so this inventory liquidation process is continuing.

Savings rate boosted despite stimulus too

Alan Greenspan cut his teeth on inventory investment cycles. So banks are deleveraging, and companies are liquidating inventories. How did households respond to the biggest tax stimulus of all time? They boosted their savings rate from 0.3% in the first quarter to 2.6% in the second quarter, which is only the third steepest increase in the savings rate in any given quarter in the past 55 years. Now you probably didn't read that in the front page of The Wall Street Journal, but I find that to be a very relevant statistic.

So we have financial sector deleveraging. We have business sector inventory liquidation overlaid with the households boosting their savings rate. These are new themes, and the theme is about getting small. That's going to play very well into Rich Bernstein's decision two months ago to allocate an extra 15 percentage points to his fixed income portfolio. Now we're talking about fixed income. We're talking about bonds that are high quality and have non-callable protection.

Nominal GDP growth has highest correlation with yields

I'll tell you that the really key forecast next year coming from the economics department here is the nominal GDP, nominal, price times quantity, because we're calling for nominal GDP growth next year to average 1.5%. That is going to be very bullish for sectors that have proven earnings stability and reliable dividend growth, and it's going to be very bullish for bonds. I say that, because I know that the critical driving factor for bonds is not fiscal deficits. It's not the dollar and, guess what, it's not commodities. Nominal GDP growth has the highest correlation. People look and they say, "Four percent 10-year note; who'd want to touch it?" The reality is that nominal GDP growth this year is averaging 4%. The fact that the 10-year note is averaging 4% is not really a big mystery, if you're looking at the macro underpinnings.

Now, if I'm right on 1.5% nominal GDP growth for next year, all I can tell you is that the last time we had a condition like that was in 1958. All I can tell you is that 1958, the funds rate averaged to 1.5% and the 10-year note averaged 3%. If you're going to ask me if we have a realistic chance of going back and retesting the June 2003 lows and the 10-year note or the March 2008 lows and the 10-year note, I firmly believe that's going to happen. I believe that's going to also provide you with very handsome total returns.

Your glad to see oil dropping in price analyst,

John Mauldin

Inflation Is Not The Problem

John Mauldin — Tue, 15 Jul 2008 01:34:58 GMT

This week we are going to do something unusual for Outside the Box. Normally I take an essay and send it to you to read. Today I am going to give you a link and strongly suggest you click to it. Long time readers are familiar with friend and comrade James Montier, who along with Albert Edwards, migrated to Societe Generale earlier this year. They are co-heads of Global Cross Asset Strategy and based in London.

Kate Welling does some of the best interviews anywhere in her Welling@Weeden letter, and this one of Montier and Edwards is typical of her immensely enjoyable style. She gave my good friend Prieur du Plessis permission to reprint the letter, and I provide you with a link to his blog and if you scroll down 6 short paragraphs you get the link to the letter, which includes the graphics and is much more fun than just me cutting and pasting. You can also subscribe to Prieur's blog if you wish. Once a week he provides a very useful review of what was written the previous week.

Montier and Edwards speak quite forcefully about the problems they see in the market today, and they are truly Outside the Box thinkers.

"They are, in a word, skeptics, and at this juncture most deeply skeptical of any and all notions that 'the worst is over.' The recession, which has barely begun, is more likely to be deep than shallow, market valuations are hideously expensive and the -flation policymakers should be worried about starts with de-, not in-. For their reasons, keep reading, if you dare."

The link is: http://www.investmentpostcards.com/2008/07/05/market-fundamentals-are-appalling/

And no, despite the picture, they are not twins separated at birth.

John Mauldin, Editor
Outside the Box

Quarterly Forecast: Third Quarter 2008

John Mauldin — Thu, 10 Jul 2008 18:39:00 GMT

As we begin the new quarter, now is an excellent time to take stock of your basic investment thesis. Ask yourself if your allocations still reflect what you think the world is going to look like over the next several months. And as part of that process, I'm here to tell you that making "financial" decisions based solely on "financial" inputs grossly oversimplifies the way the world really works. As I've said before, investing in debt, equity, or commodity markets without geopolitical intelligence is like trading juice futures without getting a weather forecast. You can do it, but good luck to you.

I get my geopolitical intelligence from Stratfor. My friend George Friedman and his team have just published their 3rd Quarter Forecast. I got George to give me a copy I can share with you in this Special Edition of Outside the Box. As a Stratfor Member, you can get the 3Q Forecast - as well as their other forecasts and daily analyses - at a preferential rate available to my readers by clicking here. I strongly encourage you to add this valuable weapon to your investing arsenal.

Here are just some quick examples of how I use Stratfor to guide my thinking, in these cases on energy prices:

Just living in Dallas, I'm pretty familiar with rig counts and EIA inventory numbers, but I confess that the power-sharing negotiations between the Nigerian government and the Ijaw tribe aren't the most common lunchtime talk.... What will those talks mean for Nigerian supply figures?
At first glance it's not obvious that the Olympics is supporting oil prices. But then you dig down and realize that China's showcase for global credibility requires lots and lots of smiling citizens. Lots and lots of smiling citizens requires plentiful and cheap fuel. Plentiful and cheap fuel requires government purchases/subsidies - at prices that may not be sustainable. So when the TV cameras go home, how much will the communist government keep paying out to maintain those smiles?
And those Iranian missile tests that just spiked crude prices? Do those mean war is really coming, or are these the last-round raises, before the US and Iran reach a settlement on Iraq?

There are no simple answers here. No price targets or earnings estimates to the penny. But gentle reader, that's the real world. Today's markets require hard thinking on a whole range of fronts, with geopolitics being right at the top of the list. Join Stratfor today, and you'll get the same intelligence I use to map out where I think the markets are going. And enjoy this Forecast...

John Mauldin, Editor
Outside the Box

Quarterly Forecast: Third Quarter 2008

Introduction

For the first half of 2008, Stratfor focused its attention on three features of the international system. All three remain key factors, but all have also evolved notably.

First, we anticipated an endgame between the United States and Iran over the future of Iraq. We have been surprised at just how fast U.S.-Iranian negotiations have progressed, and consequently violence has dropped to its lowest levels since the 2003 invasion (something that would be impossible without Iranian assistance). What is truly amazing is how few items necessary for a deal are not already in place. We are unlikely to have a formal "Camp David" moment, but the U.S.-Iranian understanding seems to be building quickly on the ground.

Second, Russia's efforts to rebuild its influence throughout Eurasia have been at a critical point. With the Western-backed independence of Kosovo making a mockery of Russian foreign policy, we predicted that Moscow either had to strike back or see its credibility in key former Soviet Union territories crumble. As it turned out, Russia's internal factional struggles distracted and exhausted the Kremlin. Striking back at Europe and the United States in any place that would have caused harm proved impossible, forcing the Russians to concentrate on places such as Central Asia, the Caucasus and Ukraine. In the long run, this may well prove to be the worst of all worlds, as the Europeans are convinced they beat the Russians, while the Russians are equally convinced that they have drawn a line in the sand. For the moment, however, Russia requires time to plan and flesh out its new organizational structures. That will take up the bulk of the third quarter.

Third, we forecast that high energy prices would create a flood of petrodollars that mostly would end up flowing into U.S.-dollar assets, greatly stabilizing the financial system and helping the United States shake off its economic funk. This prediction proved true in spades, and U.S. economic growth has certainly turned a corner, but two related developments have taken root. First, having oil prices increase by 40 percent in three months cannot help but have an enervating impact on economic growth, particularly in the heavily industrialized states of East Asia. Second, all that oil income is beginning to have additional impacts.

The Arab Gulf states are grossing approximately $2 billion per day, with half of that amount flowing into the coffers of Saudi Arabia. This provides the Saudis — and other Gulf Arabs — not only with tremendous wealth, but also with tremendous political power. A key trend in the third quarter will have these states using that wealth to invest, bribe and cajole their friends and enemies into following policies more to Riyadh's liking.

This money will be most politically active in two locations: Lebanon and Iraq. In both places the Saudis want to see some flavor of a peace deal. The common thread to the two issues is the Saudi fear of Iran. An Israeli-Syrian peace deal means reducing Tehran's influence within the Sunni world — specifically, the influence it holds over Damascus and Hezbollah. A U.S.-Iranian deal over Iraq means re-establishing Iraq as a buffer against Iranian expansion. In both cases, Saudi money is useful in bringing the various players to the table — most notably Damascus and the various Iraq Sunni factions — and paying them to stick to an agreement. In the case of Israel and Syria, the constellation of forces in play suggests a deal will be struck sooner rather than later.

There is one additional topic that will feature grandly in the third quarter: the Beijing Olympics. Ruling China has always been a difficult prospect, as the country is riven with urban-rural and coastal-interior splits. But while the Olympics were supposed to have been a celebration of China's "arrival" as a modern state, they are instead serving as a showcase for all the ways in which China falls short. But dealing with these issues — entrenched corruption, financial dysfunction, (unapproved) regional autonomy, unaffordable energy subsidies — is difficult for Beijing in the weeks leading up to the Olympics because, under the glare of international spotlights, it can no longer use the tried-and-true tools of an authoritarian state. The result is a string of patchwork fixes that highlight China's weaknesses, making the Asian giant vulnerable to any foreign power with an interest in demonstrating that the emperor is less than fully clothed. Not exactly the global celebration that Beijing intended when it bid for the Olympics all those years ago.

Note to readers: Our third-quarter forecast is intended to be a supplement to our annual forecast and second-quarter forecast. Within each section of this quarterly we have extracted the critical trends identified in our previous forecasts and indicated where we have been right or wrong and what is coming in the next three months. We have also examined new trends that have evolved from regional developments, independent of the earlier forecasts.

Middle East

Regional trend: The United States has successfully forced the countries that made al Qaeda possible into the American alliance structure. It will now use that structure to clamp down on those still resisting American power. In doing so it may inadvertently trigger tensions with Israel.

In the second quarter, U.S. efforts in the Middle East received a surprising boost in the form of petrodollars. Like the United States, Saudi Arabia wants to see Iraq stable and Iran blocked from expanding its influence. High oil prices are bringing the Saudis more than a billion dollars a day in revenues, some of which they are using to push Sunnis into Iraq's governing coalition.

Syria has found a role in the tightening Arab-American alliance, but that role has taken an unexpected form: peace talks with Israel. Soon after the negotiations came into the public eye, political instability in Israel threatened to derail them, but a deal between Israel's Kadima and Labor parties now ensures that the talks will proceed even if Israeli Prime Minister Ehud Olmert is replaced toward the end of the third quarter. While Washington certainly has its reservations about an Israeli-Syrian detente, the United States is refraining from sabotaging the talks — in part because Saudi money is supporting the initiative, in part because Turkey is hosting the talks, and in part because Hezbollah will be defanged if the talks prove successful.

The third quarter could well prove to be a decisive turning point for many actors in the region. Hezbollah has no good options. It needs to find a way to scuttle the Israeli-Syrian peace talks, and an attack on Israel might be the only way it can do so — but then it risks inviting a major retaliatory attack by Israel. Iran and the United States need to seal a deal on Iraq before the U.S. elections in November, or else risk the situation remaining unresolved for years. If a U.S.-Iranian deal proves elusive, Israel needs to ensure that Iran is knocked down a few pegs before a new U.S. administration potentially restricts the Jewish state's military options. Israel can bomb Iran only with U.S. approval.

The player that will work the hardest to ensure none of these situations spins out of control is Saudi Arabia. High commodity prices are showing signs of eating into global demand, and the last thing Riyadh wants is a war-related price spike that would push many economies over the brink. So Saudi oil income will play a growing role in buying calm throughout the region.

We expect rapid progress in the region's major peace negotiations — those between Israel and Syria and those between Iran and the United States — because most of the heavy lifting has already been done. There has been a near-halt to violence in Iraq, and Israel has been preparing its public to give up the Golan Heights. We would not be surprised at all to see deals materialize in the third quarter, with Syria and Israel more likely to be successful than Iran and the United States.

In the Israel-Syria talks — assuming that they are not derailed — we expect the traditional fanfare of a peace deal, complete with public handshakes. The U.S.-Iranian negotiations, however, are unlikely to present such a tableau. Tehran and Washington seem content to dial back tensions without dropping their public hostility, for fear that their respective populations would not approve of a public burying of the hatchet.

Regional trend: Turkey is emerging as a major regional power and in 2008 will begin to exert influence throughout its periphery — most notably in northern Iraq.

Turkey is becoming bolder on the international stage: sending troops into northern Iraq, mediating Israeli-Syrian peace talks, pushing energy projects in the Caucasus and Central Asia and making its influence felt in the Balkans. But internally, the country is paralyzed. A domestic power struggle over the nature of the state, pitting the new socially and religiously conservative elite against the established ultrasecular elite, has stalled not only local economic growth and foreign investment but also Ankara's progress toward regional player status.

We expect Turkey's court system — operated by the ultrasecularists — to dictate terms to the elected Islamist-rooted government, likely resulting in the ruling Justice and Development Party's dissolution. A verdict is expected in mid-August on a pending case that seeks to do just that, though we cannot rule out the possibility of a compromise. Toppling the government will not reverse or deflect the underlying trend of Turkey's re-emergence as a leading regional power, but it will delay it significantly.

Eurasia

Regional trend: Should it occur over Russian objections, Kosovar independence would deliver a massive blow to Russian credibility. Thus, Kosovo will serve as the litmus test for either the return of Russian power or a surge in the West's expansion.
Regional trend: Russia's internal power struggles will hamper Moscow's ability to pursue its international agenda.

Russia spent the bulk of its energy in the second quarter on managing the transition from Vladimir Putin the president to Vladimir Putin the prime minister. In the shuffle, Russia's restless power clans struggled for supremacy, with the conflict reverberating through some of Russia's most crucial institutions, including the Federal Security Service, Gazprom, Rosneft and the defense sector. This struggle is now over — with the battle lines ending roughly where they began — but the fighting consumed nearly all of Moscow's attention and energy for the bulk of the second quarter.

During this reorganization, the West — particularly the Europeans — did manage to force Kosovar independence over Russian objections, making a mockery of the Russian position in Europe. But Russia did not exact any retribution — or at least, not in Europe. What Russia did do was focus some of its energy on the area where its influence is strong: its immediate periphery. Belarus, Ukraine, Armenia, Azerbaijan and Georgia all witnessed a surge in Russian attention as Moscow locked down its positions in regions it feared the West was eyeing.

The result is a continuing mismatch of perceptions: the Europeans feel that their victory in Kosovo proves the Russians are more bark than bite, while the Russians feel that they have made their true red-lines clear by focusing on their near abroad. Major Eurasian conflicts have been rooted in far smaller misperceptions, but that will be a crisis for another day.

Luckily for both sides, each has other issues to occupy it for now. The Europeans have turned inward after yet another failed attempt at a constitution, and the Russians have to get their affairs in order in the third quarter before venturing outward again.

Putin has implemented major personnel reshuffles across the length and breadth of the Kremlin, with the biggest changes in the energy industry, the military and the defense-industrial complex. Additionally, Russia is a major energy exporter and a moderate food exporter, but it still struggles with inflation — doubly so now that qualitative and quantitative labor shortages are starting to bite, courtesy of Russia's deepening demographic crisis.

While Russia might be in its best posture financially, politically and militarily since the end of the Cold War, it faces a number of nagging problems that it is organizationally ill-suited to solve. Finding a way to get through these problems is not a severe challenge, but it will take time. We expect no major moves out of the Kremlin until the very end of the third quarter at the earliest. But when Russia does return, it will do so with the most money — courtesy of petrodollars — and the best leadership team it has had in 20 years.

Regional trend: The Concert of Powers will return as the dominant organizing structure of inter-European relations.

Europe is returning to its roots. Countries are arguing over monetary policy, France is making a grab for control of Europe's Mediterranean policy, Poland is aggravating Russia, Greece is complicating Balkan policy and the United Kingdom stands aloof as ever. Any serious thoughts of pan-European integration were thrown into disarray in June when Irish voters defeated the Lisbon Treaty, the latest attempt at a European constitution.

For the third quarter, all eyes will be on France, which will hold the rotating EU presidency for the remainder of the year. Since France is one of Europe's heavyweights, its turn at the presidency would have been notable even had Ireland ratified the EU treaty — but with political integration efforts in limbo, France now has a chance to realign European structures with its own national interests. This will not take the old Gaullist form of ambitions for French superpower status. Instead, Paris will seek to wrest the economic and political leadership of Europe away from Berlin by subtly (and perhaps not-so-subtly) undermining the EU institutions that France perceives as giving Germany an advantage.

Economically, France is better poised than Germany to weather the storm of sustained high commodity prices: It has a less-industrialized economy, is an exporter of foodstuffs and has a huge capacity to generate electricity from nuclear power rather than petroleum fuels. But Paris is well-positioned politically as well. President Nicolas Sarkozy's honeymoon might be over, but Germany finds itself distracted and divided by a failing, conflicted governing coalition that is about to enter an election campaign. Germany is still the rising star of Europe, but that rise has hit a bit of a pause, and France will seize the moment to adjust Europe's direction to its own liking as much as possible.

Regional trend: Serbian elections will end Belgrade's position in geopolitical no-man's-land — one way or the other.

Europe has seen Serbia as the litmus test of whether the Balkan region as a whole will move decisively toward the West — with each of the Balkan states eventually joining the European Union — or whether there will be a radical wild card in the center of Southeastern Europe, which could give Russia a foothold in the region.

However, we should have known better than to think that the Serbian election could generate a clear result. While Serbia enters the third quarter with its most stable government yet, it would be a mistake to label it firm enough to execute a clear break with the country's past. Undoing 18 years of contradictory policies and international isolation is simply too large a task for any government to complete in short order, much less an untested coalition containing five parties and three ethnic groups.

Nevertheless, steps toward Serbia rejoining Europe — complete with halting steps toward EU membership — appear to be in the cards for the third quarter. Vojislav Kostunica, whose power plays have often upended Serbian policy, will not be in the new government, leaving pro-Western factions with more flexibility than they have known in years. But it will take far more than three months of progress before the probabilities for success can be assessed.

Global Economy

Regional trend: Oil prices will soften in 2008 due to the fading of geopolitical risks in key locations. The price drop, however, is contingent upon an expected weakening of geopolitical risks.

Things are going to get worse before they get better. Global crude oil prices have risen by 40 percent since the beginning of the year — and all of that took place in the second quarter — largely because of geopolitical risks that Stratfor believes will likely ease. We envision four events occurring in the third quarter that should take some of the heat out of the markets.

First, the U.S. Congress appears to be moving toward regulations intended to lessen the impact of speculation in oil trading. This will almost certainly have some unintended consequences, but will probably result in at least a minor cooling of prices.

Second, we expect a planned Nigerian energy summit to result in additional sums of oil income being funneled to the ethnic Ijaw of southern Nigeria. The Ijaw, who typically feel cut out of the oil patronage system, are responsible for most of the large attacks on oil infrastructure. A deal that enfranchises them should result in more stable Nigerian output.

Third and fourth, we expect two deals to slide into place in the Middle East: one between Iran and the United States on the future of Iraq, and another between Israel and Syria on the future of Lebanon. The Iranian-U.S. negotiations are taking place largely behind the scenes, but will impact the oil markets indirectly if they succeed in finally stabilizing Iraq. Meanwhile, Israeli-Syrian moves toward a very public peace deal should calm those parts of the oil markets that get jumpy every time they see a headline containing the words "Israel" and "Arab."

Regional trend: Countries the world over will pull their energy sectors back from the free market in order to stave off social instability and/or maximize profit.

The primary manifestation of this forecast in the second quarter came in the form of reinforced energy subsidies, with Russia, France, Italy, India, Venezuela, Argentina and Iran being the most obvious players. Technically, such steps are not nationalizations, but they make the liberalization of energy sectors de facto impossible (no private firm wants to supply a subsidized market).

In the third quarter, we expect more dramatic steps toward direct management of energy sectors in Malaysia and China — two states in which recent efforts to lighten the subsidy burden are likely to backfire. Europe, too, will wrestle with moves to involve the state more deeply in energy questions, as high energy prices finally begin to bite hard enough to force a government response.

Regional trend: Despite much talk to the contrary, the United States will enjoy strong economic performance. In part, this is because of the massive inflow of money into the United States from Asian and Arabian states.

While talk of recession in the United States remains par for the course, the U.S. Federal Reserve is both becoming optimistic and leaning toward interest rate increases to contain inflation. The Fed will always err on the side of triggering faster growth (and inflation with it) rather than slower growth that could lead to deflation and induce a Japanese-style depression. Add in roughly $100 billion in stimulus checks, and the United States is well past the worst that the slowdown of the latter half of 2007 presented. This does not mean that the "strong economic performance" we anticipated has materialized — but the truth so far is much more positive than the doom-and-gloom talk that dominated American media the first half of the year.

Obviously, not all things are cheery. The American property market is far from recovery — the rising inventory of unsold homes in particular is a critical factor to watch — and strong commodity prices are making the U.S. consumer take pause. Additionally, a combination of American subprime contagion and regional structural and cyclical weaknesses could trigger a European banking crisis in the third quarter. But Stratfor's primary economic concern for U.S. growth remains tied to the election cycle. Neither presidential candidate has any interest in pointing out positive aspects of the current government's economic management. And, in past elections, "It's the Economy, Stupid" has not only garnered votes, but also has had the side effect of amplifying public perceptions of the economy's problems.

Regional trend: Inflation is on the rise on a global scale.

But while the United States is looking toward better times, the reverse could prove true elsewhere. The sheer size of combined American purchasing power means that the United States can weather high energy and commodity prices relatively well — runaway commodity inflation plus the subprime meltdown still did not push the U.S. economy into negative growth. The same cannot be said for the rest of the global system, where inflation is now pushing 5 percent.

And of course $140 a barrel oil is still $140 a barrel oil. Most countries can no longer absorb such cost increases, and Stratfor expects to see the cracks that developed in major industrialized economies in the second quarter begin to lead to fundamental breaks in the third. Barring a truly deep price drop, a great many states are beginning to have a great many problems. Between robust prices for energy and food, there is not an economy in the world that has not had to make some sort of adjustment. Stratfor divides the effects into two categories.

First, food shortages impact political stability immediately; so food prices have been — and remain — the key issue to watch. In the second quarter, the world witnessed only sporadic, minor, localized food shortages. While grain prices continue to rise, there is some light at the end of the tunnel: plantings and weather have been favorable for most crops, and most grain forecasts for harvest in the next few months are atypically large (with corn in the U.S. Midwest being the notable exception.) It is far too early to predict a price drop, but it seems safe to say that there will not be onerous supply crunches.

Second, the broader inflationary trend remains firmly in place and will disproportionately impact the heavily industrializing — and thus energy-intensive — economies of East Asia (which is hardly to say that the rest of the developing world will escape). The country facing the biggest problems will be China, which imports massive amounts of increasingly expensive commodities. Beijing will face a growing risk of widespread social unrest as these pressures take their toll on its economy, but it will be constrained from restoring order in its accustomed fashion — that is, a security crackdown — in the third quarter because of the international spotlight brought by the Olympics. Efforts to manage the problem thus far have not proven very effective, and they are complicating parallel efforts by the government to recentralize control of the energy sector.

High commodity prices — specifically high energy prices — have also had an unforeseen impact. The political power of countries raking in large numbers of petrodollars — the Arab states of the Persian Gulf now gross a combined $2 billion daily — is at its highest point in a generation. The last time these states had this amount of financial power they underwrote projects such as the Afghan mujahideen and contributed to the fall of the Soviet Union. This time around, they are concerned with Iran's involvement in Iraq and Lebanon, and are applying their riches toward pushing the Israeli-Syrian and American-Iranian peace processes forward.

East Asia

Regional trend: The Chinese government intends for the year 2008 to be China's day in the sun, with the Olympics showcasing how advanced and stable the country has become. This requires Beijing to act preemptively to prevent anyone with an interest in marring China's image from disrupting the Olympics.

Anti-Chinese foreign activist campaigns have been neutered with a mix of visa policy and slick organizing of counterprotests, while security has been tightened ostensibly in response to the threat of domestic terrorism. But these small victories belie much larger problems that have nothing to do with the Olympics.

The Olympic Games have created an inflection point in Chinese development, disrupting the stability of Beijing's political decision-making process. On some issues, this break point has caused the government to postpone decisions beyond when they would usually have been made, while on others, decisions have been accelerated ahead of the time frame Beijing would have preferred. Reducing energy subsidies was a policy from the former group, but the attempt to delay skidded out of the government's control. Meanwhile, allowing more media access because blackouts proved no longer feasible is an example of the latter.

In short, the Olympics have forced what is normally a gently-gently decision-making process into chaotic fire-fighting mode, and rising commodity prices are forcing the entire system into the pressure cooker. All things considered, China is juggling the issues admirably, but the scope and depth of the challenges it faces guarantee tension and a continuous trickle of small crises for the next quarter (not to mention that everyone who has an interest in seeing a weaker China will use the next several weeks to nudge the country toward as many of those crises as possible).

But the Olympics are still the Olympics, the Chinese people are still very proud to be hosting them, and regional leaders fully realize that the Politburo will certainly come for them if they spoil the show. Stratfor expects this combination of nationalism and fear to see the government through the worst of the problems. Then, once the last hungover tourist steps onto the last departing plane, cracks will likely start showing, the system will start creaking, and the gloves will come off — with the acceleration of price reforms the most likely first order of business.

Regional trend: In order to tighten its grip on an often unstable and chaotic economy and Communist Party, the Chinese Central Committee is reshuffling the bureaucracy, with an eye to creating energy, aviation and finance superministries directly under its control.

Efforts to consolidate the energy sector are proceeding, but not quickly. The central government is meeting resistance from all of the expected groups — state oil firms, local distributors and retailers, and especially regional leaders — who stand to see their influence, wealth and sources of income all subjugated to Beijing's will. With the added complications of the Olympics and global high energy prices, the central government has been forced to shuffle and reshuffle the plans several times to keep them more or less on track.

In the quarter to come, President Hu Jintao will attempt to bring all the disparate threads of the energy sector more or less under his personal control, a task that will become even more complicated once the burning incentive of the Olympics has passed and all the players take a good hard look at their bottom lines. But in many places, the push for consolidation will not rise above the level of rhetoric, given that many of Hu's key supporters are local leaders who continue to resist change on multiple issues in order to maintain their own viability and profitability. As such, Hu will likely take his campaign to provinces and regions led by people outside of his personal network — a move that will create some tensions and contradictions in the inconsistent application of central government directives across the country.

By comparison, consolidation of the aviation sector will be a cakewalk.

Regional trend: The U.S. alliance structure in Asia is being readjusted as states feel out both bilateral and multilateral relationships in order to maximize their influence in an evolving world.

This readjustment intensified in the second quarter, with several states becoming increasingly proactive in how they manage their bilateral relations with the United States and their neighbors. As we expected, U.S. allies sought not to sever, but simply to adjust, the ties that bind.

Australia short-circuited several plans to exclude the United States from various proposed Asian clubs by proposing to create and lead its own version of the Asia-Pacific Economic Cooperation to manage the region's economic and military affairs. South Korea, despite domestic opposition, continues to put finishing touches on a free trade deal with the Americans, still vying to become the only major Asian state to land such an agreement. Taiwan's new government sought to find a middle ground that keeps its American alliance intact while allowing it to nudge closer to Beijing. And the United States took advantage of a hurricane disaster in the Philippines to demonstrate vividly that, while it might not be flying the flag in Asia as much as in times gone by, it has hardly vacated the premises. Meanwhile, one state that is by no means a U.S. ally — North Korea — saw its relations with the United States continue shifting away from crisis management toward routine bureaucracy.

This process is only in the beginning stages and will continue to intensify and accelerate in the third quarter. Bear in mind that all four of Washington's primary allies in the region — South Korea, Australia, Thailand and Taiwan — have freshman governments that are feeling their way forward. And with China's attention absorbed by the Olympics and the Americans preoccupied by the Middle East and their own election cycle, all four realize that the time to adjust their alliance relationships is now.

South Asia

Regional trend: The Pakistani army/state will hold together even as confusion and distractions in Islamabad greatly reduce the Pakistani government's ability (and willingness) to rein in jihadists.

This has certainly proven to be the case. Pakistan's incoming coalition is fractious, inexperienced (it has been 10 years since civilians ran the government) and certainly not in the mood to rock any domestic boats. This has led Islamabad to do everything in its power to avoid unduly angering Islamist militants operating in the country's northwestern reaches. The dawning problem is that this ungoverned land is providing opportunities for militants battling NATO forces in neighboring Afghanistan to rest, recruit and rearm — re-creating precisely the sort of environment that allowed al Qaeda to operate so efficiently until Sept. 12, 2001. In response, NATO forces are beginning to target these militants regardless of the political border, critically damaging the credibility of the Pakistani government.

The third quarter will force the new government in Islamabad to decide whether it is more afraid of NATO forces or of its own militants — who now have made leaps eastward out of the tribal areas into the North-West Frontier Province (NWFP). Ultimately, we expect the government to choose to target the militants, however half-heartedly, rather than make a stand against NATO's incursions into territory that is nominally under Islamabad's writ. The government will be driven by the fear that a conflict with NATO could, at worst, destroy Pakistan or, at best, trigger a military coup — which would end the first civilian government in a decade. In the meantime, U.S. forces will escalate their overt operations in the tribal badlands and perhaps even in the NWFP, which will complicate both the security and political situation in the country.

Regional trend: India's schizophrenic policies regarding everything from tax regimes to special economic zones to basic infrastructure are proving that the idea of "Shining India" is a myth and will lead to a waning in foreign investment.

Hopes for a "Shining" India have all but darkened, and even that assumes that there is no fallout from the deepening militant struggle in Pakistan.

With oil prices skyrocketing, India's energy subsidized economy cannot cope and state oil refiners are buckling under the pressure. This not only spells a highly uncertain political future for the ruling Congress party, but it also raises the specter of fuel shortages in an extremely riot-prone society should the government slip in managing this fuel crisis. Add in infrastructure bottlenecks and a government that is paralyzed due to rising food prices, and it is clear even to the Indian government that New Delhi's foreign direct investment (FDI) hopes are overinflated. But with inflationary pressures in the country nearing a critical point, maintaining FDI has slid well down the government's priority list.

In the third quarter, India will continue to be squeezed by economic pressure and stymied by political paralysis, both getting worse by the day. A break point is unlikely in the next three months, however. New Delhi still has enough quick fixes at its disposal to manage the impact of the commodity crisis day-to-day, but its attention is now almost fully consumed with containing domestic dissent. The political tension will continue to intensify, but with elections still more than half a year away, the situation will continue to simmer without quite boiling over.

Regional trend: The rest of South Asia will be consumed with domestic issues.

In the rest of South Asia, domestic squabbles between governments and their opponents took place as per our predictions with one exception: Afghanistan. The advances made by the Taliban, the diversion of U.S. attention to Afghanistan because of progress in Iraq, and the rise of Pakistan's own indigenous Taliban movement has pushed Afghanistan into a world very different from the self-contained situations in Sri Lanka, Bangladesh and Nepal. In the third quarter, the decaying security situation in Pakistan will intensify Afghan militant activity, and will push NATO in general and the United States in particular to boost the involvement of their troops in southeastern Afghanistan.

Latin America

Regional trend: Brazil is rising as the continental hegemon of South America.

Politically, financially and militarily, Brazil is truly prospering by Latin American standards. Independent of the fact that the country discovered yet more oil fields in the second quarter, Brazil certainly surged ahead of the rest of the continent by any measure.

The economic realm is where Brazil is shining brightest. It exports or is self-sufficient in many of the commodities whose prices are causing the rest of the world no end of problems — but its governance is professional and competent enough that it is, so far, managing the stress of high prices at home.

In the meantime, its primary regional competitors — Argentina and Venezuela — are struggling, falling backward in relative power as Brazil strides forward. Brazil is leveraging this growing space competently. In the second quarter, Brazil became the largest single investor in Argentina. And in the third, it will take its first shipments of liquefied natural gas, setting the stage for it to declare full energy dependence from its unreliable neighbors. And with its investment into the energy industries of those same neighbors, Brazil is laying the groundwork for controlling their energy options, not the other way around.

New regional trend: Crises are brewing in Latin America's leftist bloc.

In the annual and second-quarter forecasts, we dealt with Argentina, Bolivia and Venezuela separately. We now weave those three trends together: The populist policies that all have adopted are coming home to roost.

Argentina's financial, political and economic stability is taking a sharp turn for the worse. Argentine President Cristina Fernandez de Kirchner's populist efforts to placate a variety of groups have consistently laid the foundations for future, greater problems. The juggling already has radically increased Argentina's debt and reduced the country's trade surplus by a quarter — despite soaring international prices for all of Argentina's exports. This shortsightedness is triggering unrest on a national level, sparking runaway inflation of the type that has made previous Argentine governments fall. It also is gutting the country's productive capacity in industries in which it was until recently a global leader, and is raising the specter of food shortages in the not-so-distant future — quite possibly before the end of the third quarter.

Meanwhile, Bolivia is slowly sinking into chaos as the divisions deepen between the poorer, populous and indigenous highlands led by President Evo Morales and the more European and richer lowlands. Morales will hold a referendum on centralizing power in the third quarter, essentially attempting to force the lowlands into economic and political submission. So long as the lowlands physically control the economy on which the government depends, however, they cannot be talked or voted or threatened into submission. When the government realizes it cannot resolve the situation through constitutional channels — and we do not expect this realization to occur in the third quarter — Bolivia will have its defining crisis. Until then, the imbalance of political and economic forces in the country will only become more skewed, making the eventual conflict that much worse.

In Venezuela, it appeared at the beginning of the year that the opposition was beginning to coalesce into a meaningful political force that could challenge President Hugo Chavez. That trend has since faded away, but Chavez's own economic and political mismanagement has more than compensated for the lack of threats to the regime. Chavez has in many ways become his own worst enemy. Rising food and commodity prices, combined with self-destructive means of dealing with them, have soured the Venezuelan population on Chavez's leadership and fractured the ruling party. Many of Chavez's attempts to rally nationalist sentiment — threatening war against Colombia, for example — have instead backfired badly.

The country's social stability has been reduced to the point where it depends on Chavez's lavish social programs. But the cost of these programs is rising faster than the country's oil income, making Venezuela unique among oil exporters as the only one getting poorer with global crude prices at historic highs. Against this backdrop, it would be logical for foreign states hostile to Chavez to take a swipe at him, or for domestic opposition to rally against him, but no one with the capability to hurt Chavez has a deep enough interest to take any dramatic steps (the same, incidentally, goes for the Argentine and Bolivian governments). In the third quarter we expect Chavez's credibility to take hits — abroad, but even more so at home — as the system's coherence begins to crumble.

The problems of all three states feed upon each other. Bolivia's secession crisis and poor economic management are reducing natural gas flows to Argentina, complicating Argentina's existing power crisis. Venezuela's political — and by some reports, military — support for Bolivia's Morales only outrages and emboldens the secessionist lowlanders there. Venezuela's financial support for Argentina not only reduces the cash Caracas has to stabilize its own system, but several billion dollars of debt linkages now tie the economic problems of one state to the other. These connected problems, mostly rooted in the three countries' populist economics, have been building for years. In the first two quarters, cracks in the facade began to show — but in the third quarter the depth of the problems will become apparent. We do not expect any catastrophic failures in the next three months, but it is time to start thinking of just that.

New regional trend: Mexico is facing a moment of truth in the government's war against the drug cartels.

In our annual forecast, we predicted a continuing intensification (but not a resolution) of the Calderon administration's war against the country's powerful drug cartels, particularly along the Mexican-U.S. border. But in the second quarter, the cartels began carrying out high-profile assassinations of top law enforcement personnel in Mexico City itself, and this has forced the country to a decision point that will evolve the war into something new. Sustained attacks on key personnel in the halls of power are something that no state can tolerate. If they continue, it will mean that one (or a combination) of three things must happen eventually:

Mexico City could strike a truce with the cartels to save the central region.
Mexico could hurl every asset it has into the war in an effort to at least secure the country's core.
The cartels could strike a truce with each other and force the government away from the border and onto the defensive. In essence, this would turn Mexico into a failed state.

None of the options is easy or pretty — and none might come to pass in the third quarter — but this much is clear: the current situation is untenable.

Africa

Regional trend: In contrast to previous years, there will be little direct involvement of the major outside — or even inside — players. The one exception will be Angola, which will enjoy a rare day in the sun as the continent's up-and-comer.

It would have been hard to hit this one any more directly: Africa simply has not seen any meaningful direct involvement from the traditional players, whether from the continent or beyond. China has made a couple of commodities deals, but little more. India and Japan each hosted Africa summits but have not pursued other engagements. The French are participating in the European Union peacekeeping force (EUFOR) in eastern Chad, but they are keeping their heads down and have not intervened between the Chadian government and opposing rebels. The United States pulled back on plans to relocate its Africa Command (AFRICOM) headquarters from Germany to Africa. Nigeria is preoccupied with managing the Niger Delta, and South Africa has engaged in very little direct activity in Zimbabwe. Even Angola, the region's up-and-comer, is currently focused on internal development. (In the second quarter, it overtook Nigeria to become Africa's leading oil-producing state.)

But if the second quarter was quiet, it will seem like a roar compared to the third.

China has the Olympics, France has the EU presidency, and the United States is in the middle of an election campaign season and has little capacity for putting pressure on its African allies over relocating AFRICOM.

Nigeria's perennial problems with internal stability will take center stage as the country's Ijaw ethnic community makes its firmest — and, if necessary, most violent — bid for a larger slice of the country's oil revenues when Nigeria's government convenes the Niger Delta Summit, expected to commence in late July.

In South Africa, the internal issues that absorbed the country's attention for the past quarter continue to beckon. President Thabo Mbeki truly is already a lame duck and has minimal room to maneuver in either domestic or international politics. A leadership transition is only a year away, and the likely next president, African National Congress chief Jacob Zuma, continues to be hounded by corruption allegations, complete with court cases. The single issue on which Mbeki can act is Zimbabwe, where growing international condemnation has provided an opening for Pretoria's more nuanced policy of engagement.

Only Angola, awash with oil revenues, will have the luxury of picking the issues it wants to address without fear of reprisal or competition. But even Angola will have internal issues to keep it busy. Parliamentary elections — the first since 1992 — will occur in the third quarter, and the government wants to add a stamp of electoral legitimacy to its list of achievements. The rest of the world, it seems, can wait for another day.

John Mauldin

John Mauldin's Outside the Box : Economic Forecast

The Uncomfortable Dance Between V'ers and U'ers

The Uncomfortable Dance Between V'ers and U'ers

Debt and Deflation

Quarterly Review and Outlook Second Quarter 2009

DEBT ACTS AS A BRAKE ON THE MONETARY ENGINE

THE COMPLEX MONETARY CHAIN

A FISCAL POLICY DRAG

BUSINESS CYCLE IMPLICATIONS FOR EQUITIES

DEBT DEFLATION AND BONDS

Thoughts on the Market Rebound

Watch Out For the Second Leg of the Downturn

A Stock Market Rebound Closely Linked with Economic Data Surprises

Foundations of Crisis

Foundations of Crisis

Dow 5,000 Redux

Dow 5,000 Redux

The Stock Market is Not in Uncharted Territory

The Stock Market is Not in "Uncharted Territory"

Price Fluctuations, Support Levels, and Valuation in Bear Markets

Market Climate

Two Little-Noted Features Of The Markets And The Economy

Two Little-Noted Features Of The Markets And The Economy

The Financial Side First

Pain in the Real Economy

Banking Crises Around The World

Banking Crises Around The World

Dithering Costs

Relevant Examples

A Better Bailout

Bailout Stats And Graphs

Haste Makes Waste

Haste Makes Waste

The Paulson Plan

An Alternative Bailout Plan

The HCM Bailout Plan

Will The Paulson Plan Work?

Japan Redux?

American Oligarchy

Observations on a Crisis

Observations on a Crisis

It all began with housing and it will end with housing.

Don't trust central banks to always do the right thing.

Policy mistakes are likely to be repeated.

The golden era of investment banks is over.

The final shoe hasn't dropped yet.

Leverage is 'dead' but capital is not.

The end of the crisis looks further away than it did a year ago.

Traditional risk management has lost its way

The Fall of Lehman and The Terrible Lessons of Bear Stearns

The Fall of Lehman: How To Fix It - Part II

The Terrible Lessons of Bear Stearns

Dead Men Walking

Dead Men Walking

Are There Corporations that are "Dead Men Walking"?

The Failed Fannie Mae/Freddie Mac Experiment

More Dead Men Walking-Is There a Pattern?

Who Are the Dead Men Walking?

Zions Bancorp

KeyCorp

Fifth Third Bank

Washington Mutual

National City

Regions Financial

General Motor/GMAC

Ford/Ford Motor Credit Co

Wachovia

CitiGroup

Who are in the "Limping but Not Dead Man Walking Crowd"?

Summary - This is NOT Shaping Up to be a Pretty Couple of Years

The Elusive Bottom

The Elusive Bottom

We aren't past the halfway point of this recession

300-point rallies in the Dow happen in bear markets

How can there be recession with GDP still positive?

Employment has been down seven months in a row

GDP is useful but it has its limitations

You'll miss a lot of action waiting for GDP to go negative

Dating the recession is a very scientific process

We should actually be welcoming the recession call

Quarterly Review and Outlook
Second Quarter 2009