Today we drop back to take a look at the economy
and its long term effect on our portfolio returns. I am in Orlando this week,
speaking at the Newport Advisor Conference sponsored by the Newport Group. The
attendees are primarily investment advisors focused on larger retirement
accounts and pensions. This week's letter is the gist of my speech I gave
yesterday, as the entire speech would be way too long for a weekly letter. I
want to thank the Newport Group for letting me do this, and thanks for the very
kind way they have hosted me. Note: this week's letter will print a little
longer as there are a lot of graphs. And next week I will address the housing
market, as was my intention this week.
The Muddle Through Economy:
The Future of the Market and
It is increasingly widely agreed that we are now
in a recession as I predicted this time last year. The good news is that much
of the underlying economy is not in that bad a shape, but it has had two
serious body blows administered by the twin collapsing bubbles of the housing
market and the credit crisis.
My position is that the recession will be rather
long and relatively shallow, and the inevitable recovery will be longer and
more drawn out than is typical, resulting in what I call The Muddle Through
Economy for a period of several years. I define a Muddle Through Economy as one
which grows below normal trend GDP growth of 3% for a period of time, typically
in the 2% range.
So, one of the key questions is: "When does the
recovery start and how long will it take to get back to 3% GDP?"
I think the answer is that it will not be before
the latter half of the year and will take at least two years to get back to
trend growth. The reason for such a drawn out recovery is simple. The twin
causes (housing and the credit crisis) will take at least two years and
possibly longer to normalize, and that process is going to negatively effect
several other sectors of the economy.
But then I am an optimist. Duke University released a survey yesterday of Chief Financial Officers of major
corporations. This is a gloomy bunch. 54% think we are already in a recession.
My friend Duke Professor Campbell Harvey said: "In contrast, 90 percent of the CFOs do not believe the economy will
turn the corner in 2008. Indeed, many of them believe it will be late 2009
before a recovery takes hold."
Let's look at a chart courtesy of John Burns Real
Estate Consulting. This shows that part of the bubble in housing was in the
number of transactions that occurred during the bubble years. In 2005 alone,
there were 48% more housing transactions that occurred than should have been
expected based on historical average sales per household. In large part this
was caused by "investors," many of dubious financial strength, buying homes and
condos on readily available credit with no real lending standards and no way to
pay the loans if they were not able to sell them at a higher price.
As a result, there are now 3.5 million excess
homes that need to be filled by qualified homeowners. Over time, due to growth
in the population, the demand will eventually catch up, but that will be a
process of several years. Housing prices will have to fall by another 15-20% or
so to get to a place where homes become affordable to the marginal buyer. And
that assumes rates can stay low.
Annual new and existing home sales are currently
running at about 5.5 million. John Burns expect that will fall to about 4
million before we see the bottom of the market. Notice, in the above chart, the
drop in sales after the increase in housing sales above the trend projection in
the 70's. We have a long way to go to correct the recent bubble, and Burns's
research suggests that we will get there sooner rather than later.
But this means that home values will drop
another 15% or more. Homeowners are going to see $5-6 trillion in home equity
vanish in the next year. Remember that point as we will address it in a minute.
Honey, I Vaporized My Customers
By now, everyone knows that the subprime crisis
started with non-existent lending standards which resulted in the large numbers
of foreclosures we are seeing today. Those foreclosures will be rising
throughout the year. We are not near anything like the top of the rising number
of foreclosures. Ben Bernanke said last July that losses from the subprime
would be in the $100 billion dollar range. True confession. I think I wrote six
months earlier that it would be $200 billion. I point that out to make the
point that I am an optimist by nature. The latest "bidding war" number for the
amount of total losses is about $500 billion from Goldman Sachs, and a neat $1
trillion from uber-bear Nouriel Roubini.
Add in hundreds of billions from losses which
are piling up in other credit markets and you can easily get to $1 trillion in
losses which are going to have to be eaten by all sorts of financial
institutions, without being all that pessimistic.
Banks are being forced to reduce their loan and
margin books in order to get the necessary capital required by regulatory
authorities. Plus, credit is now more expensive as risk premiums rise from
absurdly low levels in what more than one authority called a "new era of
finance." Turns out it was just normal old era greed.
It is not just the mortgage market. It is
commercial mortgages, safe municipal bonds, credit card debt, student loans and
a host of credit that is under fire and cannot find a buyer at what should be a
We should not be surprised at the lack of
liquidity in the credit markets. We have essentially vaporized 60% of the
buyers of debt in the last six months. The various alphabet of SIVs, CLOs, CDO,
ABS, CMBS, and their kin that were the real shadow banking system are either
gone or on life support. It took decades to build these structures and it is
not realistic to think we can replace them in six months. This is going to take
And time is what the Fed has bought this week by
offering to take AAA mortgage paper and swap it for T-bills. They will start
with $200 billion on offer. Remember you read it here first that that number
will be increased and increased again. From the markets initial euphoric
response, you would think the problems have been solved and banks will once
again start lending. Sadly, this is probably not true.
is similar to the action by the bank
regulators in 1980, when nearly every major bank had losses that were
than their capital on Latin American loans which had defaulted. The
Fed, with a
wink and a nod, allowed the banks to carry these worthless loans on
at full face value. It took six years before they started to actually
them down. But without that measure, every major bank in the US would
have gone bankrupt. And technically, they were for several years. But
the Fed action simply
bought the banks time to re-liquefy. It was the right thing to do.
This week's action by the Fed is essentially the
same thing. It buys time. This 28 day auction will be around for a long time.
If the banks had to write down the potential losses on their AAA Fannie Mae
paper and other similar assets, it could have brought the banking system to its
knees. Eventually, we will get a market clearing price for all this paper, but
the key word here is eventually. We are going to see foreclosures and losses
for another 18 months. It is going to take a long time to know exactly what the
losses will be.
I think the losses on many of the various forms
of debt have been marked down way too far by the various derivative markets. (I
would hasten to add this does not include the subprime markets, as many of
those assets are going to zero.) I doubt the loss in a lot of the debt paper
will be nearly as much as the current credit default swaps prices indicate. For
instance, some municipal bond debt is priced for 10-15% losses, when losses of
less than 0.5% are normal. When there is a buyers strike, prices fall, and
sometime to quite low levels. In the fullness of time, the price of these bonds
will rise back to "normal" levels. There is a reason Bill Gross is buying
municipal bonds by the train car load. Many are simply at the best prices we
will see in my lifetime.
But if that debt is now on a bank's capital
books, they have to write it down to the latest mark-to-market. The Fed's move
simply allows the banks to move what will eventually (or maybe the better word
is should eventually) be marked back to reasonable values. It avoids a crisis
The next crisis? I read a very chilling piece
from Michael Lewitt this morning. He speculates on what if the rumors were true
that Bear Stearns is basically bankrupt. Bear is in the too big to fail
category. They are at the heart of the chain of Credit Default Swaps which run
like fault lines throughout the world's financial system. If Bear were allowed
to collapse, it would simply cascade throughout the world so fast it would
truly make the current level of the credit crisis seem small potatoes.
So, why can I be so sanguine? Because the
regulators (the Fed and the SEC) would step in and whatever large bank was
failing would be merged or bought very fast. Liquidity and assets would be
provided. The Fed and the rest of the world's central banks get that we are in
a crisis. They will do what is necessary. Those of us sitting in the cheap
seats in the back of the plane may not like it, as it will look like a bailout
of the big guys who caused the problem, but you have to maintain the integrity
of the system. A hedge fund here or there can go, but not one of the world's
I wrote the above paragraphs on
Thursday, and sure enough, the NY Fed and JP Morgan stepped in to bail out
Bear. This will not be the only time or bank. The regulators may have been
asleep, but the depth of this crisis has awakened them.
But this is a boost for my contention that we
will be in a Muddle Through Economy for a long time. This latest Fed actions
simply draw out the time over which the market will correct. But that is a good
thing, as a too swift, dead drop correction could spawn a very deep recession,
destroying vast amounts of capital, which would take much longer to come out
Now, let's look at the implications
of this crisis on our long term returns and retirement portfolios.
Consumer Spending is Going,
I have used this graph before, but it bears
keeping this in mind. Mortgage Equity Withdrawals (MEWs) accounted from 1.5%-3%
of overall GDP from 2001 through 2006, as the US consumer used borrowed on the
equity in their homes to spend.
And it's not just MEWs weighing on the consumer.
Higher energy costs are just as effective as a tax in lowering consumer
spending. If oil stays where it is today, gasoline will be $4 a gallon this
summer. Unemployment is slowly rising, which of course is not good for consumer
spending. Inflation is hurting, especially in light of the very low growth in
real consumer income. Combine that with less availability of cheap and easy
borrowing and the consumer is clearly going to have to re-trench.
So, what does that mean? Two things. I think it
will mean lower corporate profits for a variety of US corporations, and as we
will see, in a normal recessionary pattern pull the stock market lower. And
that is going to lead to less than expected long term returns on retirement
portfolios, which will have its own consequences.
Let's review some basics. I made the contention
in Bull's Eye Investing that we should look at bull and bear market cycles in
terms of valuations rather than price. Stock markets go from high valuations to
low valuations and back to high valuations over very long term cycles,
averaging around 17 years. That would mean we are roughly halfway through this
secular bear market which began in 2000. I also pointed out a few weeks ago
that the bottom in terms of price in the last secular bear market (1966-1982)
was made in 1974, but it was 8 years later than the bottom in valuations as
expressed by Price to Earnings Ratio was reached. These periods of low
valuation are the springboard for the next bull market rise, so there is a bull
market coming. We just have to be patient.
It is entirely possible that we see the bottom
of the market in terms of price this year as the market falls due to the
pressures of the recession we are in, yet valuations continue to fall even as
prices rise. In fact, that is typical of the secular bear cycles. This happens
as earnings rise faster than stock prices.
And why is that important? Because the returns
on your stock portfolio are closely and highly correlated with the P/E ratios
at the time of your investments. Besides the following chart, you can go to
www.2000wave.com and look at the stock
market charts on the right side to see what kind of returns you would have had
over any given period during the last 100 years. Notice on those charts that if
you start with high P/E ratios, your returns could be negative for 20 years!
Not quite the 10% compounding that many planners promise.
So, where are today's P/E ratios? Let's go to
the data provided by Standard and Poor's for the S&P 500. In January of
2007, S&P estimated that earnings for 2007 would be $89. Earnings for 2007 were
actually $71.56, down about 20%. Last year about this time S&P estimated
that earnings for 2008 would be $92. Today they estimate 71.20 for 2008. Lately
every time new estimates come out they are down. But that is typical in a
recession. Analysts are generally behind the curve.
But as the table below shows, we
are now at P/E ratios that are back up over 20, and going to 22 by the middle
of the summer. That would suggest that total returns are going to be under
pressure for the next few years at a minimum and maybe for a decade. That does
not bode well for retirees who are expecting the stock market to compound at
8-10% annually in order for them to be able to retire in the style to which the
want to be accustomed. Real (inflation adjusted) returns of between 0 and 4%
are more likely based on historical returns from today's valuations.
The Boomers Break the Deal
I have good news and bad news. First, the good
news. Basically, my generation - the Baby Boomers- is going to break the deal
my Dad's generation made with my kids. They agreed to die on time. The Boomer
Generation and subsequent generations are going to live longer -potentially
much longer - than the current actuarial tables suggest because of major
breakthroughs in medicine and health care. It is quite conceivable that we will
see another average ten years of average life for the Baby Boomer Generation. I
personally fully intend to enjoy those years.
But the bad news is that many have not saved enough for an
extended life span, let alone 30 years of retirement. My friend Ed Easterling
at Crestmont Research did some very interesting analysis a few months ago. You
have saved and invested, and now you want to retire. You decide to take out 5%
of your total portfolio to live each year and increase the amount for
inflation, so that you can maintain your lifestyle (a number which a surprising
number of investment advisors would say is ok). Let's say you are an aggressive
older couple and decide to stay in the stock market because that is where you
are told that you can get the best returns over time. And you know that at
least one of you have the probability of living 30 years. On average you are
going to get 7-8% or more on your stock portfolio, right?
Ed calculates what you would get for 78 different
30-year periods since 1900. Let's say you start with a million dollars. On
average, this has been a good bet. You could maintain your lifestyle and end up
with $3.6 million. You've been pretty conservative, right?
Wrong. Because the returns you get over the next 30
years are highly dependent on the P/E ratios at the beginning of those 30
years. Let's break up those 30-year periods into four quartiles of beginning
valuation. If you start in a period when P/E ratios are in the highest
quartile, you find that over 50% of the time you end up penniless, on average
within 22 years. Here's that data from Ed:
As we saw above, valuations are well into that top
25% quartile. Notice that even when starting with the lowest-quartile
valuations that 5% of the time you ran out of money within 23 years. Want to
take a lifestyle bet that you have a 1 in 20 chance of losing? It will not be
fun to have to go to work as a Wal-Mart greeter at 80.
Of course, there are other implications. A generation living
longer means that the seemingly pessimistic forecasts of doom and gloom for
Social Security and Medicare are not pessimistic enough. Defined benefit
pension plans will be in real trouble at the end of the next decade.
So, what should you do? In secular bear cycles like we are in
now, you should look for absolute return style investments, like income
portfolios, hedge funds and other alternative style investments, be more nimble
in your stock picking rather than using index funds and expect overall lower
returns. We need to be patient and wait for the lower valuations which have
always eventually made themselves evident.
Mexico, London, and Switzerland
The Newport Group brought in Chris Gardner to
speak after me. It was one of the most inspirational stories I have ever heard.
Chris was the man who wrote the Pursuit of Happyness which was the basis for
the movie of the same name with Will Smith playing the role of Chris. As he
related his life, it was even tougher than the movie. It makes me realize how
important being a father is, and how much we owe to our parents who stayed with
us, and how incredibly important it I to be there for our kids. Get the book
and see the movie, and if you ever get a chance to her him speak, do so.
I get more than a few letters from readers who
think my Muddle Through Scenario is a little too optimistic. If you want to
read the bearish case, you can sign up for my friend Bill Bonner's the Daily
Reckoning. It is a free service and very well written. Bill and his associates
are from the Austrian economic camp, and go through a lot of data in an
entertaining manner. You can subscribe for free at:
As noted above, I am in Orlando and getting ready to go to the
Arnold Palmer Invitational Golf tournament in a few minutes. The speech went
well, and now it is R&R time. It looks like I will be going to Playa del
Carmen in Mexico (south of Cancun) in a few weeks over a weekend to speak to a
group of NFL football players. Now that
should be interesting.
Then I will be in London for two days April 15-16 and then on to
Switzerland for the rest of the week. Drop me a note if you want to
Lunch and golf are calling, so I am going to his
the send button early. Have a great week, and remember to have some fun on the
way as we Muddle Through.
Your life is getting better every week analyst,
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