few weeks ago I asked for readers to send me questions and said I would
try and answer them while I was in Switzerland. Some of them were quite
good and have given me ideas for whole newsletters but will require a
lot of research. But a lot of them fell into two basic camps. This week
we look at a number of questions from readers about my thoughts on the
Muddle Through Economy.
One group basically asked, "John, given
all the bad news [insert your favorite bearish statistic on housing,
the credit crisis, inflation, doom and gloom, etc.] how can you be so
optimistic and think we will only see a modest recession and a Muddle
Through Recovery? Don't you think we will actually have a serious
recession and/or a soft depression?"
The second group asks the
obverse of the coin: "John, how can you see a long, slow recovery? Look
at all the good things like [insert your favorite bullish statistic:
low interest rates, a rising stock market, the worst of the credit
crisis behind us, the stimulus checks just now getting to consumers,
etc.]. Don't you think that means we will get back to a full growth
economy by the end of the year?"
I have given both questions some
thought as to which I should answer first. I think it makes more sense
to start with the bullish question first and then go into why things
are not as bad as many analysts suggest.
Clowns to the Left of Me, Jokers to the Right of Me,
Here I am Stuck in the Muddle Through Middle With You!
take some comfort in being in the middle. It is when you get on the
edge that you are most often wrong, but that also means you have the
most people who disagree with your position. And there are a lot of
people who disagree with me. But then, a lot of people disagreed when I
said the subprime crisis would be serious enough to cause a recession.
As to whether I am right about Muddle Through this time, we will see.
But It is where my thinking comes out.
So, let's make the case
for a recession which will last at least for two if not three quarters
and then a slow recovery of at least a year and half where GDP is in
the range of 2% on average.
First, this recession is
fundamentally a consumer recession, brought on by a bursting of the
housing bubble and a credit crisis. Consumer spending is under pressure
from several main areas.
First, as the housing market stalled and
then began to drop, we saw a fall in housing related spending, in
construction, furniture, mortgages, etc. Remember when most economists
and analysts wrote last summer that there would not be a recession from
the housing crisis because housing was only 5% of the economy? The rest
of the economy was doing just fine, they opined. Don't worry. Be happy.
problem is that the resulting fall in housing prices produces a
negative wealth effect. I have used the following chart many times, but
it is good to review it again quickly.
that without mortgage equity withdrawals the US economy would have been
in outright recession for two full years in 2001-2, and would have been
quite sluggish for the next two years. That is what you should expect
from the bursting of a major equity market bubble and 9/11. But because
the value of the US housing stock was rising and doing so rapidly,
people felt comfortable borrowing against the ever-rising value of
their homes. We borrowed and spent our way out of that recession.
Coupled with the Bush tax cuts (a very important element!) and low Fed
rates, we bounced backed rather handily.
But now, home values are
falling and will likely do so for another year at the least. As Woody
Brock pointed out in this week's Outside the Box, we are at the
beginning of a reversion to the mean on national wealth. We are getting
a reverse wealth effect. People either can't or won't borrow as much
and thus we get negative stimulus from housing prices. It is likely
that people are going to start saving more, which while a good thing
from an individual stand point, it is a drag on overall consumer
Second, even though core inflation is tame, real
inflation that includes the things you and I actually buy is high and
rising. I drove past a gas station in La Jolla where the price of gas
was over $4 a gallon. Money that is spent on gas and rising energy
bills is money that cannot be spent on discretionary items. Rising food
bills means that there is less money left over to buy entertainment and
other modest luxury items.
Third, rising unemployment clearly
means that a small but growing segment of the population has less money
to spend. Unemployment is at 5.1% and is likely to rise to over 6%.
That is clearly bearish of consumer spending.
All of these
factors suggest a recession of at least two quarters if not three.
While lower Fed funds rates and the efforts by Congress to stimulate
lower mortgage rates will eventually help, it will not be an immediate
As to a slow and prolonged recovery, the "Muddle
Through Recovery," the reasons to me are clear. The cause for the
current recession is the bursting of the twin bubbles of the housing
markets and the credit crisis. These are problems that are going to
take several years to solve, not matter that the Fed does to interest
rates and opening the discount window to investment banks for all sorts
of mortgage and other asset backed paper. While doing so is a good
thing, we still have to work our way through 3.5 million excess homes,
2 million of which are vacant. That will take a few years.
we have to develop new sources for the buying of debt. We vaporized 60%
of the market for debt in the implosion of CDOs, SIVs, CLOs, etc. These
buyers are never going to come back. It took 15 years to create that
market. It will take a few years to create its replacement. (More
thoughts on how we do that in a later letter.)
Let me offer one
caveat. If the Bush tax cuts are not kept largely intact you will see
the recovery that I think will be coming in late 2009 and 2010
evaporate quickly. If an Obama (probably) or a Clinton (small chance)
get their way, we will see the largest tax increase in history. That is
not the medicine that the economy needs when it is weak already. It
could easily push the economy back into recession as it will make the
consumer even weaker.
A Soft Depression? Not.
if things are all that bad, why won't we roll into the soft Depression
that Bill Bonner and others predict? It is quite easy to make a very
bearish case with a falling dollar, rising inflation, a seemingly
never-ending rise in oil and commodity prices, a nasty housing market
crash, a frozen credit market and more.
To establish a basis for
my relative optimism, I have to re-visit what is for me a painful
moment in my forecasting life. This is just between you and me, gentle
reader, and I would appreciate you keeping this just between us.
in 1998, I thought the US and the world would drift into a recession
caused by the failure of some large computer programs not being fixed
on time for the Y2K rollover. I did not think it would be the disaster
some thought, but I did see the potential for problems.
Because of one statistic that was very clear. 50% of all major software
projects for 40 years did not finish on time, and a large percentage of
those missed their targets by years. That number had not changed for
The Y2K software problem was very real. There were
thousands of huge software projects under way by late 1998 to fix the
problem. I went to many software conferences and talked with the
software developers and management who were quite distressed. Their
concern was real.
How, I asked them (and myself), could we expect
all the projects to be done on time when the clear record said that
software was difficult and managers very poor at getting things done on
time. While I expected most things to be fixed, it seemed reasonable to
think that there would be some problem areas. And I generally got
agreement from very serious managers and consultants.
talking about this with the late Harry Browne, a true friend and a very
wise investment writer (and the nominee of the Libertarian Party for
President for two elections). Harry was generally bearish on many
things. But he told me there would be no Y2K problem. I confronted him
with my evidence and research.
"John, you are missing the main
point. A free market figures out how to solve problems. This is a
problem that we know about well in advance. It is not slipping up on
us. If it must get solved in order for a company to survive, it will
get solved. End of story."
I just shook my head and took comfort
in my research. And I was wrong, of course. Interestingly, all the
investment advice in that book ended up being right as the stock market
did drop, long term interest rates fell, and the economy did go into a
recession and so on. I ended up being right for the wrong reason. And
some of my very first and now long term readers met me through that
book, so all was not lost.
But in looking back on it, I realize
what I had missed. Whenever I talked to managers at these conferences
(and I talked to a lot of them), they all told me privately that they
were going to meet their deadlines, but the real concern was other
companies or projects. I missed the forest for the trees. Everyone was
busy making sure they were going to be fine. I look back now and wonder
how did I miss it?
As it turned out, Harry was absolutely right.
Because there was a literal drop dead date on each of the projects,
management became very focused. It seems now that we know software
projects can be finished on time if the motivation is survival of your
It is a lesson that has been burned into me.
let me throw out a very important and interesting point. Today I am in
Switzerland speaking on behalf of Bank Sarasin to their mainly
institutional clients. (I should note my hosts at Sarasin were most
thoughtful. It is a very impressive bank with very good people.) The
conference was in German except for my speech and one by a Swedish
Economics professor named Dr. Kjell Nordstrom. I attended that session
and am glad I did. It was a fascinating presentation.
travel around the world, I am used to a certain amount of America
and/or Bush bashing. It is just part of the background noise.
I was somewhat surprised to see the professor, in the middle of a talk
on why some businesses succeed and others fail, put up a rather large
flag of the United States and went on to say that the US would be the
dominant developed country for his life, the life of his children and
the life of their children's children. You could feel the surprise in
the room. It is not what they were expecting to hear. I certainly did
He started out saying that someone could come to the US and
within 3-5 years you could become a citizen. Making a long story short,
in his native Finland it took 3-4 generations before you would be
considered Finnish. He went on around the world. There are very few
cultures where an immigrant can become a naturalized citizen and be
accepted into the culture. China? No. Japan? No.
In Germany, the
professor recently talked to the top 100 managers of Siemens. This is a
company that employs 462,000 people doing business in 192 countries. In
that room of the top management there were 99 Germans and one Austrian.
Think of similar multi-national companies in the US. Such a room would
be full of diversity.
A young lady Ph.D in physics in Lajore,
Pakistan does not dream at night of immigrating to China or Germany,
where opportunities would be very limited. No, she and millions more
like her dream of coming to the US. He said that 85% of the people
living in Silicon Valley were immigrants. The best and brightest in the
world choose to go there.
Because for him, America is not a
country, but an idea. It is the idea that any person can come and make
a life for themselves as an equal. And it is that freedom to rise or
fall that makes the US what it is.
So, what does this have to do with Muddle Through? Let's return to the original question.
things are not as bad as they seem. Most of the US economy is doing
just fine. Businesses have not overbuilt capacity, have large cash
positions and lower debt than is normal at the end of a business cycle.
In the 70's and 80's, we were much more dependent upon manufacturing
for employment, and thus were subject to large increases in
unemployment when too much capacity met slack demand and businesses cut
back as quickly as they could. Even if we rise to 6 or 7 percent
unemployment, that does not rise to the level of a major recession.
(And yes, I know if you lose your job it seems like a depression.)
the Fed has responded, if a little late, to the credit crisis, buying
time for banks to find capital. While there will be many more
write-offs from bad debts and mortgage paper in the future, most banks
will survive in some form. The key is that the Fed did buy us time. The
banks and pension funds are still going to have to write off about
twice what they already have, but not all at once. It will be several
years before we are through this mess, but that is why we Muddle
Through and not crash. I still contend that if the Fed had allowed Bear
Stearns to crash that we would experience a soft depression. It would
have been ugly. But they didn't and we won't.
And while the
housing crisis is really bad if you are trying to sell a home, it is
also an opportunity if you are a buyer. We will work through the excess
homes that are in the market, as US population is growing and the
natural demand that stems from that growth will help pick up the slack.
the credit crisis? It will get solved, because like the Y2K problem, it
must be solved if we are to survive. (I am working on a paper in which
I will outline how I think this will work itself out.) And the
creativity that infuses this country will rise to the occasion. Yes, I
know that it was that creativity coupled with greed which caused the
problem in the first place. But hopefully we will get it right this
time. Again, for reasons I will outline in later letters, I have reason
to believe we will.
So, I think my position in the middle is the
right one. We do have very real problems and will suffer a recession.
The problems will not be solved quickly. But they are not fatal
problems. Time is required for the markets to heal themselves. And
during that time, things will be slower than has been the case in
recoveries from "normal" recessions.
And let's close with a
quick commercial. Investing in this environment is tricky. The speakers
at my recent Strategic Investment Conference in La Jolla gave us some
very good insights, and I intend to post their speeches over time. If
you are an accredited investor (net worth over $1.5 million), and would
like to see some of the specific recommendations and presentations of
the hedge and commodity funds that presented, you can go to www.accreditedinvestor.ws,
and my partners at Altegris Investments will be glad to show you the
world of commodity and hedge funds. (In this regard, I am president and
a registered representative of Millennium Wave Securities, LLC. Member
I spent part of this week in London with my partners
there, Absolute Return Partners, and am quite excited about what we are
doing in the area of alternative investments for those of you that are
in Europe. You can also sign up at the same site mentioned above.
now, for those who have a net worth of less than $1.5 million, as we
announced a few weeks ago, I am now working with my friend Steve
Blumenthal and his team at CMG to offer a variety of investment
managers who can work directly with you. I am proud of the managers we
have on the platform. To see the managers and their returns, and how
they are doing lately in this turmoil, just click on the following link
and fill out the simple form. The minimum account size is $100,000. http://cmgfunds.net/public/mauldin_questionnaire.asp
South Africa and Swiss Mountains
am seriously struck by the beauty of Interlaken. The mountains are
simply magnificent. The Eiger and the Jungfrau are awesome on their
beauty. Tomorrow we will tour the area courtesy of a local guide who is
a reader and return next Monday. And the Victoria Jungfrau Hotel
deserves is reputation as one of the finest in the world. I highly
recommend it if you are in the area.
I will leave in two weeks
for South Africa. If you would like to come to the presentations I will
be making there, you can go to www.investmentpostcards.com and click on the link to write Prieur du Plessis a note.
mountains and local attractions are waiting, and I think I am going to
hit the send button a little early and go be tourist for the weekend.
They have had bad weather up until I arrived, and I hope that luck
holds for a few more days. Have a great week.
Your glad to be stuck in the middle with you analyst,
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