|La Jolla, Conversations, and Richard Russell|
When confronted about an apparent change of his opinions, John Maynard Keynes
is reported to have said, "When the facts change, I change my mind. What do you
do, sir?" The earnings season for the 4th quarter is almost 80% complete, and
the facts are dismal. It is worse than the current data shows, and could get
uglier. Unemployment is increasing, and consumers are both saving more and
spending less as incomes are not keeping pace with what little inflation there
is. All in all, a very different set of facts than a few quarters ago. This week
we examine some of the new facts, and start out by analyzing how Thoughts from
the Frontline has done over the past two years with some of the more important
predictions. It should make for an interesting letter.
At the end of the letter, I have a few notes on my upcoming Strategic
Investment Conference in La Jolla, April 2-4 (which looks like it will sell
out), information on the Richard Russell Tribute Dinner, a mention of my new
Conversations srvice (which is getting very good reviews), and the need for one
or two part-time editors.
The Right Direction, At Least
Over the last year, I have become increasingly more bearish on the economy
than I was in January of 2007. In my 2007 annual forecast issue, I said that we
would be in a recession by the end of the year (we were), and that it would be a
long but not too deep recession, with a multi-year below-trend Muddle Through
period to follow. I was thinking GDP would maybe be down 2-3%. As I have
repeatedly written in this letter and said in speeches, the US stock market
drops by an average of 43% in recessions. I saw no reason to be in the stock
market, as there was just too much risk of a serious bear market. Further, since
international markets now have close to a full correlation with the US markets,
foreign stock indexes would be in trouble as well. I also said interest rates
would be coming down and deflation would be a problem before we got through this
(As an aside, there are a lot of very well-known perma-bearish analysts who
called the recession, but were very bearish on the US dollar and positioned
their clients in emerging-market stocks or other markets. Their clients have
been mauled. Just because you get the economy call right doesn't necessarily
mean you can call the right investment shots. Before you invest with a manager
because he seems to have been right about something, look to see what his actual
investment strategy has done. And that includes me or my partners.)
I also predicted the bursting of the housing bubble and the subprime credit
crisis in late 2006 and 2007. While I was completely wrong about the severity of
the current recession, at least I got the direction right. My advice would have
been the same, which was avoid long-only stock portfolios and mutual funds, be
long bonds, and access active, absolute-return managers and funds.
But the facts have changed. The reality is that we are in a much worse
recession than I thought it would be two years ago. And as I wrote last month,
we will probably be in recession for the full calendar year 2009, with the same
lengthy multi-year Muddle Through Economy I originally envisioned, albeit from a
lower base. So, what does that look like? Let's look at a likely set of facts,
in no particular order.
1. Consumers are going to save more and spend less. It is likely that US
consumers are going to push the savings rate back up to 6% (or more). Total US
net worth decreased by $7.1 trillion through the third quarter of 2008, from
housing and stock market losses. The trend suggests that could easily be up
another $6-7 trillion by the end of this quarter. Greg Weldon speculates that is
could easily be $15 trillion by the end of the cycle. That is a massive amount
of wealth destruction. And while the absolute numbers are not as large in the
rest of the world, the relative magnitudes are. This is a truly global
recession. Economists say that anything below 2.5% in world growth is a global
recession. We are down to 0.5% and falling.
2. The stimulus package is simply a pork-laden, misguided piece of
legislation. The nonpartisan Congressional Budget Office released a report (I
think yesterday) that says "CBO estimates that this Senate legislation would
raise output and lower unemployment for several years... In the longer run, the
legislation would result in a slight decrease in gross domestic product (GDP)."
There is way too much spending on items that have very little current effect on
I am in principle in favor of a deep and large stimulus package. We need one,
but what is on tap is not what will stimulate real job growth. All it does is
create more debt that will have to be paid later by our kids. What else could we
do? For instance, US companies have so much money squirreled away that Allen
Sinai of Decision Economics concluded that, if the US lowered tax rates
temporarily on repatriated earnings, companies would repatriate US$545 billion.
There is a precedent for this: we saw US companies bring home $360 billion in
2004 as a result of the temporary 5% tax rate contained in the American Jobs
Creation Act. (Sent to me by Louis Gave of GaveKal, whose work will be
highlighted in next Monday's Outside the Box)
Why not set a 10% tax rate to simply bring the money home, and a 5% rate if
they use it for capital spending or to create jobs? Now that is stimulus that
would actually result in more taxable income! And that money did help to create
a boom in 2004. On an aside, this just goes to show how out of balance the US
corporate tax system is.
What little real stimulus is in the bill will not hit all that much in the
first half of this year. The fourth quarter of 2009 is likely to look better
than the first quarter, but it is also likely to have a negative sign in front
of it. I hope I am forced by the facts to change that prediction.
3. I am somewhat more hopeful about the Federal Reserve and Treasury
programs, although all they really do is buy time for financial corporations to
heal themselves. That is not all a bad thing, though. Volker did it in the early
1980s by allowing banks to carry debt from Latin American countries that was in
default at full loan value. Otherwise every major bank in America would have
And I agree that a lot of the process will be wasteful and unproductive. But
such is the nature of crisis planning. Hopefully, they will not put into service
the notion of a large "bad bank," but rather go ahead and put the zombie banks
to sleep and help the healthy ones survive. But if US taxpayer money is
involved, then shareholders should be wiped out first. If the rest of us have to
lose on our stock investments, then bank investors should not be in a special
The downgrades by Moody's today of 2,446 different classes of Residential
Mortgage Backed Securities will be a real blow.
"Moody's warned in a report last week that loss assumptions would be
increased for RMBS and that downgrades could be expected. Moody's is projecting
that alt-A deals originated in the second half of 2007 will experience 25.5%
losses of original balance, compared to 23.9% of 1H07 deals, 22.1% for H206
deals and 17.1% for 1H06 deals. The rating agency in May expected average losses
for 2006 and 2007 vintage deals to reach 11.2% and 14.7%, respectively." (The
These losses are just going to keep coming. Commercial mortgage paper will
soon be written down as well. Banks will likely need at least $1.5 trillion in
private investment and government funding.
4. As I have noted for almost two years, it will take until at least 2011 for
the housing market in the US (and bubbles elsewhere, as in England and Spain,
etc.) to stabilize. It will take several years for the creation of a new credit
system to rationally replace the old "shadow banking system." This is why the
recovery will take so long.
For an economy to grow over time, you need some combination of increasing
population, productivity increases, and credit creation. We have destroyed a
large part of our credit creation model (which was deeply flawed, even though
for awhile it seemingly worked well) here in the developed world, and simply
have to build a new one. That is why I believe we are going to see the creation
of a massive new Private Credit Market that will compete with banks. You can see
this developing here and there, but it is going to take time. The Fed is
stepping in now and buying mortgages, credit card debt, student loans, etc.,
which is useful in the interim, but they need to make sure they do it at rates
that will attract private capital and capital formation. We do not want to turn
the Fed or Treasury into a national mortgage bank subject to political whim.
That would be worse than what we have now. As an example, the government is now
nearly the only source for student loans, as they set prices which just did not
allow private companies to compete. We must not do that with mortgages.
5. The US government will run multi-trillion-dollar deficits for at least two
years. As noted above, I think the current stimulus package will not be deemed
sufficient by the third quarter, and the compelling need politicians will feel
to do more will be almost uncontrollable.
Interestingly, the increase in federal spending is going to be accompanied by
a substantial decrease in state and local spending, as almost all nonfederal
entities must balance their budgets, and tax receipts are way down. If consumers
are spending 5% less, it stands to reason sales taxes are down by 5%. Property
taxes will be down, as will the state portion of income taxes. Increasing taxes
will bring about local voter rebellion, so spending cuts will be the order of
the day. As an example, state employees in California have every other Friday
off, which cuts their pay by 10%. Expect more such cuts everywhere and on
And while I am on the subject, state, county, and municipal pension plans are
woefully underfunded. As in by trillions of dollars -- much as I wrote in
Bull's Eye Investing in 2003. The signs were so there, and in a few years
governments are going to have to figure out how to deal with major shortfalls in
funding, as many municipal pension plans will be technically bankrupt.
Accompanying the increase in federal spending will be a real decrease in
federal tax receipts, which will make the deficits worse.
6. The main driver in the economic world is deflation, as I have been writing
for a long time. Yes, we had a brief whiff of inflation last year, but that was
primarily commodity-driven, and that force is now spent. Commodities are likely
to rise in price again, but not in the near future.
This is going to give the Fed the room to print money to monetize the federal
deficit, and indications are that Bernanke will do it with a vengeance. He will
do everything in his power to keep the US economy from catching "Japanese
Disease," that is, descending into a deflationary spiral. I fully expect them to
"move out the yield curve" and set longer rates at some lower number as
All of the above leads me to the following conclusions.
We are going to some new lower level of GDP and consumer spending, maybe as
much as 5% lower, which is a serious recession. And the "recovery" is going to
be slow. We don't get back to 3% GDP growth in 2010. Let me once again print a
graph I have used several times, but it is just so important. You need to think
about this one. This shows what the US economy would have been without mortgage
equity withdrawals from 2001 to 2006.
Notice that the US economy would have grown less than 1% a year for five
years, and barely that by 2006. And that is with consumers saving less than
1-2%! Now, let's imagine a world with savings going to 6% (or more), because
shell-shocked US consumers now realize they may actually have to save to be able
to retire. And what is it going to feel like when housing drops another 10-15%?
Or more?!?!? And what if we have a repeat of a major summer bear market â€“ which
I make the case for in a few pages?
The Jobs Will Come
We could see well-below-trend growth for several years. I spoke this week to
a small group of entrepreneurs that my daughter is involved with. (It is a
business development/mentoring program called Vistage. I know several people who
have seen their businesses really take off because of what they learned. If you
are running your own business, I highly recommend it. I can see the differences
it is making in my business because of Tiffani and other people I know who are
involved. Their web site is www.vistage.com)
What I told them is that for those businesses which are dependent on the US
consumer, their world is going to be smaller for a long time. We are in a period
where the economy is going through what economists call rationalization. We are
going to have to reduce the number of retail stores, coffee shops, automobile
plants, fast food restaurants, car dealerships, etc., until we get to a level
that makes rational sense for the size of the economy. We just built too much
stuff, launched too many stores, and created too much capacity for almost
The idea for the business person today is to still be standing when we get
through this, as we will. That is what free market economies do. The day will
come when we get back to 3-4% GDP growth. But it will be a rational growth based
in real fundamentals, one that will last a long time. So hope is not a business
strategy. You need to be planning for a lengthy recession and a slow
And if your business is one that helps producers cut costs? Or improve
production? Then this is your time to shine. It is not clear what the stimulus
plan will be, but look at it to see if there is something you can do to get in
the flow of that money. There are opportunities out there.
We were in a similar period of malaise in the late 1970s. Everyone wondered
where the new jobs would come from. The correct answer was, "I don't know, but
they will." As it turned out, we saw the creation of whole new industries, which
the government had little to do with. It is still the right answer. The new
industries that we will see next decade? Biotech? Energy? A new wireless telecom
build-out? Something out of left field? The correct stance is to be cautiously
I am seeing some amazing private equity deals and new ventures. It is really
a great time if you have capital, as you can pick among some very nice
Can We Have a Little Inflation, Please?
Getting back to the Fed and deflation, there will come a point (I hope) when
the Fed will actually bring about some inflation. That means they will have to
tap on the brakes to keep from letting that get out of hand. That of course will
slow any recovery, which is another reason I think the recovery from the current
recession will be a lengthy one. It is asking too much for them to get it "just
right." There is no formula here. They really do have to make it up as they
And while I don't think it is the likely case, it is quite possible that we
could see a repeat of '70s-style stagflation. We could also slip into
Japanese-style deflation, as the Fed may be pushing on a string. There is just
no way of truly knowing. You have to stay nimble and go with the facts as they
come down the road.
As investors, your goal is also to be standing when we get through this.
There is another bull market in our future, as hard as that may be to imagine
now. But it is several years off. Now is still a time for absolute returns and
active management. You want to arrive at the dawn of the next bull with as much
of your assets as possible. How will we know when we are there? Because
valuations will be low. Which is a perfect time to segue into an analysis of
current market valuations, as we close the letter.
Those Wild and Crazy Analysts
I have been writing about analyst earnings forecasts for some time. Earnings
forecasts just keep dropping. I talked with the very interesting and gentlemanly
Howard Silverblat from Standard & Poors, who is in charge of assembling the
data for the S&P earnings. When I went to the web site, I noticed that
"core" earnings were not on the spreadsheet. Core earnings take into account
pension fund commitments and other items that sometimes do not make it into
reported or operating earnings. During the last bear market, core earnings were
a lot lower than reported earnings, as companies adjusted their pension
commitments to make things look better than they were. I was wondering if we
would see the same thing happening now.
I asked Howard about that, and he said they were having some issues in
calculating them but expected the core earnings numbers to be back up in a month
or so. And he quoted sources that suggested S&P companies were underfunded
by $250 billion in their defined-benefit pension plans. Late last year, the Bush
administration waived the requirement that companies fund their pensions to at
least 92% of needed capital. It is now down to 80%. That leaves companies some
room to play with on their balance sheets.
I commented on how bad earnings were last quarter. The web site shows
earnings were a negative $3.14 a share, the first time they have ever been
negative for a quarter. Ever! That was with 65% of companies reporting. He
commented that it was worse than that. They don't have it up yet, but with 78%
of companies reporting, losses are now a staggering -$8.56 a share. And it could
get worse. The write-offs this quarter are just huge.
As he wrote, companies are not only throwing in the kitchen sink, but the
refrigerator, washer, and anything else they can find as they seek to write off
everything they can, to get it over with and start the new year fresh. They need
to do a kitchen remodel, but there is no financing available.
So, how does that affect total earnings for 2008? The table above shows
analyst projections from March of 2007 through today. Notice how they kept
falling over time. They are now down 70% from what was expected two years ago.
Earnings for 2008 are a paltry $29.57 and dropping. The S&P 500 closed at
868.60. That makes the P/E (price to earnings) ratio 29.4. (I use a decimal to
show I have a sense of humor.)
So, what are they projecting for 2009? Let's take a look. Notice that they
too have been falling over time.
If the S&P 500 were to close where it is today, and using the estimates
for the first two quarters of 2009, the P/E ratio would be 36.4 on July 1.
But what if earnings merely fall to where they were in the last recession, or
about 55-60% of where the projections are today? That would drop the 12-month
trailing earnings for the four quarters ending June 30 to $15.90 and result in a
nose-bleed P/E of 54.7 by the middle of the year.
If earnings don't come in dramatically better for the first quarter as
opposed to last quarter, we could be setting up for a nasty summer bear market.
Even in the bear market of 2001-2, the P/E did not get above 47. Which, by the
way, at a 47 multiple would correspond to a range for the S&P of either 1111
if the earnings come in as projected or 731 if they come in at the lower
I see nothing on the horizon which suggests the economy is going to get
manifestly stronger in the next two quarters. The real risk is that earnings
come in weak for both quarters and investors simply despair this summer,
throwing in the towel and bringing about a vicious bear market. I would
seriously consider hedging any long positions you have before earnings season
this next April. If they come in stronger, then we will see.
La Jolla, Conversations, and Richard Russell
As I mentioned at the beginning of this letter, along with my partners
Altegris Investments, I will be co-hosting our 6th annual Strategic Investment
Conference in La Jolla, California, April 2-4. I have invited some of the top
economic minds in the country to come and address us, giving us their views on
what seems to be a continuing crisis. It will be a mix of economic theory and
practical investment advice. WE WILL SELL OUT, so do not procrastinate if you
intend to register.
Already committed to speak are Martin Barnes, Woody Brock, Dennis Gartman,
Louis Gave, George Friedman (of Stratfor), and Paul McCulley. I anticipate
adding another stellar name or two, as a lot of very famous people are coming
for the Richard Russell Tribute Dinner (see below). This is as strong a lineup
as we have ever had, and on par with any conference I know of anywhere. And as a
special bonus, we have invited Fredrik Haren from Sweden. I heard him speak at a
conference in Stockholm last year and was blown away. You can click on the link
below to learn more about the speakers.
Due to securities regulations, attendance is limited to qualified
high-net-worth investors and/or institutional investors, because we will be
showcasing a select number of commodity fund managers and other alternative
strategies. Early registrants will get a discount. Last year we had to close
registration, and I anticipate we will run out of room again, so I would not
procrastinate. Click this link to find out more and register: https://hedge-fund-conference.com/register.aspx.
And if you cut and paste this link, make sure you copy the "https:" so you go to
the secure site.
And the first of the "Conversations with John Mauldin" is up! We recorded it
last week, with Ed Easterling and Dr. Lacy Hunt. I thought it went very well for
an inaugural talk. The complete audio and transcript are in the Membership
Library already. For those who have subscribed, you should have received an
email and be able to log in and listen or read the transcript. We are getting
very favorable reviews. Multiple readers have let us know that the first
Conversation was worth their entire year membership. I am quite pleased with the
first transcript and the response to it. My next Conversation is in two weeks,
with Nouriel Roubini; and then after the release of banking data in early March,
I will do a Conversation with good buddy Chris Whalen and a few real banking
experts, on where the US banking system really is. I will offer it as a bonus to
those that have already subscribed, as it will be more me asking questions than
a real Conversation. I expect it to be very informative.
The regular price for a yearly subscription is $199, but you can subscribe
now for $109, and still get access to the timely Conversation with Ed and Lacy.
Don't wait, as I am sure my staff will only keep raising the price. To find out
more, just click on the link and put in code JM77, which will give you the
discounted price. https://www.johnmauldin.com/newsletters2.html
Now, about the Richard Russell Tribute Dinner on Saturday, April 4. It will
be at the Hyatt in San Diego. We are going to be sending out invitations early
next week to everyone who has responded so far, which is well over 500 people.
If you have already responded, you will get a chance to register first, before
we open it up again. Next week we will have a page where you can sign up; but
when you get the invitation, I suggest you act quickly, as it really could sell
out. This is going to be a very special night. If you are one of Richard's many
thousands of fans you will not want to miss this. As I said, there are going to
be a lot of well-known names there. We are still planning the program, but it
will be special. (Note: to those who are attending my conference, noted above,
this is a separate event, with separate tickets, in a different Hyatt.)
If you would like to attend, just contact us and we will get you an
invitation. The cost will be $195.
And finally, Tiffani and I need an editor or two to help us in the process of
editing our taped interviews with millionaires. Drop us a note.
It is time to hit the send button. Have a great week!
Your really optimistic for the long run analyst,
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