|Biotech, Conversations and Babies|
Our immersion in the details of
crises that have arisen over the past eight centuries and in data on them has
led us to conclude that the most commonly repeated and most expensive
investment advice ever given in the boom just before a financial crisis stems
from the perception that 'this time is different.' That advice, that the old
rules of valuation no longer apply, is usually followed up with vigor.
Financial professionals and, all too often, government leaders explain that we
are doing things better than before, we are smarter, and we have learned from
past mistakes. Each time, society convinces itself that the current boom,
unlike the many booms that preceded catastrophic collapses in the past, is
built on sound fundamentals, structural reforms, technological innovation, and
- This Time is Different (Carmen M.
Reinhart and Kenneth Rogoff)
does a potential crisis become an actual crisis, and how and why does it
happen? Why did most everyone believe there were no problems in the US (or
Japanese or European or British) economies in 2006? Yet now we are mired in a
very difficult situation. "The subprime problem will be contained," said now
controversially confirmed Fed Chairman Bernanke, just months before the
implosion and significant Fed intervention. I have just returned from Europe,
and the discussion often turned to the potential of a crisis in the Eurozone if
Greece defaults. Plus, we take a look at the very positive US GDP numbers
released this morning. Are we finally back to the Old Normal? There's just so
much to talk about.
first, I want to give you a chance to register for my 6th (where do
the years go?!) annual Strategic Investment Conference, cosponsored with my
friends at Altegris Investments. The conference will be held April 22-24 and,
as always, in La Jolla, California. The speaker lineup is powerful. Already
committed are Dr. Gary Shilling, David Rosenberg, Dr. Lacy Hunt, Dr. Niall
Ferguson, and George Friedman, as well as your humble analyst. We are talking
with several other equally exciting speakers and expect those to firm up
from those who attend often run along the lines of "This is the best conference
we have ever been to." And each year it seems to get better. This year we are
going to focus on "The End Game," that is, on the paths the various nations are
likely to take as they try to solve their various deficit problems, and how
that will affect the world and local economies and our investments. We make
sure you have access to our speakers and get your questions answered, and
you'll come away with excellent, practical investment ideas.
This conference sells out every
year, and you do not want to miss it. There is a physical limit to the space.
Every year I have to tell people, including good friends, that there is no more
room. Don't wait to sign up. There is an early-bird discount of $200. And while
it pains me to say it, you must be an accredited investor to attend the
conference, as there are regulations we must follow in order to offer specific
advice and ideas. Click on the link and sign up now.
At the end of the letter I am going
to comment on my latest Conversations with two of the leading lights in the
biotech world and give you a link to my recent Outside the Box on biotech,
which has had more response than almost any letter I have posted. If you missed
it, you should read it, as I outline why I am actually buying stocks in the
biotech space, even as I think we are headed for a double-dip recession and a
rather sharp bear market. But now, let's jump into today's letter.
The Statistical Recovery Has Arrived
Before we get into the main
discussion point, let me briefly comment on today's GDP numbers, which came in
at an amazingly strong 5.7% growth rate. While that is stronger than I thought
it would be (I said 4-5%), there are reasons to be cautious before we sound the
"all clear" bell.
First, over 60% (3.7%) of the
growth came from inventory rebuilding, as opposed to just 0.7% in the third
quarter. If you examine the numbers, you find that inventories had dropped
below sales, so a buildup was needed. Increasing inventories add to GDP, while,
counterintuitively, sales from inventory decrease GDP. Businesses are just
adjusting to the New Normal level of sales. I expect further inventory build-up
in the next two quarters, although not at this level, and then we level off the
latter half of the year.
While rebuilding inventories is a
very good thing, that growth will only continue if sales grow. Otherwise
inventories will find the level of the New Normal and stop growing. And if you
look at consumer spending in the data, you find that it actually declined in
the 4th quarter, both annually and from the previous quarter.
"Domestic demand" declined from 2.3% in the third quarter to only 1.7% in the
fourth quarter. Part of that is clearly the absence of "Cash for Clunkers," but
even so that is not a sign of economic strength.
Second, as my friend David
Rosenberg pointed out, imports fell over the 4th quarter. Usually in
a heavy inventory-rebuilding cycle, imports rise because a portion of the
materials businesses need to build their own products comes from foreign
sources. Thus the drop in imports is most unusual. Falling imports, which is a
sign of economic retrenching, also increases the statistical GDP number.
Third, I have seen no analysis
(yet) on the impact of the stimulus spending, but it was 90% of the growth in
the third quarter, or a little less than 2%.
Fourth (and quoting David): "... if
you believe the GDP data - remember, there are more revisions to come
- then you de facto must be of
the view that productivity growth is soaring at over a 6% annual rate. No doubt
productivity is rising - just look at the never-ending slate of layoff
announcements. But we came off a cycle with no technological advance and no capital
deepening, so it is hard to believe that productivity at this time is growing
at a pace that is four times the historical norm. Sorry, but we're not buyers
of that view. In the fourth quarter, aggregate private hours worked contracted
at a 0.5% annual rate and what we can tell you is that such a decline in labor
input has never before, scanning over 50 years of data, coincided with a GDP
headline this good.
"Normally, GDP growth is 1.7% when
hours worked is this weak, and that is exactly the trend that was depicted this
week in the release of the Chicago Fed's National Activity Index, which was
widely ignored. On the flip side, when we have in the past seen GDP growth come
in at or near a 5.7% annual rate, what is typical is that hours worked grows at
a 3.7% rate. No matter how you slice it, the GDP number today represented not
just a rare but an unprecedented event, and as such, we are willing to treat
the report with an entire saltshaker - a few grains won't do."
Finally, remember that third-quarter
GDP was revised downward by over 30%, from 3.5% to just 2.2% only 60 days
later. (There is the first release, to be followed by revisions over the next
two months.) The first release is based on a lot of estimates, otherwise known
as guesswork. The fourth-quarter number is likely to be revised down as well.
Unemployment rose by several
hundred thousand jobs in the fourth quarter, and if you look at some surveys,
it approached 500,000. That is hardly consistent with a 5.7% growth rate.
Further, sales taxes and income-tax receipts are still falling. As I said last
year that it would be, this is a Statistical Recovery. When unemployment is
rising, it is hard to talk of real recovery. Without the stimulus in the latter
half of the year, growth would be much slower.
So should we, as Paul Krugman
suggests, spend another trillion in stimulus if it helps growth? No, because,
as I have written for a very long time, and will focus on in future weeks,
increased deficits and rising debt-to-GDP is a long-term losing proposition. It
simply puts off what will be a reckoning that will be even worse, with yet
higher debt levels. You cannot borrow your way out of a debt crisis.
This Time Is Different
While I was in Europe, and flying
back, I had the great pleasure of reading This
Time is Different, by Carmen M. Reinhart and Kenneth Rogoff, on my new
Kindle, courtesy of Fred Fern.
I am going to be writing about and
quoting from this book for several weeks. It is a very important work, as it
gives us the first really comprehensive analysis of financial crises. I
highlighted more pages than in any book in recent memory (easy to do on the
Kindle, and even easier to find the highlights). Rather than offering up
theories on how to deal with the current financial crisis, the authors show us
what happened in over 250 historical crises in 66 countries. And they offer some
very clear ideas on how this current crisis might play out. Sadly, the lesson
is not a happy one. There are no good endings once you start down a
deleveraging path. As I have been writing for several years, we now are faced
with choosing from among several bad choices, some being worse than others. This Time is Different offers up some
ideas as to which are the worst choices.
If you are a serious student of
economics, you should read this book. If you want to get a sense of the
problems we face, the authors conveniently summarize the situation in chapters
13-16, purposefully allowing people to get the main points without drilling
into the mountain of details they provide. Get the book at a 45% discount at
Buy it with the excellent book I am
now reading, Wall Street Revalued,
and get free shipping.
A Crisis of Confidence
Let's lead off with a few quotes
from This Time is Different, and then
I'll add some comments. Today I'll focus on the theme of confidence, which runs
throughout the entire book.
"But highly leveraged
economies, particularly those in which continual rollover of short-term debt is
sustained only by confidence in relatively illiquid underlying
assets, seldom survive forever, particularly if leverage continues to grow
"If there is one common theme to
the vast range of crises we consider in this book, it is that excessive debt
accumulation, whether it be by the government, banks, corporations, or
consumers, often poses greater systemic risks than it seems during a boom.
Infusions of cash can make a government look like it is providing greater
growth to its economy than it really is. Private sector borrowing binges can
inflate housing and stock prices far beyond their long-run sustainable levels,
and make banks seem more stable and profitable than they really are. Such large-scale
debt buildups pose risks because they make an economy vulnerable to crises of confidence,
particularly when debt is short term and needs to be constantly refinanced.
Debt-fueled booms all too often provide false affirmation of a government's
policies, a financial institution's ability to make outsized profits, or a
country's standard of living. Most of these booms end badly. Of course, debt
instruments are crucial to all economies, ancient and modern, but balancing the
risk and opportunities of debt is always a challenge, a challenge policy
makers, investors, and ordinary citizens must never forget."
And this is key. Read it twice (at
"Perhaps more than anything else,
failure to recognize the precariousness and fickleness of confidence-especially in
cases in which large short-term debts need to be rolled over
continuously-is the key factor that gives rise to the
this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem
to be merrily rolling along for an extended period, when bang!-confidence
collapses, lenders disappear, and a crisis hits.
"Economic theory tells us that it
is precisely the fickle nature of confidence, including its dependence on the
public's expectation of future events, that makes it so difficult to predict
the timing of debt crises. High debt levels lead, in many mathematical
economics models, to "multiple equilibria" in which the debt level might be
sustained - or might not be. Economists do not have a terribly good idea
of what kinds of events shift confidence and of how to concretely assess confidence
vulnerability. What one does see, again and again, in the history of financial
crises is that when an accident is waiting to happen, it eventually does. When
countries become too deeply indebted, they are headed for trouble. When
debt-fueled asset price explosions seem too good to be true, they probably are.
But the exact timing can be very difficult to guess, and a crisis that seems
imminent can sometimes take years to ignite."
How confident was the world in October of 2006? I
was writing that there would be a recession, a subprime crisis, and a credit
crisis in our future. I was on Larry Kudlow's show with Nouriel Roubini, and
Larry and John Rutledge were giving us a hard time about our so-called "doom and
gloom." If there is going to be a recession you should get out of the stock
market, was my call. I was a tad early, as the market proceeded to go up
another 20% over the next 8 months.
As Reinhart and Rogoff wrote:
"Highly indebted governments, banks, or corporations can seem to be merrily
rolling along for an extended period, when bang! - confidence collapses, lenders
disappear, and a crisis hits."
is the right word. It is the nature of human beings to assume that the current
trend will work out, that things can't really be that bad. Look at the bond
markets only a year and then just a few months before World War I. There was no
sign of an impending war. Everyone "knew" that cooler heads would prevail.
We can look back now and see where
we made mistakes in the current crisis. We actually believed that this time was
different, that we had better financial instruments, smarter regulators, and were
so, well, modern. Times were different. We knew how to deal with leverage.
Borrowing against your home was a good thing. Housing values would always go
Now, there are bullish voices
telling us that things are headed back to normal. Mainstream forecasts for GDP
growth this year are quite robust, north of 4% for the year, based on evidence from
past recoveries. However, the underlying fundamentals of a banking crisis are
far different from those of a typical business-cycle recession, as Reinhart and
Rogoff's work so clearly reveals. It typically takes years to work off excess
leverage in a banking crisis, with unemployment often rising for 4 years
running. We will look at the evidence in coming weeks.
The point is that complacency
almost always ends suddenly. You just don't slide gradually into a crisis, over
years. It happens! All of a sudden
there is a trigger event, and it is August of 2008. And the evidence in the
book is that things go along fine until there is that crisis of confidence.
There is no way to know when it will happen. There is no magic debt level, no
magic drop in currencies, no percentage level of fiscal deficits, no single
point where we can say "This is it." It is different in different crises.
One point I found fascinating, and we'll
explore it in later weeks. First, when it comes to the various types of crises with
the authors identify, there is very little difference between developed and
emerging-market countries, especially as to the fallout. It seems that the
developed world has no corner on special wisdom that would allow crises to be
avoided, or allow them to be recovered from more quickly. In fact, because of their
overconfidence - because they actually feel they
have superior systems - developed countries can dig deeper holes for
themselves than emerging markets.
Oh, and the Fed should have seen
this crisis coming. The authors point to some very clear precursors to debt
crises. This bears further review, and we will do so in coming weeks.
Greeks Bearing Gifts
On Monday, the government of Greece
offered a "gift" to the markets of 8 billion euros worth of bonds at a rather
high 6.25%. The demand was for 25 billion euros, so this offering was rather
robust. Today, those same Greek bonds closed on 6.5%, more than offsetting the
first year's coupon. Greek bond yields are up more than 150 basis points in the
Why such a one-week turnaround?
Ambrose Evans Pritchard offers up this thought: "Marc Ostwald,
from Monument Securities, said the botched bond issue of E8bn (6.9bn pounds) of Greek
debt earlier this week has made matters worse. Many of the investors were 'hot
money' funds that bought on rumors that China was emerging as a buyer, offering
them a chance for quick profit. When the China story was denied by Beijing and
Athens, these funds rushed for the exit."
Greece is running a budget deficit
of 12.5%. Under the Maastricht Treaty, they are supposed to keep it at 3%. Their
GDP was $374 billion in 2008 (about E240 billion). If they
can cut their budget deficit to 10% this year, that means they will need to go
into the bond market for another E25 billion or so. But they
already have a problem with rising debt. Look at the following graph on the
debt of various countries.
Russia defaulted on its debt
and sent the world into crisis in 1998, they had total debt of only E51
billion. Greece now has E254 billion and added another E8 billion
this week, and needs to add another E24 billion (or so) later this
a debt-to-GDP ratio of over 100%, well above the limit of the treaty,
which is 60%.
from being in the Eurozone by getting very low interest rates, up until
recently. Being in the Eurozone made investors confident. Now that confidence
is eroding daily. And this week's market action says rates will go higher,
without some fiscal discipline. To help my US readers put this in perspective,
let's assume that Greece was the size of the US. To get back to Maastricht
Treaty levels, they would need to cut the deficit by 4% of GDP for the next few
years. If the US did that, it would mean an equivalent budget cut of $500
billion dollars. Per year. For three years running.
That would guarantee
a very deep recession. Just a 10% suggested pay cut has Greek government unions
already planning strikes. Nevertheless, the government of Greece recognizes
that it simply cannot continue to run such huge deficits. They have developed a
plan that aims to narrow the shortfall from 12.7% of output, more than
four times the EU limit, to 8.7% this year. That reduction will be achieved
even though the economy will contract 0.3%, the plan says. The deficit will
shrink to 5.6% next year and 2.8% in 2012.
The market is saying
they don't believe that will happen. For one thing, if the Greek economy goes
into recession, the amount collected in taxes will fall, meaning the shortfall
will increase. Second, it is not clear that Greek voters will approve such a
plan at their next elections. Riots and demonstrations are a popular pastime.
Both French and
German ministers made it clear that there would be no bailout of Greece. But
here's the problem. If they ignore the noncompliance, there is no meaning to
the treaty. The euro will be called into question. And the other countries with
serious fiscal problems will ask why they should cut back if Greece does not.
If Greece does not choose deep cutbacks and recession, the markets will keep
demanding hikes in interest rates, and eventually Greece will have problems
meeting just its interest payments.
Can this go on for
some time? The analysis of debt crises in history says yes, but there comes a
time when confidence breaks. My friends from GaveKal had this thought:
is the next step? Having lived through the Mexican, Thai, Korean and Argentine
crises, it is hard not to distinguish a common pattern. In our view, this means
that investors need to confront the fact that we are at an important crossroads
for Greece, best symbolized by a simple question: 'If you were a Greek saver
with all of your income in a Greek bank, given what is happening to the debt of
your sovereign, would you feel comfortable keeping all of your life savings in
your savings institution? Or would you start thinking about opening an account
in a foreign bank and/or redeeming your currency in cash?' The answer to this
question will likely direct the next phase of the crisis. If we start to see
bank runs in Greece, then investors will have to accept that the crisis has run
out of control and that we are facing a far more bearish investment
environment. However, if the Greek population does not panic and does not
liquefy/transfer its savings, then European policy-makers may still have a
chance to find a political solution to this growing problem.
"What could a
political solution be? The answer here is simple: there is none. So if Europe
wants to save Greece from hitting the wall towards which it is now heading, the
European commission, the ECB and/or other institutions (IMF?) will have to bend
the rules massively. In turn, this will likely lead to a further collapse in
the euro. But for us, an important question is whether it could also lead to a
serious political backlash. Indeed, at this stage, elected politicians are
likely pondering how much appetite there is amongst their electorate for yet
another bailout, and for further expansions in government debt levels. The fact
that the intervention would occur on behalf of a foreign country probably makes
it all the more unpalatable (it's one thing to save your domestic banking
system ... but why save Greece?)."
If Greece is bailed out, Portugal
and Ireland will ask "Why not us?" And Spain? Italy? If Greece is allowed to
flaunt the rules, what does that say about the future of the euro? Will Germany
and France insist on compliance or be willing to kick Greece out?
A few months ago, the markets
assumed that not only Greece but Portugal, Italy, Spain, and Ireland would have
a few years to get their houses in order. This week, the markets shortened
their time horizon for Greece.
Even so, we get this quote, which
may end up ranking alongside Fisher's quote in 1929, that the stock market was
at a permanently high plateau, or Bernanke's quote that "The subprime debt
problem will be contained."
"There is no bailout problem,"
Monetary Affairs Commissioner Joaquin Almunia said today at the World Economic
Forum's annual meeting in Davos, Switzerland. "Greece will not default. In the
euro area, default does not exist."
The evidence in This Time is Different is that default
risk does in fact exist. You cannot keep borrowing past your income, whether as
a family or a government, and not eventually go bankrupt.
Are we at an inflection point? Too
early to say. It all depends on the willingness of the Greek people to endure
what will not be a fun next few years, for the privilege of staying in the Eurozone.
And on whether the bond market believes that this time is different and the
Greeks will actually get their fiscal house in order.
Oh by the way, did I mention that
the history of Greece is not exactly pristine in terms of default? In fact,
they have been in default in one way or another for 105 out of the past 200
years. Aristotle, can you spare a dime?
And one last thought. The US is
running massive deficits. If we do not get them under control, we will one day,
and perhaps quite soon, face our own "Greek moment." Look at the graph below,
Obama offering to freeze spending by
17% in US discretionary-spending programs, after he ran them up over 20% in
just one year, is laughable. Greece is an object lesson for the world, as Japan
soon will be. You cannot cure too much debt with more debt.
Biotech, Conversations, and More
quick commercial notes. I mentioned a few weeks ago that I was going to start a
stock-buying program for the first time in 15 years (I normally invest in
managers and funds rather than specific stocks). I published an Outside the Box
last week that talked about why I think biotech stocks could be at the
beginning of a decade-long run, and why I wanted to participate directly. You
can read that Outside the Box by clicking on this link.
I offer a subscription service called Conversations with John Mauldin, where I
hold conversations with people who I think have something important for us to
understand. It has been very well received. We provide both audio and a transcript.
I just posted my latest Conversations, in which I interviewed two gentlemen who
are CEOs of companies that I think are at the very bleeding edge of the biotech
revolution. Subscribers have already gotten that posting. Over the year, in
addition to the usual economic Conversations we have, I will be interviewing
other industry leaders who will be changing the world of medicine in the coming
decade. You can subscribe at https://www.johnmauldin.com/newsletters2.html.
In addition, George Friedman and
Niall Ferguson and I are exchanging emails on a time to get together for
another of the series where George and I talk about geopolitics. I guarantee a
lively and fascinating Conversation.
It is good to be back from Europe.
While it was fun, it was mostly long days and a lot of planes, trains, and
automobiles. I arrived home to find baby bottles and other baby paraphenalia
around the house. Tiffani and Ryan are starting to come back to work at the
house with me, and of course my granddaughter Lively will be here most days
with them, along with a nanny so Mom can actually work. It has been a long
time since I had a baby around. As I went to bed, I realized that I was going
to get to watch this grandchild grow up on an almost daily basis. It was with a
sigh of contentment that I went to sleep.
And then today, they came and
brought her. She has grown so much in just the week I was gone! Once again, I
get to experience the miracle of kids growing up. Only this time I don't have
to change the diapers. Life is good.
Your believing my grandkids will have a better future
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