How Shall We Then Invest? by John Mauldin

Warren Buffett says buy. Jeremy Grantham says it will get worse. Both are celebrated value investors. Who is right? It all depends upon your view of the third derivative of investing. Today we look at valuations in the stock market. This is the second part of a speech I have given in the past few weeks in California and Stockholm. I am updating the numbers, as the target keeps moving. While from one perspective things look rather difficult, from another there is a ray of hope. What can you expect to earn from stocks over the next five years? It should make for an interesting letter. Note: this will be a little longer than usual, but part of it is there are a LOT of charts.

I should note that I am rewriting this on Monday. For the first time in over 8 years, I missed my Friday night deadline (see below). Last week’s title for the letter was “The Economic Blue Screen of Death.” By that I referred to the old “blue screen of death” that we used to get on early versions of Microsoft MS-DOS and Windows. You could be working away and suddenly, for no apparent reason, the computer would freeze up and you would get a blue screen. The only thing you could do was unplug the computer and hit the reset button - losing everything that was not saved when the computer crashed.

I likened this to the economic situation we are in now. With consumer spending “resetting” to a new lower level, we are going to have to hit the reset button on many business plans, and thus investments, as consumers are going to spend less and save more. Is that level 3% less? 5%? More? No one knows, but since we have not had a consumer-led recession since 1982, too many businesses assumed that the US consumer, like Superman, was bulletproof.

What will be the eventual savings rate? Will we get back to 7-9% from less than 1%? Maybe, because people are going to realize that savings today are the key to a happy retirement. That would put the new level of consumer spending a good deal lower than it has been. Thankfully, that climb in savings will not happen all at once but will play out over more than a few years. I think we will look back in the middle of the next decade and be quite amazed at how much US personal savings have increased. However, this is the Paradox of Thrift: what is good for the individual is hard on the economy, as by definition increased savings reduces consumer spending.

A quick point. This decrease in consumer spending that we are seeing now will not be a permanent condition. After we find that new lower level, consumer spending will start to grow again, albeit more slowly due to increased savings. That is because the US economy and population are growing, and increases in consumer spending are the norm in such conditions.

Now, and I have 100 Swedish witnesses for this, after I finished my speech Thursday morning in Stockholm for the institutional investors of Kaupthing Bank, I sat down and turned on my laptop, which is an Apple MacBook Air. There was a strange noise and then, I swear, I was staring at a blue screen. My Apple notebook, supposedly immune from the Blue Screen of Death, had frozen in a pale shade of blue. Later that night, over drinks, we speculated as to how Bill Gates could manage to do such things, remotely, in revenge. However, since the next day Apple in Malta could not fix it, I missed my deadline. I apologize. Now, let’s jump right into the letter.

Those Wild And Crazy Analysts

Quick review: Last week we showed how consumer spending is falling, as we are in a recession. We then highlighted how analysts are dropping earnings estimates as time goes on. From projecting 15% earnings increases for 2008, they have dropped projections over 40% from March 2007 until today. Actual numbers will be much lower, as analyst projections for the fourth quarter are too high.

The same holds true for 2009. Since March of this year, just six months ago, earnings projections for 2009 have dropped 40% and are almost 10% lower than they were projected for 2008. However, estimates for operating earnings are still roughly double those for as-reported (or what’s on the tax return) earnings. Analysts are still wildly overoptimistic. You can read last week’s (October 17) letter here.

Now, let’s look at the rest of the presentation. I argue in Bull’s Eye Investing and this letter that we should look at long-term secular bull and bear markets not in terms of price but in terms of valuation. On September 26, 2003 I wrote about why we see long-term secular bear markets. I summarized the letter in the speech, but I think it will be useful to review a portion of it today. Remember, this was written in 2003, as a “new bull market” was already nearly a year old. The S&P 500 was at 1,000. So, for the last five years, you are down over 10%.

Investing is more than about price. It is about timing and valuations. Let’s review. I put in bold some important points.

The Evidence for Investor Overreaction

Long-time readers know that it is my contention that we are in a decade-long secular bear market. It typically takes years for valuations to fall to levels from where a new bull market can begin. Why does it take so long? Why don’t we see an almost immediate return to low valuations once the process has begun?

Because investors overreact to good news and underreact to bad news on stocks they like, and do just the opposite to stocks that are out of favor. Past perception seems to dictate future performance. And it takes time to change those perceptions.

This is forcefully borne out by a study produced in 2000 by David Dreman (one of the brightest lights in investment analysis) and Eric Lufkin. The work, entitled “Investor Overreaction: Evidence That Its Basis Is Psychological” is a well-written analysis of investor behavior which illustrates that perceptions are more important than the fundamentals. Let’s look at that study in detail. Stay with me. This is important.

In any given year, there are stocks which are in favor, as evidenced by high valuations and rising prices. There are also stocks which are just the opposite. Dreman and Lufkin (or DL for the rest of this letter) look at a database for 4,721 companies from 1973 through 1998. Each year, they divide the database up into five parts, or quintiles, based on perceived market valuations. They separately study Price to Book Value (P/BV), Price to Cash Flow (P/CF), and the traditional Price to Earnings (P/E). This creates three separate ways to analyze stocks by value for any given year, so as to remove the bias that might occur from just using one measure of valuation.

The top and bottom quintiles become stock investment “portfolios” for all three valuation measures. You might think of them as a mutual fund created to buy just these stocks. They then look ten years back and five years forward for these portfolios. There is enough data to create 85 such portfolios or funds. They first analyze these portfolios as to how they do relative to the market or the average of all stocks. They then analyze the portfolios in terms of five basic investment fundamentals: Cash Flow Growth, Sales Growth, Earnings Growth, Return on Equity, and Profit Margin. They do this latter test to see if you can discern a fundamental reason for the price action of the stock.

First, both the “out-performance” and “under-performance” of these stocks happens in the ten years leading up to the formation of the portfolio. Almost immediately upon creating the portfolio, the price performance comparisons change, and change dramatically. The “in-favor” stocks underperform the market for the next five years, and the out-of-favor (value) stocks outperform the market.

I should point out that other studies, which Dreman does not cite, seem to indicate that the actual experience of many investors is more like these static portfolios than one might first think. That is because investors tend to chase price performance. In fact, the higher the price and more rapid the movement, the more new investors jump in. The Dalbar study, among many others, shows us that investors do not actually make what the mutual funds make because they chase the hottest funds, buying high and selling low when the funds do not live up to their expectations. The key word, as we will see later, is expectations. Other studies document that investors tend to chase the latest hot stock and shun those which are lagging in price performance. Thus, forming a portfolio of the highest-performing quintiles is an uncanny mirror to what happens in the real world.

Why does this “chasing the hot stock” happen? DL tells us it is because investors become overconfident that the trends of the fundamentals in the first ten years will repeat forever, “… thereby carrying the prices of stocks that appear to have the ‘best’ and ‘worst’ prospects. Investors are likely to forecast a future not very different from the recent past, i.e., continuing improving fundamentals for favorites and deteriorating fundamentals for out-of-favor issues. Such forecasts result in favorites being overpriced, while out-of-favor issues are priced at a substantial discount to the real worth. The extrapolation of past results well into the future and the high confidence in the precise forecast is one of the most common errors made in finance.”

The more we learn about a stock, the more we think we are competent to analyze it and the more convinced we are of the correctness of our judgment.

Since you are not looking at the graphs, let me describe them for you. Predictably, the fundamentals improve quite steadily for the first ten years for the favorite stocks in comparison to the entire universe of stocks. But the price performance rises at very high rates, far faster than the fundamentals, particularly in the latter years. It clearly accelerates. It seems the longer a stock does well the more confident investors are that it will continue to do well and thereby award it with higher and higher multiples. The exact opposite is true of the out-of-favor stocks. Even though many of the fundamentals were actually slowly improving in relationship to the market as a whole, the stocks were lagging and the market punished them with ever-lower relative prices.

At five years prior to the formation of a portfolio, the trends of each group were set in place. The next five years just reinforced these trends. This re-strengthened the perceptions about these stocks and increased the level of confidence about the future. Again, past (and accumulated and reinforced over time) perception creates future price action.

Never mind that it is impossible for Dell to grow 50% a year or GE to compound earnings at 15% forever. As many times as we say it, investors continue to ignore the old saw “Past performance is not indicative of future results.”

How much better did the good-performing stocks do than the bad-performing stocks in the ten years prior to creating the portfolios? The highest P/BV (Price to Book Value) stocks outperformed the market by 187%. The lowest stocks underperformed the market by -79%, for a differential of 266%! If you look at the P/CF (Price to Cash Flow) the differential between the two is 172%.

Yet in the next five years, the hot stocks underperformed the market by a negative -26% on a P/BV basis, and -30% on a P/CF basis. The out-of-favor stocks did 33% and 22% better than the market, respectively. This is a HUGE reversal of trend.

So, what happened? Did the trends stop? Did the former outcasts finally get their act together and start to show better fundamentals than the all-stars? The answer is a very curious “no.”

“… there is no reversal in fundamentals to match the reversal in returns. That is, as favored stocks go from outperforming the market, their fundamentals do not deteriorate significantly, in some cases they actually improve…. The fundamentals of the ‘worst’ stocks are weaker than both those of the market and of the ‘best’ stocks in both periods.”

In some cases, the trends of the worst stocks actually got worse. Even as the out-of-favor stocks improved in relative performance in the last five years, their cash-flow growth actually fell from 14.6% to 6.6%. While cash-flow growth for the best-performing stocks did drop by 6%, it was still almost 2.5 times that of the lower group. Read the following carefully:

“Thus, while there is a marked transition in the return profiles [share price], with value stocks underperforming growth in the prior period and outperforming growth stocks in the measurement period, this is not true for fundamentals. In nearly every panel [areas in which they made measurements], fundamentals for growth stocks are better than those for value stocks both before and after portfolio formation.”

“Although there is a major reversal in the returns [prices] to the best and worst stocks, there is no corresponding reversal in the fundamentals.” In fact, in many cases the fundamentals continue to improve for the growth stocks and deteriorate for the value stocks. The data and the graphs clearly show that the fundamentals for the growth stocks clearly beat those of the value stocks, even for the five years after portfolio formation.

And yet, there was a very stark reversal in price. Why, if not based upon the fundamentals?

DL goes to another research paper, which shows “… that even a small earnings surprise can initiate a reversal in returns that lasts many years.” They demonstrate that negative surprises on favorite stocks result in significant underperformance of this group not only in the year of the surprise but for at least four years following the initial event. They also show that positive surprises on out-of-favor stocks result in significant outperformance in the year of the surprise, and again for at least the four years following the initial event. DL attributes these results to major changes in investor expectations following the surprise.

So where was the overreaction? Was it in the years leading up to the surprise, which resulted in a very high- or low-priced stock (relative to the fundamentals), or was it in the immediate reaction to the surprise?

Other studies show analysts (as opposed to investors) are too slow to react to earnings surprises by being too slow to adjust earnings. Even nine months later, analysts’ expectations are too high. (We will see this as we look at analyst performances today!)

Stock Prices Are In Our Heads
Or, Maybe Investors Are Just Head Cases

Dreman and Lufkin then come to the meat of their analysis. For them, underreaction and overreaction are part and parcel of the same process. The overreaction begins in the years prior to the stock reaching lofty heights. As Nobel laureate Hyman Minsky points out, stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction.

The cause of the price reversal is not fundamentals. It is not risk, as numerous studies show value stocks to be less risky.

“We conclude,” they write “that the cause of the major price reversals is psychological, or more specifically, investor overreaction.”

But DL go on to point out that when the correction comes, we tend to (initially) underreact. While we do not like the surprise, we tend to think of it as maybe a one-time thing. Things, we believe, will soon get back to normal. We do not scale back our expectations sufficiently for our growth stocks (or vice-versa), so the stage is set for another surprise and more reaction. It apparently takes years for this to work itself out.

As they note in their conclusion, “The [initial] corrections are sharp and, we suspect, violent. But they do not fully adjust prices to more realistic levels. After this period, we return to a gradual but persistent move to more realistic levels as the underreaction process continues through [the next five years].”

The studies clearly show it takes time for these overvalued portfolios to “come back to earth” or back to trend. Would this not, I muse, apply to overvalued markets as a whole? Might this not explain why bear market cycles take so long? Is it not just an earnings surprise for one stock which moves the whole market, but a series of events and recessions which slowly change the perceptions of the majority of investors?

Thus my contention that we are in just the beginning stages of the current secular bear market. These cycles take lots of time, anywhere from 8 to 17 years. We are just in year three, and at nosebleed valuation levels. The next “surprise” or disappointment will surely come from out of nowhere. That is why it is called a surprise. When it is followed by the next recession, stocks will drop one more leg on their path to the low valuations that are the hallmark of the bottom of secular bear markets. [Note: I wrote that in 2003.]

Given the level of investor overconfidence in the market place, and given the length of the last secular bull, it might take more than one recession and a few more years to find a true bottom to this cycle. It will come, of course.

But in the meantime, investors would do well do examine their own perceptions about the future, both positive and negative, and see if they might possibly be clouding their investment strategies. Remember, just because stocks are in a secular bear cycle does not mean there are not plenty of investment opportunities in other markets and strategies.

Just as there is more to life than work and money, there is more to investments than the stock market.

Can We Actually Predict Earnings?

Ed Easterling of Crestmont Reseach offers us the following very important chart. It is reported earnings compared to the historical trend line. As I have repeatedly written, earnings, especially when seen from a valuation standpoint, are mean reverting. They will fluctuate around the long-term trend line. And interestingly, that long-term trend line is nominal GDP. (Nominal GDP includes the effects of inflation.)

Total corporate earnings for any particular large country and stock market by definition cannot grow faster than nominal GDP (though individual stocks can do so). And since the S&P 500 is largely reflective of the US corporate world, earnings for the S&P 500 index will fluctuate around nominal GDP.

Notice how smooth that growth line for nominal GDP is? That will be important in a few paragraphs. But first, let’s look at how well Easterling’s historical trend line (which is nominal GDP) compares with Robert Shiller’s ten-year smoothed earnings. Rather than use the earnings from any one year, which as we know can fluctuate wildly, he smoothes them by using a ten-year average.

Important: Notice how closely correlated the earnings for Crestmont’s nominal GDP and Shiller’s smoothed earnings are.

Now, this is where it gets interesting. Shiller’s data is not predictive. But remember how smooth the earnings trend line from Crestmont was? Ed contends, and I agree, that there is a predictive element when we use nominal GDP. In other words, at some point in the future, earnings will grow back to and then exceed the long-term trend in nominal GDP.

So, while we are in the process of dropping below the mean or below the long-term trend line of earnings in terms of nominal GDP, we can be confident that at some point in the future those earnings will again revert above the mean. It seems to have been part of the economic laws since the time of the Medes and Persians.

This has important implications for future values. Let’s look at the next graph, from Vitaliy Katsenelson. Vitaliy uses a 6% growth of earnings as his baseline (which is, not coincidentally, very close to the long-term rise in nominal GDP). Again, notice how earnings fluctuate around the mean.

Notice also the small box on the right, which show where earnings could actually fall to if earnings drop by the same percentage as they did in the 2000-02 recession. That would suggest that earnings will drop below $40, from the currently projected $48. Remember, last year projections for 2008 were $82.

We will come back to this; but if we can project that at some point in the future earnings will once again revert to nominal GDP trendline, then we can make some projections about what earnings will be in the future, or at least what “trend” earnings should be!

Buffett versus Grantham

On October 16 Warren Buffett wrote an op-ed in the New York Times called “Buy American. I am.” Quoting from the beginning of the piece:

“THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

“So … I’ve been buying American stocks. This is my personal account I’m talking about, in which I previously owned nothing but United States government bonds. (This description leaves aside my Berkshire Hathaway holdings, which are all committed to philanthropy.) If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

“Why? A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

Jeremy Grantham, head of GMO, which manages $150 billion, has another opinion. Note that Grantham lost a great portion of his management business in the late ’90s when he decided that the tech market was a bubble and did not participate. His huge pension fund clients decided he did not “get it” and left him in large numbers. He was right, they were wrong, and now his business is vastly larger. And again, he is putting his opinion and client money on the line. This from a recent Money Magazine article (courtesy of my friend Richard Russell):

“Historically, when a market bubble has popped, it has almost always overcorrected. But after the tech bubble burst in 2000, the stock market didn’t hit the lows it should have. Before it could, the housing bubble and tax cut that followed 9/11 kicked off the biggest sucker rally in history from 2002 to 2006. So I think the market isn’t cheap yet. There is more pain coming. I don’t think we’ll hit the low until 2010.

“Previously in the interview, Grantham had this to say. ‘All you have to do is open a history book and see what happens when you have a bubble. In this case, there was a bubble in housing and there was a magnificent bubble in risk-taking People were just shoveling their money into risk on the pathetic idea that risk is always rewarded. You don’t get rewarded for taking a risk. You get rewarded for buying cheap. Leverage is the ultimate demonstration of risk, and we never had system-wide leverage like this before. Ever. We had several firms that were leveraged 30 to 1(for every $30 of assets they put up $1 of equity and borrowed the other $29). At leverage of 30 to 1 you have to lose only about 3% of your $30 worth of assets and your dollar of equity gets wiped out. You’re bankrupt.”

So, who is right? And the answer depends on your view of what I call the third derivative of value investing. The first two are price and earnings. The third derivative istime.

Long-time readers know I contend that markets go from high valuations to low valuations and back to high over very long secular bull and bear markets which last anywhere from 13-20 years, or about 17 years on average. These cycles do not stop in the middle and reverse. They tend to go the full course. That is why I could contend back in 2003 that were we not in some new long-term bull market. Valuations had not reached the levels from which bull markets are made. Stock market cheerleaders tried to spin it, but valuations are the fundamental ground of investing. You ignore them at your own peril.

Now, let’s look at two more charts from Vitaliy. These show the long-term secular cycles in terms of valuation, both from one-year and ten-year smoothed P/E ratios. Note that we are not back to even below the mean, much less to some place we could call “low.”

 

So, let’s be a bit of an optimist. Let’s look at yet another chart from Crestmont Research. What happens if stock market earnings revert to the mean in either 3 or 5 years? Ed also assumes that P/E ratios once again rise back to 22.5. From last Friday’s close, such a reversion would yield very handsome returns: 23.5% compounded for 3 years and 15.9 % for five years. If you believe like Buffett that US earnings will revert back to (and above) the mean, then that suggests this is a time to buy, if you are buying for the long term. The full report is at http://www.crestmontresearch.com/pdfs/Stock%20PE%20Report.pdf

Back to 1974?

Go back and look at the valuation charts above. Note that in late 1974 valuations were still at about their long-term average. Buying then was not compelling from a valuation standpoint. But Richard Russell called the bottom in one of his more famous calls late in the year. And it was a “price” bottom.

There was a great deal of volatility in the next eight years, and another recession at the end of the period, before valuations finally got down to extremely undervalued single-digit levels. Thus, those years saw a rising stock market and ever-lower P/E ratios. That happened as earnings grew faster than the prices of the stocks! Why did prices not rise along with the earnings growth?

Now, gentle reader, we come full circle, back to the Dreman and Lufkin study. Investors, twice burned in the late ’60s and early ’70s, were reluctant to get back into the market in a large, overtly bullish way. They were cautious.

I think we may be in a reflection of that same period. While it is possible we have put in the lows for this cycle, I think that as the recession will be deeper and longer than most of us have experienced (think 1982), we will see more rounds of earnings disappointments. I think the market has more downside in its future. But sometime, whether it was last week, or a few quarters in the future, we are going to see a cycle low in terms of price.

But it will most likely be a repeat of 1974-1982. Lots of volatility. Very large run-ups followed by quick and vicious sell-offs on the way back up to new highs. This is NOT going to be a recovery back to new highs in two years. This is going to take a long time. Further, I don’t think nominal GDP will be 6% for the next three years, for reasons stated last week.

Investors are going to get their hearts broken by their favorite companies time and time again. The economic news will not be good for another year at a minimum. This is not the stuff that wild bull markets are made of. That time will come, but it is not yet.

That being said, I am a believer in American business. They will figure out how to maneuver and prosper in this new environment. In 12 years, earnings will have doubled from the trend of last year, which suggests earnings could be $140 in 2020. Put a multiple of 20 on that and we have an S&P 500 at 2,800, up over 3 times from today. That is the long view.

How Should We Then Invest?

Am I personally a buyer today, like Buffett? No, as I think that in a secular bear market you should see absolute returns rather than the relative returns of passive index investing. And, I think there is more pain to come in the market. But there are opportunities other than index funds or long-only mutual funds. So, where should we put money to work today?

1. While I don’t want to be long an index fund, if you are a stock picker (as Buffett is), then there is value out there. And if I am right and there is some more downdraft in the markets, then there will be more value in the near future. This is not a time for hope, it is a time for conviction. I wrote several long chapters inBull’s Eye Investing on value investing. Vitaliy Katsenelson recently wrote a book called Active Value Investing. It is a good guide.http://www.amazon.com/Active-Value-Investing-Range-Bound-Markets/dp/0470053151/ref=sr_1_1?ie=UTF8&s=books&qid=1225134991&sr=1-1 Take your time. There is no hurry. But start your analysis and research now. 
   
2. I like active absolute return managers and investing. In particular, I like actively managed commodity funds which have a bias for volatility. Note: this is NOT an endorsement of long-only commodity index funds. Also, there are a small number of active managers who have demonstrated an ability to navigate this market. As Buffett says, it is not until the tide goes out that we know who is swimming naked. We now have a MUCH better idea of what volatility can do to an investment manager and his systems, and who understands the meaning of the word hedge. 
   
3. It is somewhat heretical to say it in this market, but there are specific styles of hedge funds I like. We are seeing the gut-wrenching demise of many black-box quantitative hedge funds. Hopefully, investors have learned their lesson. There is no free lunch. However, I think that long-short hedge funds (and the few mutual funds that use that style, like John Hussman’s) will once again find an environment in which they can prosper. If you want to be in the market, this makes a lot more sense to me. 
   
4. I think that sometime next year it will be time to really think seriously about emerging market investments. Those markets have in general been beaten down far more than the developed-world markets. And the developed world is going to be growth-challenged in respect to emerging markets. You can find some real value. As an example, the largest liquor distributor in Thailand now pays an 8% dividend. Why? Because it was a large part of Thai index funds, and foreigners unloaded those funds in the current sell-off. And while Sweden can hardly be called emerging, last Thursday institutional investors were talking about the value there as foreigners have fled their markets, pushing values down.
   
   Now, here’s a rule. Write this down. If you are going to invest in an emerging market, make sure it is with someone who knows that local market. I do not want to have a manager with the name of Smith sitting in New York looking at a computer screen investing in Thailand for me, and neither should you! You need someone who understands the local scene.

 

5. Income is going to be critical. If you are going to put some money into bonds and other fixed-income instruments (not funds!), you should be doing it now. As I have been writing, there are simply steals out there in the fixed-income markets, as the margin clerks are forcing funds and individuals to sell any- and everything. The prices we see today will not be there in six months, and I doubt they will be there in three. If you are a fixed-income investor, you should be buying with both fists. But only if you know what you are doing. This is not the time for on-the-job training. Sometimes those bonds are selling at low numbers for a reason other than liquidity and margin calls. If you are not a seasoned fixed-income investor, then get professionals to help you. For portfolios of over $250,000 I can help you find a manager. 
   
6. As I wrote months ago, we are seeing the rise of a new asset class I call Private Credit. These income and asset-backed lending funds are going to take market share from banks and become a market force of their own. 
   
7. While today may not be the time in all markets, it will not be too long until you will be able to find either residential or commercial real estate at distressed prices almost anywhere, which you can buy and then rent out. Buying real estate at the right price and letting someone else pay down the loan is a proven formula for wealth in many a millionaire household.

In general, your target is not to beat the market. It is to beat zero. As I have written for years, the investors who win in this market are the ones who take the least damage.

Home Again and a New Home

It is good to be home from all my travels. Other than a trip to the Minyanville Christmas party in New York, I have no plans for travel until mid-January and not much more after that, although I know that will change. But it will be good to stay here and focus on writing the next book with Tiffani.

And speaking of home, I lease my abode, having sold my home years ago. I can lease cheaper than I can buy. But we now find in this market we can lease at even much better rates. We can lease a very large home in Dallas and move my office and small staff into part of it, cutting my total office and home payments by about 30-40%. There are several homes we have viewed that have good set-ups for a small office. In a few minutes, Tiffani and I will leave to go and look at the final selections, and we will make our choice. I will miss my office at the Ballpark, but saving one month a year in commute time as well as a lot of dollars just makes sense and cents.

This letter is overly long already, so I will hit the send button. Have a great week and remember, we will get through this.

Your looking for value analyst, 

John Mauldin
John@FrontLineThoughts.com

Copyright 2008 John Mauldin. All Rights Reserved 

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments atwww.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements. 

Why The Worst Will Soon Be Over from Bedlam Asset Management

 

“I’ve seen an elephant fly”, weather forecasts, and why the worst will soon be over It is almost sad for us that the worst of the world’s largest ever bank crisis is just about to or may even have passed its peak. It was fun not to hold any and be thought a crazy, even though if any bank director was asked the right questions, it was clear the system had to fall over. Now that it has, we move on (but still hold no financials). There are other aspects we’ll miss too. The impotence of Politicians revealed — no power to affect the direction of the business cycle, and even less understanding of the economies over which they portentously believed themselves in charge. Who will forget the British Chancellor’s vacant stare whenever asked a simple financial question, even as his eyebrows squirmed like caterpillars in their death throes thus betraying his ignorance? Then there’s the regulators, so far behind the curve it’s embarrassing. No wonder in recent speeches PM Brown announced that he and the Treasury would sort out the banks, even though the role is split between the FSA and the Bank of England. We won’t miss the shocks after combing through the balance sheets of Bradford and Bingley, Anglo-Irish, Northern Rock, RBS, Soc Gen and UBS to discover how weak and sloppy were their business models; and we look forward to illogical panic reactions ending. For in the midst of the largest financial fire in history, more effort has been expended on arguing who is to blame, rather than trying to find the extinguishers. Happy, happy days. Farewell. If you do not weep uncontrollably whilst watching Dumbo (the movie, not the people above), then you have no soul. The climax of the story is that without his white feather he could not fly, and was but a terrified and rather badly drawn pachyderm at the top of the high dive. With a little persuasion however, he realised the lack of his comfort blanket did not preclude him from his destiny, so off he flew. The multiple financial implosions of September and early October reduced governments, central banks and regulators into a Dumboesque, catatonic inertia. Fortunately, the panic in all markets has made them realise that they did have sufficient powers: if not to fly, then at least to prevent an immediate Depression. Thus for the first time this century, there is good clarity on the medium term future, both for the global economy and stock markets. This is one of a steep recession, followed by several years of a mild and stuttering recovery. Surprisingly, this is a good result. The eye of the storm has just passed over As long ago as 1999, a long and thoughtful front page article in the New York Times highlighted the dangers of the world’s two largest mortgage underwriters, Fannie Mae and Freddie Mac. They had just been blessed by the regulators, Congress and President Clinton to tear up the risk book: to offer large and easy mortgage terms to those Americans who could never realistically hope to own a home. This relaxation of prudent lending rules was soon widely imitated, particularly in economies with a property owning mentality. The consequence was a global economic growth chimera, accelerated by the reduction of the dead hand of bureaucracy in third world countries such China and India. This allowed them to achieve far better growth rates. From 1999 onwards the hurricane started to build, moving ever closer to the world’s financial system, obvious even to the man in the street. Yet the near-term gains were so beneficial to individuals and government budgets that every Finance Minister threw prudence down the well. Chancellors even became popular. Bizarrely, the only people who did not recognise the inevitable were the regulators, senior bankers and fund managers. In 2007, the storm ripped into the banks. There was a brief calm as the eye came overhead, within which complete regulatory and political paralysis developed, even as institution after institution imploded. Now the eye is passing; we’re back into the other side of the storm. Initially the winds will be extreme, but each crisis will be a little less than the one before. It is the best possible outcome, for the alternative was an immediate vertical drop into a deep economic Depression. This would have made the 1930s look a picnic. The ‘positive’ alternative may not seem that glamorous as many small countries are already in recession and the major ones will follow before the end of this year. Yet this recession will be a 45 degree slope, not a 90 degree fall. This is because the correct response is now in train. It means that as early as 2010, a stuttering recovery could commence. The British solution goes global? It is a great surprise that three small islands off North Western Europe have been the cause, and the cure, of the crisis. It was Ireland’s emergency guarantee of all deposits which set off the nuclear reaction: risible, because its blanket nature covering all deposits for its six banks worked out at $576bn, nearly three times gross domestic product, $130,000 per head or $200,000 per person in employment. Within these numbers was a sub-liability of nearly $50,000 per head over foreign deposits, mostly British. Despite now excellent Anglo-Irish relations, if these guarantees had been called, they could never have been paid. Immediately Germany, Spain, Greece and smaller countries followed suit. Mildly anti-EU British politicians then peculiarly started to bleat about supra-national solutions - an impossible dream - and did nothing. More sensible foreign leaders reacted nationally to the inevitable consequences of their electorates seeing their local banks disappear in a puff of smoke. Fortunately, market mechanisms then kicked in. Large British deposits were being sucked out, into unreal Irish bank guarantees at an alarming rate. Meanwhile in Iceland, the third offshore island, the entire bank system finally decided to die. Although this was assured much earlier (see Pick of the Week No. 48, “Abdul and Jorvik Go Shopping”), it had staggered on for a surprisingly long time. The twin Irish/Iceland events resulted in dramatic falls in British asset prices and even worse gridlock in the lending markets. Outflows to Ireland were swiftly followed by a sudden realisation that simply idiotic deposits worth over £5bn had been placed into hopeless Icelandic-owned institutions and were about to disappear. Depositors included over 100 UK local government authorities as well as unwise financial intermediaries. Without warning and in a single bound, the British governing class leapt from narcolepsy to sprinting at gold medal speed. The key change has been the rapid implementation of the most comprehensive bank bail out package ever seen. It should work, because it addresses the overlapping problems of too little Tier 1 capital, the fear of bank counterparty risk, the inability to roll over corporate loans and the risk of deposit flight. The result is state directed capitalism. It has lead to howls of outrage across the investment and political spectrum, from the purists who believe market forces should be allowed to work themselves out, to the mob baying for capitalist blood. The cacophony of noise and finger pointing will continue for many years, but both arguments are irrelevant. They are based on old rules. For just as in war habeas corpus and other rights are torn up, so in a financial meltdown the old rules are shredded. The British decision has been to save the core of the national banking system and create a more realistic structure than the blanket guarantees of Ireland. The sums pledged are large enough to meet all the capital required to support the capital of each major domestic bank. The use of high yielding preference shares and permanent income bearing securities is likely to mean the government may end up owning perhaps a mere quarter of three to six banks, yet its ability to control them all, and their lending, is a certainty. This multiple approach is already being favourably viewed in other countries; it is speedy, cheaper and turns the all-important psychology from one of utter despair to merely gloom. It is more effective, and overall less burdensome on the taxpayer than any other solution. In the UK and elsewhere, the previous drip feed of liquidity into the markets, started by Mr Paulson in the US, simply proved the law of diminishing returns. Ever larger funds had to be provided to produce ever weaker results. To be fair, the unique (so far) British solution is almost the same as Mr. Buffet’s bail-out of Goldman Sachs. His very high yielding preference stock and presumably many other strings must have provided a guide. Britain’s Treasury mandarins had also dusted off and absorbed the lessons of earlier French, Swedish and Japanese models. The result is a more effective hybrid. Since President Mitterand nationalised the banks in 1980 (later part re-listed), France has had state directed capitalism dominated by three banks. Inevitably these are ponderous and suffer poor shareholder returns, but in a whacky way, the system works. In Sweden, the necessary nationalisation of anything with ‘bank’ on its nameplate also proved effective; although the stock market did not recover for 18 months, the economy managed weak growth in almost every quarter. Japan’s Resolution Trust Corporation initially failed because the government dithered for six years after the 1990 crash, before taking any meaningful action. Subsequently, vast amounts of debt were issued to hoover up bankrupt banks and duff corporate loans. It worked. We believe that most G7 (i.e. including America) and G20 countries will adopt Britain’s hybrid ruse in the near future; if so, the storm is passing for sure. Foreseeable consequences Some are most unpleasant. The authorities will have little control over these and it would be foolish if they seek to cover every eventuality. Staying with our three islands, one result is that Britain has probably exacerbated the Irish banking crisis; the depositors who fled there for “safety” will soon work out they are better off and better covered in government controlled banks back home. As the new UK rules bite, runs on some mutual groups such as building societies or Spain’s equivalent, the Caixas are likely; in both cases their prime purpose is to take deposits to fund property purchases. Government guarantees do not and cannot extend to such groups. Banks like Santander will be forced to absorb dozens of these local mutuals, as will Commerzbank in Germany. This trend is extant already with the large banks in America. Most major industrial countries therefore will end up with a handful of large semi state banks which will dominate the domestic deposit markets. Other casualties may include leasing companies. With no deposit base, often no overall regulator and dependence on wholesale funding, their future is not exactly bright. More casualties abound in Eastern Europe; many countries there needed to devalue even before the storm hit. Now devaluations are imminent. Elsewhere, several larger countries will have their own particular problems. One we fear for is Australia, ironically because of a very good policy. After Singapore and Chile, it has one of the most logical and best funded pension schemes in the world (curiously, this is a legacy of its most socialist Prime Minister, Gough Whitlam; even more curious, he was ‘deposed’ by the British High Commissioner and Mr Rupert Murdoch in 1975). The scheme is beautiful in its simplicity. From the first day at work, employees and employers put large percentages of salary until retirement into a personal, untouchable pension pot. Tax-free and ring-fenced, these huge flows are managed by a host of competitive and usually efficient ‘Superfund’ managers. Of all reasonably sized advanced countries, Australia alone has ensured that an ageing population will be able to fund itself without drawing down from the state. Yet a flaw has developed. The industry is competitive, Australians are ruggedly entrepreneurial. Personal pensions are portable at the push of a button. Recently, some Superfund valuations have been exuberant. Many have as much as a third of investments in unlisted property, private equity and other opaque vehicles. Often performance seems remarkable: to June 2008 perhaps +20% in a year, usually based on internal valuations. Yet similar investments listed on the public markets have seen large falls in value. It unlikely there’s much, if any, fraud, merely denial and over-optimism. Given Australians are well-educated and financially literate, it seems only a matter of time before some awake and transfer their pensions from the optimistically priced super funds and switch to those whose prices are more realistic, and low. It is the smart thing to do. If there is one lesson from the crisis, it is ‘if there can be a run, there will be one’. Another country is Italy. It seems to think itself relatively safe. Italians (and most Europeans) have shown a hubris over financial implosions in America. It is worth recalling that in absolute terms, and pro rata to national GDPs, European institutions own more of America’s mistructured and bankrupt sub-prime debt than the Americans themselves. Where is it? Too much we believe in Italy. There, opaque bank balance sheets make Japan’s look as clear as glass. The industry is fractured. Like Iceland (but to a far lesser extent), there are considerable cross holdings, mystery nominee companies and asset shuffling by feisty entrepreneurs. These in turn are often highly geared, with a maze of cross-holding debt structures. When the giant hornet of the recession flies into this web, it will simply it snap. Embrace the recession A global Depression is likely to be avoided by a whisker; a fast and vicious recession now is a certainty. Although key forecasts are being revised lower, they still lag this outlook. The IMF’s latest suggestion that China will grow next year by 9.6%, and that the volume of World trade by 4% are but two examples of excess optimism. China will enter a recession, defined as 4-6% growth. At this level, social unrest tends to accelerate. The collapse in commodity imports, from copper to steel, show a slowdown already under way. Another obvious cause is the once insatiable appetite of American consumers, to import at least five toasters and three refrigerators for each home has already ceased. As regards growth in world trade, the 4% forecast is also optimistic, given demand for bulk commodities, such as oil and iron ore, is tumbling. Consumer incomes will be squeezed until the pips squeak, because of correct government actions to focus only on saving the major banks. National budgets are blowing up into huge deficits. The idea that America, the world’s most important economy, is sure to have a budget deficit of 10% of GDP in 2008/9 is simply eye-popping, as is the 40% increase in the last six months in the public sector borrowing requirement in the UK. To finance these giant deficits, governments will have to tax more and spend less. Just as the bank rule book has been torn up, so the global abattoir is hardly large enough to slaughter the queue of sacred cows. In Britain, the burgeoning black hole in of state sector pension funds will have to be minced. Apart from the fact that many have been mismanaged for years (their leap into Icelandic deposits because they were approved by discredited rating agencies, or their belief that the higher the deposit rate, the better the bank, prove the statement), their over-generous terms are now unaffordable. Whether the government achieves this through a wholesale rise in the retirement age, increased taxation on pensions, or a cap on the payout rate like utilities to RPI minus, is a moot point. Another chopper must be taken by all governments to welfare. Although welfare abuse is rampant across Europe, statistically it is worst in British and is both unaffordable and wasteful. As we have reported before, false unemployment statistics have dominated the last decade. Unemployment sank from well over two million to under a million. Meanwhile, those of working age but permanently incapacitated soared from under a million to well over two million. Cute trick. So Britons are the puniest people on the planet, according to officialdom. Aggressive steps will have to be taken to prune the number, if only because of the certainty that unemployment will rise, thus busting the budget even further. State directed capitalism must emerge with heavier-handed, state monitoring of its population. Whilst liquidity and lending will gradually improve, governments will want to rebuild ‘their’ banks’ balance sheets as fast as possible. Globally, official interest rates will be slashed; the unusually co-ordinated cuts earlier this week by six major central banks is but the start. Lending rates however, will stay high thus increasing the margin between deposit rates and the price of loans. Fees will also soar, such as new extra charges in most economies for arranging a mortgage. Many did not exist at all even a year ago. Credit card companies will lower credit limits to individuals, irrespective of true personal wealth, as their imperative has switched from maximising profits to minimising losses. Only the best personal balance sheets will get decent-sized limits. If individuals cannot obtain credit, they are forced to save if they want to buy a new car, or a home. In the 1970s and early 1990s recessions, savings rates in advanced countries rose dramatically: in Britain from 2% to 12%, in America a slightly smaller rise. 12% again seems a good educated guess, especially as the starting point is record low savings rates (-1.1% in the UK for the first quarter). Thus the impact on retail economic activity is dire. As governments tax more and cut expenditure, and the consumer is forced to save, this is why for 2009 we pencil in at least two quarters of serious GDP contraction for the UK, US, Spain, Australia, Ireland and Italy. Unforeseen consequences We did not expect that within two weeks of a financial meltdown, Russia would have achieved a key military ambition. As four Scandinavian governments dithered over supporting their fifth cousin a window opened, in through which Putin flew like Count Dracula, with a $4bn lifeline to Iceland’s government: “no strings attached”. Oh yes? Russia in Europe has always been “choked”. The Black Sea/Bosporus ext is tricky. Large naval vessels can leave Petersburg but the Baltic straights too, are narrow. Hence much of the fleet is in the only other port, Murmansk. Even from there, the problem has been that to get the navy into the North Atlantic, it is blocked by other straits such as the English Channel. In 2005/6, NATO schizophrenically decided to poke Russia in the eye by putting missiles along its European border, and also to close its Keflavik Airbase in Iceland (although there are still a few odd American planes there). It has handed Russia at worst a neutral sea passage, almost certainly a refuelling base/friendship zone. This makes us slightly dither about defence stocks. They look cheap but historically in recessions, governments have slashed military expenditure. The UK could cut back its still quasi-imperial ambitions and become a Belgian-type power. Even so, across all Western Europe, so antiquated are many armaments and so poorly equipped many of the troops, it may be that defence, usually the first cow to the slaughter is actually fattened up instead. America too has usually slashed defence budgets in previous recessions, and could do so now. Any one of the 14 battle fleets has more fire power than the entire Chinese navy. The totality of America’s naval firepower is nearly 60% of the entire world’s navies combined; such overwhelming superiority is unnecessary in terms economic expenditure or national security. Yet operating in two oceans, with Russia sending off a fleet to Venezuela in one (we’re amazed the rust buckets got there at all) and a Chinese naval building programme which is accelerating, we suspect America’s military will continue to claim its full funding. So too wills NASA: rocket launches already planned from Asia will allow more communist cadres to peer down at Houston from space than ever before. This is not going to be popular. This is cheerful? For all these imponderables and uncertainties, investors can start to do that ‘light at the end of the tunnel’ thing. If the hurricane had hit in 2005 or 6, the damage would have been less; but this is spilt milk, move on. The light is that correct actions are now in train. Many savers will still lose money in those weaker institutions which the governments have rightly decided to sacrifice, to preserve the core of the system. It will be unfair and unpleasant, but the right action. More important is that just as banks in each country will consolidate down to a core handful, so the same will apply in many other sectors. Consolidation is the new trend. Normally the advice would be to buy small bombed-out niche companies with good businesses, knowing that giant multi-nationals, most of whom have surprisingly strong balance sheets, will be buyers. However, the number of already wounded, as their banks reduce or refuse to roll over their loans at all, mean these multi-nationals can be very picky, and wait. Just as government-induced bank consolidation ensures their balance sheets should recover far faster than had there been no intervention, so more voluntary consolidation in other sectors will have a similar result. Consider the semi-conductor industry (if only for a moment). It is about to be obliterated. Huge over-capacity and rapidly tumbling demand. By as soon as end 2009, it is a good bet the number of manufacturers will have halved. Their profit cycle will then boom. Consolidation in pharmaceuticals has already started, one of the few sectors with very strong free cash flow and growth. In telephony, the parasitic companies are about to be sprayed with DDT. These lived off the incompetence of once state owned incumbents to move into the mobile market and almost universally, are highly borrowed, rely on ever-available bank credit and ever-rising sales. The consumer always foregoes trips to the cinema or theatre in a recession. This time he will hunker down in front of his broadband-fed, all singing and all dancing pc/TV/call-centre/work station. Only the ex-national monopolies can proved this service, the rest blow away like chaff. Despite consensus forecasts for corporate profits in 2009 being still way too happy — we are pencilling profits ex the banks for the MSCI World Index in 2009 of minus 9% - the return to an almost forgotten world of national and international cartels to reboot the economic cycle may well ensure that after a steep recession, a return to mild profit growth may be none too far away. The ‘death’ of free markets is sad: for a while we were all rich, it was fun and you didn’t have to work much either; just own a house and a lot of debt. The imminent brave new world of state directed banks and cartelisation of sectors is inherently corrupt and less efficient, but should work. It is certainly the least bad solution for us all; yet this very different and cartelised world could be rather interesting, and profitable. Although indices have every chance of a roaring bounce soon, in 2009 many will sink again. Even so, too many large company valuations are already forecasting a Depression. We think state owned banks are temporarily rather a good idea, and many company valuations look pretty interesting, especially versus bonds, property or even cash. Growing huge ears or sticking a white feather up your nose is another option, but not advised.

John F. Mauldin johnmauldin@investorsinsight.com

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The International Currency Crisis

by Dennis Gartman, Gavekal, and Wolfgang Munchau

First, from Dennis Gartman:

The dollar and the Japanese yen reign absolutely supreme as the world continues the rush to exit from the EUR in whatever form it now holds them. Stock markets around the world are imploding it seems, and as they do, “risk” in any form is being unwound, forcing the Yen/EUR cross to move several “Big Figures” in the shortest span of time we have seen in our years of trading. Only in the “Russian/Emerging Markets Panic” in August of several years ago have we seen movements such as these. We stand in awe and we stand in fear.

 

Thus to begin, we say here this morning, mincing no words whatsoever, we are more frightened now for the future of the global capital markets than we have been at any time in our thirty+ years of watching, commenting upon and taking part in them. We are fearful… and we mean this fully… that we have passed the tipping point; that things are now spinning out of control; that forces have been unleashed that cannot be stopped without some truly massive, truly strong-handed, governmental action including the closure of markets and limits upon bank withdrawals, et al. These are troubling times, and our fear is palpable and growing. Worse, these concerns are giving rise to the likelihood that the Left shall be in ascension, and that manifestly left-of-centre, interventionist government lies ahead here in the US and in Europe. Higher, rather than lower taxes will be the end result. Greater… indeed very much greater… intervention in the capital markets lies ahead. Trade and act accordingly.

 

To put things into proper perspective, it is reasonable to see the Yen/EUR cross move within a 1 Yen range, high to low in any twenty four hour period of time. Beyond that, the situation becomes uncommon. 1.5 Yen movements, although not rare, are unusual, and 2 yen movements in the cross as “Black Swans” indeed. Now, it seems the world is filled with black swans, looking about for the few white ones that remain, for the Yen/EUR cross, having closed near 144.50:1 on Friday afternoon… which was already rather weak for the cross was trading 156 only a bit more than a week ago…is this morning trading 140.50!

 

We have long said that this cross relationship is the barometer of the relative health of the global capital markets, for over the course of the past several years as risk was embraced Mr. and Mrs. Watanabe would sell their Yen holdings and “swap” them for investments abroad that might return them more money. At the same time, foreign non-Japanese investors were very willing to borrow in Yen terms, take that low cost capital outside of Japan and invest elsewhere. This was the “Carry Trade” and it was one of the driving forced in the global capital market. Hedge funds around the world employed the “carry,” borrowing cheap Yen and investing into anything, anywhere around the world where the returns were larger. Once confidence began to ebb, however, and once the losses on the carry trade itself began to wane, the pressure upon those exposed grew.

 

Now, not only are those who borrowed Yen and bought EURs, or Aussie dollars, or Russian Rubles, or gold, or equities anywhere around the world, or debt securities of almost any kind, finding that they are losing money on the “cross” itself, they are losing more and vast sums on the investments they made. It is horror story writ large and getting larger.

 

Is there any fundamental investment reason to be bullish of the Japanese Yen? No there is not. The demographics of Japan are horrid as her population ages and begins to actually decline. We have written often of this demographic time-bomb that is exploding consistently over time in Japan. The country’s population is imploding and it continues to do so despite government policies aimed at changing that trend. However, once demographics as consequential as what is happening to Japan become entrenched, time… and very, very long periods of time,… decades certainly; centuries perhaps… are needed to reverse the course.

 

Thus, the only thing driving Yen higher is the panic liquidation of the “carry trade.” This unwinding has been going on for several months, having begun in earnest in July when the cross touched 170:1 ever-so-briefly. It took years to build the trade up as Yen was borrowed and the EUR bought since the turn of the Millennium. It may take months yet to unwind these years of accumulation. The process is not pretty. The damage wrought is enormous. The panic lies still ahead.

 

Moving on, the unwinding of the long EUR/short Yen cross is being made all the more dramatic as investors find reason to shun the EUR and investments in Europe generally as confusion regarding the EUR’s future has leaped dramatically to centre stage. As we pointed out last week, Dr. Milton Friedman once said regarding the EUR… in which he tended to have very little confidence…that he doubted it would last through its first real recession. His fears are being put to test today. The world is testing the very mettle of the European confederation experiment, and investors the world wide are watching to see just how well the officials in Brussels and Frankfurt can resolve their large and growing differences.

 

When the economic weather is mild, the “boat” that is a unified Europe runs pleasantly upon the water. The passengers may be a bit unruly, and they may argue amongst themselves, but their arguments rarely will tip the boat for at least the waters are calm. However, when the waters around the boat are riled, the least bit of unruly activity amongst the passengers is amplified and made serious. When the waters are riled, what would have passed for mere annoyance during periods of quiet become life-threatening instead. We are at that point.

 

The unravelling began last week when Ireland, fearful of a run on its capital markets, touched off by the frightening weakness of her stock market last Monday, moved to guarantee all deposits within the Irish banking system. The other nations of Europe, then fearful that capital would logically rush to Ireland to seek protection, said that Ireland’s decision was at best unwise, perhaps un-European and unconstitutional, and simply downright wrong. They protested. Frankfurt and Paris led the way. Mr. Trichet said that Ireland’s unilateral decision was wrong and that all decisions of this matter should be a pan-European decision, not a parochial one. Confusion, as we have always, said, breeds contempt, and with that confusion the EUR came under assault.

 

Matters have gotten worse… and indeed much, much worse over the weekend, for Germany, having taken Ireland to task only last week, moved to follow Ireland’s lead as Chancellor Merkel moved to guarantee all deposits in Germany. She really had no choice. Acting to stem these swift changes in the European banking landscape, the EU’s Competition Commissioner, Ms. Neelie Kroes, said that blanket guarantees on bank deposits by individual countries within the European Union shall be considered “discriminatory.” Mr. Kroes made her comments on Dutch television over the weekend.

 

Ms.Kroes said that Ireland is moving to change its deposit insurance plan so that it will conform with European rules, although we have not seen in what ways Dublin is moving… or even if Dublin IS moving at all. Were we Dublin, we’d not change, for our first responsibility is to the depositors in Ireland’s banks and to the Irish capital markets, not to depositors on the Continent. Ms. Kroes said that on television that

 

We are now in close contact. My people were in Dublin on Friday and Saturday and returned with reports that changes will be made…. A guarantee without limits is not allowed … [but we expect] that it will be brought into a form for which we can together state that it is in line with the treaty.

Germany disagrees with Ms. Kroes and Brussels, apparently, for a spokesperson for Germany’s Finance Ministry, Mr. Torsten Albig said over the weekend that “The state guarantees private deposits in Germany” while a second spokesman said the guarantee was and can be unlimited. Now that Ireland has moved in this fashion, and now that Germany has followed, Greece has said that it shall also. Others will follow, overwhelming Brussel’s ability to protest Ireland’s and Germany’s decisions, and thus forcing Ireland to take other actions to continue to draw capital to her. Ireland’s Finance Minister, Mr. Brian Lenihan, openly defended his government’s plan to guarantee the deposits and debts of six Irish-owned banks for the next two years and pointed to the panic felt by investors over Irish financial stocks this week. We can find no fault whatsoever with Mr. Lenihan’s position. Were we he, we’d do precisely the same thing… perhaps even a bit faster.

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And from my friends at Gavekal:

Was it just ten days ago that Peer Steinbruck railed at the US for the banking crisis and mentioned that, because of the pneumonia in the US, Europe may well have to endure a cold? Ten days later, a cold seems like wishful thinking. Instead, it looks as if the US pneumonia is inflicting a serious case of tuberculosis across Europe!

In the past ten days, not only have we seen European governments forced to offer blanket guarantees for depositors in banks (e.g., Ireland, Greece…) but we have also witnessed a number of banks coming hat in hands to their respective governments (Hypo Real Estate, Glitnir, Fortis, Dexia, Bradford & Bingley…). Which of course begs the question of what the respective European governments can do? Some (Finland, Holland…) with overall low government debt and small budget deficits, can afford bank bail-outs. For others, whose economies may already be in a recession (e.g., Italy, Spain, Ireland…), financing large-scale bailouts may be more of a challenge. Which brings us back to a long-standing GaveKal theme, namely how the (no) Growth and Stagnation pact (see The European Divergence Trade)  hampers EU governments from taking necessary action in the face of a banking crisis. Worse yet, in Europe, investors simply have no idea who the lender of last resort is, or if there is one. And, as we are finding out, this question is no longer a rhetorical question. After all, if the numbers bandied about by Der Spiegel of a necessary €100bn to recapitalize Hypo Real Estate (and that is just one bank!) are even close to the mark, where will the money come from? As we see it, there are two possible options:

 

The first option is that the ECB prints money aggressively to finance a European-wide bank bailout. This could prove rather inflationary for the Old Continent as wages there tend to be very sticky. It would also entail an absolute collapse in the Euro.

 

The second option would be for the ECB to tell the various European governments that the banking mess is their own problem, and that they have to deal with it. This would most likely entail a continued divergence in the yields at which European governments borrow (currently standing at post-Euro introduction record highs).

 

And this brings us back to a long- standing GaveKal theme: for the Euro to survive, either a) it will have to be a structurally weak currency or b) some of the weakest links (i.e.: Portugal? Italy? Greece? Spain?…) may end up being forced out. The path of least resistance is, of course, for the Euro to a structurally weak currency.

 

Which seems to be where we are heading. Indeed, despite the baffling decision by the ECB to maintain rates unchanged last Thursday, the Euro has been in a serious freefall against the US$, CHF, Yen, etc… Of course, this weakness could also be a sign that the ECB, with its stubborn unwillingness to adjust monetary policy in the face of rapidly changing events, has seriously undermined investor confidence in the Euro area. After all, 48 hours after the ECB board met, the rescue plans for both Hypo RE and Fortis were struggling. Surely, the ECB had to know that two major banks were in dire straits? Or was the ECB board drinking the same Kool-Aid as Peer Steinbruck?

However one cuts it, it is hard to escape the conclusion that Europe is not only experiencing its own credit crunch, but will experience a nasty recession. This recession will put most European government budgets into serious deficits; foreign investors may thus start to question the logic of owning the debt of governments whose balance sheets and income statements keep on deteriorating, and whose currency is free-falling? Milton Friedman once said that the Euro would likely not survive its first major “bump in the road”. We will soon find out. The great “European Divergence Trade” is no longer about theory; it is happening before our very eyes.

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And from Wolfgang Munchau in today’s Financial Times:

This has been a week of self-congratulation in Europe. We have saved a handful of banks. We have, in effect, started to cut interest rates. We even had a summit of European leaders that produced warm words of solidarity. It looks as though the Europeans have reached substantive agreement that no systemically important bank should ever be allowed to fail….The rescue of Fortis and Dexia last week, two large, but not too large, cross-border European banks, should be seen as a sign that our emergency procedures are working. Look, they say, we met quickly and decided what needed to be decided. It was fast and unbureaucratic. We do not need a European rescue fund, let alone any new institutional set-up to deal with this, they say. We can do it ourselves.

I agree that the few ad hoc rescues have worked. But do not fool yourself. They worked because they were the first wave of rescues and because they involved banks such as Fortis - of just the right size, based in just the right small- to medium-sized country where political leaders are sufficiently rational not to hold each other to ransom as midnight approaches on Sunday.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.

What worked for banking rescues numbers one to five may not work for rescues number six to 50 - the estimated number of systemically important banks in Europe. And that number does not include some banks we have already rescued, which politicians judged to be important for their domestic banking system, like Germany’s IKB Bank, but with no European relevance whatsoever. We have been squandering money.

Nor does it include the likes of Hypo Real Estate, which is not even a bank at all….

The Europeans are of course right in their overall ambition not to allow systemically important banks to fail. They are also right in their scepticism about their ability to distinguish between illiquidity and insolvency during an emergency. But I fear we are still well short of a strategy. We might be lucky, and scrape through what could well become the most dangerous month of the crisis so far. If, for example, the credit default swap market were to blow up in the next couple of weeks - a non-trivial probability - we have no plan.

Nicolas Sarkozy, the French president, was therefore right when he appeared to back a €300bn rescue fund. Regular readers of this column will probably recall my somewhat constrained enthusiasm for his economic policies. But this had the makings of a good plan. He ended up distancing himself from it, when it became clear that Angela Merkel, the German chancellor, would not support it. But he was right and she was wrong. Of course, a European plan should not have been a copy of the bail-out that was finally adopted by Congress on Friday. The US plan failed to address the problem of an undercapitalised banking sector. That issue is even more important in Europe where many banks have an extremely weak capital base, with leverage ratios of 50 or more.

Europe does therefore not need any bail-out plan, but a plan that specifically addresses the capitalisation problem. Concretely, three things are needed: the first and most important is money. A sum of €300bn will not cover the EU in a worst-case scenario, but it is a sensible number to start with; secondly, you need a semi-permanent crisis committee empowered to take decisions; and finally you need a strategy to apply symmetrically and based on clear rules about when to recapitalise, and when not.

If you pursue a strategy of taking purely national decisions, you run the risk that at least one government will hit its own financial ceiling before this crisis is over, or that decisions have negative spillovers on the banking systems of other countries. Moreover, you end up with a beggar-thy-neighbour regulatory race, as we saw last week when Ireland and Greece unilaterally issued blanket guarantees for large parts of their banking sector. Last night, Germany was preparing a full deposit guarantee for its own banking system. Last but not least is the risk of violent political setback against a process that lacks transparency.

For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe’s monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.

John F. Mauldin
johnmauldin@investorsinsight.com

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John Mauldin is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; and Plexus Asset Management. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

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The Curve in the Road

The “Bailout Plan” was passed. Will it work? The answer depends on what your definition of “work” is. If by work you mean no more government intervention and no further costly programs and a functioning market, then the answer is no. But there are things it will do. This week I try to help you see what might lie ahead around the Curve in the Road. We look at how the rescue plan will function, see what is happening in the economy, and finally muse as to whether Muddle Through is really in our future. It will make for an interesting, if not very upbeat, letter, so strap in. I would like your promise to not shoot the messenger. I am just trying to give you some of my thoughts as to what may lie in our future. And remember, as you read this, we will get through it. There are better days “a’coming.”

But first, a few housekeeping items. Let me welcome some 200,000 new readers from EQUITIES Magazine. I have recently joined EQUITIES Magazine as a regular contributing editor. My column, Back to the Frontline, is featured in both their print publication and at equitiesmagazine.com. I am excited to be associated with this esteemed magazine with a rich history covering the global markets for over 57 years.

They’ve once again agreed to offer any reader of mine a free subscription to EQUITIES Magazine. For those who did not take advantage of the free subscription the first time, here is your chance. You can go to http://www.equitiesmagazine.com/mwi    and simply register to get the magazine sent to your home or office. There is also a link to an interview I did in April with them. They have a lot of content and free resources like “live” real-time stock quotes and “live” real-time portfolio managers. Check it out!

Second, a quick commercial. There are managers who are successfully navigating these markets. If you would like to learn more about who they are and how you can put them to work for you, my partners would be delighted to introduce them to you. If you are an accredited investor (generally, net worth of more than $1.5 million), please go to www.accreditedinvestor.ws, register there, and my partners in the US (Altegris Investments) or London (Absolute Return Partners) will show you various alternative investments like hedge funds and commodity funds which might help diversify your portfolio. You really should see what is available behind curtain #3.

And for those with not quite that amount of net worth, I work with CMG in Philadelphia. They have developed a platform of money managers who can take direct accounts, and I recommend that readers interested in outside money management take a look at them. If you would like to talk with Steve Blumenthal and his team about the managers on the platform, simply click on the following link, fill out the form, and they will call you.http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

(In this regard I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA. And please read all the risk disclosures.) And now, let’s jump in to the letter.

The Curve in the Road

When you are out driving on a strange new road, you can’t see around the curve ahead. But you can read the warning signs to get an idea of what might be coming. And while we can’t really know how the developments in the economic world will actually unfold, there are some signs we can point to that might give us a few ideas.

First, let’s look at the “rescue plan” as passed by Congress. As I pointed out last week, this is a bad bill. But it was necessary to pass something, and soon. Earlier this week I sent out a report that reviewed a study of 42 major baking crises. The conclusion: navigating them successfully depended upon quick action.

As everyone should know, the credit markets are almost completely frozen. LIBOR is bid only, no offers. Commercial paper markets are imploding. And what is trading is often at rates that are much higher than they were a few months ago. Corporations are being strangled on high rates. Corporations have little or no access to normal credit markets, and they will face massive problems when it comes time for them to roll over short-term debt.

LIBOR has gone crazy. This is not an orderly market.

 

Look at the following chart from friend Greg Weldon. For most readers, the commercial paper market is something you don’t think about. But it is the lifeblood of business. We have seen this market drop by almost 30% in a year and by 10% in just the last three weeks! I simply cannot overstate how serious this is. Left unchecked, business activity in the US would soon slow enough to bring thoughts of the Great Depression. It will not be left unchecked.

 

 

The credit crisis is not simply a Wall Street issue. It has fast become a Main Street issue. And Main Street is where jobs are created and maintained.

As I have said repeatedly for months, the problem is that financial institutions are having to deleverage. They have massive losses and simply have to raise capital in order to survive. If you can’t raise equity capital (and most can’t), one of the ways you do that is to make fewer loans and to take less risk. You also charge more for the loans you do make.

Larger institutions cannot raise capital on competitive terms. GE is an AAA-rated company. Yet they had to pay Warren Buffett 10% to get $5 billion, plus in-the-money warrants worth at least another 10%. Buffett is likely to double his money on this deal over 4-5 years. A short while ago, GE could get short-term commercial paper for a few percentage points. That difference is going to significantly impact GE’s bottom line. But they had no real choice. They took the money.

As did Goldman Sachs. Yet another Buffett $5 billion preferred-share purchase (with more warrants) at a rate that even Goldman will find it hard to make money on. But they had to raise capital quickly, and they had little choice.

I had lunch with Michael Lewitt and Joe Harch yesterday. They were in town to meet with a client, and we took the opportunity to get together and share notes. They run (among other things) a collateralized loan obligation fund. They buy bank and corporate debt. They now have the opportunity buy well-collateralized loans from rated companies at prices well below par. They related story after story of debt from quality, highly rated companies selling below $.90 on the dollar, and some much lower.

If GE and Goldman are paying 10%, what do you think it costs a firm with “only” a B rating? 15%? More? Junk bond yields have simply gone ballistic. Firms which used the credit market to access capital now are simply shut out. If they are a small public company, they can go to what are known as PIPE hedge funds (Private Investment in Public Equity) and sell equity at usurious rates (which is what Buffett does but on a larger scale). But a small or medium-sized private company? It is a hard time to go looking for money.

Left alone for the markets to work out, the economy of the US and the world would be in a depression within two quarters and would need years to recover. Think Japan.

Necessary but Not Sufficient

Now for the bad news. The Rescue Plan was necessary but not sufficient to fix the crisis. There is going to have to be more heavy lifting, I am afraid. Let me offer a few ideas about what possible actions might be taken in the future. I am not advocating these actions, I am simply telling you what might happen. These are possible, because authorities will do whatever they deem necessary to avoid a systemic economic meltdown and a potential depression.

If you are a large investor or sovereign wealth fund which put money into banks last year, you are down anywhere from 35-50% (unless you invested in Washington Mutual, and then you are down 100%). You are unlikely to invest more in any financial institution without some very real understanding of what is on the balance sheet of the bank that is asking for your money. What the Paulson plan potentially does do is remove the questionable debt. The bank may have to write down assets in order to sell the debt to the government, but they end up with a transparent balance sheet with hopefully known risks. Then they can go to the market and try and raise capital. Shareholders will get diluted. Such is the way of the world.

Sidebar: taxpayers really must demand that someone like Bill Gross of PIMCO and/or other savvy market specialists run this new government operation. He offered to do it, and I think we should take him up on his offer. Taxpayer losses should be kept to a minimum, and I believe someone like Gross would do his best to see that would be the case. The point of this exercise is to restart the frozen credit markets, NOT to bail out banks. Some banks may get bailed out in the process, but it should be at a cost to their shareholders and management, not to the taxpayer.

I am asked, why can’t private money solve the problem? Because there is simply not enough private money. Buffett offered to take 1% of the new government pool. If that is all the largest pile of free money in the world can take, why does anyone think there is enough private capital to take the other 99%? Insuring the mortgage bonds is not sufficient, because there is not enough money to buy them in this market. When things have sorted themselves out in a few years, I think the bonds can be insured and sold, and likely at a profit if bought correctly. But we do not have the luxury of waiting a few years.

Between the relaxation of the mark-to-market rules and removing ambiguously priced loans from financial institutions at prices which allow the government pool to make a small profit, if held for five years, that part (the lack of a known price) of the problem can be solved. Banks can hopefully buy themselves time in which to work their way out of the problems they created.

It is much like 1982, when every major US bank thought it was a good idea to loan lots of money to Latin American countries. It was a most profitable business, right up until the countries decided to default. Then every US bank was more than just technically bankrupt. In a mark-to-market world, every large US bank would have collapsed. It would have been the end of the world as we knew it.

What did they do? The Fed let the banks keep the loans on their books at face value. Over time, they worked their way through the debt, making enough money to be able to write down the loans. That was done simply to give the banks the ability to buy time.

We are in a very similar situation. We have to buy some time in order for financial institutions to heal.

Why the Government Had to Step In

I had a lot of readers write me very nice letters this week, starting out with how much they like my letter, my insights, etc. Then they (mostly - but not all - and politely) launched on me for backing the rescue plan. Many of you had much better ideas than what was passed by Congress, which is not surprising.

I really do hate the idea of having to support a rescue plan. It goes against my every instinct. But I also know that doing nothing would result in an economy which would blow right through 10% unemployment within a few quarters, and take years to recover. The stock markets and the savings of millions of retirees would be wiped out. Home values would really go into a tailspin. Being right in theory is not worth seeing that kind of devastation.

Herbert Hoover sat by and decided to let the market solve the problems of 1929. He decided to run budget surpluses and ignore collapsing institutions. Combined with disastrous Federal Reserve policy (raising rates in a recession) and Smoot Hawley (which caused major trade wars and a slowdown in global trade), what should have been a serious recession turned into the Great Depression and resulted in the conditions for World War II.

The rescue plan does not address the need for the increased levels of capital needed by banks. As noted above, it simply creates the conditions under which capital might be raised. Banks have already raised $440 billion. They have written down $590 billion. Losses are estimated from a mere $1 trillion to as much as $2 trillion. About half of those losses would be in banking institutions worldwide. That means anywhere from $200 to $400 billion more must be raised in order for banks to get back to capital adequacy. It is probably closer to the latter number.

Until banks are adequately capitalized, they are not going to be able to do normal business lending. Further, large deposits are fleeing banks. Even with the new level of $250,000 of FDIC insurance, there is $1.9 trillion in uninsured deposits. These are mostly deposits of small to large businesses and financial institutions, which can leave a bank at the push of a button.

Nouriel Roubini tells us that there are 800 billion dollars deposited in US banks by foreign counterparties. Up until this week, if you were a foreign operation, would you rather be in large money-center US banks or European banks? Tough choice, but on balance you would pick the US. Then this week Ireland decided to simply insure every deposit in Irish banks, no matter the size. Predictably, money started flowing from all over Europe into Ireland. National banks and finance ministers are furious with Ireland.

However, Ireland may have no choice but to backstop its own depository institutions to keep them from losing deposits and becoming insolvent from a bank run by corporations acting in their own best interests. Belgium, The Netherlands, and Luxembourg each took 49% of their respective parts of Fortis Bank in return for a massive injection of capital, declaring the bank too big to fail - also wiping out a lot of already diminished shareholder equity. Europe has its own quite serious problems.

But what if the various countries, one by one, decide to guarantee deposits in order to protect their own banks? If you are an international corporation, especially if you are outside the US, do you want your $10 million in Europe or the US if Europe guarantees your deposits with no limit? Could we see silent runs on US banks?

I think it is about an even chance that the government will have to guarantee for a period of time (say 6 months to a year) every bank deposit, regardless of size, in the US.

That is a staggering thought. The potential will be large for almost-insolvent banks to pursue risky behavior to try and work their way through problems. If such a policy is pursued, tight controls must be administered so risky banks do not offer high CD rates in order to garner assets. The FDIC must closely monitor such activity. Perhaps such guarantees should be for existing depositors and not new customers. Insolvent banks and those on the edge must be shut down quickly in such an event, to prevent risky behavior.

Unthinkable? I bet you there is a working committee of government and Fed officials thinking about just that very thing and how to do it. It would be even more scary if there is not one. We are in completely uncharted waters, and every contingency needs to be thought through well in advance. We simply don’t need more last-minute Paulson plans.

In the next few weeks and months, I think you can count on more extraordinary actions by the Fed and Treasury to try and jump-start the credit markets. Actions which were highly improbable a few months ago will be on the table. Will the Fed open its balance sheet to non-banks? Possibly. If they can guarantee money markets, will there be a scheme to insure commercial paper at some price? Not out of the question. Will European governments take more equity in large European banks? Very likely. Will the Fed and/or the Treasury invest even more capital in larger financial institutions? Given that We the People now own 80% of AIG and 100% of Fannie and Freddie, it is certainly within the realm of possibility that we will be the proud owners of even more private institutions.

Again, this is not just a US issue. We will likely see similar actions in Europe and some of the developing world. This is a worldwide crisis, and the response will be from central banks all over the world.

Understand, I am not advocating these actions. I am simply trying to help you understand what actions might be put into place by the various government of the world in an effort to avoid systemic economic collapse.

All The King’s Horses

The reality is that the rescue plan does not fundamentally alter the US economic landscape. There can be no doubt we are in a recession. I think it will be dated from the beginning of the year, notwithstanding the odd 2^nd quarter growth. The manufacturing ISM was a dismal 43.5 (under 50 means a contracting US manufacturing industry). Such a level is typically associated with recessions, as the chart below shows. Given the financial crisis and the freefall in auto sales, this index is likely to fall further.

The “good news” is that the service portion of the economy is right at 50, which means that at least that important area is not contracting.

Unemployment rose by 159,000, with nearly every sector affected. Almost 1,000,000 jobs have disappeared over the last 12 months, and it is likely that we will lose another 1,000,000 jobs in the coming year. Since December, the ranks of the unemployed have grown by 1.8 million, and those not in the labor force but wanting a job by 370,000. Almost 3/4 of the increase in the unemployed have been job losers, with half the increase from permanent job losers (not temporary layoffs). (The Liscio Report)

Next week we will explore the economic landscape in detail, but let me provide a few thoughts. As I have said for a long time, we will be talking about deflation this time next year. Recessions are by definition deflationary events. Given that we have had two bubbles burst (housing and credit), there is even more potential for deflationary pressures. Add into the mix the deleveraging process, which will take years to finally abate, and the recent bout of price inflation caused by energy and food will pass, as demand destruction for oil will hold oil prices in check.

As I have said for a long time, the next move of the Fed is likely to be a cut. We are now close to such an action. A 1% Fed funds rate is again a real possibility. I am not sure it will help as much as some market participants think, but I think it likely the Fed will move before the end of the year, if not much sooner.

Europe and Japan are also probably in recession, and it is likely we are going to see a worldwide global slowdown. It would be nice if the European Central Bank, the Bank of England, and the Fed could coordinate a joint rate cut to signal that they are working together on the problems. I would not want to be short the markets that day.

At the beginning of the year, I was predicting a small recession with a lengthy and slow recovery period. I now think that the recession could be deeper than a 1% contraction. I think we could see a rather lengthy recession. Quite simply, the credit crisis has been allowed to spin out of control. That Congress almost failed to act is beyond belief. Given the above circumstances, it is not out of the realm of possibility that a recession lasts through the middle of 2009. As recessions go, that is a long time. But trust me on this, it will pass. The recovery will be a slow Muddle Through affair, though. It will be a few years before we are growing at a sustained 3%. Over the next few weeks, we will look at what that means for earnings and the stock markets. Investors who utilize a traditional 60% stocks, 40% bonds portfolio are not going to be pleased. We will look at alternatives.

Stay tuned.

How Can I Be 59?

This has been a particularly hard letter to write, as I know it is rather gloomy, and I wish had more encouraging news. I have been writing this letter for over eight years. Every letter since the beginning of 2001 is in the archives, so my record is open for inspection. I have no particular axe to grind. Since I basically help investors (in conjunction with my partners) find investment managers and funds, we can adjust the choice of funds and management ideas to suit the times, and frequently do make changes in the mix. My goal in this letter is to help us all think about the economy and our investments and to be as “right” as I possibly can. Sometimes, like today, that means not being very upbeat. But it also means looking for ways to go with the tide rather than against it. I actually hope I am wrong and the bulls are right. But that is not the way I see it tonight.

Tomorrow is my birthday. The years seem to roll by at an ever accelerating pace. (I had the reason this happens explained to me once. When you are 10, a year is 10% of your life. When you are (sigh) 59, it is 1.6% of your life. It makes some sense.) It is hard to believe I am 59. Maybe it is because I am around my kids so much, but I don’t feel that old. Seven kids from 31 to 14 (plus assorted spouses and their friends) can do that. And they are all coming to town to celebrate next weekend, so tomorrow will be a quiet day. And Tiffani is already planning for a serious 60^th birthday weekend next year.

Life has been good to me, for all its ups and downs. And I firmly believe that my best years are ahead of me. I am simply having more fun than at any time in my life, with more opportunities than I know what to do with. I am blessed with great business partners. I have the best readers of any analyst anywhere. One million closest friends. I am truly one of the world’s wealthiest men when it comes to friends and family, and at the end of the day that is what counts.

Thanks for being part of my life. I plan on writing for a long time, so take care of yourself so you can keep reading. And have a great week!

Your actually optimistic analyst, 

John Mauldin
John@FrontLineThoughts.com

Copyright 2008 John Mauldin. All Rights Reserved 

Note: The generic Accredited Investor E-letters are not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for accredited investors who have registered with Millennium Wave Investments and Altegris Investments atwww.accreditedinvestor.ws or directly related websites and have been so registered for no less than 30 days. The Accredited Investor E-Letter is provided on a confidential basis, and subscribers to the Accredited Investor E-Letter are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private investment offerings with other independent firms such as Altegris Investments; Absolute Return Partners, LLP; Pro-Hedge Funds; EFG Capital International Corp; and Plexus Asset Management. Funds recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements. 

 

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John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore 

To subscribe to John Mauldin’s E-Letter please click here: 
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If you would ALSO like changes applied to the Accredited Investor E- Letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com 

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. 

John Mauldin is also president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of John Mauldin. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. 

Thoughts from the Frontline
1000 North Ballpark Way, Suite 216
Arlington, TX
76011 

 

 

 

You have permission to publish this article electronically or in print as long as the following is included: 

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore 

To subscribe to John Mauldin’s E-Letter please click here: 
http://www.frontlinethoughts.com/subscribe.asp 

To change your email address please click here:
http://www.frontlinethoughts.com/change.asp 

If you would ALSO like changes applied to the Accredited Investor E- Letter, please include your old and new email address along with a note requesting the change for both e-letters and send your request to wave@frontlinethoughts.com 

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. 

John Mauldin is also president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. All material represents the opinions of John Mauldin. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. 

Thoughts from the Frontline
1000 North Ballpark Way, Suite 216
Arlington, TX
76011