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林森池的投資十戒

2048-01-17T00:01:00.000+08:00

林森池1969年初己涉足香港股市。1972年受聘於英國維高達證券公司（香港分行），成為"在職受訓"（Trainee）證券分析員，對香港上市的股票進行基礎分析。他的經驗值得參考﹕-

一、戒短線急攻近利買賣，不要貪圖蠅頭小利。

二、戒被捲入狂潮的洪流，不要被外來不理性的亢奮，令你跟隨潮流作出投資。例如科網泡沫、地產狂潮等都是好例子，2000年買入科網股，或1997年地產高峰時買入住所，你都會很痛苦。最近，澳門賭業概念股急升，亦是活生生的例子。

三、不要被貪婪及無理性恐懼控制投資決定。股市大崩潰時群眾的拋售，一定會導致你產生恐懼。這時候你要克服恐懼，作出人棄我取，購入「千里馬」。

四、戒買新股。畢非德從不買入新股，這是他的成功要素之一。他作出投資決定前，必須分析公司過往的業績。

五、避開所有衍生工具，林治和畢非德同樣認為政府要取締衍生工具。衍生工具的經營者，就是天空中的獵鷹，無時無刻窺伺你的小雞蛋。

六、戒聽流言或「貼士」，流言會令人疏於學習，不做自己應做的工作，迷失方向，不從事正確的分析。

七、不要過分分散投資。這個世界「千里馬」不多。過分分散投資，會拖低你的投資回報，好的「千里馬」可能三、五隻已經足夠。

八、不要買落後股。落後的馬匹很難有奇?出現再迎頭趕上，公司股價表現落後，背後一定有其原因，你要細加分析，不要有撿便宜的心態。

九、避開他人的「婚禮」。從過往收購合併的經驗中，筆者發覺很多「婚姻」都是悲劇收場，例如盈科收購香港電訊就是最好的例子。1973年置地收購牛奶，至今置地股價仍沒法回復當年水平。

十、戒有「刀仔鋸大樹」的心態。緊記投資是一門嚴肅的工作，並非「六合彩」的賭博。筆者年輕時也有同樣的心態，認為一家小公司能夠順利發展的話，從小到大的增長過程，會比市值大的公司快，這個概念是錯誤的。

理論上，每個行業都會經歷起飛階段，但當一個行業起飛時，並非所有公司都能在起飛階段得益，從事同樣行業的小公司，在經營方面是有意想不到的掣肘，令到他們比大公司落後。例如大公司現金流充足，在重新投資的時候，規模比較大，所以爭取到經濟效益，增長會較快；小型公司除了面對資金的掣肘外，其他方面如內部監管、管理層的誠信、品牌的建立等，所面對的困難會比大公司為多。「細細粒，容易食」的心態是絕對要避免的。

舉例說，八十年代航運業出現困難，包玉剛系的隆豐投資，可以成功轉型收購九倉，因為公司有足夠的規模，得到銀行的支持。另一家大公司和記洋行，1974 年出現財務困難，但由於規模太大，香港不容許這樣大規模的企業倒閉，所以由匯豐銀行接管，最後將控制權賣給長實，成為今天的和黃。同樣情況，今時今日在中國大陸，國務院絕對不容許中國人壽破產。一旦出現的話，其影響太深遠，社會不能承擔。但是上海地產、歐亞農業，都是可以置之不理的公司，可以隨時人間蒸發，也無傷大雅，損失的只是無知的小投資者。2004年10月20日，《亞洲華爾街日報》透露，投資老將林治亦損手於細價股。2003年林治購入一百八十萬股SafeScript Pharmacies Inc.，相當於該公司8%股權。2004年10月，美國證監會向該公司的前管理層提出訴訟，認為管理層曾經誇大營業額與溢利，股價當然應聲下跌，林治亦措手不及，只有認命。管理層的人事關係及誠信，往往是小公司的無法茁壯成長的要素。

林森池的分析公司的工具 - 八種分析公司的工具

2046-04-19T02:31:00.000+08:00

在網上可以到聯交所的網址（www.hkex.com.hk）索取公司的業績報告、年報及上市文件等。其次，有很多分析比例的定義，可以到以下網址：（www.investopedia.com）找尋
。另一個重要網址是恆生指數服務有限公司（www.hsi.com）。這個網址相當有用，包括了恆指每隻股份在指數里的比重，也可找到恆指的市盈率及息率，及其他指數的數據。
若你不喜歡用計算機，可以從大會堂圖書館或中央圖書館的參考叢書，尋找公司的資料。若真有興趣成為一個專業分析員，或想深入理解財務報告的分析，則要尋找教科書的
協作，一本有用的書是：The Analysis and Use of Financial Statements（Gerald White），這是一本考取CFA的教科書，對一般投資者會苦澀一些，然而這不是必讀的書，
只是當你希望深造時才有需要。
如何利用分析比例來分析公司年報：
（一）市盈率（PE Ratio）的正確用途
市盈率是一個誤導的比率，正確的用法是將市盈率倒轉，將盈利除以市價，得出一個盈利回報。筆者強調要用盈利回報率，不用市盈率，避免混淆。例如市盈率20倍，盈利回
報率則為１/20，即5%的回報。一個5%的回報可以直接與長期債券回報作一比較，不會因為20倍而受到誤導。
市盈率的正確用法，並非用來衡量一家公司的市價是否便宜，正確的使用法，是將市盈率除以公司盈利增長率，得出的係數來比較。例如A公司市盈率20倍，公司盈利增長率為
20%，得出的係數為1。B公司的市盈率為15倍，而盈利增長率為10%，所得係數為1.5。換言之，雖然A公司市盈率較高，但因為有較高的增長率，所以反而較B公司便宜。這就是
（PE/Growth）的用法。
（二）邊際利潤率（Profit Margin）是一個相當有用的指標
這是在選股過程中必用的指標。可以用毛利率或純利率來計算。將銷售額扣除經營成本，得出溢利總額，將溢利總額與銷售額作比較便是毛利率。而純利率則是將股東應占純
利與銷售額作比較。純利率包涵很多不同因素，例如兩家公司從事同一行業，但是他們在負債、機器設備的折舊率方面不同，結果其純利率將會有所不同；毛利率只是比較生
產或運作的毛利，不是比較公司的賺錢能力。毛利率適用於工業類公司，當工業產品已經達到國際水平，標籤化，用毛利率來比較，可以看到公司生產過程的經濟效益。這是
毛利率的作用，相當有局限性。
純利率對投資者更加實用，它反映了公司的借貸及其他成本，也反映了設備的更新及折舊，更反映了稅率等各方面因素，故此，比毛利率全面得多。最好的方法是將同類型公
司整合為一組作出比較，表22是簡單例子。
表22：電訊股的純利率比較
電訊行業 2003年上半營業額 2004年上半營業額 2003年上半純利(RMBM) 2004年上半純利(RMBM) 2003年純率 2004年純利率 (RMBM) (RMBM) 中移動 76,657 86,420 17,469 18,828 23% 22%中電信 74,068 80,217 13,058 14,708 18% 18%中聯通 31,967 39,372 2,385 2,809 7% 7%行業總數 182,692 206,009 32,912 36,345 18% 17.60%

從表22觀察３家中國電訊公司的純利率，可以看到中聯通的純利率是最低的，2003年及2004年上半年都是7%；只及中移動的三分之一。這是響起的警鐘，中聯通在營運方面是
否出現問題呢？在折舊、利息開支是否較其他電訊企業大呢？所以開始便用純利率比較同一行業的公司，可以提高我們的警覺性。稍後於第八篇，筆者分析電訊股時，再詳加
解釋。
分析毛利率或純利率時，要特別留意以下的數種情況：
1.以上海實業作為例子，2004年上半年，其純利大增89%，至9.3億港元，其中大部分來自中芯國際上市時，出售其部分股份所獲得的利潤。反而經常性業務出現倒退，所以要
將這些非經常性的項目剔除，才能夠計算純利率。
2.汽車行業也有些特別情況。例如駿威汽車在年報中的營業額不多，沒有包括與日本本田合作在廣州生產汽車的銷售額。駿威持有這家聯營公司不足50%的股權，以應占盈利（
Equity Accounting）作收入。因此要計算純利率的話，要花些時間在年報的附註中，找出聯營公司的營業額。
3.很多商品行業或運輸行業，像海運或航空事業，他們的純利率波動性很大。商品行業的純利極受商品價格波動所影響，例如石油價格變動對油公司的純利影響。運輸業的固
定成本相當高，所以在逆境時容易出現虧損。在順境時，其純利可以突然大增，令純利率上升。對欠缺穩定純利的公司，純利率這個比例往往失去指標的作用。
（三）回報率
看公司的回報，最簡易的方法是看股東資金回報率（Return On Equity）或者資產回報率（Return On Asset）。股東資金回報率，是將公司純利除以股東資金，資產回報率計
算方法有二：第一是將純利除以公司的總資產；第二是將純利加上利息支出，再除以總資產，後者稱為利息前資產回報率（Pre-interest Return）。利息前回報，是主要用於
某些資本性投資特別大的行業，例如發電企業，因為貸款特別大，若利率的波動對純利出現影響，用利息前回報更能看到真正的經營狀況。
（四）金融行業的回報指標
分析銀行及保險業會用不同的比例，銀行業我們會用壞帳與總貸款相除，（Bad Debt/Total Advances）；保險業有同一類的性質，會用賠償與總保金收入相除，
（Claims/Total Premiums）。還有一個最重要的指標，就是成本與收入比例，（Cost/Income Ratio）。筆者在此不作例子了，因為稍後在分析銀行業時會實際加以運用。
（五）公司財務狀況的穩健性指標
包括負債與股東資金比率（Debt/ Equity Ratio），即將所有長短負債除以股東資金；另外還有經營現金流（Operating Cash Flow），即將純利加上折舊及攤銷，然後減去股
息開支。現金流與資本開支比率（Cash Flow/Capex Ratio）。
（六）資產淨值指標
資產淨值（Net Book Value）最適合用於金融服務業、地產業或其他資源股份如石油、煤及礦產等。這個指標可以在買入股票時與市價作一比較。筆者在分析石油股及銀行股
時，再討論如何找出資產淨值的方法。
（七）收購價的指標（EV/EBITDA）
企業價值（Enterprise Value）與除稅、利息、折舊及攤銷前溢利（EBITDA）相除。企業價值的定義，是公司市值加上負債及優先股，減去現金或現金等值投資。近年分析員
喜歡用這個指標，來衡量公司是否值得投資。這個指標是投資銀行家，用作衡量收購時所付出的估價值，EV等於理論上的收購價。理論收購價與公司的毛利現金流（EBITDA）
作一比較，認為可以在多少年內回本，即毛利可以在多少年內抵消收購價。實際上筆者對此比例抱有很大的懷疑。2000年穆迪投資有一份刊物，批評用EBITDA作指標的不可靠
性。因為有很多行業，像石油業、高科技業等，折舊及攤銷是非常龐大的，需要大量資金來再重新投資新的科技或新的勘探工作，所以這個「現金流」不可視作股東投資的收
入。石油的勘探可能是毫無結果，但其開支則是必然的，因此折舊不可視為公司賺錢能力的一部分。科技的投資與鑽油的情況相似，投資未必有豐厚的結果。
筆者稍後剖析華能國電時，會用這個比例，來衡量華能2004年收購５家發電廠的收購價是否合理。這個指標最適合應用於運作較穩定的行業如發電，其設施壽命相對較長，可
以維持15－20年以上，當除稅、利息、折舊及攤銷前收入（即是毛利）能夠在短時間內抵消收購價的話，電廠餘下的運作時間便變成無本生利，提高投資吸引力。
（八）現金流折現法
現金流折現法（Discounted Cash Flow）是投資最常用的工具之一。例如一個地產發展項目，需時多年才能完成，唯一的方法要假設樓宇建築期需要的建築費、利息開支作為
成本之一，然後在若干年後，賣出時所得回來的銷售額，減去這些成本及要支付的稅項，將溢利以折現率，折現成為現時的價值。例如一個地產項目需時５年才能完成，賣出
後扣除建築成本、利息開支及稅項後，連地價的現金流為1億元，以5%的折現率計算，這５年後的1億元相等現時的7,835萬元。計算方法相當簡單，將1億元乘以表23中的5%、5
年的係數0.783526。在其他行業分析我們也可以用現金流折現法，尤其是作長遠投資的時候。
表23：現金流折現係數一覽表
年份 / 4% 5% 6% 7% 8% 9% 10%折現率 1 0.961538 0.952381 0.943396 0.934579 0.925926 0.917431 0.9090912 0.9294556 0.907029 0.889996 0.873439 0.857339 0.84168 0.826446. . . . . . . .5 0.821927 0.783526 0.747258 0.712986 0.680583 0.649931 0.620921. . . . . . . .30 0.308319 0.231377 0.17411 0.131367 0.099377 0.075371 0.057309

曹仁超 - 投資守則

2046-01-19T02:16:00.000+08:00

一、寧買當頭起，莫買當頭跌。最佳入貨訊號係投資對象上升10－15％後。例如金價2001年4月 2日見二百五十五元九角美元，上升10－15％即見二百八十一元五角至二百九十
四元三角，係最佳買入訊號，上述訊號去年1月已出現，即2002年起對黃金態度係逢低吸，直到有一天金價回落10－15％才平倉（依家最高見三百五十四美元，即止蝕位⑹三百
零一美元！）。
二、睇實、睇實再睇實。任何投資項目買入後必須睇實，股票如此，物業如此、債券亦如此。股票必須每周檢討其方向是否改變；債券必須每月檢討方向有冇改變；物業亦必
須每季檢討方向，千萬不可買入後放十年八載便以為天降財富。天下間冇咁便宜的事，一旦方向改變立即離開。
三、去年同新城電台搞「曹仁超投資智慧」，介紹KISS理論（Keep It Simple, Stupid !），任何投資自己無法理解者最好唔參與。其實發達可以好簡單！KISS另一解釋
係Keep It Safe, Smartguy !（安全第一，醒目仔）！許多人一味努力賺錢，而唔知道唔蝕錢更重要！成功與失敗不在閣下賺得快而在乎閣下留低幾多！97年時千萬富翁隨街
走，一項冇科學根據嘅統計指出，當時等巴士長龍中有百分之七十二點五係千萬富翁（住緊げ層樓已值近千萬矣），但今時今日千萬富翁漸成稀有品種……。點解會咁？因為太
多人留「佢」唔住，一味死博爛博而唔懂得持盈保泰，97年唔少千萬富翁今天淪為負資產一族。
四、困難日子唔代表冇銀搵。例如8x9年x六x四x事件後已證明乃入市最佳時機；97年8月本港樓市出問題，都係投資英、美、澳洲等地物業最佳時機；甚至 2002年投資外匯及
黃金者一樣獲可觀利潤。賺錢如發掘寶藏，必須有藏寶圖、刻苦及鍥而不舍的精神，然後找到定位，一舉而成功（但分分鐘失效）。
五、唔好問和尚借梳。有Ｄ所謂投資專家，自己都係負資產人士，又點可以教識你發達之道？大部分證券行內從業員職責唔係為你賺錢，而係為自己賺取傭金。因此唔好向經
紀諮詢投資意見，只可利用經紀代你完成買賣，因為佢地唔係受訓做投資顧問，佢地嘅責任只係代客買賣股票。學嘢應請教投資已成功的人士，而非自己投資失敗而改行做投
資專家的人士（對唔住！又得罪人）；股票市場可以賺錢理由皆因別人犯錯！股票市場永遠係少數人賺大多數人蝕的地方。 ----------
在投資之前有冇問問自己：
一、該公司係咪一間穩健及有聲譽的公司？它是否擁有良好及有效率的管理層？
二、該公司生產什麽或提供什麽服務？在可見將來，社會對該產品或服務需求怎樣？
三、該公司從事的行業是否面對過分激烈競爭？它是否處於有利地位？
四、公司策略制訂者是否有遠見及進取？同時有冇過分擴充，令財政出現困難？
五、有冇細看公司資產負債表，核數師的評語如何（依家應該加上げ個核數師是否誠信可靠）？
六、公司過去有冇良好純利紀錄及合理派息政策，如有段日子唔派息，有冇好好解釋理由？理由是否充分？
七、公司中長期貸款及短期貸款有冇超過安全極限？該公司股價⑹過去有冇大幅波動或無法解釋的波幅？ ----- 其實投資好簡單，挑選優質股買入，直到股價上升一倍或以上才考慮獲利回吐，再用止蝕盤保護，以防自己分析錯誤，如此一來虧損被局限在15％之內；至於利潤，不妨
讓它往前跑，通常獲利100％是最起碼要求，不少情況下利潤可達200％或以上。
-------- 發達容易搵食更艱難
我老曹相信差唔多任何人都可發達，發達並唔需要特別天才、家庭背景甚至學歷。我老曹曾經寫過「發達容易，搵食艱難」，即發達較搵食容易，但點解社會上咁少人發達？
理由係95%そ人響發達過程中犯錯，事關佢地唔記得開門七件事：
甲、誤信貼士。太多人唔做功課，睇報紙大標題買股票，如果D專家咁叻，點解佢地自己未發達？如果你停留響聽貼士水平，我老曹保證你冇發達！
乙、識乜唔重要，認識邊個才重要。請多點交朋友，我老曹係指可互相扶持的朋友，而非豬朋狗友。如果你同猴子在一起，你的思想行為遲早同猴子接近。
丙、做事要專心。唔少人以為別人發達係勤力，其實剛相反，世上最勤力的人通常從事低收入工作，富人工作時間並唔長但專心，一旦投入工作往往可廢寢忘餐，直到工作完
成或上軌道後交畀屬下員工為止。
丁、誤信錢搵錢，以為自己窮係上一代冇蚊年剩落。事實上，唔少人富有的理由便是上一代貧窮，佢地立心脫離窮籍，結果錢愈賺愈多，最後富甲一方。佢地そ致富之道係一
旦機會來臨便利用槓桿原理（不懂借錢的人唔會發達，亂借錢的人很快破產），因此佢そ財富唔只由一百萬元變成二百萬元，而係由一千萬元變成一億元。換言之，看準機會
響一段時間（例如十年）內令財富高速增長，然後及時減債便可以印印腳矣。
戊、大富由天、小富由儉，呢個世界冇天時地利人和，你唔可能成為蓋茨、畢非德或李實發，呢類人一千萬人中少於兩個，真係一命二運三風水……。對一般人而言，一千萬元
應該十分吸引，如你肯花三十年時間去達到上述數字，人人可以做到，並非白日夢。
己、好多人話「財富係一項負擔」，呢句話係講畀窮人聽そ，唔好信。財富絕對唔係一項負擔，你可以交畀私人銀行負責或請專人負責。財富的好處係令你財政獨立，唔使為
幾萬銀折腰，可從心所欲地去做自己喜歡的事。
庚、富有的人視賺錢為一種興趣而非一項苦差，一如我老曹每天寫呢個專欄三十年不變，有人問辛唔辛苦？答案係有時冇材料都幾辛苦，除此之外都係樂趣，希望讀者透過我
老曹提供的財務意見改善自己理財方法；同時，在為讀者搜尋資料過程中，我老曹亦搵到投資機會。任何視賺錢為苦差者一定唔會發達。
在此順便重溫我老曹的「投資哲學」-A、不要趁低買入，因為你唔知幾時才係最低，寧買當頭起，莫買當頭跌；B、永遠記住行使止蝕，防止小損失變成大損失；C、買賣前先做功課；D、財富係透過逐小逐小累積起來的，唔好期望一朝發達；E、冇必勝投資但有必勝投資策略。 --------- 有D投資戒條連我老曹自己亦可能忘記，在此同各位重溫。
一、無論情況如何緊記溝上唔溝落。
二、股票市場係賺錢地方，因此絕對要跟紅頂白而非鋤強扶弱，幾時都應吸納強勢股，沽出弱勢股。
三、持有蝕本股不放有兩大損失：A、股價上嘅損失；B、失去將資金投資其他項目嘅損失。因此絕對要止蝕。
四、股市唔係低價買入高價賣出嘅地方（冇人做得到），應該高價買入更高價賣出，因此宜高追不宜趁低買入。
五、牛市中錯失獲利機會冇有怕，因為下一浪更高；熊市中寧可賺少D，亦不應太遲離市。
六、股市表現可能同自己想法背馳好耐，所以淡市莫估底，旺市莫估頂。
七、第一次出現裂口上升時不妨買入；如出現裂口回落係時候離開。
八、旺市時不妨膽大D，因為形勢在我；淡市時少玩，因為氹仔浸死人。
九、投資成功先了解基本因素，再利用技術分析決定買賣時機，只識技術分析唔了解基本因素者，只係花拳繡腿（睇得但唔打得）。
十、升市將盡小心「單日轉向」或「單周轉向」走勢，通常幾有用。最簡單的技術分析最有用，太複雜的技術分析只係用嚟嚇初學者。
十一、了解群眾心理亦十分有用，因群眾常常睇錯市。
十二、止蝕唔止賺，通常賣出之後股價才大升，我地少賺50%或以上。獲利回吐易，止蝕賣出難，只有克服上述心理，才能在股市立足。 ----------- 寧願蝕息不可蝕價
股聖畢非德旗下巴郡哈撒韋透露去年度手上現金高達三百六十億美元（2002年年底只有一百三十億美元），響現今低利率情況下，點解保留咁多茄殊在手？投資涉及兩問題：
一B賺息（例如存款有利息、買樓有租收、買股票有股息、買債券有債息）；二、賺價（外匯有波動、樓價有升降、股價有上落、債券價格可升可跌）。一般人過分強調賺息，
因為仍需要利息收入去改善生活素質；有錢人卻強調賺價，因為佢地嘅收入已唔再需要收息。令你富有嘅係賺價，唔係賺息；令你貪窮嘅亦係蝕價，唔係蝕息。1997年8月買樓
收租至今，結果七年租金收入抵不上樓價回落；反之，過去三年摣金冇息收，但卻可賺價。雖然黃金冇利息，但金價上升60％，跑贏過去三年樓價！
股份亦一樣，高息股通常唔係增長股，而且隨時面對派息減少甚至唔派息；增長股從來唔可能派高息，因為資金有更佳用途。合理股息應響三厘半之下，一旦高於三厘半，已
再唔係增長股。有時客觀情況係面對蝕息或蝕價嘅問題，畢非德教曉我地寧可蝕息，不可蝕價。 --------各位應緊記以下八大格言：一、訂立守則管制自己行為（例如止蝕沽盤）；二、不要只見高回報率，忽略高風險所在；三、未買先賣（未買入任何投資前，先計計自己可以輸幾多）；四、不可承擔超過自己能力的投資（例如有三十萬元炒一百萬元貨）；五、不可感情支配理智（面對損失之時因輸唔起而感情用事）；六、不可自己冇主見而誤聽別人意見（忘記真主意、假商量守則）；七、不可冇為自己行為負責的性格；八、切勿忘記以上七大格言。

If This Is Recovery... - John Mauldin's Weekly E-Letter

2009-11-15T02:56:00.000+08:00

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Thoughts from the Frontline Weekly Newsletter If This Is Recovery... by John Mauldin November 13, 2009
In this issue: If This is Recovery, Where Are the Taxes? Last Business Standing Stimulus, What Stimulus? The Reality of Unemployment Let the Good Times Roll The Quick Double-Dip Scenario Phoenix, New York, and Thoughts on the Internet
No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting. If This is Recovery, Where Are the Taxes? I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let's look at sales taxes first. First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we're in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010. There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%. On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf. The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com) Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising? Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them. Last Business Standing Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business." Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter's creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors. So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%. Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out? And the answer is that we won't know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report) But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes: Stimulus, What Stimulus? "Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating? "The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market." The Reality of Unemployment All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts. In August, I did an interview with CNBC from Leen's Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started. That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we've lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000. Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom. Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade. I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios. All three scenarios are based on assumptions, so let's see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result. You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below. For those interested, you can read Mish's very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let's look at his assumptions: Job losses are likely to continue for a minimum of another year. When job gains start, they will be very slow at first, then pick up. An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs. A falling participation rate (boomers retiring) will continue to mask reported unemployment. Starting in 2013 the labor pool will start decreasing because of Boomer demographics. The noninstitutional population will rise by 2.5 million workers a year. The spreadsheet below needs a little explanation. Let's start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number. By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike's blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let's look at scenario 1. This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario. Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession. Let the Good Times Roll What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let's be optimistic. And the graph below shows the unemployment numbers for the Good Times Scenario. Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner. The Quick Double-Dip Scenario When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession. I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax. Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept. Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn't look like that will be the case. So, let's quickly see what a double-dip scenario might look like. Let's be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives. Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph. Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right. We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario. The letter is getting long and it's getting late, so let me close with a few thoughts. First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years. Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other. Third, the only way out of this morass is to create an environment where small business can thrive. As I've noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that. Phoenix, New York, and Thoughts on the Internet Next week I take a quick one-day trip to Phoenix, then back to do a satellite-remote speech to a South African hedge fund conference. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org). Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there. The 7 kids, spouses, and grandkids are starting to gather. We will all have brunch Sunday and then a shower for Tiffani. She has another 6 weeks before she is due, and she is really uncomfortable. Walking is literally a pain. Permit me to reminisce. A little over 9 years ago I started this letter on the internet with about 2,000 email addresses. It was a new version of what had been a print letter, as that was the business I knew. The internet was still a new thing to me, but it seemed like a good idea at the time. Little did I know. I am still amazed at the growth and the direction my business and life have taken. My letters are sent out by various publishers and affiliates to over 1.5 million readers and posted on dozens of web sites, and the numbers have been growing rapidly of late. I am grateful. But I wonder what would happen if I started it today. Ten years ago there was little in the way of free economic letters. Not a lot of competition. Today, there is so much free information that it's staggering. There have to be thousands of blogs and hundreds of free letters, some with very large circulations. It seems a new star is born every few months. While much of it does not add to the level of conversation, some of it is quite excellent. I think I am lucky to have started when I did. And I am grateful for the kind attention you give me. As I turn 60, I note that this has been a rather overwhelming last ten years. A lot of changes for me, and almost all of them very good. But there are more to come. The last two flights I was on I was connected to the internet at 35,000 feet. I sense a lot more changes coming. I am thinking a lot about how to keep up and not get left behind, how to make sure that you, gentle reader, continue to get my best. That is what, at the end of the day, drives me. Have a great week. I know I shall. Dad loves it when his kids (from 15 to 32) and spouses and grandkids are all under one roof. Your amazed at it all analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; Fynn Capital; Nicola Wealth Management; 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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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 To unsubscribe please refer to the bottom of the email. 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 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 NASD 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. 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. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to cs.victor@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

The Glide Path Option - John Mauldin's Weekly E-Letter

2009-11-07T14:46:00.000+08:00

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Thoughts from the Frontline Weekly Newsletter The Glide Path Option by John Mauldin November 6, 2009
In this issue: The Present Contains All Possible Futures The Ugly Unemployment Numbers Argentinian Disease The Austrian Solution The Eastern European Solution Japanese Disease The Glide Path Option Philadelphia, Orlando, and Phoenix
The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we're headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.2000wave.com and search for terms I am writing about. And I will start out by briefly touching on today's ugly unemployment numbers, with data you did not get in the mainstream media. But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.2000wave.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don't know, I write a brief monthly column for them. The Ugly Unemployment Numbers The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast. Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households. Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn. My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg: "Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual 'change' in the underlying labor market situation ... in which case, October's figure of 817,000 represents the fourth LARGEST yet, behind last month's (September's) second largest figure of 1,021,000 ... for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer 'in' the Labor Force ... "... the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million. "Bottom line ... basis this measure AND the 'Total Unemployment Rate,' we could conclude that not only is there NO 'improvement' in the labor market, but moreover, that it continues to DETERIORATE, intently." There are plenty more implications in the data, but let's turn to the topic of the day. The Present Contains All Possible Futures Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea. Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets. If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from? The answer is that it can't be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes. We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let's review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.) Argentinian Disease One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower? One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here? Hyperinflation is not an economic event; it is a political choice. I think last Tuesday's election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything's possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen. I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices. The Austrian Solution Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run. In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of. Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view. That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade. The Eastern European Solution As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world's problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He's a very fun and knowledgeable guy. As we were talking about possible paths, he brought one to mind that I hadn't thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day. We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change. Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can't even get the obvious changes needed in the financial regulatory world. Sidebar: I am outraged at the paltry proposed financial "reforms." Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don't care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen. Japanese Disease I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their "lost decades" with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago. As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!) And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don't make sense can go on longer than we think. Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor's Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame. So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets. Japan elected to run large deficits and raise taxes. As I wrote in the October 16^th letter (http://www.2000wave.com/article.asp?id=mwo101609), "Savings equal Investments: GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or: GDP = C + I + G + (E-I) I don't want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama's chairman of the Council of Economic Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect. In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in "G" must be made up by savings from consumers and businesses and foreigners. But "G" does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business. And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth. This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits for longer than most observers currently believe. We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare. Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take. The Glide Path Option A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term. If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years. The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce "G" (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do. The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs. That's pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a "V" ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time. And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that's for another time. Philadelphia, Orlando, and Phoenix I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy. Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4^th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/), Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there. Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds. It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed. Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy. I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time. Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year. Your always optimistic at the beginning of the season analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; Fynn Capital; Nicola Wealth Management; 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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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 To unsubscribe please refer to the bottom of the email. 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 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 NASD 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. 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. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to cs.victor@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

Just Desserts and Markets Being Silly Again - John Mauldin's Outside the Box E-Letter

2009-11-04T02:49:00.001+08:00

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	Print Version

Volume 5 - Issue 51
November 3, 2009

Just Desserts and
Markets Being Silly Again
By Jeremy Grantham

My long time readers are familiar with Jeremy Grantham of GMO as I quote him a lot. He is one of the more brilliant and talented value managers (and I should mention very successful on behalf of his clients). He writes a quarterly letter which I regard as a must read. I have excerpted parts of his recent letter, where the chief investment strategist really takes the current financial system follies to task. Typical of his great writing and thinking is the quote from this week's Outside the Box selection:

"I can imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship's construction, of the company's policy, or of the captain's competence. "No one could have seen this coming," would have been their constant refrain. Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today with our efforts to redesign the financial system in order to reduce the number and severity of future crises."

You can get the full letter at www.gmo.com (You will have to register).

Your glad to be back home at least for a week,

John Mauldin, Editor
Outside the Box

Just Desserts and Markets Being Silly Again

by Jeremy Grantham

Just Desserts

I can't tell you how surprised, even embarrassed I was to get the Nobel Prize in chemistry. Yes, I had passed the dreaded chemistry A-level for 18-year-olds back in England in 1958. But did they realize it was my third attempt? And, yes, I will take this honor as encouragement to do some serious thinking on the topic. I will also invest the award to help save the planet. Perhaps that was really the Nobel Committee's sneaky motive, since there are regrettably no green awards yet. Still, all in all, it didn't seem deserved. And then it occurred to me. Isn't that the point these days: that rewards do not at all reflect our just desserts? Let's review some of the more obvious examples.

1. For Missing the Unmissable

Bernanke, the most passionate cheerleader of Greenspan's follies, is picked as his replacement, partly, it seems, for his belief that U.S. house prices would never decline and that at their peak in late 2005 they largely just reflected the unusual strength of the U.S. economy. As well as missing on his very own this 3-sigma (100-year) event in housing, he was completely clueless as to the potential disastrous interactions among lower house prices, new opaque financial instruments, heroically increased mortgages, lower lending standards, and internationally networked distribution. For these accumulated benefits to society, he was reappointed! So, yes, after the fashion of his mentor, he was lavish with help as the bubble burst. And how can we so quickly forget the very painful consequences of the previous lavishing after the 2000 bubble? Rewarding Bernanke is like reappointing the Titanic's captain for facilitating an orderly disembarkation of the sinking ship (let's pretend that happened) while ignoring the fact that he had charged recklessly through dark and dangerous waters.

2. The Other Teflon Men

Larry Summers, with a Financial Times bully pulpit, had done little bullying and blown no warning whistles of impending doom back in 2006 and 2007. And, famously, in earlier years as Treasury Secretary he had encouraged (I hope inadvertently) wild and reckless financial behavior by helping to beat back attempts to regulate some of the new and most dangerous instruments. Timothy Geithner, in turn, sat in the very engine room of the USS Disaster and helped steer her onto the rocks. And there are several others (discussed in the 4Q 2008 Letter). You know who you are. All promoted!

3. Misguided, Sometimes Idiotic Mortgage Borrowers

The more misguided or reckless the borrowers, the more determined the efforts to help them out, it appears, although it must be admitted these efforts had limited effect. In comparison, those who showed restraint and either underhoused themselves or rented received not even a hint of help. Quite the reverse: the money the more prudent potential buyers held back from housing received an artificially low rate. In effect, the prudent are subsidizing the very same banks that insisted on dancing off the cliff into Uncle Sam's arms or, rather, the arms of the taxpayers - many of whom rent.

4. Reckless Homebuilders

Having magnificently overbuilt for several years by any normal relationship to the population, we have decided to encourage even more homebuilding by giving new house buyers $8,000 each. This cash comes partly from the pockets of prudent renters once again. This gift is soon, perhaps, to be extended beyond first-time buyers (for whom everyone with a heart has a slight sympathy) to any buyers, which would be blatant vote-buying by Congress. So what else is new?

5. Over-spenders and Under-savers

To celebrate the overwhelming consensus among economists that U.S. individuals have been dangerously overconsuming for the last 15 years, we have decided to encourage consumption and penalize savers by maintaining the aforementioned artificially low rates, which beg everyone and sundry to borrow even more. The total debt to GDP ratio, which under our heroes Greenspan and Bernanke rose from 1.25x GDP to 3.25x (without even counting our Social Security and Medicare commitments), has continued to climb as growing government debt more than offsets falling consumer debt. Where, one wonders, does this end, and with how much grief?

6. Banks Too Big to Fail

Here we have adopted a particularly simple and comprehensible policy: make them bigger! Indeed, force them to be bigger. And whatever you do, don't have any serious Congressional conversation about breaking them up. (Leave that to a few journalists and commentators. Only pinkos read pink newspapers anyway!) This is not the first time that a cliché has triumphed. This one is: "You can't roll back the clock." (See this quarter's Special Topic: Lesson Not Learned: On Redesigning Our Current Financial System.)

7. Over-bonused Financial Types

Just look at Goldman's recent huge "profits," two-thirds of which went for bonuses. It is now estimated that this year's bonus pool will be plus or minus $23 billion, the largest ever. Less than a year ago, these same guys were on the edge of a run on the bank. They were saved only by "government" - the taxpayers' supposed agents - who decided to interfere with the formerly infallible workings of capitalism. Just as remarkably, it is now reported that remuneration for the entire banking industry may be approaching a new peak. "Well, we got rid of some of those pesky competitors, so now we can really make hay," you can almost hear Goldman and the others say. And as for the industry's concern about the widespread public dismay, even disgust, about excessive remuneration (and, I would add, plundering of the shareholders' rightful profits)? Fuhgeddaboudit! In the thin book of "lessons learned," this one, like most of our other examples, will not appear.

8. Overpaid Large Company CEOs

Even outside the financial system, there are many painfully obvious unjust desserts in the form of top management rewards. And most of the excessive rewards come out of the pockets of our clients and other stockholders, which is particularly galling. When I arrived in the States in 1964, the ratio of CEO pay to the average worker was variously reported to be between 20/1 and 40/1. This seemed perfectly respectable and had held for the previous 30 years. By 2006, this ratio had exploded to between 400/1 and 600/1, which can only be described as obscene. The results certainly don't suggest such high rewards: a) 10-year stock market returns are close to zero in real terms; and b) U.S. GDP growth has finally slipped below its 100-year trend of 3.5%. After deducting the effect of the rampant increase in the financial system, the growth in GDP ex-finance has fallen to 3.1% since 1982 and well below 3% since 2000, all measured to the end of 2007 to avoid the recent crisis. The corporate system, to be frank, seemed to run faster and more efficiently back in the 1960s before CEOs and financial types began to gobble up other people's lunches. I suppose I have done my share of gobbling. But, it still ain't right!

9. Holders of the Stocks of Ridiculously Overleveraged and Wounded Corporations

Yes, I admit this is part envy and part hindsight investment regret. But, really, our financial leaders so overstimulated the risk-taking environment that junky, weak, marginal companies and zombie banks produced a record outperformance (the best since 1933) of junk over the great blue chips. (Ouch!) In a world with less moral hazard, which would be a world of just, although painful desserts, scores of these should-be-dead companies would be. As it is, they live to compete against the companies that actually deserve to be survivors. Excessive bailouts are just not healthy for the long-term well-being of the economy.

10. The Well-managed U.S. Auto Industry

While firms in other industries fail and their workers look for new jobs, the auto industry is rewarded by direct subsidized loans, governmental arm-twisting of creditors forced to settle far below their legal rights, and direct subsidies for their products. All of this for their well-deserved ranking as the most short-sighted industry of the last 20 (40?) years, and one of the worst managed.

11. The World's Most Over-vehicled Country

We chew up a dangerously large amount of Middle Eastern oil (and oil desperately squeezed from Canadian tar sands), which is ruinous for our globalpolitical well-being (and ability to avoid war) and also not so good for an overheating world. So the answer must be to subsidize more car purchases, and when the subsidies run out, you can have all the fun again. Good long-term thinking!

12. Stock Options

This, of course, is the crème de la crème of unjust desserts. Recent practices have basically been a legalized way to abscond with the stockholders' equity. So if the stock price crashes, perhaps with considerable help from management, that's all right - just rewrite the options at the new low prices. There has been no serious attempt to match stock option rewards (or total financial rewards for that matter) to the building of long-term franchise value. Instead, the motto is: grab it now and run! You can fill in your own favorite anecdotes here - there are so many of them!

13. Finally, Just in Case You've Forgotten, We Have My Old Nemesis, Greenspan

Alan Greenspan receives the title of Maestro in the U.S. and is knighted by the Queen for thoroughly demolishing the integrity of the U.S. financial system. He overtly ignored the great threat of bubbles in asset classes and, in fact, encouraged them. He Ayn Rand-ishly facilitated the progressive dismantling of governmental restrictions on financial behavior, he deliberately kept real interest rates at zero for years, etc., etc., etc. You have heard it before. Now, remarkably, in his very old age he has become imbued with the spirit of Hyman Minsky: "Unless somebody can find a way to change human nature, we will have more crises." Now he finally gets it. Too late! In his merely old age, he ignored or abhorred Minsky, and consistently behaved as though markets were efficient and the players were honest and sensible at all times. But for all of the egg on his face, the Maestro continues to consult with the rich and famous, considerably to his financial advantage. In the good old days, he would have been set in the village stocks, and not the kind you buy and sell. And I would have been right there, Alan, with very ripe tomatoes.

The Last Hurrah and Markets Being Silly Again

The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally.¹ After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast. Exhibit 1 shows my favorite example of a last hurrah after the first leg of the 1929 crash.

After the sharp decline in the fall of 1929, the S&P 500 rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But on April 12 it was once again overpriced; it was down only 18% from its peak and was back to the level of June 1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economic outlook was a candidate for the brightest in history with effectively no unemployment, 5% productivity, and over 16% year-over-year gain in industrial output. By April 1930, unemployment had doubled and industrial production had dropped from +16% to -9% in 5 months, which may be the world record in economic deterioration. Worse, in 1930 there was no extra liquidity flowing around and absolutely no moral hazard. "Liquidate the labor, liquidate the stocks, liquidate the farmers"² was their version. Yet the market rose 46%.

How could it do this in the face of a world going to hell? My theory is that the market always displayed a belief in a type of primitive market efficiency decades before the academics took it up. It is a belief that if the market once sold much higher, it must mean something. And in the case of 1930, hadn't Irving Fisher, arguably the greatest American economist of the century, said that the 1929 highs were completely justified and that it was the decline that was hysterical pessimism? Hadn't E.L. Smith also explained in his Common Stocks as Long Term Investments (1924) - a startling precursor to Jeremy Siegel's dangerous book Stocks for the Long Run (1994) - that stocks would always beat bonds by divine right? And there is always someone of the "Dow 36,000" persuasion higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum.

Today there has been so much more varied encouragement for a rally than existed in 1930. The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008. This time, we also saw history's greatest stimulus program, desperate bailouts, and clear promises of years of low rates. As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great job of driving equity markets and speculation higher. In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not. Looking at previous "last hurrahs," it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt. I must say, though, that I never expected such an extreme tilt to risk-taking: it's practically a cliff! Never mess with the Fed, I guess. Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road. So, probably, we will continue to live in exciting times, which is not all bad in our business.

Lesson Not Learned: On Redesigning Our Current Financial System

I can imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship's construction, of the company's policy, or of the captain's competence. "No one could have seen this coming," would have been their constant refrain. Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today with our efforts to redesign the financial system in order to reduce the number and severity of future crises.

After a crisis, if you don't want to waste time on palliatives, you must begin with an open and frank admission of failure. The Titanic, for example, was just too big and therefore too complicated for the affordable technology of its day. Given White Star Line's unwillingness to spend, she was under-designed. The ship also suffered from agency problems: the passengers bore the risk of unnecessary speed and overconfidence in "too big to sink!" while the captain stood to be rewarded for breaking the speed record. No captain is ever rewarded for merely delivering his passengers alive. Greenspan, nearly 100 years later in his short-lived "irrational exuberance" phase, did not enjoy being metaphysically slapped by the Senate Subcommittee for threatening the then speedy progress of the economy. What is needed in this typical type of agency problem is for the agent on those rare occasions when it really matters, whether a ship's captain or a Fed boss, to stop boot licking and say, "No, this is wrong. It is just too risky. I won't go along."

We have a once-in-a-lifetime opportunity to effect genuine change given that the general public is disgusted with the financial system and none too pleased with Congress. I have no idea why the current administration, which came in on a promise of change, for heaven's sake, is so determined to protect the status quo of the financial system at the expense of already weary taxpayers who are promised only somewhat better lifeboats.

It is obvious to most that there was a more or less complete failure of our private financial system and its public overseers. The regulatory leaders in particular were all far too captured and cozy in their dealings with reckless and greedy financial enterprises. Congress also failed in its role. For example, it did not rise to the occasion to limit the recklessness of Fannie and Freddie. Nor did it encourage the regulation of new financial instruments. Quite the reverse, as exemplified by the sorry tale of CFTC Chairman Brooksley Born's fight to regulate credit default swaps.

But, at least now, Congress seems to realize the problem: the current financial system is too large and complicated for the ordinary people attempting to control it. Even Barney Frank, were he on his death bed, might admit this; and most members of Congress know that they hardly understand the financial system at all. Many of the banks individually are both too big and so complicated that none of their own bosses clearly understand their own complexity and risk taking. The recent boom and the ensuing crisis are a wonderfully scientific experiment with definitive results that we are all trying to ignore. And, except for bankers, who have Congress in an iron grip, we all want and need a profound change. We all want smaller, simpler banks that are not too big to fail. And we can and should arrange it!

Step 1 should be to ban or spin off that part of the trading of the bank's own money that has become an aggressive hedge fund. Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients. How quaint that scrupulousness now seems. Indeed, from, say, 1935 to 1980, any banker who suggested such behavior would have been fired as both unprincipled and a threat to the partners' money. I, for one, saw Goldman in my early days as a surprisingly ethical firm, at worst "long-term greedy." (This steady loss of the old partnership ethic is typically underplayed in descriptions of Goldman.) Today, Goldman represents a potential hedge fund trade as being attractive precisely because they themselves have already chosen to do it. These days, all - or almost all - large banks do proprietary trading that is pure hedge fund in nature. Indeed the largest bank, Citi (owned by us taxpayers), is gearing up to substantially increase its aggressive prop trading as I write. ("No, no, we're not!")

Some insiders have argued that we should not worry about prop trading because they claim it did not play an important part in the recent crisis. I think this is completely wrong for it misses the very big picture. Prop trading can easily introduce an aggressive hedge-fund type mentality into the very hearts of what ideally should be conservative, prudent - even boring - banks. This hedge fund mentality became a dominant organizing principle, particularly with respect to compensation practices. It encouraged personal aspirations over corporate goals and invited bonus-directed behavior at the clients' expense and ultimately, as we have seen, at the taxpayers' expense to rid itself of this problem. All Congress has to overcome is the lobbying power and campaign contributions of the finance industry itself, which I admit is no small feat. In a bank with a hedge fund heart, you can't reasonably expect ethical or non-greedy behavior, and you haven't seen it.

Of course, commercial and investment banks need to invest their own capital. They probably should have the right to do genuine hedging against investments that flow naturally from their banking business. As for the rest, they could easily be required either to limit the leverage used on prop desk trading or to be restricted to investing in government paper and, at the very least, play by the same rules as other hedge funds. What they certainly should insurance, as is now the case.

In the early 1930s, following the famous Pecora hearings, the conflict of interest between the management of other people's money as fiduciary and the business of dealing and underwriting in securities was considered so inimical to the public interest that Congress almost compelled separation of proprietary trading and client trading. Close, but no cigar. Instead, Glass-Steagall made the probably less useful step of separating commercial and investment banking. Unfortunately, they left intact the obvious conflict between the banks' managing their own money and simultaneously that of their clients. We now have a unique opportunity to revisit this matter.

(As we ponder the problem of prop trading, let us consider Goldman's stunning $3 billion second quarter profit. It appeared to be almost all hedge fund trading. Be aware also that this $3 billion is net of about $6 billion reserved for future bonuses. Goldman's CEO had, in fact, the interesting job of deciding how much of this $9 billion profit would be arbitrarily awarded to shareholders. [In this case, one-third. Could be worse!] This means that they extracted every penny of $9 billion from a fragile financial system. "Good for them," you may say, and they indeed are very smart. But surely they should not have been insured against failure by us taxpayers! Remember, they are now also a commercial bank yet very, very little of their $9 billion came from making loans. Three months later their bonus pool for the year is estimated to be a new record at $29 billion. And the whole banking industry is back to a new record for remuneration. How resilient! How remarkable! How basically undesirable for our economy!)

In Step 2, the Justice Department, together with Congressional and other advisors, should be invited to develop a special set of rules for the banking industry that recognizes the moral hazard of "too big to fail." If really too big to fail, banks should be divided by Justice into manageable, smaller pieces that can indeed be allowed to fail. With these two steps and possibly with an intelligent son of Glass-Steagall, the deed would be done! Regulators would have a fighting chance of being able to regulate, unlike their recent woeful past. If an angel appeared, waved his wings and, lo, it was so, almost every single Congressman would sigh with relief.

The separation of commercial banking from investment banking is not as vital as the removal of prop desk complicated enterprises both smaller and simpler, which characteristics I for one believe are probably essential if we are to avoid further disasters. So what is the problem? The argument against all major changes, without at least some of which we will soon surely be back in another crisis, is always the same. "Oh, you can't roll back the clock." But, even repeated twice before every breakfast, it is not persuasive. Why exactly can't you roll back the clock? We did it once before and, although it was very imperfect and probably missed the central point of conflict of interest, it still produced an improved system that was successful enough for 50 years. In general, countries with simpler and less aggressive banks have had much less pain in the recent crisis while we were pawning the Crown Jewels - sorry, the Federal Jewels - to bail out aggressive bankers who were out of their depth in the new complexities.

Step by step, even as the complexity grew, our regulatory leaders enabled systemic risk to grow. They continued to push the boundaries for banks by allowing more leverage, new instruments, and less control. The details are familiar. All this was done in the name of untrammeled, unfettered capitalism, and almost all of it was a bad idea.

"Oh!" say the bankers, "If we become smaller and simpler and more regulated, the world will end and all serious banking will go to London, Switzerland, Bali Hai, or wherever." Well, good for those other places. If that means they will have knee-buckling, economy cracking, taxpayer-impoverishing meltdowns every 15 years and we will be left looking like a boring back water, that sounds fine to me. Remember, just like our investment management branch of the financial system, banking creates nothing of itself. It merely facilitates the functioning of the real world.

Yes, of course every country needs a basic financial system to function effectively with letters of credit, deposits, and check writing facilities, etc. But as you move beyond that it is worth remembering that every valued job created by financial complexity is paid for by the rest of the real economy, and talent is displaced from real production, as symbolized by all of the nuclear physicists on prop trading desks. Viewed from the perspective of the long-term well-being of the whole economy, the drastic expansion of the U.S. financial system as a percentage of total GDP in the last 20 years has been a drain on the health and cost structure of the balance of the real economy. To illustrate this point, in 1965 the financial sector of the economy took up 3% of the GDP pie. The 1960s were probably the high water mark (or one of them) of America's capitalism. They clearly had adequate financial tools. Innovation could obviously have occurred continuously in all aspects of finance, without necessarily moving its share of the economy materially over 3%. Yet by 2007 the share had risen to 7.5% of GDP!

The financial world was reaching into the GDP pie and taking an unnecessary extra 4%. Every year! This extra rent is enough to lower the savings and investment potential of the rest of the economy. And it shows. As mentioned earlier, the growth rate of the GDP had been 3.5% a year for a hundred years. It had proven to be remarkably robust. Even the Great Depression bounced off it, and soon GDP growth was back on the original trend as if the Depression had never occurred. But after 1965, the growth of the non-financial slice, formerly 3.4%, slowed to 3.2%. After 1982 it dropped to 3.1% and after 2000 fell to well under 3%, all measured to the end of 2007, before the recent troubles. These are big declines. It is as if a runner has a growing and already heavy blood sucker on him that is, not surprisingly, slowing him down. In the short term, I realize that job creation in the financial industry looked like a growth driver, as did the surge in financial profits (which we now realize were ludicrously overstated). But in the long term, like a sugar high, this stimulus was temporary and unhealthy.

The financial system was growing because it could. The more complex and confusing new financial instruments became the more "help" ordinary citizens needed from the experts. The agents' interests were totally unaligned with the principle/clients' interests. This makes a mockery of "rational expectations" and the Efficient Market Hypothesis, which assumes (totally unproven, as usual) equivalent and perfect knowledge on both sides of all transactions. At the extreme, this great advantage in knowledge and information held by the financial agents has the agents receiving all the rewards, according to the recent work³ by my former partner, Paul Woolley, and his colleagues at the Woolley Centre for the Study of Capital Market Dysfunctionality. (With a great name like that their job is half done before they start.)

The second problem, right on the heels of the too-big-and complicated issue, is that of inadequate public oversight. Even with existing institutions, we would have avoided most of the recent pain, borne by taxpayers, if we had had better public leadership. Yes, the public bodies had flaws, but the individuals running the shop had far bigger flaws. Greenspan, with arguably the most important job in the world, simply did not believe in interfering with capitalism at all. His regulatory colleagues such as Bernanke and Geithner fell into line without any challenges. And Congress, strongly influenced by the financial industry, or merely misguided, or often both, facilitated the approach that capitalism in general and banking in particular would do just fine if left entirely alone. It was a very expensive error. Does anyone think we would have run off the cliff with even one change - Volcker at the Fed? I, for one, am confident that we would have done far less badly.

Behind this weakness in the recent cast of characters is a systemic (suddenly the trendiest word in the English language) weakness in our method of job selection. How can Greenspan, with his long-established record of failure as a professional economist, have resurfaced as the Fed boss? With no record of success in any important job, he gets one of the world's two most important jobs! Now we have to decide how much more decision-making power to give to the Fed - an institution with a 25-year proven record of failure. How can we separate the logical neatness of institutional design from our recent proven inability to pick effective, principled leaders with strong backbones?

It is a conundrum: too many regulatory agencies and you have too many opportunities for financial interests to shop around for regulatory bargains and to find and exploit the ambiguous seams between them. Too few agencies and we run the risk of my worst nightmare: waking up and finding Alan Greenspan with twice the authority!

At the least we must recognize the improbability of acquiring great leaders and that our financial system must be simple and robust enough to withstand the worst efforts from time to time of poor or even bad leadership. A simpler, more manageable financial system is much more than a luxury. Without it we shall surely fail again. And it looks as if we are bound and determined to bend once again to the will (and the money) of the financial lobby, which is encouraged by the unexpected conservatism of the current administration's "Teflon" men. They seem terrified to make any substantial changes. And the one person with the character to make tough changes - Paul Volker - is window dressing, exactly as I suggested in January. A sad, wasted opportunity!

Summary

Yes, this was a profound failure of our financial system.
The public leadership was inadequate, especially in dealing with unexpected events that often, like the housing bubble breaking, should have been expected.
Of course, we should make a more determined effort to do a more effective job of leadership selection. But excellence in leadership will often be elusive.
Equally obvious, we could make a hundred improvements to the lifeboats. Most would be modest beneficial improvements, but in the long run they would be almost completely irrelevant and, worse, they might kid us into thinking we were doing something useful!
But all of the above points fail to recognize the main problem: the system has become too big and complicated for even much-improved leaders to handle. Why should we be confident that we will find such improved leaders? For, even in an administration directed to "change," Obama and his advisors fell back on the same cast of characters who allowed, even facilitated, the development of the current crisis. Reappointing Bernanke! What a wasted opportunity to get a "son of Volker" type. (Or should that be "grandson of Volker?")
The size of the financial system continues to grow and shows every sign of being out of control. As it grows, it becomes a bigger drain on the rest of the economy and slows it down.
The only long-term hope of avoiding major recurrent crises is to make our financial system simpler, the units small enough that they can be allowed to fail, and, above all, to remove the intrinsically conflicted and dangerously risk-seeking hedge fund heart from the banking system. The rest is window dressing and wishful thinking.
The concept of rational expectations - the belief in the natural efficiency of capitalism - is wrong, and is the root cause of our problems. Hyman Minsky, on the other hand, was right; he argued that the natural outcome of ordinary people interacting is to make occasional financial crises "well nigh inevitable." Crises are desperately hard to avoid. We must give ourselves a chance by making the job of dealing with them much, much easier.
All in all we are likely to have learned little, or rather to act, through lack of character, as if we have learned nothing. In doing so we are probably condemning ourselves to another serious financial crisis in the not too- distant future.

PS: As quite often happens, since I write painfully slowly (even without extra tick-borne delays), a professional slipped in with a great column that gets to the heart of this matter. Please read John Kay in the Financial Times of July 9. It is short and persuasive. "Our banks are beyond the control of mere mortals" - now, that's what I call a title!

Footnotes:

1 Erratum: Last quarter I cast mild aspersions on Finanz und Wirtschaft by suggesting that I had not precisely said that the S&P would scoot rapidly up to 1100; I remembered it more as between 1000 to 1100. Never mess with a Swiss journalist: this one duly pointed out that his tape of April 1 confirmed his accuracy. Either way, here we are, more or less (at 1098 on October 19).

2 Andrew Mellon, Secretary of the Treasury, 1931.

3 Biais, Bruno; Rochet, Jean-Charles; and Woolley, Paul. Rents, Learning and Risk in the Financial Sector and other Innovative Industries. September, 2009. Working Paper Series 2009, The Paul Woolley Centre for the Study of Capital Market Dysfunctionality.

http://www.lse.ac.uk/collections/paulWoolleyCentre/news/RentsLearningAndRisk.htm

John F. Mauldin
johnmauldin@investorsinsight.com

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Catching Argentinian Disease - John Mauldin's Weekly E-Letter

2009-10-31T12:42:00.000+08:00

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Thoughts from the Frontline Weekly Newsletter Catching Argentinian Disease by John Mauldin October 30, 2009
In this issue: Catching Argentinian Disease? The Ascent of Money The Independence of the Fed Threatened A Few Quick Thoughts on the Dollar, GDP, and the Recession Uruguay, Philadelphia, Orlando, and then...
I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security. This week, we will look at the Argentinian experience and ask ourselves whether "it" - hyperinflation - can happen here. The Ascent of Money I will be quoting from Niall Ferguson's recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already. If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn't happen more often. In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp." As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com) As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all. Catching Argentinian Disease At the beginning of the 20^th century, Argentina was the seventh richest nation on earth. It's very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors." Argentina had actually defaulted on its debt in the late 19^th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press. My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more. Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!) Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar? Let's look at some quotes from Ferguson (emphasis mine): "The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement... To understand Argentina's economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon... "To put it simply, there was no significant group with an interest in price stability... "Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy." Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money. In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it's not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices. As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today's thought process is about what happens if they don't. Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow? Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy. In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed. I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason. For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter. The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part. I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don't have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way. I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it. The Independence of the Fed Threatened The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok: "It's now official. The proposed legislation to reform America's financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America's central bank. "The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period. "The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board. "The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice. "In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis." This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement. (Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.) All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching. A Few Quick Thoughts on the Dollar, GDP, and the Recession Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here. And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%: "Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more." John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report) And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go -- and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market. "Only 29% of those polled believe the economy has hit bottom -- imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally -- not the onset of a new bull market) has not swayed their view (or ours for that matter)." Uruguay, Philadelphia, Orlando, and then... I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile. My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living. One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices. Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary. Your ready to be in his own bed analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; Fynn Capital; Nicola Wealth Management; 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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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 To unsubscribe please refer to the bottom of the email. 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 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 NASD 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. 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. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to cs.victor@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

A Crisis in the Kremlin - Outside the Box Special Edition

2009-10-30T00:05:00.000+08:00

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Volume 5 - Special Edition
October 29, 2009

A Crisis in the Kremlin
By George Friedman

Earlier this week, I sent out a piece that talked about the dangers of ignoring the big picture - even for the "bottom up" investor. Every once in a while, we all have to step away from the Dow Jones Industrial Average, housing prices and other indicators to look at what's going to influence these factors in the long term.

Today I give you a video about Russia and how a plan to fix the economy might throw off the political balance of power. I regard Moscow's situation as a valuable lesson for our country - also in the throes of an economic crisis - and for investors affected by global markets. Click here to watch this great video by my friends at STRATFOR, a global intelligence company. You can also sign up to get free weekly intelligence from them, so you don't have to depend on my occasional mail-out.

John Mauldin

A Crisis in the Kremlin

John F. Mauldin
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Liquor before Beer - In the Clear - John Mauldin's Outside the Box E-Letter

2009-10-27T11:16:00.000+08:00

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Volume 5 - Issue 50
October 26, 2009

Liquor before Beer - In the Clear
By David Einhorn

I am in Argentina today, but still have found time to read a rather provocative speech by David Einhorn, who is President of Greenlight Capital, a "long-short value-oriented hedge fund", which he began in 1996. Einhorn has long been a critic of the current investment banking business, and today he discusses the problems with not only the proposed new government regulations (or lack thereof), but also the problems with the US debt and our currency valuations. It is a most thought-provoking and fun speech.

It is especially poignant as I sit in a country that has seen the ravages of hyper-inflation, talking with business leaders and investors who experienced the problems first hand and how they deal with it today. I will be writing about what I am learning this Friday I think. But now I have to run and give my third speech today. Have a good week!

Your very surprised to find Argentinean beef as good as that of Texas analyst,

John Mauldin, Editor
Outside the Box

Liquor before Beer - In the Clear

Value Investing Congress - David Einhorn, Greenlight Capital

One of the nice aspects of trying to solve investment puzzles is recognizing that even though I am not always going to be right, I don't have to be. Decent portfolio management allows for some bad luck and some bad decisions. When something does go wrong, I like to think about the bad decisions and learn from them so that hopefully I don't repeat the same mistakes. This leaves me plenty of room to make fresh mistakes going forward. I'd like to start today by reviewing a bad decision I made and share with you what I've learned from that error and how I am attempting to apply the lessons to improve our funds' prospects.

At the May 2005 Ira Sohn Investment Research Conference in New York, I recommended MDC Holdings, a homebuilder, at $67 per share. Two months later MDC reached $89 a share, a nice quick return if you timed your sale perfectly. Then the stock collapsed with the rest of the sector. Some of my MDC analysis was correct: it was less risky than its peers and would hold-up better in a down cycle because it had less leverage and held less land. But this just meant that almost half a decade later, anyone who listened to me would have lost about forty percent of his investment, instead of the seventy percent that the homebuilding sector lost.

I want to revisit this because the loss was not bad luck; it was bad analysis. I down played the importance of what was then an ongoing housing bubble. On the very same day, at the very same conference, a more experienced and wiser investor, Stanley Druckenmiller, explained in gory detail the big picture problem the country faced from a growing housing bubble fueled by a growing debt bubble. At the time, I wondered whether even if he were correct, would it be possible to convert such big picture macro-thinking into successful portfolio management? I thought this was particularly tricky since getting both the timing of big macro changes as well as the market's recognition of them correct has proven at best a difficult proposition. Smart investors had been complaining about the housing bubble since at least 2001. I ignored Stan, rationalizing that even if he were right, there was no way to know when he would be right. This was an expensive error.

The lesson that I have learned is that it isn't reasonable to be agnostic about the big picture. For years I had believed that I didn't need to take a view on the market or the economy because I considered myself to be a "bottom up" investor. Having my eyes open to the big picture doesn't mean abandoning stock picking, but it does mean managing the long-short exposure ratio more actively, worrying about what may be brewing in certain industries, and when appropriate, buying some just-in-case insurance for foreseeable macro risks even if they are hard to time. In a few minutes, I will tell you what Greenlight has done along these lines.

But first, I'd like to explain what I see as the macro risks we face. To do that I need to digress into some political science. Please humor me since my mom and dad spent a lot of money so I could be a government major, the usefulness of which has not been apparent for some time.

Winston Churchill said that, "Democracy is the worst form of government except for all the others that have been tried from time to time."

As I see it, there are two basic problems in how we have designed our government. The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be re-elected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

Paul Volcker was an unusual public official because he was willing to make unpopular decisions in the early '80s and was disliked at the time. History, though, judges him kindly for the era of prosperity that followed.

Presently, Ben Bernanke and Tim Geithner have become the quintessential short-term decision makers. They explicitly "do whatever it takes" to "solve one problem at a time" and deal with the unintended consequences later. It is too soon for history to evaluate their work, because there hasn't been time for the unintended consequences of the "do whatever it takes" decision-making to materialize.

The second weakness in our government is "concentrated benefit versus diffuse harm" also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose "special interests" invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, "without banks, we would have no economy." Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.

But then the question becomes, once you bail them out, what do you do to discipline the misbehavior? Our authorities have taken the response that kids will be kids. "What? You drank beer and then vodka. Are you kidding? Didn't I teach you, beer before liquor, never sicker, liquor before beer, in the clear! Now, get back out there and have a good time." And for the last few months we have seen the beginning of another party, which plays nicely toward government preferences for short-term favorable news-flow while satisfying the banking special interest. It has not done much to repair the damage to the neighborhood.

And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don't know the particulars or how to argue against the "without banks, we have no economy" demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn't really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

On the anniversary of Lehman's failure, President Obama gave a terrific speech. He said, "Those on Wall Street cannot resume taking risks without regard for the consequences, and expect that next time, American taxpayers will be there to break the fall." Later he advocated an end of "too big to fail." Then he added, "For a market to function, those who invest and lend in that market must believe that their money is actually at risk." These are good points that he should run by his policy team, because Secretary Geithner's reform proposal does exactly the opposite.

The financial reform on the table is analogous to our response to airline terrorism by frisking grandma and taking away everyone's shampoo, in that it gives the appearance of officially "doing something" and adds to our bureaucracy without really making anything safer.

With the ensuing government bailout, we have now institutionalized the idea of too-big-to-fail and insulated investors from risk.

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.

Twenty-five years ago the government dismantled AT&T. Its break-up set forth decades of unbelievable progress in that industry. We can do that again here in the financial sector and we would achieve very positive social benefit with no cost that anyone can seem to explain.

The proposed reform takes us in the polar opposite direction. The cop-out response from Washington is that it isn't "practical." Our leaders are so influenced by the banking special interests that they would rather declare it "impractical" than roll up their sleeves and figure out how to get the job done.

The bailouts have installed a great deal of moral hazard, which in the absence of radical change will be reinforced and thereby grant every big institution a permanent "implicit" government backstop. This creates an enormous ongoing subsidy for the too-bigto-fails, as well as making it much harder for the non-too-big-to-fails to compete. In effect, we all continue to subsidize the big banks even though we keep hearing the worst of the crisis is behind us.

In addition, the now larger too-big-to-fails are beginning to take advantage of developing oligopolies. Even as the government spends trillions to subsidize mortgage rates, the resulting discount is not being passed to homeowners but is being kept by mortgage originators who are earning record profits per mortgage originated. Recently, Goldman upgraded Wells Fargo partly based on its ability to earn long-term oligopolistic mortgage origination spreads.

The proposed reform does not deal with the serious risks that the recent crisis exposed. Credit Default Swaps, which create large, correlated and asymmetric risks, scared the authorities into spending hundreds of billions of taxpayer money to prevent the speculators who made bad bets from having to pay.

CDS are also highly anti-social. Bondholders who also hold CDS make a bigger return when the issuing firms fail. As a result, holders of so-called "basis packages" a bond and a CDS have an incentive to use their position as bondholders to force bankruptcy triggering payment on their CDS, rather than negotiate traditional out of court restructurings or covenant amendments with troubled creditors. Press accounts have noted that this dynamic has contributed to the recent bankruptcies of Abitibi-Bowater, General Growth Properties, Six Flags and even General Motors. They are a pending problem in CIT's efforts to avoid bankruptcy.

The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialized risks by moving the counter-party risk from the private sector to a newly created too-big-to-fail entity. I think that trying to make safer CDS is like trying to make safer asbestos. How many real businesses have to fail before policy makers decide to simply ban them?

Similarly, the money markets were exposed as creating systemic risk during the crisis. Apparently, investors in these pools of lending assets that carry no reserve for loss expect to be shielded from losing money while earning a higher return than bank deposits or T-bills. Mr. Bernanke decided they needed to be bailed out to save the system. It is hard to imagine why this structure shouldn't be fixed, either by adding them to the FDIC insurance program and subjecting them to bank regulation, or at least forcing them to stop using $1 net-asset values, which gives their customers the impression that they can't fall in value.

The most constructive aspect of the Geithner reform plan is to separate banking from commerce. This would have the effect of forcing industrial companies to divest big finance subsidiaries, which would have to be regulated as banks. During the bubble, companies like GMAC, AIG Financial Products and GE Capital, with cheap funding supported by inaccurate credit ratings, took enormous unregulated risks. When the crisis hit, GMAC and AIG needed huge federal bailouts. The Federal Reserve set up the Commercial Paper Funding Facility to backstop GE Capital among others, and GE became the largest borrower under the FDIC's Temporary Liquidity Guarantee Program, even though prior to the crisis it wasn't even in the FDIC.

In response to the Geithner proposal, GE immediately let it be known that it had "talked to a number of people in Congress" and it should not have to separate its finance subsidiary because it disingenuously asserted that it hadn't contributed to the crisis. We will see whether the GE special interest is able to stave-off this constructive reform proposal.

Rather than deal with these simple problems with simple, obvious solutions, the official reform plans are complicated, convoluted and designed to only have the veneer of reform while mostly serving the special interests. The complications serve to reduce transparency, preventing the public at large from really seeing the overwhelming influence of the banks in shaping the new regulation.

In dealing with the continued weak economy, our leaders are so determined not to repeat the perceived mistakes of the 1930s that they are risking policies with possibly far worse consequences designed by the same people at the Fed who ran policy with the short-term view that asset bubbles don't matter because the fallout can be managed after they pop. That view created a disaster that required unprecedented intervention for which our leaders congratulated themselves for doing whatever it took to solve. With a sense of mission accomplished, the G-20 proclaimed "it worked."

We are now being told that the most important thing is to not remove the fiscal and monetary support too soon. Christine Romer, a top advisor to the President, argues that we made a great mistake by withdrawing stimulus in 1937.

Just to review, in 1934 GDP grew 17.0%, in 1935 it grew another 11.1%, and in 1936 it grew another 14.3%. Over the period unemployment fell by 30%. That is three years of progress. Apparently, even this would not have been enough to achieve what Larry Summers has called "exit velocity."

Imagine, in our modern market, where we now get economic data on practically a daily basis, living through three years of favorable economic reports and deciding that it would be "premature" to withdraw the stimulus.

An alternative lesson from the double dip the economy took in 1938 is that the GDP created by massive fiscal stimulus is artificial. So whenever it is eventually removed, there will be significant economic fall out. Our choice may be either to maintain large annual deficits until our creditors refuse to finance them or tolerate another leg down in our economy by accepting some measure of fiscal discipline.

This brings me to our present fiscal situation and the current investment puzzle.

Over the next decade the welfare states will come to face severe demographic problems. Baby Boomers have driven the U.S. economy since they were born. It is no coincidence that we experienced an economic boom between 1980 and 2000, as the Boomers reached their peak productive years. The Boomers are now reaching retirement. The Social Security and Medicare commitments to them are astronomical.

When the government calculates its debt and deficit it does so on a cash basis. This means that deficit accounting does not take into account the cost of future promises until the money goes out the door. According to shadowstats.com, if the federal government counted the cost of its future promises, the 2008 deficit was over $5 trillion and total obligations are over $60 trillion. And that was before the crisis.

Over the last couple of years we have adopted a policy of private profits and socialized risks. We are transferring many private obligations onto the national ledger. Although our leaders ought to make some serious choices, they appear too trapped in short-termism and special interests to make them. Taking no action is an action.

In the nearer-term the deficit on a cash basis is about $1.6 trillion or 11% of GDP. President Obama forecasts $1.4 trillion next year, and with an optimistic economic outlook, $9 trillion over the next decade. The American Enterprise Institute for Public Policy Research recently published a study that indicated that "by all relevant debt indicators, the U.S. fiscal scenario will soon approximate the economic scenario for countries on the verge of a sovereign debt default."

As we sit here today, the Federal Reserve is propping up the bond market, buying long-dated assets with printed money. It cannot turn around and sell what it has just bought.

There is a basic rule of liquidity. It isn't the same for everyone. If you own 10,000 shares of Greenlight Re, you have a liquid investment. However, if I own 5 million shares it is not liquid to me, because of both the size of the position and the signal my selling would send to the market. For this reason, the Fed cannot sell its Treasuries or Agencies without destroying the market. This means that it will be challenged to shrink the monetary base if inflation actually turns up.

Further, the Federal Open Market Committee members may not recognize inflation when they see it, as looking at inflation solely through the prices of goods and services, while ignoring asset inflation, can lead to a repeat of the last policy error of holding rates too low for too long.

At the same time, the Treasury has dramatically shortened the duration of the government debt. As a result, higher rates become a fiscal issue, not just a monetary one. The Fed could reach the point where it perceives doing whatever it takes requires it to become the buyer of Treasuries of first and last resort.

Japan appears even more vulnerable, because it is even more indebted and its poor demographics are a decade ahead of ours. Japan may already be past the point of no return. When a country cannot reduce its ratio of debt to GDP over any time horizon, it means it can only refinance, but can never repay its debts. Japan has about 190% debt-to-GDP financed at an average cost of less than 2%. Even with the benefit of cheap financing the Japanese deficit is expected to be 10% of GDP this year. At some point, as American homeowners with teaser interest rates have learned, when the market refuses to refinance at cheap rates, problems quickly emerge. Imagine the fiscal impact of the market resetting Japanese borrowing costs to 5%.

Over the last few years, Japanese savers have been willing to finance their government deficit. However, with Japan's population aging, it's likely that the domestic savers will begin using those savings to fund their retirements. The newly elected DPJ party that favors domestic consumption might speed up this development. Should the market re-price Japanese credit risk, it is hard to see how Japan could avoid a government default or hyperinflationary currency death spiral.

The failure of Lehman meant that barring extraordinary measures, Merrill Lynch, Morgan Stanley and Goldman Sachs would have failed as the credit market realized that if the government were willing to permit failures, then the cost of financing such institutions needed to be re-priced so as to invalidate their business models.

I believe there is a real possibility that the collapse of any of the major currencies could have a similar domino effect on re-assessing the credit risk of the other fiat currencies run by countries with structural deficits and large, unfunded commitments to aging populations.

I believe that the conventional view that government bonds should be "risk free" and tied to nominal GDP is at risk of changing. Periodically, high quality corporate bonds have traded at lower yields than sovereign debt. That could happen again.

And, of course, these structural risks are exacerbated by the continued presence of credit rating agencies that inspire false confidence with potentially catastrophic results by over-rating the sovereign debt of the largest countries. There is no reason to believe that the rating agencies will do a better job on sovereign risk than they have done on corporate or structured finance risks.

My firm recently met with a Moody's sovereign risk team covering twenty countries in Asia and the Middle East. They have only four professionals covering the entire region. Moody's does not have a long-term quantitative model that incorporates changes in the population, incomes, expected tax rates, and so forth. They use a short-term outlook only 12-18 months to analyze data to assess countries' abilities to finance themselves. Moody's makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.

Their main role, again, appears to be to tell everyone that things are fine, until a real crisis emerges at which point they will pile-on credit downgrades at the least opportune moment, making a difficult situation even more difficult for the authorities to manage.

I can just envision a future Congressional Hearing so elected officials can blame the rating agencies for blowing it, as the rating agencies respond by blaming Congress.

Now, the question for us as investors is how to manage some of these possible risks. Four years ago I spoke at this conference and said that I favored my Grandma Cookie's investment style of investing in stocks like Nike, IBM, McDonalds and Walgreens over my Grandpa Ben's style of buying gold bullion and gold stocks. He feared the economic ruin of our country through a paper money and deficit driven hyper inflation. I explained how Grandma Cookie had been right for the last thirty years and would probably be right for the next thirty as well. I subscribed to Warren Buffett's old criticism that gold just sits there with no yield and viewed gold's long-term value as difficult to assess.

However, the recent crisis has changed my view. The question can be flipped: how does one know what the dollar is worth given that dollars can be created out of thin air or dropped from helicopters? Just because something hasn't happened, doesn't mean it won't. Yes, we should continue to buy stocks in great companies, but there is room for Grandpa Ben's view as well.

I have seen many people debate whether gold is a bet on inflation or deflation. As I see it, it is neither. Gold does well when monetary and fiscal policies are poor and does poorly when they appear sensible. Gold did very well during the Great Depression when FDR debased the currency. It did well again in the money printing 1970s, but collapsed in response to Paul Volcker's austerity. It ultimately made a bottom around 2001 when the excitement about our future budget surpluses peaked.

Prospectively, gold should do fine unless our leaders implement much greater fiscal and monetary restraint than appears likely. Of course, gold should do very well if there is a sovereign debt default or currency crisis.

A few weeks ago, the Office of Inspector General called out the Treasury Department for misrepresenting the position of the banks last fall. The Treasury's response was an unapologetic expression that amounted to saying that at that point "doing whatever it takes" meant pulling a Colonel Jessup: "YOU CAN'T HANDLE THE TRUTH!" At least we know what we are dealing with.

When I watch Chairman Bernanke, Secretary Geithner and Mr. Summers on TV, read speeches written by the Fed Governors, observe the "stimulus" black hole, and think about our short-termism and lack of fiscal discipline and political will, my instinct is to want to short the dollar. But then I look at the other major currencies. The Euro, the Yen, and the British Pound might be worse. So, I conclude that picking one these currencies is like choosing my favorite dental procedure. And I decide holding gold is better than holding cash, especially now, where both earn no yield.

Along these same lines, we have bought long-dated options on much higher U.S. and Japanese interest rates. The options in Japan are particularly cheap because the historical volatility is so low. I prefer options to simply shorting government bonds, because there remains a possibility of a further government bond rally in response to the economy rolling over again. With options, I can clearly limit how much I am willing to lose, while creating a lot of leverage to a possible rate spiral.

For years, the discussion has been that our deficit spending will pass the costs onto "our grandchildren." I believe that this is no longer the case and that the consequences will be seen during the lifetime of the leaders who have pursued short-term popularity over our solvency. The recent economic crisis and our response has brought forward the eventual reconciliation into a window that is near enough that it makes sense for investors to buy some insurance to protect themselves from a possible systemic event. To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable.

As investors, we can't change the course of events, but we can attempt to protect capital in the face of foreseeable risks.

Of course, just like MDC, there remains the possibility that I am completely wrong. And, personally, I hope I am. I wonder what Stan Druckenmiller thinks.

John F. Mauldin
johnmauldin@investorsinsight.com

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The Best of Times - John Mauldin's Weekly E-Letter

2009-10-24T13:23:00.001+08:00

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Thoughts from the Frontline Weekly Newsletter The Best of Times by John Mauldin October 23, 2009
In this issue: It's The Best of Times The Elements of Deflation It's More Than Half Full Argentina, Brazil, and Uruguay
What's a Fed to do? We get talk about tightening and taking away the easy credit, but we got the fourth largest monetization on record last week. This week we examine the elements of deflation, look at some banking statistics that are not optimistic, and then I write a reply to my great friend Bill Bonner about why it's the best of times to be young. I think you will get a few thought-provoking ideas here and there. But before we get to the main letter, I want to recommend a book to you. I am on a 17-day, 12-city speaking tour. It is rather brutal, but I did it to myself. However, one of the upsides of traveling is that I get quiet time on airplanes to read books. I am working my way through a very large stack of books on my desk. One that caught my eye - and I'm glad it did - is a book by Tom Hayes called Jump Point: How Network Culture is Revolutionizing Business. Hayes writes about how we are getting ready to experience a cultural change every bit as profound as the Industrial Revolution. He argues that as the 3 billionth person gets online sometime in 2011, it will shift the dynamic of how we interact as businesses and consumers. We get to 5 billion by 2015. The mind boggles. Clearly, it is already changing things, and I am not sure if I buy Hayes' thesis that 3 billion is a magical number, though it is great marketing. That being said, I found something on almost every page that I underlined or highlighted. This book made me think about the future in ways that my kids already get but Dad doesn't. I like to read books about "important stuff" by people who have done a lot of thinking about their subjects, and who can write easily and fluidly and communicate their thoughts without weighing me down with unnecessary verbiage. Hayes has done that. (I am sure some of you, my patient readers, wish I could be better at that!) No long review here. Go to Amazon and read the reviews. One writer wrote: "I gave the book 5 stars not because it was perfect -- I think Hayes's enthusiasm sometimes makes him jump to conclusions - but because there are so many ideas and observations here that it would take ages to put something like this together from other sources." I agree. If you are in business, any business, you need to read this. As an aside, I will insist that all my partners worldwide get this book and read it. You can go to Amazon.com and buy the book. And Tom, if you get this (and I bet one of your friends will forward it to you), call me. The Elements of Deflation One of the advantages of travel is that it gives you time away from the tyranny of the computer to think. (Am I the only one who feels like I am drinking information through a fire hose?) But getting the information is important too, as it gives you something to think about. And I have been thinking a lot lately about deflation. I get asked at almost every venue where I stop, whether I think we will see inflation, or deflation. And I answer, "Yes." And I am not trying to be funny. I think the primary forces in the developed world now are deflationary. When asked if I don't think that the Fed monetizing debt of all kinds won't eventually be inflationary, I answer, "We better hope so!" Let's quickly summarize some of the ideas from the last few months of this letter. Just as water is made up of two parts hydrogen to one part oxygen, so deflation has its own elemental structure. The first element is Rising Unemployment. There has never been a sustained inflationary period without wage inflation. Wages are basically flat and falling. With 9.8% unemployment, 7% underemployed (temporary), and another 3-4% off the radar screen because they are so discouraged they are not even looking for jobs, and thus are not counted as unemployed (who made up these rules?), it is hard to see how wage inflation is in our near future. Think about this. Only a few years ago, less than 1 in 16 Americans was unemployed or underemployed. Today it is 1 in 5. That is a staggering, overwhelming statistic. Mind-numbing. Keynes said that you should stimulate the economy in recessions in order to bring back consumer spending. That is not going to happen this time. As my friends at GaveKal point out, this time we will have to have an Austrian (economic) recovery, or a business-spending recovery. My argument will be, when I am with them in Dallas in December at their conference, "Where are we going to get business-investment spending when banks aren't lending and capacity utilization is at an all-time low?" This, of course, leads the Keynesians to jump in and say, "The government has to step up and jump-start consumption!" Which means more debt. Wash. Rinse. Repeat. The next element of deflation is massive Wealth Destruction. Two bear markets and a housing market collapse have put the American consumer on the ropes. And the next bear market will bring him to the canvas. Then we have Reduced Borrowing and Lending, as consumers are paying down debt and banks are reducing their lending. Both are necessary in a credit crisis-caused recession. Bank lending is basically back to where it was two years ago, and shows no sign off rebounding. Banks, as I have written, are buying US government debt in an effort to shore up their balance sheets. Lending to small business, the real engine of job creation, is sadly decreasing each month. (See graph below.) Next up in our elemental list we have Decreased Final Demand and its counterpart Increased Savings. Although the savings rate has come back down to 3% from 6% a few months ago, almost every expectation is that it will rise over the next 3-5 years back up to the 9% level where it was only 20 years ago. The psyche of the American consumer has been permanently seared. Consumption and savings habits are being changed as I write. And of course we must address the element of Low Capacity Utilization. While capacity utilization is rebounding, it is still lower than at any time since the data has been collected, other than the last few months. It is hard to see where businesses are going to get pricing power, when not only US but world capacity utilization is still extremely low. The chart below is not the stuff that inflation is made of. And let's just quickly throw in Massive Deleveraging and $2 trillion in Bank Losses and a Very Weak Housing Market. Which brings us to a Slowing Velocity of Money. As I have written on several occasions, prices are a function of the amount of money times the velocity of money. If the velocity of money is slowing, the amount of money can rise without bringing about inflation. It is a delicate balance, but nonetheless the hyperventilation in some circles about the coming hyperinflation is, well, overinflated. Simplistic. Economically naive. The Fed is going to do what it takes to bring about inflation (in my opinion). But they will not monetize US government debt beyond what they have already agreed to. If they need to "print money" to fight deflation, they can buy mortgage or credit-card or other forms of private debt, which have the convenience of being self-liquidating. Read the speeches of the Fed presidents and governors. I can't imagine these people will recklessly monetize US debt. You don't get to their level without having a stiff backbone. (Yes, I know the gold bugs will call me terminally naive. We will have to wait to see who is right. Peter Schiff, care to make a bet on this one?) Bernanke warned Congress again last week about rising deficits. Watch the deficit rhetoric coming from the Fed after the next two governors are appointed next year, side by side with Bernanke's reappointment. There will be a line drawn in the sand. Some in Congress will not be happy, but my bet is that the Fed will maintain its independence. If they do not, then my recent letters will prove far too optimistic (and many of you protest my rather less-than-positive suggestion of a double-dip recession). But I must admit I cannot imagine that happening. And there are not enough votes in Congress to change that independent status. There is a day of reckoning coming with the US debt. And thank God for that. Bottom line: The Fed will do what it takes to keep us from deflation. They will deal with the problems of the ensuing inflation. I wrote six years ago that the best outcome from all the easy monetary policy and budget deficits would be stagflation. I see no need to change that assessment. I am not happy with stagflation, but as I came into my young adult life in the '70s (see below), I know that we can deal with that. The far more worrisome prospect is continued trillion-dollar deficits. It Is the Best of Times Now let's change the topic. My friend Bill Bonner, of Daily Reckoning and Agora Publishing fame, recently wrote about his mother. Bill also turned 60 recently. I wrote to him about the similarities between our mothers. Both were born in hard circumstances, on farms that had no indoor plumbing. They joined the WACs and met their husbands. They struggled raising families. Bill and I both grew up in rather humble circumstances (to put a mild spin on it). That exchange caused Bill to write about the future our kids face. He has six kids and I have seven. He has graciously allowed all my kids to invade his chateau in rural France (where they mingle with his kids), and has invited us back next summer. I think Bill is the best writer, the best "turner of a phrase," in the business. I often feel like a house painter standing in front of a Rembrandt when I read his work. But Bill is a tad pessimistic. He makes me look like Larry Kudlow. He wrote (among other books) Financial Reckoning Day, which has just been updated and is now titled Financial Reckoning Day Fallout: Surviving Today's Global Depression. It makes for some interesting reading. Get it with Jump Point. Now to the point. As I said, Bill wrote about the future our kids face. I will repeat what he said and then respond. Bill's thoughts: "We sat in a cab yesterday, stuck in traffic in central London. We watched people walk by and wondered. What are they thinking about? What do they want out of life? What do they think of themselves? "There were hundreds of them...different shapes...different sizes. A businessman in a pin-striped suit, briefcase in hand, concentrating on his sales report; he almost stepped in front of a motorcycle. A salesgirl, grotesquely overweight...yellow hair streaked with brown...wishing she hadn't had so much to drink the night before. A lawyer daydreaming about his secretary. A man who would have rather been fishing...still in his waxed coat. A woman annoyed about something. A heavy construction worker, his legs splayed outward as he walked. A tense young woman who dared not look up. A woman worrying about her son. A man thinking about buying a new car. One man trying to remember a line from a song he learned 30 years ago. Another talking to herself. One looked like a doctor taking an afternoon stroll. Another was stark raving mad. "All of them walking along...from one place to another...shuffling along...the living towards the dead. "We were thinking of our children. What a different world they grow up in. And yet, it is still the same too. A man might have been stuck on a London street 50 years ago...and hundreds of years ago he might have watched the same shopkeepers and carpenters walk by, each caught in his own thoughts like a fly in a spider's web. "Our old friend John Mauldin wrote to say that his mother's experience was not much different than ours. She joined the WACs during the war...met John's father...and then nature took her course. "But both John and your editor had a big advantage in life. We both caught the upswing. "Not so with our children. They inherit a different world. America was the world's leading nation in the '50s and '60s. And it was growing in power and wealth - rapidly. We grew up with it. Things were getting better and better...we were sure we'd live much grander, richer, and more exciting lives than our parents. The sky was always the limit! "Now, America is in decline. China's economy grows while hers declines. The Far East has savings, while she has none. The Asia nations are net exporters, making huge profits...while American industries are judged too old, too expensive, and too highly regulated to compete. Americans have debt up the kazoo, while their competitors have little. A young person in America has to look forward to supporting 70 million retired baby boomers...and paying for their drugs, their food, their wars, and their bailouts. "For our children - ours and John's - the situation on a personal level is different too. Coming from poor families, we could look forward to much more wealth and material success than our parents ever knew. "We came back to Ireland this week for a reason that our parents would never have dreamed of. Your editor has set up a family office. It is a very modest affair by family office standards. The typical family office manages a fortune of $100 million, according to The New York Times. We may not even be on the same planet with these rich families; but we are in the same universe. That is, we try to think about...and manage...our wealth as rich people do...as a family legacy or an endowment, not as a retirement fund. "What wealth we have accumulated - even if it is paltry - will be held by a family-owned corporation. Then, the corporation, run largely by the adult children, manages the assets - from our base in Ireland. "Your editor, freed from the responsibility of managing his own money, will be free to wander and think...like a vagabond, a gypsy, a refugee, an itinerant mendicant...forced to sup on whatever is at hand and take lodging wherever he can find it - but favoring the Four Seasons and Chateau Margot when they are available. "Whatever else this does, it puts the children in a very different situation from their parents. Instead of starting out with nothing, they're starting out with something. While this would seem to be a big advantage to them, it has huge hidden disadvantages. Like America itself, they are in danger of finding themselves slipping downhill. Instead of expecting things to get better, they may find it hard even to hold onto what they've got. Instead of the "Morning in America" that Ronald Reagan promised, they may find that it seems more like evening, both in their personal as well as their national lives. "'From shirtsleeves to shirtsleeves in three generations,' say the French. The grandfather begins without a coat. His grandson ends that way. "But what to do? Spend it all now...so the children begin with the same clean slate we had? Move to Brazil or India - countries with more obvious upside? "In the deep, cosmic end, it probably doesn't matter. The advantage to starting out on an upper rung of the ladder may be about equal to the disadvantage of having to worry about falling off. Who can know? "Every man has to play the cards he's been dealt. What else can he do? He may have a humpback or a beautiful voice. He may have had a hard upbringing or a soft head. He may have a fortune worth of poetry in his soul but not a dime in his pocket. As far as we can tell, every young man starts out even. Each one begins life in the same place - where he is. And every generation takes what it is given, and makes the best of it. "The real advantage in life is having the gumption to get on with it; no one knows where that comes from." It's More Than Half Full Ok, Bill, let's review those wonderful days from whence we sprang, so fraught with the advantages of having nothing. So potent with opportunity. It was the middle of the '70s when we started our careers. Inflation was high and rising. The Soviets were seen as a major threat. Japan was beating our brains out and buying everything, even if nailed down (like Pebble Beach and New York skyscrapers). I had to borrow money at 15% (or more) to buy paper in order to meet customer demands for printing. And guess what? The banks got into trouble and called loans willy-nilly. (My bank even called my mother and threatened her to pay off my loan - against written agreements - and she did. Evil sons of bitches. The more things change... And that bank did fail, I report delightedly! Not that I hold a grudge.) There were multiple successive and ever-deeper recessions. Gold was rising and the dollar was seen as a joke. Howard Ruff (a good friend to both of us when we were starting out!) and almost every newsletter writer were telling people to buy gold and freeze-dried food to protect themselves against a near-certain economic, if not apocalyptic, catastrophe. Unemployment was high and rising for a decade. The correct answer to the question, "Where will the jobs come from?" back then was, "I don't know, but they will." And that is the correct answer today. In 20 years, no one will want to come back to the halcyon days of 2005. Our kids (all 13 of them) are getting ready to live through what will be the most exciting period in human history. There will be a century's worth of change, measured by the standard of the 20^th century, just in the next ten years, and then we will double that pace in the next ten after that. Medical miracles will mean our kids and grandkids will live a lot longer than their dads, although I intend to be writing well into my 80s, like our mutual hero Richard Russell. There will be whole new industries developed in the US. How do I know that? Follow the money. The rest of the world spends a fraction of what we do on research and development. Where do you go if you are looking for venture capital? Do I care if the Chinese and the "developing" world are far better off, relatively speaking, than the US in 20 years? Not a whit. Good on them. I hope they make discoveries and inventions and grow new businesses that benefit us all. But we are not going into some long dark night. We, and our kids, get to choose how we respond to what is the reality of the day. Our nation had to almost hit the wall in 1980 before a Volker could come along and force us to take the pain of recession to beat back inflation. And we will have to come perilously close to the wall this time before we take action as a nation. Way too close for comfort. Maybe you are right, and we have a soft depression. I hope not; but even so, the world will be better, far better, in 20 years, with far more opportunities than today. It was not fun starting new businesses in the '70s and early '80s. But we did. I remember coming to Baltimore and being (literally) afraid to get out of the car to visit your offices in the slums. But that was what you could afford. A far cry from the chateau in Ouzilly. I lived in a small mobile home. Tiffani was born there, and we converted part of the kitchen to be her bedroom. (Yes, I was white "trailer trash.") But I got up every morning just like you did and killed as many alligators as I could. The rest had to wait 'til the next day. And that is the legacy our kids have. They know what it is to wade into the swamp every morning. Never quitting. In thinking about this, you may be the father I respect the most. You have raised your kids to be multilingual children of the world. What a work ethic. How did you get them to scrape window shutters at your chateaus? (I actually saw this, and my kids marveled. Thereafter I threatened to make them go live with you when they didn't behave!) You have given your kids the opportunity to follow their dreams, even demanded that they do so. And such dreams they (and mine) have. Will they succeed? Who knows? But they will go at it with gusto, in a world with more opportunities than you and I ever imagined 40 years ago. And, oh boy, were we optimists back then. How else could we have done what we did? If we believed the rhetoric that the world was coming to an end, would we have dared to venture out? You cannot have raised your kids to be such bold adventurers without instilling in them a certain high level of optimism. I am going to out you, Mr. Bonner. You present yourself to your readers as a bona fide end-of-the-world pessimist. But you are a really and truly a closet optimist. Your whole business empire (and what an empire it has become!) is based on finding people who are optimists, in the sense that they think they can actually get people to send them money for what they write. Which they do! Even if it is to read why the world will come to an end, which thankfully it never does. You are right in this: it is personal gumption that makes or breaks us. There are those who started out with less than we did (hard to imagine but true) and made a lot more. And there are those who started out with far more and made less. But there are very few who are happier than either of us. Or luckier. Our kids? It is not the times that dictate the man (or daughter!), but the response of the man which dictates his own time. Today promises a brighter future for someone young than any other time in history, whether they are in the US or Brazil or China. They just have to seize it. And as our kids do just that, and as the millions of kids of those who read us do so, and the billions of kids who are just now getting ready to bust loose all work to achieve their dreams, the world is going to be a far more fantastic place. Smooth ride? Not a chance. We didn't get one; and in thinking through history, there have not been many smooth rides. Why should we think that will get any better? Our kids will just have to live with our generational (and individual) iniquities, government debt and all, and figure out how to master their own fates. But if I had a choice to take the '70s or today? In less than a heartbeat I would choose today. And I bet you would too! (Side note: You can subscribe to the Daily Reckoning and read more of Bill's great prose. Warning: it is bearish, but lively and fun.) Argentina, Brazil, and Uruguay Tonight I am in Orlando, where I spoke at the Commonwealth national conference. I have been to a few conferences here and there, but I must admit to being impressed. A conference for brokers and advisors who are affiliated with them, it was exceptionally well done. And a very smart crowd. These guys have attracted some exceptional talent. Tomorrow morning I fly back to Dallas, where I get to see my new grandson, Hayden, for the first time. Born this week a little early while I am on the road, I get a call at 3 am on Monday telling me the news and sending me a picture. Wow. The heck with deficits and deflation. How can you not be an optimist? Then later in the afternoon I am off for Argentina, Brazil, and Uruguay, speaking in four cities and meeting with clients (and future clients) of my Latin American partner, Enrique Flynn. And then back to Philadelphia, again in Orlando, Scottsdale, and one trip to New York in early December. Then not much else is scheduled - but past performance says that will change. There is a steak and a bottle of wine waiting for me down the hall, so it is time to hit the send button. Have a great week. I know I am. I love South America, and look forward to coming back to you with my impressions. Your wondering who made up this schedule analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; Fynn Capital; Nicola Wealth Management; 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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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 To unsubscribe please refer to the bottom of the email. 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 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 NASD 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. 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. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to cs.victor@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

理財讀心理投資睇性格

2009-10-24T10:36:00.001+08:00

2009年10月24日

理財讀心理投資睇性格

姚志新

曾經向許多基金經理討教，要成為出色投資者需要具備什麼條件？除了要有選股能力、逆市思維外，基金經埋幾乎都提及過一項必備條件，就是良好的心理因素。

金融海嘯發生後，愈來愈多人重溫「投資心理」學說，因為心理狀況往往直接影響「財務行為」。這門學說的關鍵人物是卡尼曼（Daniel Kahneman），他在2002年獲得諾貝爾經濟學獎，在學術界哄動一時。卡尼曼提出，在投資心理學上有五種心理誤差，常會左右我們的投資決定，影響最後投資回報成果。

簡單歸納，五項心理偏差包括：一、過度自信，低估風險；二、心理賬戶，對風險猶豫；三、避免後悔，變得保守；四、心理處分效果，賠錢而不止蝕；五、只集中投資熟悉項目，無形中提高風險。

巴克萊財富行為財務主管Greg Davies劍橋大學畢業，其博士論文研究結合心理決定和金融理論，分析人的財務行為及心理風險，可說師承卡尼曼一派。

他認為，了解客戶承受風險程高低是財富管理非常重要的一環，但傳統設計問卷可能只包含幾個簡單問題，不能確切做到這一點。

事實上，卡尼曼出的五點，說明即使我們量度了個人的風險承受能力，但是，我們其實卻不太了解自己的心理，因此才會出現錯誤決定。

他反覆強調，財富管理是一個「旅程」，沒有任何一個組合設計可以一勞永逸；相反，旅程當中，我們會有情緒上被市場聲音影響，做錯誤決定。

Davies表示，巴克萊先讓客戶填寫一套三十六條問題的問卷，再了解該客戶的收入和資產狀況、投資目標及資產需求，總結出一個「財務個性」，當中包含六個重點，包括：

1. 風險承受程度：能否忍受價格波動，長線追求更高回報。

2. 冷靜／情緒反應：對市場波動的反應、壓力，分數低的人會傾向頻密更改組合。

3. 參與市場程度：對金融市場是否安心，低分數的人應避免蒙受重大損失。

4. 金融經驗和熟悉程度：高分數的人更容易表達經驗和投資傾向，更能夠自行做決定。

5. 投資授權程度：是否相信投資經理管理投資，更能受惠。

6. 是否相信投資技巧：是否相信投資專家能夠得到更出色回報，或跑贏大市。

事實上，上述六點絕對不是新鮮事，但當我們嘗試把這些放在一起觀察時，方發現我們存有各種各樣自己都不知道的矛盾。打個譬如，你可能願意承受較高程度的風險，對短期回報升跌不太擔心，但面對市場不明朗時却不能冷靜，那麼閣下可能需要分配更多流動性更高的資產，或者絕對回報策略的投資。

Zen Lessons in Market Analysis - John Mauldin's Outside the Box E-Letter

2009-10-20T08:31:00.001+08:00

	Contact John Mauldin
	Print Version

Volume 5 - Issue 49
October 19, 2009

Zen Lessons in Market Analysis
By Dr. John Hussman

"Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation."

Long time Outside the Box readers are quite familiar with Dr. John Hussman, as he is a frequent choice for this column. But this week I think he has written one of his bests essays ever. He cleverly weaves in quotes from a Zen master who is his friend and gives us a very fresh look at market analysis. This is a thought piece and you should set aside some time to absorb the lessons. You will be well rewarded.

Dr. John Hussman is president of Hussman Investment Trust. You can find out more about the mutual funds he is involved with at http://www.hussmanfunds.com/.

And I recorded three sessions for Yahoo Tech Ticker in New York this morning. You can go to Yahoo and see them. All the best,

Your on the road again analyst,
John Mauldin for Outside the Box

Zen Lessons in Market Analysis

By John P. Hussman, Ph.D.

"The best way of preparing for the future is to take good care of the present, because we know that if the present is made up of the past, then the future will be made up of the present. All we need to be responsible for is the present moment. Only the present is within our reach. To care for the present is to care for the future."

This week's comment is dedicated to my dear friend Thich Nhat Hanh, a Vietnamese Buddhist monk who was born on October 11, 1926, having been born previously in January of that same year, and twice again about 25 years earlier, not to mention countless other times through his ancestors, teachers, and other non-Thich Nhat Hanh elements. Thay (the Vietnamese word for "teacher") would simplify this by saying that today is his eighty-third "continuation day," because to say it is his birthday is not very accurate.

If the quote at the top of this page looks somewhat familiar to our long-term shareholders, it may be because the practice of tending to the present moment responding to prevailing conditions rather than relying on forecasts is central to our investment discipline.

Focusing on the present moment doesn't imply ignoring the past or failing to consider the future. It's clear, for example, that we put a great deal of attention on estimating future cash flows and discounting them appropriately in order to evaluate whether various investments are priced to deliver satisfactory long-term returns. We certainly devote our attention to macroeconomic pressures and latent risks that threaten to become full-blown crises later. Still, we rarely make near term forecasts. Nor do we answer surveys like "where do you think the S&P 500 will be at year-end?" a question that falls entirely outside of our way of thinking like asking Columbus what sort of trees he thinks are planted along the edge of the Earth. The reason we avoid forecasts, very simply, is that they are not required, and that they can be a hindrance.

Expectations

One of the major debates among investors is between buy-and-hold investing and market timing. Think of the market as a big hat that has both red and green marbles in it, red corresponding to declines, and green corresponding to advances. The buy-and-hold investor essentially believes that it is impossible to predict which color marble will be drawn next, but that on average the marbles will be green. So the buy-and-hold approach simply holds on, regardless of prevailing conditions. The market return expected by a buy-and-hold investor is the "unconditional expected return" something that has historically been about 10% annually. Let's call this E[R]

In contrast, a forecaster does believe that the next draw can be predicted given some information "X". As that information varies, forecasters will decide to buy or sell. But forecasters typically do something extra. Generally speaking, forecasters are not content with dealing with the present moment, and instead are prone to making bold forecasts about the next month, quarter, year, or even an entire stream of future returns (bull markets and bear markets).

The problem with this, in our view, is that it implicitly assumes that the information set "X" will remain constant. Worse, the size of the forecasts is generally far too large to be rational. A good forecast is most often a humble one.

Robert Hall of Stanford University (also the chair of the NBER Business Cycle Dating Committee that officially dates the beginning and end of recessions) calls this the Iron Law of Econometrics the variance of a proper forecasting approach will always be smaller than the variance of the actual data. The reason is that if actual returns are equal to expected returns plus a random error,

R = E[R] + e

then a proper forecast is one where the errors are independent of (not correlated with) the expected returns. That means that the variance of actual returns call it V(R) must be equal to the variance of your expected returns V(ER) plus the variance of the error terms V(e). As long as there is any forecast error at all, an efficient forecast will always be one where your expected returns are less variable than what actually takes place. Forecasters hate this, because they like to make big, flamboyant predictions about a whole string of events, rather than focusing on the present moment.

Consider that hat full of marbles again. Suppose you are told that 80% of the marbles are green, and that 10 marbles will be drawn (with replacement). If someone asks your forecast, it's very likely that you'll be comfortable predicting that 8 of the marbles will probably be green.

Now suppose the first marble is drawn, and suddenly, someone switches the hat, right in front of you. What happens to your confidence in your forecast? Well, it should collapse, because suddenly you're facing a new X. If the information set X can change, then it is not reasonable to make forecasts that assume that it will be constant over the forecast horizon.

So if we don't want to assume that market returns are simply constant at 10% regardless of valuations or other conditions, and we also don't want to make inefficient forecasts, what is the alternative?

For us, it is to focus on the present moment. We focus on "conditional expected returns" - the return we can expect, given the particular information set X that we have in hand. This is generally written E[R | X]. But unlike forecasters, we recognize that the predictable component of market behavior for any given period is so small, relative to random noise, that making specific forecasts is futile. We take our information set one X at a time, and we rely on discipline and the law of large numbers to mute the impact of that random noise over the long-term.

Specifically, we can go back over history and use observable conditions such as valuations, market action, overbought/oversold status, macroeconomic factors, and so on to separate history into various "bins." Each bin represents a combination of observable conditions occurring together (what I've called "X"). Then we can ask, for every observation in the bin, what was the market return over a short subsequent period like a week or a month. Each bin then can be associated with a particular expected return and risk profile. Our basic practice is to align our investment position with the set of conditions that we observe at each moment, and to shift our position as the evidence shifts.

Rather than treating the next week, month, quarter or year as a horizon that demands a specific "forecast," we simply treat each realization as part of a "repeated game," and rely on the law of large numbers that is, the idea that if we follow our discipline period after period after period, over time our inevitable errors will average out, and our long-term results will be largely what we expect. The best way to take good care of the future is to take good care of the present moment.

But isn't E[R | X] a forecast?

One might object that by aligning our investment position with the average return/risk profile associated with a given set of conditions, we must, by definition, be forecasting. This is true in the sense that we do have some expectation that market returns under a given set of conditions will be satisfactory or unsatisfactory, given the risks involved. But we differ from "forecasters" in recognizing that the expected return E[R | X] for any short period of time is overwhelmed several times over by the conditional error term "u". It is only over many, many repetitions that the error terms dampen out.

This is a property that statisticians call "consistency." Specifically, if a process is consistent, then as you increase the number of observations some random outcome, the average value of your observations will tend toward the true "population" average.

[Geek's Note: If R = E[R | X] + u, then over N repetitions, the standard deviation of the average error is the standard deviation of the actual error terms, divided by the square root of N. So if your conditional error terms tend to have a mean of zero, plus or minus 2.5% on a weekly basis, you would expect that over 100 weeks, your average error would be zero, with a standard deviation of about 0.25%. Over a full market cycle, you will have made a lot of individual mistakes in your investment position, but as long as your errors are not systematic, the combination of discipline and the law of large numbers will work strongly in your favor. Your results will be largely as you expected despite the fact that you made lots of individual errors along the way].

This is basically the dynamic at work when you sail a boat. If you hop into a sailboat and start across Lake Michigan, it is not particularly helpful to make predictions about the direction and speed of the wind over your entire journey. Much better to align your sails as those conditions change, making numerous modest errors, but getting across the lake.

Inquiry

"Suppose the mind consciousness is observing an elephant walking. During the time of observation, the object of mind consciousness may not be the elephant in and of itself. It may only be a mental construction of the elephant based on previous images of elephants that have been imprinted in store consciousness.

"Inquiry means not using the mental creation, but allowing yourself to get in touch, and to try to see how things truly are. We practice not to be influenced by the name, because when we are caught in the name we can't see reality."

Thich Nhat Hanh

It is important that we don't place so much emphasis on "average outcomes" that we ignore the facts about particular instances. We still have to look carefully at reality to make sure that we aren't assuming away particular features that are important.

This is a risk that market participants seem to be taking here in a major way. Specifically, we have seen a great number of research reports with the basic thesis of "The recession is over. Here is how the market (or the economy, or employment, etc) has performed after a recession is over." The difficulty is that these are basically attempts to say "here is an elephant" and then immediately move to describing elephants in general, when in fact, this particular elephant is very likely to be pink, or white. Specifically, valuations here are far different than they have been at the beginning of the typical economic expansion. Moreover, economic expansions have historically always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just one-off cash for clunkers) demand for automobiles. In prior recoveries, debt-financed expenditures have turned up quickly and have typically led other classes of expenditure by nearly a year.

If we want to see things as they truly are, we have to look both at the elephant, and at anything that might set this particular elephant apart. With regard to the investment markets, if we suspect that the particular features of the present situation make things "different" than they have been historically, then it is best to look closely and get more data.

As an example, during the late 1990's, it was often argued that technological innovation had changed the economy so profoundly that the market valuations of the time were actually reasonable, if not incredibly attractive (remember Dow 35,000?). So we had to open ourselves to the possibility that things were different in an important way. But when we actually looked at the data, there was simply no historical example in any productivity spurt since the Industrial Revolution that could support the sort of growth rates that were implicitly priced into stocks.

When we look at the current market environment today, it is clear that the enthusiasm about the market here is largely based on the idea that the recent recession is over, and that the economy will form a "V" shaped recovery similar, but much stronger quantitatively, to standard post-war recoveries. This is a very difficult argument to make, because the drivers of economic growth that existed in typical economic recoveries particularly debt origination and consumption growth are very compromised at present. Our perspective on the ongoing credit risk in the economy is much like that of economists Kenneth Rogoff and Carmen Reinhart, who foresaw the recent financial crisis, and are far less sanguine about the prospects for sustained recovery.

As I've discussed in several weekly comments, this is a subject that I have struggled with in recent months. Even if we could assume that the recent crisis was a standard post-war downturn, and that we are now in a standard post-war recovery, valuations would still concern us because at these levels, stocks are not priced to deliver satisfactory long-term returns in any event. However, we would have a greater willingness to take a moderate speculative exposure based on market action and prospects for sustained economic improvement. On the other hand, when we include other post-crash periods into our data set, and allow for the possibility that those instances better describe present conditions, the case for accepting speculative exposure is much more limited. Of specific concern is the tendency in those periods for strong advances (as we've seen in recent months) to be followed by spectacular failures.

So we have to be very careful about how we name things. When people label stocks as being in a "bull market," the implicit suggestion is that stocks will continue to advance for a sustained period of time. When people say that the recession has ended and we're now in a "recovery," the temptation is to look at how the market has performed in previous recoveries, without noting the profound differences between those instances and the current environment.

As Thay says, "We practice not to be influenced by the name, because when we are caught in the name, we can't see reality." The picture in our head can be very influenced by the words we attach to it.

As Zig Ziglar says, "You can tell your wife that she looks like the first day of spring, or you can tell her that she looks like the last day of a long, hard winter. There is a difference."

Koans

In Zen, there is a teaching tool known as a "koan" a question that serves as the object of meditation, and is intended to reveal something about teachings like mindfulness and interconnectedness. Western observers sometimes mistake these for riddles, non-sequiturs, or nonsensical statements, but if you look at them carefully, they are questions or stories intended to prompt the listener to see things as they really are.

A riddle is something like this:

Q: "How does a Zen monk know his pizza is enlightened?"
A: "It's one with everything."

Here is a koan:

A novice monk approaches his teacher and asks, "Is this a bull market or a bear market?"
The teacher replies, "If it is a warm day, and I say that it is winter, will you still wear your heaviest coat?"

Causes and Conditions

"This is, because that is. This is not, because that is not."

Buddha

"The seed and the fruit are not two different things. The fruit is already contained in the seed. It's waiting for different conditions in order to be able to manifest. The fruit doesn't have a separate existence; it's a formation. Using the word "formation" reminds us that there is no separate existence in it. There is only a coming together of many, many conditions. "

Thich Nhat Hanh

When we think about events, either in our daily lives, or in the market or the economy, it is important that we don't think of them as simply existing or coming out of nowhere. This is, because that is. This is not, because that is not. We cannot create or remove a condition, expect it to emerge or expect it to disappear, without understanding the seed that produces it, and the causes and conditions that allow it to spring up.

Generally speaking, the seed we water is the one that grows. That's why if we spend our energy thinking about what we don't want, what we don't like, what is wrong we'll tend to nurture and strengthen exactly the wrong things. If we water the seeds of peace, understanding, empathy, happiness, and so on, those are the seeds that will grow.

The basic condition for anything to emerge is for the seed to exist. But that is not enough. The seeds of a bear market are often fully present in the later stages of a bull market overvaluation, excessive speculation, acceptance of risk without sufficient compensation, extension of credit to poor credit risks, belief in the sustained growth of cyclical businesses, overconfidence, and so forth.

But in order to manifest as a flower, or a weed, or as fruit, other conditions have to be present. Buddhists distinguish two kinds "same direction" and "opposing direction."

Conditions in the opposing direction tend to hold back the manifestation of the seed, but can also force it to become stronger before it manifests. If you plant a seed in firmer soil, the roots may be forced to dig deeper in order to establish themselves and find water, whereas a seed in easier soil may grow more quickly but have weaker foundations, so it can be uprooted easily. Conditions in the same direction are those like water and sunlight, which provide the background environment necessary for the seed to grow.

Some of our best investment insights have been driven by this focus on causes and conditions. These often take the form of "Aunt Minnies" sets of conditions that may not mean much by themselves, but have very strong implications when they occur together (a person may have one feature or another, but if you have just the right combination, you know it's Aunt Minnie). These include, for example, the conditions I noted in A Who's Who of Awful Times to Invest, and our recession warning composite. To find Aunt Minnies, we look for a seed, identify conditions in the opposing direction (if any) that have made the seed strong, and then look for conditions in the same direction that are capable of bringing the seed to fruition.

Many of my concerns about the markets in recent years have emerged because too often, financial market participants and policy makers focus on manifestations rather than causes and conditions. This is why investors produced the dot-com bubble, the tech bubble, the mortgage bubble, the debt-financed private equity bubble and the commodity bubble without thinking of the seeds of crisis that were latently emerging, or how violently they would manifest. Our policy makers have bailed out poorly run financials by creating massive federal deficits, and think they've solved the problem in the same way as someone who runs over a weed with the lawnmower. The roots have simply grown deeper, because the seeds are still there, but we've applied a few conditions in the opposing direction. Those of you who have read these missives for a long time know that my geopolitical views are largely the same. This is, because that is. This is not, because that is not.

We can have an overvalued market and the seeds of a bear market, but if we apply opposing conditions in the form of easy money in order to prop up the market and prevent the consequences of bad behavior, the seed will simply grow stronger, and its ultimate manifestation will be more powerful. We can have a mortgage market that is setting new records for delinquencies and foreclosures every month, combined with increasing unemployment and a heavy reset schedule on Alt-A's and option-ARMs that is just now picking up. But we lower the bar on financial reporting, fail to restructure debt, and ignore the strengthening seed because we're single-mindedly enthusiastic about the thin-rooted green shoots of stabilization born solely of a burst of fiscal profligacy then we'll predictably be blindsided when the problems re-emerge.

Predictably blindsided. That's happened again and again in recent years. And it happens when we fail to think about the seeds we are watering. If we look only for fruit and ignore the seeds of crisis, then every bit of fruit will be followed by crisis, and nobody will understand why.

Interbeing

"As thin as this sheet of paper is, it contains everything in the universe in it."

Thich Nhat Hanh

If you look closely at a sheet of paper, you can see the clouds, the rain, the soil, the sunshine, the mill, the truck, and so forth, because without these things, there would be no sheet of paper. In Buddhist terms, the paper is "empty" and has no self. That doesn't mean that the paper is not there, but rather that the paper is made entirely of non-paper elements. Empty of self means full of everything non-self.

There's a phrase alambana pratiyaya which means that object and subject are always born together. The idea of interbeing is that nothing has a separate existence that each thing is connected to the others. It's an inherently peaceful way of thinking, because it recognizes that we are all made of the same substance, that to take care of others is to take care of ourselves, and that we can only understand something if we understand the context that surrounds it.

So here's a koan "What is the sound of one hand clapping?"

If you think about it as a riddle, you'll keep looking for the punch line. But the koan is really about encouraging the listener to consider the true nature of things. Nothing is possible in the absence of interbeing. Subject and object must occur together or nothing manifests at all.

Here's another one "If a tree falls in the forest and nobody is there to hear it, does it make a sound?"

Our immediate impulse is to think, of course it makes a sound. But look more carefully. If a tree falls, it certainly will make the air move, but what is sound? Sound is the interpretation that our brains give to those air vibrations. If we are not there, the air vibrates, but is the experience of sound there? One might think, but wait, we could put a microphone there in the forest. But what is the microphone picking up? The air vibrations. If we play that recording on a video monitor with no speakers, you'll see visual images, but no sound. In order to get sound, you have to have speakers, and the speakers simply take the recorded signals and turn them back into air vibrations, which become what we call "sound" when there is a brain to interpret them. Subject and object have to occur together.

So here's another koan "If a share of stock is sold in a forest, and nobody is around to buy it, does it still generate a fill?"

The immediate implication of interbeing is that we are forced to think about "general equilibrium" rather than imagining that one side of a trade can exist without the other. This immediately clarifies all sorts of misconceptions that we could fall victim to if we aren't careful.

For example, it immediately tells us that "cash on the sidelines" is not a useful concept, except as a measure of issuance. See, whatever "cash" is there on the sidelines exists because government has created paper money, or the Treasury has issued bills, or because companies have issued commercial paper. Until those securities are actually physically retired, they will and must remain "on the sidelines" because somebody will have to hold them.

If Mickey wants to sell his money market fund to buy stocks, the money market fund has to sell commercial paper to Nicky, whose cash goes to Mickey, who uses it to buy stocks from Ricky. In the end, the commercial paper Mickey used to have is now held by Nicky. The cash that Nicky used to have is now held by Ricky, and the stock that Ricky used to have is now held by Mickey. There is exactly the same amount of "cash on the sidelines" after this transaction as there was before it.

Similarly, money never moves "into" or "out of" a secondary market, or from one sector to another. If I bring $1 "into" the stock market, that same dollar goes back "out" a moment later in the hands of a seller. If it did not, there would be no trade, no fill.

We can talk about differences in eagerness or in pressure as moving stock prices. But we cannot talk about money going in or money going out. We cannot talk about supply being greater than demand or vice versa. In equilibrium, the two must be equal.

One of the most useful ways of interpreting price and volume behavior is this: if something makes a given trader want to buy, the price must move in a way that either removes that impulse or induces another trader to sell. There is no other option.

Here's another koan:

A novice monk approaches his teacher and asks "What is the price movement of one share being bought?"

The teacher holds out a cypress leaf in his palm and asks, "Did I catch the leaf as it fell from the tree, or did I raise it from the ground?"

We are used to thinking that the act of buying necessarily implies rising prices. But think about this for a second. In either case, the teacher gets the cypress leaf. What makes the difference so far as direction is concerned is where the pressure is coming from. If the cypress leaf is being offered down by gravity, it is caught on a decline. If the leaf is being lifted by the teacher, it is caught on an advance. Remember that. It is easy to get trapped in wrong thinking by people who talk about "cash on the sidelines" or talk about "investors" buying or selling in aggregate.

There was no excess of stock that was "sold" in March that has to be "bought" back now. Investors didn't "get out" of the market last year, and we shouldn't think that they have to "come into" the market now. Every share that was sold was bought. That has been true for every minute of every trading day since the beginning of the financial markets.

Prices and Volume

A good way to think about prices and trading volume is to abandon the idea that money goes in or out, and to think instead about the market as a collection of various groups. Imagine there being fundamental investors, who are interested primarily in value (buying on weakness and selling on strength), and technical investors, who are interested primarily in trends (selling on weakness and buying on strength). These people also trade on different horizons and base their trading on different extent of movement.

In this sort of equilibrium, trading volume is a measure of strong views and disagreement. As the market turns weaker, trend-following investors typically abandon stocks, while fundamental investors accumulate. The reverse is true on significant strength. So spikes in trading volume tend to occur primarily at extremes relative to the target prices of fundamental investors. Volume spikes also tend to be correlated with a series of positive or negative shocks that then abate. In contrast, dull volume is a measure of low sponsorship, strong agreement, and lack of external shocks.

Equally important is that net incipient buying from both technical and fundamental investors cannot exist, so large price movements are typically required to relieve the disequilibrium. If you've got an overvalued market which then loses technical support, the outcome can be extremely negative, because technical investors are prompted to sell, but fundamental investors have weak sponsorship at that point, so large price declines are required to induce the fundamental investors to absorb the supply.

In contrast, if you've got an undervalued market where fundamental investors raise their outlook, the demand from fundamental investors is not typically provided by technical investors (who would tend instead to buy on advances in price), so the price must increase enough to induce fundamental investors with shorter horizons to supply the stock.

All of these dynamics have been active in the market over the past two years, but the most significant outlier has clearly been the past few months, where volume behavior has demonstrated much weaker sponsorship than we would have expected for an advance of this size. Normally, the volume characteristics we've seen have been much more typical of short-squeezes and less durable advances.

Presently, my primary concern is that stocks are now overvalued, to about the same extent as they were in the late 1960's, and just prior to the 1987 crash, but certainly less overvalued than they were at the 2000 or 2007 peaks. Our 10-year total return projection for the S&P 500 is centered modestly above 6% annually, even if one assumes that the long-term path of earnings has been unchanged by the events of recent years. If we assume that the economy will require a much longer period to recover than has been typical of post-war recessions, the prospects for long-term returns are lower, but we don't need to assume this in order to be concerned about valuation here. (The green, orange, yellow and red lines imply terminal price/peak earnings multiples of 20, 14, 11 and 7 a decade from now. The dark blue line charts actual annual total returns over the subsequent decade).

Though rich valuations and a fresh overbought condition last week argue for tepid returns going forward, my expectation is that strong downward pressure would be most likely if market internals deteriorate somewhat particularly in terms of breadth. Again, if technical investors are prompted to sell in an environment where sponsorship from fundamental investors is weak, large price changes may be required to relieve the disequilibrium.

A quick summary

Present moment, only moment. Sound investment does not require forecasts. It is enough to align the investment position with the prevailing, observable evidence.

Labels can help to classify, but they can also obscure truth. There is no quantitative substitute for mindfulness. That said, if "this time is different," one should be able to find appropriate parallels using a sufficiently broad set of historical or international data.

The seed and the fruit are not two different things significant market moves are generally the fruit of causes and conditions that latently precede them.

Everything, including the market, is ultimately empty of a separate self. One market can only be understood and analyzed in the context of other markets and conditions. Supply and demand, in particular, should not be considered in isolation.

Finally, Thay would add something more, which is to breathe, bring yourself back to the present moment, and recognize that even the smallest, simplest thing can be the basic condition for your happiness.

"If you touch one thing with deep awareness, you touch everything."

John F. Mauldin
johnmauldin@investorsinsight.com

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Muddle Through, R.I.P? - John Mauldin's Weekly E-Letter

2009-10-18T06:18:00.000+08:00

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Thoughts from the Frontline Weekly Newsletter Muddle Through, R.I.P? by John Mauldin October 16, 2009
In this issue: Muddle Through, R.I.P? Savings Equal Investments Japanese Disease Who Will Buy the Debt? The New Muddle Through Economy On the Road Again
I first wrote about the Muddle Through Economy in 2002, and the term has more or less become a theme we have returned to from time to time. In 2007 I wrote that we would indeed get back to a Muddle Through Economy after the end of the coming recession. If you Google the term, at least for the first four pages more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle through middle is comfortable to me. Last week I expressed my concern that we as a country are taking actions that could indeed "Kill the Goose" of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting. But first, two housekeeping items. I want to welcome the 150,000 members of the National Association of the Self-Employed to this letter. They have asked me to be a special consulting economist to their group, and they will send this letter each week to their members. Since its beginning in 1981, the National Association for the Self-Employed has pioneered support for micro-businesses and the self-employed, and been a forceful advocate for small business in this country. (www.nase.org) I am honored. I am pleased to add you to my 1 million closest friends. I hope you find it useful. Second, I will be going to South America at the end of next week, to Buenos Aires, Montevideo, Sao Paulo and Rio. I will be speaking in those cities and traveling with my new Latin American partner, Enrique Fynn of Fynn Capital (based in Uruguay). If you would like to find out about this tour or what services he can help you with, you can go to www.accreditedinvestor.ws and sign up and Enrique will get in touch with you. And as always, if you are an accredited investor, you can go to that website and one of my partners in the world will get back to you. (In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter. Muddle Through, R.I.P.? I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting. I am not surprised about the response of the Fed to the current recession and credit crisis, whether it's the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we'll survive. However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019. And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics. Savings Equal Investments GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or: GDP = C + I + G + (E-I) (For the wonks out there, GDP is usually termed "Y".) You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings. This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality. Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments. In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth. Japanese Disease Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can't we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high. In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management's latest letter (last week's Outside the Box): "The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370). "This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output." For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President's Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.) In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease - a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer). Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation. The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt. Who Will Buy the Debt? Now, let's go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion. Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate? The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks' lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that. So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk. And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle. One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody's calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt. Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral. The New Muddle Through Economy This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won't happen next year, and it's unlikely in 2011. I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think. In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices. As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly. On the Road Again I am writing tonight from Detroit. Tomorrow I will be in New York watching the Yankees/LA game. I will be the guy in the second row behind home plate in the Dallas Cowboys jacket. I will be on Yahoo Tech Ticker on Monday morning, so you should be able to go to Yahoo and see me later that afternoon. Then Philadelphia on Tuesday, speaking at my partner Steve Blumenthal's CMG conference for investment advisors. They have a very interesting platform of trading advisors. You can see them at http://cmgfunds.net/public/mauldin_questionnaire.asp I had a great deal of fun at the New Orleans conference, being with old friends and meeting new ones. David Tice (of the Prudent Bear Fund) was an exceptional host for dinner at Emeril's. I was surprised that Karl Rove actually remembered me after nine years. I thoroughly enjoyed spending some quality time with my friend Ron Paul. We share a lot of concerns about the future of the Republic. I was pleasantly surprised by how thoughtful Howard Dean was. And very personable. I go to Houston on Wednesday, Orlando on Thursday, and then South America on Saturday. I will be doing a lot of writing from hotel rooms, but all in all it will be fun. You have a great week, and remember that in 10 years none of us will look back and want to return to 2009. 2019 will be better than we can possibly imagine. We just have to make sure we all get there! Time to hit the send button and find an adult beverage. All the best, Your going to miss the Old Muddle Through analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; Fynn Capital; Nicola Wealth Management; 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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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 To unsubscribe please refer to the bottom of the email. 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 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 NASD 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. 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. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. John Mauldin can be reached at 800-829-7273. EASY UNSUBSCRIBE click here: http://www.frontlinethoughts.com/unsubscribe.asp Or send an email To: wave@frontlinethoughts.com This email was sent to cs.victor@gmail.com Thoughts from the Frontline 3204 Beverly Drive Dallas, Texas 75205

The China Files (Special Project): Real Estate - Outside the Box Special Edition

2009-10-16T04:03:00.001+08:00

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	Print Version

Volume 5 - Special Edition
October 15, 2009

The China Files (Special Project):
Real Estate
By George Friedman

Today I offer you an insightful look at China's real estate market - a "burgeoning bubble" that deserves a close eye as the possibility for breaking increases. Remember the chaos in Japan after their own housing dreamscape got violently yanked back to earth? As investors, we have to recognize opportunities - and know what to avoid. With a global economic crisis - and now surging housing prices in China - investors in any global market need to keep watch on political and economic developments around the world.

Today's analysis comes courtesy my friends at STRATFOR, a global intelligence company. They provide unique and on-the-money analysis and forecasts on all things global, essential for any alternative investment strategy. They've got a free newsletter as well, for which I encourage you to sign up by clicking here - so you're not limited to my caprice.

John Mauldin
Editor, Outside the Box

The China Files (Special Project): Real Estate

October 13, 2009 | 1149 GMT

Summary

The real estate market in China, particularly the residential side, is a burgeoning bubble that is growing bigger and more breakable by the day. Land and housing prices were already rising steadily when Beijing's stimulus package hit the sector in early 2009. Now prices are surging, with developers, bureaucrats and investors cashing in while urban Chinese - once encouraged to invest in home ownership by the central government - become less and less able to buy.

Editor's Note: This analysis is part of a series that explores China's industry, finance and statistics.

Analysis

Origins of the Bubble

Since 1978, China's pace of urbanization has increased dramatically, with the number of middle-size and large cities (those having nonagricultural populations of more than 200,000) growing rapidly. Beginning in 1985, economic reforms implemented in urban areas to make China's planned economy more market-oriented added even more momentum to the real estate boom, with real estate investment increasing by 71 percent by 1987. The government's macroeconomic policy of monetary belt-tightening helped cool this overheated market, which was further tempered by the government's continuing to provide housing for state employees (fu li fen fang, or "welfare housing").

However, when the state significantly cut back on its welfare housing program in 1998, the Chinese perception of personal property changed, and this would have an important impact on the real estate sector. The government began this privatization process by making a private dwelling a "commodity" and granting the purchaser the right to own a newly built house for 70 years. (Likewise, the developer who buys the property on which residential or commercial buildings are to be constructed may own that property for 70 years.) Home ownership in China could now be a sound financial investment.

Thus, the residential real estate market would boom in almost every urban area in China - and particularly in the "first-tier" and "second-tier" cities (only Beijing, Shenzhen, Guangzhou and Shanghai are in the first tier, with more than 20 cities, and mostly provincial capitals or coastal ports are in the second tier). But rising land prices would eventually put housing prices out of reach for the general public. In Dongguan, a coastal second-tier city in Guangdong province, land prices averaged 4,957 yuan ($726.42) per square meter in 2007, a more than 500 percent increase from 2003, while personal disposable income increased 24 percent during the same period (from 20,526 yuan [$3,008] to 27,025 yuan [$3,960] per year).

A 2006 survey conducted by the National Development and Reform Commission showed that the average ratio between housing prices and income was approaching 12:1 in many large and middle-size cities in China (in Beijing it had reached 27:1). Twelve to one is significantly higher than the World Bank's suggested affordability ratio of 5:1 and the United Nations' 3:1. The problem was compounded by the fact that, of the more than 80 percent of Chinese who owned their own homes in urban areas (generally considered cities with populations of more than 20,000), 54.1 percent were making monthly mortgage payments that constituted 20 percent to 50 percent of their monthly incomes.

The Recovery Bubble

Following a temporary drop toward the end of 2007, land prices rose steadily, then began surging again with Beijing's stimulus package and a flood of easy credit in 2009. With much of this money flowing into the real estate sector, major beneficiaries included large state-owned enterprises (SOEs) involved in speculative real estate and housing investment, contributing to the inflating bubble. Among the 10 highest-priced land purchases in major cities in the first half of 2009, 60 percent went to SOEs.

Paradoxically, as the global financial crisis continues, China sees little choice but to loosen its monetary policy even further, fearing the opposite would curtail economic growth and result in massive unemployment, which could lead to social instability. Beijing knows that one of the country's underlying economic problems continues to be an overheated real estate market, but it also knows that the real long-term solution - limiting the flow of cash and credit - could have dire socio-economic ramifications. Meanwhile, real estate developers, government officials and investors continue to speculate on real estate, raising land and housing prices.

As housing prices continue to rise, a parallel trend is manifesting itself - rising vacancy rates in urban areas. A 2009 report by the Shanghai Yiju Real Estate Research Institute revealed that, by the end of 2008, the average vacancy rate for "commodity housing" (as opposed to welfare housing) in Beijing was 16.64 percent, and vacancies reached as high as 30 percent in some districts. Most of these vacant houses, however, are not unsold ones. They have been purchased by investors as speculative investments. While there are fewer and fewer ordinary people who can afford to buy houses, there is still excessive demand for investment housing - pressure that continues to drive up the prices.

This closed loop in the Chinese real estate market is facilitated by the country's political and bureaucratic system. In China, all land is initially owned by the state, and local governments have the sole authority to sell it. And income from property taxes and land sales are a primary source of revenue for local jurisdictions. According to estimates by the State Council's Development and Research Center, tax revenue from the land in some jurisdictions accounts for 40 percent of the local budget. Moreover, net income from land sales accounts for more than 60 percent of the local governments' extra-budgetary revenue. The soft budget and lack of accountability to the people reinforces the local governments' incentive to expand their real estate investments without much concern for cost or impact on public services.

Economic performance also is the prime prerequisite for bureaucratic advancement, which gives local officials the incentive to generate as much revenue as possible through land auctions. And this generally involves a level of collusion - and corruption - among government officials, real estate developers and investors.

One typical strategy is for a developer to buy a big chunk of urban land from the local government but leave the land undeveloped, or build on only a small portion of it, thereby keeping the housing supply limited. Despite various state policies to lower land prices in order to make homes more affordable, local government officials and real estate developers control the land auctions. When a lower sale price is dictated from above, it is easy enough for the local sponsors to officially deem the auction a failure. Even when the developer does build houses on the property, a speculative investor, working hand in hand with the developer and government officials, can bribe both parties to ensure that he can buy all the houses at a low volume price and keep them off the market, thereby maintaining a limited supply and high prices.

Another factor that enters the equation is a cultural one. The Chinese people generally prefer to buy new houses, as opposed to renting homes or buying secondary houses in which people have already lived. Indeed, in urban areas, marriage proposals often include a promise to buy a new commodity house. As a result, the secondary housing market remains very small in comparison (due also to fewer available bank loans for lived-in houses and the complicated process involved in transferring ownership).

All of these factors contribute to the burgeoning real estate bubble - and make it difficult to predict when that bubble will burst. With 70 percent of real estate investment in China coming from bank loans, a dramatic drop in land values could send shock waves throughout the economy. There are already signs of decline. In Shenzhen, one of China's first-tier cities, real estate prices have been dropping for the past two years (30 percent for housing), and many developers and speculators have suffered great losses. The threat looms in other large cities such as Beijing and Shanghai and may be emerging in many second-tier cities as well.

Given the current global economy and the economic balancing act it must maintain domestically, Beijing has few good choices. It must keep enough cash flowing to maintain economic growth and social stability in the short term while tightening credit to avoid a tsunami of bad loans and a market collapse over the long term. Certainly, Beijing does not want to face the kind of collapse in the housing market that Japan experienced in the 1990s, which triggered a financial crisis and more than a decade of economic malaise.

But in China's real estate, as in most sectors of this vast and complex land, implementing and enforcing prudent regulation has never been an easy task

John F. Mauldin
johnmauldin@investorsinsight.com

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Quarterly Review and Outlook - Third Quarter 2009 - John Mauldin's Outside the Box E-Letter

2009-10-13T08:08:00.001+08:00

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	Print Version

Volume 5 - Issue 48
October 12, 2009

Quarterly Review and Outlook -
Third Quarter 2009
By Van R. Hoisington and Lacy H. Hunt, Ph.D.

I look forward at the beginning of every quarter to receiving the Quarterly Outlook from Hoisington Investment Management. They have been prominent proponents of the view that deflation is the problem, stemming from a variety of factors, and write about their views in a very clear and concise manner. This quarter's letter is no exception, where they once again delve into the history books to bring up fresh and relevant lessons for today. This is a must read piece.

Hoisington Investment Management Company (www.hoisingtonmgt.com) is a registered investment advisor specializing in fixed income portfolios for large institutional clients. Located in Austin, Texas, the firm has over $4-billion under management, composed of corporate and public funds, foundations, endowments, Taft-Hartley funds, and insurance companies. And now let's jump right in to the essay.

John Mauldin, Editor
Outside the Box

Quarterly Review and Outlook - Third Quarter 2009

Ponzi Finance

The Federal Reserve reported that as of June 30, 2009 total U.S. debt was $52.8 trillion. Total U.S. debt includes government, corporate and consumer debt. Importantly, however, it does not include a few trillion in "off balance sheet" financing, contingent unfunded pension plans for corporate and state and local governments, or unfunded liabilities of the U.S. government for such items as Medicare, Social Security and other programs. Currently GDP stands at $14.2 trillion, so there is approximately $3.73 in debt for every dollar of output in the United States, a level unprecedented in our history (Chart 1). Normally, debt levels as a percent of GDP would be uninteresting and immaterial; however, the current level of debt is unique in two ways. First, the asset side of the balance sheet purchased by the debt is falling in price. Second, the money that was borrowed to purchase those assets was often fraudulently expended. Neither the borrower nor the lender really expected the debt to be serviced. Rather, each party expected the asset price to rise extinguishing the debt.

This type of financial arrangement was correctly analyzed by the famous American economist Hyman Minsky in his paper, "Financial Instability Hypothesis", in which he described three phases of debt financing. The first is "hedge finance", where the lender expects a return on both principal and interest. The second is "speculative finance" where the lender expects to get interest on the loan but perhaps not the principal. The third case, where the lender expects neither the principal nor interest to be returned, is referred to as "ponzi finance". This was typified in the last business cycle by loans issued without documentation, no down payment home loans, extremely low cap rates on commercial real estate, and the high leverage borrowing ratio of private equity funds. Even ponzi finance works as long as asset prices are rising. But once the bubble is pricked, the debtor is left with declining asset values that preclude the rollover of their obligations.

Presently, in this worst of all post-war recessions we are witnessing the collapse of asset prices that were inflated by the speculation of earlier years. The aftermath of that speculation and its impact on the economy has been thoroughly studied prior to our present business cycle by the economists of yesteryear who marveled at the mania in the collective mindset of private citizens and their elected representatives who produced such bubbles. The most famous of these economists was Irving Fisher (1867-1947), who in 1933 wrote about this problem of over-indebtedness (Irving Fisher, 1933, Econometrica, "The Debt-Deflation Theory of Great Depressions"). He stated flatly that over-indebtedness was the difference between normal business cycles (recessions), which occur frequently through "over-production, inventory misjudgment, or commodity price fluctuations" and extreme business cycle fluctuations (depressions). Based on his analysis of the great depressions of 1837, 1873, and 1929 he outlined a pattern of economic developments that will take place when the debt cycle is broken. Seemingly old news, but it is interesting to apply his sequence of events to today's economic developments as there are disturbing similarities.

A Downward Spiral

Fisher posited that debt liquidation leads to distress selling, contracting bank deposits and declining velocity of money, all of which contribute to the fall in price levels. This accurately describes today's circumstances. Distress selling is rampant, with home foreclosures reaching all-time highs. Additionally, rapidly rising foreclosures in commercial real estate are causing the closing of financial institutions and the liquidation of their portfolios. Money supply (M2), an imperfect measure of bank deposits, is essentially flat over the last six months even though the monetary base is 100% higher than it was a year ago (Chart 2). Further, the velocity of M2 has contracted at a 12.7% rate over the past two years. The Personal Consumption Expenditure Deflator (goods purchased by consumers) has fallen from a 2.7% growth rate 12 months ago to a yearly increase of only 1.3% presently, and appears to be heading for a zero reading in 2010. GDP has recorded its greatest contraction since the 1930's, and probably is not yet at its lowest level for this cycle.

Fisher then noticed that this distress selling would lead to a fall in the net worth of businesses, a decline in profits, and a reduction in employment. Fisher may have been talking about 1929 and the 1800's, but that is precisely our present situation. Despite a 19% gain in stock prices this year, the S&P 500 has declined about 30% from its peak and stands lower than it was a decade earlier. Corporate profits are down approximately 13% on a year over year basis, and in 2008 S&P 500 profits fell for the first time since 1933. The net worth of hundreds of banks and other large corporations has fallen below zero, with some surviving only because of a massive rescue effort by the federal government. Despite these efforts, consumer net worth has fallen, price levels of homes are down about 30% from their peak levels, and business net worth has been impaired by an almost 39% decline in commercial real estate from its peak levels. Industrial production is down 13.3% since its peak, the largest 20 month decline in the post war period (Chart 3). Including potential revisions, the U.S. has lost eight million jobs in this recession, and currently 17% of the labor force is either underemployed, partially employed, or out of work seeking employment.

Fisher seems to be not so historical as prescient. He states that all the above problems create disturbances in the rate of interest, particularly the fall of nominal money rates and the rise of real interest rates. The federal funds rate is now effectively zero, and yet with the steady downward movement in price indices, real interest rates are rising. This, of course, is of concern to debtors.

The uncomfortable conclusion of Fisher's analysis is that major business cycle fluctuations are, in fact, caused by over-indebtedness and the fall in asset prices. Our present situation appears to mirror the exact sequence of events that have occurred in previous depressions. This suggests that our current "great recession" may morph into a more serious and elongated downward business cycle.

The Impossible Promise

The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370). This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output.

From a fiscal policy perspective the outlook for economic growth appears to be one of stagnation for several years due to the size of the federal debt, which is expected to rise 35.7% from 2008 levels to 76.5% of GDP over the next ten years according to the Office of Management and Budget (Chart 4). This exercise in government spending is, of course, an exact replica of the Japanese experience from 1989 to the present. Their debt to GDP ratios have gone from about 50% in 1988 to about 178% today, and yet their nominal GDP is no higher than it was 17 years ago, and their employment stands at twenty year ago levels. It is somewhat unsettling that as of the last employment report the United States employed 131 million people, a level that was first reached in 2000, which means the United States has had no net job gains for almost ten years. Indeed, it appears that the fiscal chain around the free market neck is sufficiently onerous to restrain growth for several years. The promise of the government to revive growth through increased indebtedness is, indeed, an impossible promise.

The Hesitant Fed

As Fisher stated, the write-down of debt and distress selling tends to destroy money deposits and lower the velocity of money. Despite the historical evidence of that fact, our current Fed authorities appear to be oblivious to the lessons of the past. Their initial reaction to the liquidity crisis has to be applauded for their heavy work in insuring the liquidity of the financial system. Similarly, the expansion of their bank balance sheet to $2.1 trillion from $1 trillion was the precise reaction needed to counter the emerging deflation of asset prices. However, their actions increased inflationary expectations, and they have encountered a plethora of critics. In responding to this criticism the most recent statistics suggests they are beginning to lose the fight against the deflationary impulses. Consider that the monetary base rose 1000% in the three months ending December 2008, but has been held essentially flat since then (Chart 5).

The Fed's purchases of assets to increase this base automatically created deposits that positively charged the money supply growth to a 15.2% six-month growth rate (Chart 2). If the economy were operating near full capacity, a healthy banking system would take these deposits and multiply them roughly nine times; that circumstance could be inflationary. Unfortunately the banking system is not healthy, as evidenced by the fact that we have closed 95 banks this year, more than the cumulative total of the past 15 years, and another 416 banks are on a list destined to become extinct. With consumers' asset prices falling so rapidly and banks increasingly afraid of failure, banks are more interested in collecting loans than in lending. So with fewer consumers now credit worthy, loan volumes are collapsing. As loans are paid off, deposits are destroyed, and the money multiplier that should stand at nine has gone to zero. This is evidenced by the fact that the six-month change in M2 has fallen to a 1% growth rate, meaning that monetary stimulus is on hold. Get set for negative GDP in 2010.

Dollar Weakness

The inflation outlook from the monetary and fiscal standpoint looks truly deflationary, yet some believe that dollar weakness will reverse this circumstance and create inflation. This is unlikely. First, our imports are about 13% of GDP, and even if the dollar were to halve in value, the price of imported goods would not only have to compete with U.S. producers, but also their price adjustment would have to offset the other 87% of factors included in the pricing indices. Second, unlike the 1930's a 50% decline in the dollar would be difficult to engineer. Fisher recommended to Roosevelt that the U.S. should exit the gold standard, which he did in April of 1933. That was a fixed exchange rate system, and within three months the dollar lost more than 30% against the gold block countries and fell to 60% of its former value within the next five months. This spurred our exports and provided some price inflation (2.9% per year, GDP deflator) for the next four years. Then, in 1937 the tax increases (the next policy mistake) reversed the positive growth rate of the economy and drove price levels and economic activity downward again. However, even with that small period of price increases the overall price level never recovered from the 25% decline that occurred from 1929 to 1933, and thus deflation reigned. Today the declining dollar is a good thing in terms of our trade balance, but the modest change will be insufficient to offset the negative forces of insufficient domestic demand.

Next year the core GDP deflator will fall to zero, with the possibility of negative levels. Likewise, long-term interest rates, which are highly sensitive to inflation, will continue to move toward lower levels. As stated in previous letters, we see no reason why longer dated Treasury interest rates will not mirror those of Japan, which provides a modern signpost for a deflationary environment. Currently the Japanese ten-year note stands at 1.3% with their thirty-year bond yielding 2.1%.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

John F. Mauldin
johnmauldin@investorsinsight.com

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Killing the Goose - John Mauldin's Weekly E-Letter

2009-10-10T13:28:00.001+08:00

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Thoughts from the Frontline Weekly Newsletter Killing the Goose by John Mauldin October 9, 2009
In this issue: Killing the Goose What Were We Thinking? Let's Play Turn It Around Detroit, the Red Sox and the Yankees, and Traveling Too Much
Peggy Noonan, maybe the most gifted essayist of our time, wrote a few weeks ago about the vague concern that many of us have that the monster looming up ahead of us has the potential (my interpretation) for not just plucking a few feathers from the goose that lays the golden egg (the US free-market economy), or stealing a few more of the valuable eggs, but of actually killing the goose. Today we look at the possibility that the fiscal path of the enormous US government deficits we are on could indeed kill the goose, or harm it so badly it will make the lost decades that Japan has suffered seem like a stroll in the park. And while I do not think we will get to that point (though I can't deny the possibility), for reasons I will go into, there is the very real prospect that the upheavals created by not dealing proactively with the problems (or denying they exist) will be as bad as or worse than the credit crisis we have gone through. This is not going to be something that happens overnight, and the seeming return to normalcy that so many predict has the rather alarming aspect of creating a sense of complacency that will only serve to "kick the can" down the road. This week we look at the problem, and then muse upon what the more likely scenarios are that may play out. This is a longer version of a speech I gave this morning to the New Orleans Conference, where I also offered a path out of the problems. This letter will be a little more controversial than normal, but I hope it makes us all think about the very serious plight we have put ourselves in. Let's review a few paragraphs I wrote last month: "I have seven kids. As our family grew, we limited the choices our kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. How many times did Dad say, 'What were you thinking?' and get a mute reply or a mumbled 'I don't know.' "Yet how else do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own choices. And a lot of them make a lot of bad choices. After having raised six, with one more teenage son at home, I have come to the conclusion that you just breathe a sigh of relief if they grow up and have avoided fatal, life-altering choices. I am lucky. So far. Knock on a lot of wood. "I have watched good kids from good families make bad choices, and kids with no seeming chance make good choices. But one thing I have observed. Very few teenagers make the hard choice without some outside encouragement or help in understanding the known consequences, from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up. So quickly." What Were We Thinking? As a culture, the current mix of generations, especially in the US, has made some choices. Choices which, in hindsight, leave the adult in us asking, "What were we thinking?" We made a series of bad choices and suffered the credit crisis because of it. Now, as a nation, we are in the middle of making an even worse choice, one that will leave us with no good choices - only choices of pretty bad to awful. Let's begin with a quote from a recent client letter by my friends at Hayman Advisors (in Dallas). "Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero). "There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures. "According to the current Office of Management and Budget (OMB) projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010, with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. [Emphasis mine] "One has to ask whether the US reached the critical tipping point. Beyond the quantitative measurements associated with government deficits and money creation, there exists a qualitative aspect to such a scenario that may be far more important. The qualitative perceptions of fiscal and monetary policies are impossible to control once confidence is lost. In fact, recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future." Let me point out that the deficits for 2010 assume a rather robust recovery, and so they could turn out to be much worse, especially if unemployment continues to rise and Congress decides (rightly) to extend unemployment benefits. The interest on the national debt in fiscal 2008 was $451 billion. Even though the debt has exploded, the interest for fiscal 2009 is down to "only" $383 billion. My back-of-the-napkin estimate says that is over 20% of total 2009 tax receipts. I guess when you take interest rates to zero and really load up on short-term debt, it helps lower interest costs. (More on that future problem later.) http://www.savingsbonds.gov/govt/reports/ir/ir_expense.htm The fiscal deficits are projected to be about 11% of nominal GDP, which is now roughly $14.3 trillion. The Congressional Budget Office currently projects that deficits will still be $1 trillion in ten years. Last spring I published as an Outside the Box a very important paper by Dr. Woody Brock on why you cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system. If you have not read it, or would like to read it again, click here. I am going to reproduce just one table from that piece. Note that this was Woody's worst-case assumption, adding 8% of GDP to the debt each year, and not the 11% we are experiencing today. The Congressional Budget Office projections are now even worse, and that assumes a very rosy 3% or more growth in the economy for the next five years. Under Woody's scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP, depending on your growth assumptions. Take some time to study the tables, but I am going to focus on 2015 and not the outlier years. $1.5 trillion dollars means that someone has to invest that much in Treasury bonds. Let's look at where the $1.5 trillion might come from. Let's assume that all of our trade deficit comes back to the US and is invested in US government bonds. Today we found out that the latest monthly trade deficit was just over $30 billion, or $370 billion annualized (which is half what it was a few years ago). That still leaves $1.13 trillion that needs to be found to be invested in US government debt (forget about business and consumer loans and mortgages). Killing the Goose $1.13 trillion is roughly 8% of total US GDP. That is a staggering amount. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about whether to create an alternative to the dollar as a reserve currency. (And if I was watching the US run $1.5 trillion deficits with no realistic plans to cut back, I would be having private talks too. They would be idiots not to do so.) There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three. Now the Fed is in fact monetizing a portion of the debt as part of its quantitative easing program, and US consumers are saving more. Tax receipts are way down. I can tell you there is a great deal of angst in New Orleans tonight about the Fed monetization. This is traditionally a "gold bug" conference, and many of the participants and speakers see only inflation in our future. Long-time readers know that I think the Fed has been able to get away with its rather large monetization program because of the massive deflationary forces let loose in the world by the credit crisis, which is forcing a monster deleveraging regime all over the world. Where has all the money gone that the Fed has printed? Right back onto the Fed's balance sheet as bank reserves. The banks are not lending, so this money does not get into the system in the usual manner associated with fractional reserve banking. Until that happens, and is accompanied by increasing wages and employment, inflation is not in our immediate future. And this brings us to our conundrum. You cannot continue to run deficits significantly larger than nominal GDP for too long without risking the demise of the economic system. Ask Argentina or any of the other nations where hyperinflation occurred, as detailed in the study mentioned above. But we are in a deflationary environment, so the Fed can monetize the debt far more than any of us suppose without risking immediate and spiraling inflation. But there is a limit to the Fed's ability to do so without causing real inflation. First, as long as the Fed is independent, at some point they will simply have to tell Congress we can no longer monetize the debt. While I am sure that some of you doubt they would do so, the Fed officials and economists I have been around are pretty adamant about that. There is a line they will not be pushed past. It may be further than I like, but it is there. The Fed cannot simply buy up all the debt needed to fund the government. Again, no one on the FOMC would either advocate or allow that. That would in fact start us down a very dangerous path rather quickly. Therefore, they must have a large number of willing bond buyers outside the Fed. The good news, gentle reader, is that we will find someone to buy that debt. That is also the bad news. Let's go back 30 years. Legend now has it that Paul Volker single-handedly took the inflation bull by the horns and ripped them off. Now, it took fortitude to do that in the face of certain recession and high unemployment. Those were not fun days. But his partner in the deed was the bond market. Bond investors simply demanded higher returns, because they were really worried about inflation. At some point, if we do not get the government deficit under control, the bond market is once again going to react. Seemingly overnight, real (inflation-adjusted) rates are going to rise, and will do so rapidly. And I am not talking about 1 or 2%. You just cannot have 8% of a $14-trillion GDP go into US government debt every year, forever, at today's low real rates. Let's play a thought game. If you take 8% of US consumer spending and save it, and it finds its way into government bonds, you have reduced consumer spending and therefore the actual GDP. But how about those who want to invest in stocks? Foreign bonds and currencies? New businesses? Loans of all types? How much are we going to have to save to get the necessary capital? How high will the saving rate have to be to finance all those other activities in a world where debt securitization is still anemic? Some will point to Japan and their government debt-to-GDP ratio, which will soon be over 200%, a far cry from where we are today. Why can't we grow our debt to 200%? Because the Japanese have long had a culture of saving and investing in government bonds. It's what you do to support the country. But even they will run into a wall as their savings rate continues to drop, because so many of their citizens are retired and are now selling bonds to finance retirement. They too are running massive fiscal deficits, on the order of the size of the US deficits. And does anyone really want to have two lost decades, like Japan? How long can we go before there is an upheaval? I don't know. The markets can remain irrational or complacent for a lot longer than most of us think. It could be years. Or not. Suddenly, it will be July 2008 and the bond vigilantes stampede. But now, we seemingly can borrow with no consequences. The deflation that is in the air, plus the lack of bank lending holds, down the normal inflation impulses. We as a nation are leveraging ourselves up. We're partying like it's still 2005. The music is playing and we are dancing. Our Congress is trying to figure out how to run even higher deficits. At some point, the consequences will be significant. There are two paths, and it is not clear which one we will take. First, we might see inflation kick in and actual rates rise. Since so much of our national debt is short-term debt, that means yet another rise in the deficit as rates rise. Mortgage rates rise, putting pressure on the housing market. There will be even more pressure on commercial mortgages. Consumer debt will be harder to get and cost more. It will mean funding costs for businesses will rise, and that hurts employment. It would be a return to the 1970s of high interest rates and stagnant growth in a very slow-growth environment. Second, we could see deflation kick in and, even though rates stay more or less where they are, real (after-deflation) rates could rise as they did in the '30s and in Japan. Some of my most knowledgeable friends argue for the inflation side, and others take the deflation side. I tend to think the Fed will fight deflation until we get inflation, but the consequences will not be pleasant. There is no benign path. How can we avoid such an upheaval? The only way is to make some very difficult choices. There have to be some adults making the choices, as the teenagers now in control clearly cannot make them. As I have written in the past, we can run deficits of 2% of GDP for a very long time, which in a few years would be about $300 billion. It is my belief that if the bond market and world investors saw a credible plan to put us on a path to a deficit no larger than 2% of GDP, the dire upheaval that is in our future could be avoided. But that will mean some painful choices. It is not a matter of pain or no pain, it is just deciding when and how bad it will be. The longer we wait, the worse the consequences. Let's Play Turn It Around There are businessmen who are called turnaround specialists. They come into companies that are sick but have a basic competency, and that with the right management can be made into viable concerns. Generally, the choices the new management makes are painful to those involved, but they are necessary if the enterprise is to remain a going concern. So, for the next few pages, I am going to suggest some things we can do to turn the US around. They are not easy fixes, and I know a lot of readers will not like what they read or will disagree on points. But something like this is going to have to be done, or we risk killing the goose. First, we must acknowledge the deficit is out of control, and spending must be cut. If we raise taxes by as much as the Obama administration now wants to, we will most assuredly put the country back into a deep recession in 2011. Think what raising taxes in 1937 did to a nascent recovery. A $3-trillion-dollar budget is 20% of the US economy. That is just simply too much. Quick fact. The most credible studies show that government expenditures exert no multiplier effect on the economy. Actually, they show them to be very slightly negative. This is not just in the US. However, the tax effect has a multiplier of 3! If we raise taxes by $300 billion in 2011, that will slam the economy in the face. Further, we will collect less taxes than projected, as economic activity will fall. You cannot cure a too much debt problem with more debt. We cannot borrow our way into prosperity. Every crisis of the past decades has been a result of too much debt and leverage and we seem to want to repeat the past mistakes, hoping that this time it will be different. It won't. Ok, now let's play the Turnaround Hammer Game. + We should start with a 5% acrossthe-board cut in spending in all programs. Federal employees, except for military personnel, should see a 5% cut in pay as part of that program. The average federal worker makes $75,419 a year, while the average in the private sector is $39,751. The rest of us are taking pay cuts in the form of higher taxes. No cost of living increases, etc. We are on an austerity program and need to do what it takes. If a program is deemed too important to be cut, then another program has to be cut more. Then the next year another 2.5% cut across the board. And then an absolute freeze on the overall budget size until the deficit is 2% or less of GDP. + Social Security must be fixed now. We all know that it is going to have to be done, so why not just do it? Means testing should be a part of the mix. As an idea, for every $10,000 in income a retiree has, he gets $1,000 less in SS payments. And increase the retirement age down the road. When SS was launched, retirement age was 65. But the average life span was 65. There are other things we can do, but whatever our poison of choice is, we need to take it. + Medicare must be revised, with real health-care reform. The national debt is $56 trillion if we count unfunded liabilities, much of which is Medicare. It will become a nightmare around the middle of the next decade. Adding more expenses now without cutting elsewhere makes no sense. If we kill the goose, no one will get anything excect very empty promises. Side note: there actually is a lot of waste in the system. Software should be written that analyzes every patient and procedure and produces an outcomes-based analysis of what is reasonable, rather than throwing every test at every patient. And the government should make sure, even if it has to spend the money, that the updated system is in place in every hospital and clinic in the country. And doctors should be given access to it so they can decide what type of care is appropriate to prescribe. And health-care reform means tort reform. Today, I got a note from a friend of mine who just had yet another heart attack. It seems his stent is now blocked by 50%. He is a vet, and his primary care is the Veterans Administration. The Veterans Hospital system will not do a procedure to unblock the stent until it is 70% blocked. He does not have any money, so he is simply waiting to have another heart attack. I am really looking forward to government-run health care. + Each year we allow almost 1 million immigrants into the US, mostly family of people already here. I suggest that for the next two years we stop that. Instead, let anyone who can buy a home, passes basic screening, and can demonstrate the ability to pay for health insurance immigrate to the US and get a temporary green card. If they behave, then the card becomes permanent after four years. We almost immediately put a floor on the housing market, absorb the excess homes, and within a year the housing-construction market, along with the jobs that are now gone, will be back. That is stimulus that costs the taxpayers nothing. + While I can't believe I am writing this, taxes are going to have to rise, if for no other reason than this Congress is hell bent on raising taxes. But rescinding the entire Bush tax cuts, plus adding a 10% surcharge as Congress wants to do in one fell swoop, is an absolute guarantee of a recession. So do it gradually over (say) 4 years, and then reinstitute the cuts when the deficit is under 2% of GDP. Remember the negative tax-multiplier effect of raising taxes. And the definitive work on that was done by Obama's chairman of the Council of Economic Advisors, Christina Romer. We should consider a VAT tax and a major cut/reorganization of the corporate tax. We need to encourage corporations to hire more, and you do that by taxing less. Let's make our corporations more competitive, not less. Our taxes are much higher than those of any of our major competitors. And please forget that insane carbon tax. If you want to cut emissions, do it straightforwardly by raising taxes significantly on gasoline. Don't back-door it on consumers. (And I am NOT advocating such a policy.) + An aggressive tax benefit for new venture-capital money that is invested in new technologies will result in new industries. The only way we can grow our way out of this mess is to create whole new industries, like we did in the late '70s and '80s. (Think computers and the internet and telecom.) + Unemployment is likely to continue to rise and last longer than ever before. We have to take care of the basic needs of those who want work but can't find it. Unemployment insurance should be extended to those who are still looking for work past the time for benefits to expire, and some program of local volunteer service should be instituted as the price for getting continued benefits after the primary benefits time period runs out. Not only will this help the community, but it will get the person out into the world where he is more likely to meet someone who can give him a job. But the costs of this program should be revenue-neutral. Something else has to be cut. + We have to re-hink our military costs (I can't believe I am writing this!). We now spend almost 50% of the world's total military budget. Maybe we need to understand that we can't fight two wars and support hundreds of bases around the world. If we kill the goose, our ability to fight even one medium-sized war will be diminished. The harsh reality is that everything has to be re-evaluated. As an example, do we really need to be in Korea? If so, why can't Korea pay for much of the cost? They are now a rich nation. There are budgetary fiscal limits to being the policeman for the world. + Glass-Steagall, or some form of it, should be brought back. Banks, which are subject to taxpayer bailouts, should not be in the investment banking and derivatives-creating business. Derivatives, especially credit default swaps, should be on an exchange, and too big to fail must go. Banks have enough risk just making loans. Leverage should be dialed down, and hedge funds selling what amounts to naked call options in any form, derivative or otherwise, should be regulated. Let me see, is there any group I have not offended yet? But something like I am suggesting is going to have to be done at some point. There is no way we can continue forever on the current path. At some point, we will hit the wall. The fight between the bug and the windshield always ends in favor of the windshield. The bond market is going to have to see a credible effort to get back to a reasonable deficit, or we risk a very difficult economic environment. The longer we wait, the worse it will be. It is not going to be easy to persuade a majority of Americans that we need to do something now. More realistically, we are going to probably have to begin to experience a crisis of some type to get politicians motivated to do something. This last Tuesday, I spoke to the Financial Leadership Association at the University of Texas at Dallas. It was mostly undergraduates, and my assigned topic was how financial research impacts our investment decisions. In touched on the topic above, in less detail, but pointing out that at some point we are going to have to bring the deficit under reasonable control. I got some push-back, as some could not understand why we just couldn't keep running deficits, as we simply owe it to ourselves. I tried to explain, but for a few of them I was not getting through (though I think most got it). And these were the finance students! I shudder to think what the sociology department would be like. We are not going back to normal, although it is likely we will see some form of Statistical Recovery. But we cannot get complacent. Somewhere out there is the real potential for another crisis, which will dwarf the last one. You will not want to be long much of anything when it happens, except hedged or liquid investments. Though admittedly, this could go on for a long time. I just don't know how long "long" is. Other than it will be too long and then not long enough. Detroit, the Red Sox and the Yankees and Traveling Too Much I leave for Detroit next Friday and speak at a private conference on Saturday, then rush to the airport to fly to New York. My friend Barry Habib has second-row behind-home-plate tickets to what we hope is a Yankees - Boston Red Sox playoff championship game. That would have to be one of the most exciting games to watch - the emotions will run as high as in any sporting event around. So I find myself in the strange position of cheering on both the Yankees and the Red Sox in the first round of playoffs, and hoping that there is not a four-game sweep in the second. Dinner with the guys at Yahoo Tech Ticker on Monday, and then an early train to Philadelphia, where I will speak at a conference hosted by my friends and partners at CMG. Dinner that night, a very early flight to Dallas, change airports, fly to Houston to speak at Salient Partners, then a late-night flight back to Dallas, up early to fly to Orlando to be with Jon Sundt of Altegris at the Commonwealth conference, fly back early (sigh) Saturday morning to Dallas, drive home, pack, and take an overnight flight to Buenos Aires to start a speaking tour with new Latin American partner Enrique Fynn, then on to Montevideo, Uruguay, Sao Paulo. and Rio de Janeiro, and then back to Montevideo for a day of R&R. Then back home Monday. I am already tired. Tomorrow I get to hear Karl Rove (wonder if he will remember me from our Texas days?), Howard Dean, Charles Krauthammer, and a lot of friends, then a series of parties tomorrow night. I always enjoy coming to The Big Easy for this conference. (Note to Chinese and Spanish translators: the Big Easy is a nickname for New Orleans. I can't expect them to know that one.) It is time to hit the send button, as I have to speak at my next session. You have a great week, and remember that together we will get through all the coming problems. Just keep paying attention. Your worried about all the unintended consequences analyst, John Mauldin John@FrontLineThoughts.com Copyright 2009 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 at www.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; 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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