Thank you for sending me your weekly e-letter. I enjoy reading them.
I have one question for all those who see gold price rising substantially. In an environment of general price deflation, if gold is a commodity, how can its price rise against all other commodities?
A case can be made that the dollar, while falling faster than other fiat currencies at the moment (as a result of it having risen faster in previous years), is still rising in value against commodity prices, except real estate for the moment, but that too will face deflationary pressure eventually. The entire global monetary system appears to be rising in value with regard to commodity prices, with the dollar still the strongest currency.
There are fluctuations in demand caused by market sentiments, but substantial changes beyond 10-20% in value among major currencies is hard to imagine. Gold has appreciated in value when viewed by how many shares of AT&T or GE an ounce of gold can buy, as has the dollar.
Henry C.K. Liu
John Mauldin and InvestorsInsight wrote:
This message was sent to hliu@xxxxxxxxxxxxxxx
The Millennium Wave Investor E-Letter
All God's Children Got Themes
by John Mauldin
September 6, 2002Theme #1 - A Secular Bear Market
Theme #2 - Deflation and Bonds
Theme #3 - The Muddle Through Economy
Theme #4 - The Decline of the Dollar and the Rise of Gold
Meet me in New Orleans
And Much More
September is the month set into my personal rhythms, and that of my generation, as a time to reflect upon the past and look to the future. The first week of school was always a time for review and to get a sense of what we would be looking forward to in the new school year. Even though school has been in session for several weeks, to those of us who went to school in the 50's and 60's, it does not feel right until after Labor Day.
With that cycle in mind, it seems that we should briefly look at the broad investment themes that have been so much a part of this letter, and speculate as to their future usefulness. That will give us a launching pad to look at some very disconcerting economic news from around the globe, and see how it all fits into our personal investment portfolios. Pay attention, class. There will be a test.
Theme #1 - A Secular Bear Market
I wrote in the latter part of '99, and then strongly in early 2000, of the over-valuation in technology stocks. In August of 2000, based upon a 1996 study by the Federal Reserve which stated that a recession has always appeared one year after the appearance of a negative yield curve (short term rates are higher than long term rates), I said investors should exit the stock market. The average drop in the stock market during a recession is 43%, and I could see no reason why investors should "buy and hold" through a 40% drop. At that time, the S&P 500 and the NYSE index were only a few points from their all-time highs. I continued to make that point, even as the Fed was cutting rates.
There were many writers who urged investors to buy stocks because of Fed rate cuts, and pointed to how well the stock market did after previous Fed rate cuts. I pointed out that there was no direct connection between rate cuts and stock market values, and any such linking of the two was misleading. We can now see that there was no direct connection, but it gave market cheerleaders another straw to grasp at the time.
As you can imagine, I got a lot of mail telling me how wrong I was to tell investors to get out of stocks, especially from the buy-and-hold-for-the-long-term community. I get fewer of those letters now.
Last year I began to write about a number of independent studies which all pointed to the probability that we were entering into a long-term secular bear market. Each of these studies came at the issue from a different viewpoint, but all led me to the same conclusion: we are now in a secular bear market.
I have finally finished compiling these studies into one report, which will be a chapter in my forth-coming book called Absolute Returns. You can read this chapter by going to www.absolutereturns.net. (If you are investing in stocks or mutual funds, or thinking about it, then I believe you should read this chapter and the one I will post next week on corporate earnings. I also have posted my chapter on how to do due diligence on hedge funds.)
Secular bear markets are not short-term phenomenon. The shortest one lasted 8 years. My guess is this will not be a short one. Successful investors will dramatically alter their investment strategies during such a period. These periods are marked by multiple recessions and poor earnings growth, for a lot of reasons which I outline in the chapter. They are also periods in which bonds and money market funds out-perform stock index funds.
Stock market investors have to be nimble and very selective in these periods. This is not a time when a rising tide will lift all boats. That is why I have stressed that for those investors who feel they must be in the stock market, you have to focus on deep value stocks, especially those which pay dividends and have a strong history of growing dividends over time. Broad-based mutual funds are simply prescriptions for frustrations (and losses) in a secular bear.
Theme #2 - Deflation and Bonds
I have been writing for over three years that deflation would increasingly be a force in the US and world economy. This is an environment in which bonds, especially long term government bonds, do quite well. I wrote that I expected inflation to fall to under 1% and that mortgage rates would approach 5%. We are still on track for both to happen, although I did think several years ago that inflation would fall somewhat faster than it has.
Since the beginning of 2000, however, my favorite bond fund for aggressive investors, the American Century Target 2025 is up over 50%, although it has been very volatile. At the beginning of 2001, I was very bullish on long bonds. They were flat to slightly down in 2001. I stuck with the prediction for 2002, and in the past few months have finally seen rates come down and bond prices soar substantially.
I still think deflation is a serious concern. When I first wrote about deflation in 1998, there were not many people who shared that concern. Today there is a growing chorus. I note the following from Dennis Gartman, who wrote today that:
"...[I have been made aware]of a very unusual "paper" written by Mr. Norbert Walter, the Deutsche Bank's chief economist, and a gentleman not given to hyperbole. Mr. Walter apparently has become more and more concerned about the very stability of the global economy after returning from an extended trip to Asia to see firsthand what is taking place there. He is now concerned that unless the central bankers of the world change their policies materially the world shall slip into 'a second leg of recession... combining with deflation.' He said in a letter now being circulated to the major central bankers:
"... around the world, the indicators leave no room for talk of an upswing. The economy is in a downswing as declining capacity utilization and increasing unemployment show. Recession cannot be ruled out, considering the multitude and seriousness of the trouble spots and potential risks to economic growth..... The people at the top seem to be losing the sight of the big picture. Pro-cyclic policy is being declared the only politically correct attitude."
Quite simply, throughout the 90's, businesses throughout the world built too much production capacity for almost every conceivable product. Capacity utilization is a problem everywhere, not just in the United States, where it is a very low 76%. Many businesses are selling products at very low or even no profit in order to keep factories busy. This keeps their competition from being able to raise prices and make a profit, and is resulting in the very poor earnings growth we have seen in what is supposed to be a period of economic recovery.
This plus numerous other factors are combining to create deflation throughout the world. Japan and China are in outright deflation, and they are exporting their problem deflation to us and to the world.
While I am hopeful that we will avoid outright deflation in the US, it remains to be seen what actually transpires. Until we see some signs that business has some pricing power, and that inflation is a concern, long bonds will continue to be good investments.
In the 80's and 90's the economy benefited mightily from slowing inflation. Lower interest costs for business, lower mortgage rates and cheaper financing for consumers all contributed to the boom. There is not much more potential benefit to be reaped from slowing inflation and lower interest rates. Rates and inflation will both go lower for the near future, in my opinion. History tells us that eventually that worm will turn and we will see higher rates and a return to (hopefully) modest inflation. But I do not have a clue as to when that will happen.
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Theme #3 - The Muddle Through EconomyFor the better part of a year, I have been talking about the Muddle Through Economy. I predicted a slow growth economy for the year, and unfortunately I have been right. I just hope that I was not an optimist.
It is not inconsistent to project a slowly growing economy and secular bear market. The US economy grew at almost exactly the same rate from 1966-1982 as it did from 1982 through 1999. The stock market was flat in the former period and up over 10 times in the latter. The connection that analysts make between the direction of the economy and the stock market are tenuous at best and simple-minded cheerleading at worst.
The US economy will muddle through as long as the consumer continues to spend in roughly the same manner as he has in the past. When the consumer begins to retreat, we will then go into a recession. It is pretty much that simple.
Gary Shiller makes the argument in his current letter that the next recession will see the housing bubble begin to deflate. He may be right, but given the close correlation between housing prices and consumer spending, I am more inclined to think that a softening of housing prices will lead to a retreat by consumers. They will probably happen so close together that we will both be able to claim we were right.
There seems to be something in the psyche of the American consumer that preternaturally allows him to spend as long as he feels good. And all the studies tell us consumers feel good as long as they have a job and their homes are rising in value. If the recent recession and plethora of economic bad news has not shaken the consumer into saving more and spending less, then it may be that this pattern continues until one of the two things that make him feel good begins to crumble.
At any rate, I think we will continue to Muddle Through for the rest of this year, although we are very close to a no growth economy, and the recent numbers from the ISM tells us we are getting slower. We are barely into a growing manufacturing and service environment, and the underlying employment picture is quite weak.
Theme #4 - The Decline of the Dollar and the Rise of Gold
Up until this spring, I was bullish on the dollar. I was bearish on the yen. As long as foreigners continued to have a huge appetite for American business, stocks, bonds and real estate, we could continue to finance our trade deficit, and the dollar would stay strong. However, in late 2001, the foreign buying began to dry up. Also, the trade deficit began to get worse, and projections showed that the deficit could expand to 5-6% of GDP in 2003. No country has ever run such deficits without a serious currency correction. I began to suggest in the early spring that the dollar was in trouble.
I will confess I did not expect the dollar to drop as much and as soon as it did after I wrote about it. I thought then that parity with the euro would come by the end of the year. We are there now. I think $1.10 in 2003 is probably a reasonable target.
That being said, the dollar has not dropped that much against a basket of world currencies, which is more indicative of how weak the recovery in the world economy is than as to the strength in the dollar.
Also, having been a bear on gold for many years, I suggested we would see gold begin to rise as the dollar dropped. In my view, gold is a "neutral" currency, and as the dollar weakens over the next few years, we will see a corresponding rise in gold. I do not view gold so much as an inflation hedge as a currency hedge. That is why I think gold can rise even in a deflationary environment. The recent rise in gold is not telling us that inflation is returning, but that the dollar is in jeopardy.
How far the dollar drops is a looming question, and in much debate. I am of the current view that it will not drop too much against world currencies, as the problem is simply, "Where do you go?" As I will discuss below, the rest of the world is slowing down much faster than we are and Japan's government is committed to currency hari-kari. The picture is very cloudy.
Gold may get a larger than normal boost simply because everything else looks so ugly.
Theme #5 - World-Wide Economic Weakness
I have long chronicled the mess that is Japan, and the problems in Europe. I have been writing for years on what Greg Weldon calls the "Competitive Devaluation Raceway," or the tendency among Asian countries to push their currency lower against each other so they can be more competitive in selling products to the US consumer. This creates all sorts of economic imbalance and pressure, and exports deflation to us.
Today, I want to look at a very alarming warning coming from Moody's about Japan. Greg Weldon (www.macro-strategies.com) is the only analyst I read who has picked up on this, and he deserves a few kudos for this briefing.
Everyone outside Japan, including me, has been calling for years for the Japanese to reform their markets and especially their banking system. The reasons they are in their current dire economic straits is the unwillingness to deal with their banking crisis. They have postponed the inevitable for almost a decade, refusing to write off bad loans and making loans to companies that are brain dead in order to keep from having to acknowledge they have made bad loans. These banks area allowed to do anything to avoid the pain of reality. It also allows management to keep their jobs. Shareholders have no voice in Japan.
Now there is finally a movement to begin reforms, although somewhat tentatively. If Moody's is right, it is not a case of "too little, too late." It is simply too late.
Quote: "The efforts by the Japanese government to instill real market discipline to the currently fragile banking system poses significant risks to both the country's financial system, and its economy at large.... Moody's believes that market reforms, in the absence of financial market stabilization, which looks increasingly likely to require public funds injection, could prove catastrophic for the financial system..... The system is not in a condition that could withstand the potential fall-out from a dramatic shift in depositor sentiment."
The Japanese government is moving to limit the deposit guarantee at banks, which has been one of just many reforms needed. Moody's is suggesting that this would cause bank runs, and risk collapsing the system.
Look at those words: catastrophic... significant risk...public funds injections. This is a very sober Moody's that is telling us, as Weldon translates their report, "The Japanese banking system is essentially broke."
To illustrate how bad things are, Japanese financial institutions (Insurance, Brokers, etc.) do not trust their banks, as they put their cash into Japanese government bonds, which they deposit at the government owned Bank of Japan.
Japan is experiencing new lows in consumption and income, while bankruptcies and unemployment are at all-time highs and government deficits are massive. Japan is moving toward banana republic status in terms of the size of its debt. Now Moody's tells us that even more government debt will be required to finance a bail-out of the banking system, or the economy will simply implode. As the largest source of financing in the world, this is not good for the world economy at a time when there is weakness everywhere. Banks which are in trouble start calling even good loans, in a desperate attempt to find liquidity.
If you sat down and tried to devise a plan to ruin a country's economy, it would look exactly like what the Japanese government has done for ten years. Given the disastrous record of the Japanese leadership in fixing their economy, it is not altogether clear that they can avoid even worse problems than they are currently having. They will continue to avoid any pain until it is too late, which may be soon, if Moody's is right. As I have been writing for years, I think the time will come when the Japanese are forced to monetize their debt. When that happens, the yen will implode.
I have written time and again that the Japanese failure to deal with their problems is the single most serious threat to a stable world economy. In a world full of things to worry about, this is near the top of my list. We can shake our heads and sigh about problems in Argentina or Turkey. These are sad, and our hearts go our to their citizens.
Japan is the second largest economy in the world. Japanese bankers, by their failure to address reality, could do more to de-stabilize the world economy than all the al quaida terrorists could hope to do.
As Weldon dryly points out, this rather dire scenario is bullish for gold.
There is no good news coming out of Europe. The German stock market is down as much as the US markets, and back to 1997 levels. Markets world-wide are making multi-year lows. I think Germany will soon be in outright recession. The recent floods in Germany are causing massive government expenditures, and in order to keep within the European Union Agreement on deficits, Germany is rescinding a tax cut. Rescinding tax cuts in the face of a recession is simply economic suicide, and guaranteed to make the economy worse.
Again Weldon points out the German retail association uses the word "catastrophic" to describe the summer sales season. Auto sales in many European countries are down 5-8% over the last year. Think what the mood would be in the US if we were to experience such a downturn.
The European Central Bank has not gotten the message that they need to begin to ease. This is a very serious issue, as Europe is critical to the world economy. Let me put it very bluntly: the head (or heads) of the ECB needs to roll. Keeping a tight money stance in the face of the current situation is ludicrous. If Greenspan had adopted such a policy going into our recession, we would be talking about mobs and rope.
Japan is down for the count. Europe is on the ropes. Forget most of Latin America. The world economy is held together only by the willingness of the US consumer to still do their duty and buy. And that will only persist as long as jobs and housing stay afloat. If world trade slows down, US jobs will suffer. It is a very unstable house of cards in which we dwell.
Even with all the bad news above, I want to remind you the world does not come to an end. American business and entrepreneurs will continue to find ways to survive and thrive. There will be plenty of opportunity for business and investors. It just won't be as easy as it was in the past two decades.
Which brings us full circle: this is precisely the type of climate in which secular bear markets persist. The investment strategies for this decade need to be ones which emphasize absolute returns. That means you should not be looking for a bottom in the stock market anytime soon.
I can say it no better than the master analyst himself, Richard Russell, does. Russell has been writing longer, and been right more often, than any other newsletter writer alive today. (When I am in my 70's, I hope some young whipper-snapper can say such kind words about me.) You can get his letter at www.dowtheoryletters.com. Today he writes:
"...I look at the situation this way -- we're three years into this bear market and stock valuations are still absurdly high. BUT WE MUST REMEMBER THAT IN A BEAR MARKET VALUES DETERIORATE THROUGH TIME.
"Since we're three years into this bear market and valuation are still sky-high, I feel that the bear has some important "catching up" to do on the downside. In other words, stocks have remained overvalued for TOO LONG.
"Therefore, it would not surprise me if this bear isn't about to make up for lost time. One phenomenon I note is that almost all media sources seem to blame this bear market action on piecemeal evidence. By that I mean each time the market declines, some current news event or some adverse statistic is blamed for the decline. And the implication is that "as soon as this problem is out of the way, the bull market will resume."
"What this tells me is that people just don't understand how bear markets work. They don't understand that once a great bull market dies in exhaustion, once the primary trend of the market turns down -- the bear market that follows will run to conclusion....
"My secret suspicion is that what we're experiencing could well be the early part of the "Daddy" of all bear markets. This bear market could be one gathering disaster. I hope I'm wrong, but they way this baby is going, nothing would surprise me."
I hope he is wrong as well, but secular bear markets, as I point out in the chapter on such, tend to come with multiple recessions and multiple drops in stock prices. The severity of the last secular bear market (1966-1982) was masked by constant and serious inflation. We do not have inflation to cushion the slide today, so this one could be worse.
It will make certain hedge fund strategies all the more important for investors who still want to see asset growth. If you are an accredited investor, you can find out more about hedge funds, and get my free monthly letter on private offerings at www.accreditedinvestor.ws.
Meet me in New Orleans
I just agreed to once again speak at the New Orleans Investment Conference November 6-10. This conference features an extremely strong line-up of speakers, along with a rare appearance by Richard Russell and Sir John Templeton. You can find out more by going to www.neworleansconference.com. I would love to meet you there.
I am writing this week's letter a day early, as I and my bride leave tomorrow morning for Hilton Head to attend the wedding of a great friend, Chip Wood. Chip is a newsletter publisher and travel aficionado. I described him to a friend as perhaps the most consistently happy man I know. Of course, it will also be nice to be away for a weekend with my wife, and to remind ourselves how wonderful a relationship that marriage can be. I wish Chip and Nancy well, and hope he is as happy as I am.
Finally, I throw this out for your weekend thoughts. The George W. Bush I know, as well as Cheney, Rumsfeld, Powell and Rice and the team would not be risking the political careers and reputations in some wag the dog maneuver by calling for a war with Iraq unless they know something that we don't currently know. This is a very smart group, and Bush is not by nature someone prone to sending our troops into war. It is my strong suspicion we are going to learn a great deal in the next few weeks about Iraq's ability to threaten world stability, not to mention kill large numbers of people. They would not all be this adamant if there were not some pretty convincing intelligence that Saddam Hussein is a serious threat. If not, then I will reassess my opinions. But until then, I bet they know something we don't.
Have a great week, and call an old friend you haven't talked to in awhile. It will help remind you that life is more than money.
Your enjoying his life more than he thought possible analyst,
John Mauldin
JohnMauldin@xxxxxxxxxxxxCopyright 2002 John Mauldin. All Rights Reserved.
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