The Seen and the Unseen

"In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

"There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

"Yet this difference is tremendous; for it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil."

- From an essay by Frédéric Bastiat in 1850, "That Which Is Seen and That Which Is Unseen"

What happens when the Fed is finished with QE2? I have been letting that filter into my thinking lately as I look at the economic landscape and the data we have seen the past few weeks. Correlation is not causation, as I often say, but all we can do is look back at what happened last time and speculate about the future. A very dangerous occupation, but your fearless analyst will plunge on ahead into the jungle of a very hazy future. You come with me at your own risk!

New York Times Bestseller

Quickly, a big Mauldin thanks to those who already bought my book, Endgame, as it made the New York Times bestseller list yesterday, earlier than I thought it would. That would be my 4^th, and that and my kids are about my only small claims to fame. I have ruthlessly promoted the book to you, and so this week I resist my inner promotional demon and simply provide a link to http://www.amazon.com/Endgame-Debt-SuperCycle-Changes-Everything/dp/1118004574/ref=sr_1_1?ie=UTF8&s=books&qid=1298937384&sr=8-1 where you can read the reviews and buy the book if you have not, or get it in your local stores. At the end of the letter, I note that I will be at a book launch party in London Monday evening, and would love to have you stop by. Details below. And now to this week’s letter.

This week’s letter is a result of two lengthy conversations I had today, which have me in a reflective mode. Plus, I finished the last, final edits of my book, all of which is causing me to mull over the unsustainability of the US fiscal situation. There is a true Endgame here, and it may happen before we are ready.

The first conversation was with Kyle Bass, Richard Howard, and Peter Mauthe, over lunch (more on Peter, who has come to work with me, below). Kyle is the head of Hayman Advisors, a very successful macro hedge fund based here in Dallas. Then I recorded a Conversation with David Rosenberg and Lacy Hunt, which is one of the best we have ever done. Subscribers will be very happy. The new Conversation with George Friedman is now online, too. You can learn more about Conversations with John Mauldin at www.johnmauldin.com/conversations/ . And please comment on this and future letters in the readers’ forums of my new website. Now, to this week’s letter. My goal is to make this one a little shorter than normal. We’ll see how I do.

This week you will get a kind of preview as this week's letter. I am desperately trying to finish the first draft of my book and am one chapter away from having that draft. I have promised my editor (Debra Englander) that she would see a rough draft next week, and the final version will be delivered on the last day of September. More on that process for those interested at the end of the letter. But this week's letter will be part of what will probably be the 4th or 5th chapter, where we look at the rules of economics.

There is just so little writing time left that I have to focus on that book for a little bit. I am writing this book with co-author Jonathan Tepper of Variant Perception (who is based in London), a young and very gifted Rhodes scholar with a talent for economic analysis and writing. We each write the first draft of a chapter and then go back and forth until the chapter has been much improved. Alas, gentle reader, you will only get my first draft. You will have to wait for the book to get the new, improved version. But this is the last one I have to write. And Jonathan has done all his initial chapters. We are on the home stretch.

But first, my partners at Altegris Investments have written a White Paper entitled "The New Normal: Implications for Hedge Fund Investing." It is a very instructive read. If you are in the US and have already signed up for my Accredited Investor letter, you should already have been sent a link or a copy. If not, and you are an accredited investor (basically net worth of $1.5 million or more) and would like to see the paper, or are interested in learning more about how hedge funds, commodity funds, and other absolute-return strategies might fit into your investment portfolio, I suggest you click on www.accreditedinvestor.ws and fill out the form, and a professional will get back to you. And if you live outside the US and are interested, I have partners around the world who can work with you, so you can sign up as well. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC. Member FINRA.) And now let's look at part of a chapter from The End Game.

From ghoulies and ghosties
And long-leggedy beasties
And things that go bump in the night,
Good Lord, deliver us!

--Old Scottish Prayer

Where the Wild Things Are is a beloved children's book and now a beautiful movie. But in the investment world there are really scary wild things lurking about in the hidden recesses of the economic landscape. Today we look at one of the unintended consequences of the Federal Reserve's low interest rate policy.

For quite some time, I have been arguing that we are faced with no good choices, not just in the US but in the entire "developed" world. I see a low-growth, Muddle Through world over the next years (with a double-dip recession just to liven things up). However, that does not mean that we will lack for volatility. Things could get volatile rather quickly. Let's quickly set the background.

Let's look at today's interest rate picture. Yesterday, we had the bizarre occurrence of banks actually paying the government to hold their cash. Three-month treasuries yield a miniscule 0.01% in interest. If you opt to buy a one-year bill you get all of 0.26%. You can see the entire spectrum below.

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 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.

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.

There is no doubt that the US is in financial trouble. Those talking of a strong recovery are just not dealing with reality. But the US is in better shape than a lot of countries. This week, we begin by looking at Japan. I have written for years about how large their debt-to-GDP ratio is, yet they keep on issuing more debt and seemingly getting away with it. But now, several factors are conspiring to create real problems for the Land of the Rising Sun. They may soon run into a very serious-sized wall. And it is not just Japan. Where will the world find $5 trillion to finance government debt? We look at some very worrisome graphs. Those in the US who think that what happens in the rest of the world doesn't matter just don't get it. There is a lot to cover in what will be a very interesting letter. I suggest removing sharp objects or pouring yourself a nice adult beverage.

But first, I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called "Toxic Equity Trading Order Flow on Wall Street." Basically, they outline why volume and volatility have jumped so much since 2007; and it's not due to the credit crisis. They estimate that 70% of the volume in today's markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn't get to play. This is a game only for big boys who can afford to pay for the "arms" needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn't affect you? That "tax" is paid by mutual funds, your pension fund, and every large institution.

This week we look at the Land of the Rising Sun. Japan is going through major upheavals, and they will have consequences all over the world. And what are those wild and crazy Swiss central bankers up to? It's time for another round of competitive devaluation. And of course I have to look at the recent Barron's cover story, about how stocks are cheap. There's a lot to cover.

But first, and quickly, I just wanted to take a moment and remind you to sign up for the Richard Russell Tribute Dinner, all set for Saturday, April 4 at the Manchester Grand Hyatt in San Diego - if you haven't already. This is sure to be an extraordinary evening honoring a great friend and associate of mine, and yours as well. I do hope that you can join us for a night of memories, laughs, and good fun with fellow admirers and long-time readers of Richard's Dow Theory Letter. The room is filling up and there will be a very large crowd.

A significant number of my fellow writers and publishers have committed to attend. It is going to be an investment-writer, Richard-reader, star-studded event. You are going to be able to rub shoulders with some very famous analysts and writers. If you are a fellow writer, you should make plans to attend or send me a note that I can put in a tribute book we are preparing for Richard. And feel free to mention this event in your letter as well. We want to make this night a special event for Richard and his family of readers and friends. So, if you haven't, go ahead and log on to https://www.johnmauldin.com/russell-tribute.html and sign up today. The room will be full, so don't procrastinate. I wouldn't want any of you to miss out on this tribute. I look forward to sharing the evening with all of you.

It is not just the US that is in recession. The world is slowing down, and rapidly. This week we quickly survey the rest of the world, and then come back to the US. We follow up with the implications for corporate earnings worldwide, and specifically address my speculations about earnings forecasts for 2009.

Let's start with some charts from my friend Simon Hunt, out of London. The following chart shows World Merchandise Export Values and World Industrial Production falling off a cliff. This is the worst such period since the end of World War II. And as the data we will examine next indicates, it is likely to get worse. Simon notes that consumer spending is about 60% of world GDP, and it is not just in the US that spending is slowing down. Consumers all over the developed world are in shock, as assets such as stocks and houses, real estate, and commodities fall in value. Unemployment is rising.

We think that almost 2,000,000 lost jobs in the last three months in the US is a catastrophe. China lost a reported 20,000,000 jobs in the last quarter, and migrant workers came back to the cities after Chinese New Year to find factories and jobs simply gone. Unemployment is rising rapidly in Europe, as the demand for goods has clearly been falling since last October.