Thoughts from the Frontline

The Grandfather of Bear Markets

October 18, 2002

Today we return to our assigned task of trying to find some patterns in the data to help us determine the direction of the economy and the markets. There are lots of bread crumbs on this trail, so let's see what conclusions they lead us to.

First, the evidence mounts that we are still in what I call the Muddle Through Economy - a slow growth, no-new-jobs type of recovery that seems to be alternately teasing us with potential for growth and frustrating us with weakness. Weakness is winning.

Richard Russell of the Dow Theory Letter says we are in the Grandfather of Bear Markets, with which I agree, and then asks how I can predict a Muddle Through Economy? This is a fair question, and one many readers have asked. I will attempt to answer it today.

For new readers, let me once again make an important point: there is no long-term connection between the growth of the stock market and the growth of the economy. As a recent example, the economy grew 373% in the 17 years from the beginning of 1965 to the end of 1981, while the Dow was absolutely flat. From 1981 through 1998 the economy "only" grew 177%, while the Dow surged over 1000%, or ten times in just 17 years. If you go all the way to the end of 1999, it was up 13 times with a growth less than half that of 1965 through 1981, when the market was flat!

The difference was the willingness of the investing public to "discount" the future. In the recent bubble, investors assumed that stocks and earnings would grow 15% a year forever, and thus were willing to "invest for the long term." If a stock was currently expensive in terms of its actual earnings, then it would only be a few years before the earnings of the company grew and made that stock a reasonable buy.

It is the willingness of investors to project their optimistic feelings into the future that allow cyclical or secular bull markets to go to an extreme. We had three of them last century, and they all ended badly.

I will not again make the case that we are in a secular bear market, much to the relief of long term readers. New readers can see the conclusive case that we are in such a cycle by going to my book-in-progress website:

Today, we will look at the emotional dynamic which powers a secular bear market, and see if this bear is at an end, or is just teasing us with a powerful bear market rally. I believe this to be a bear market rally, and one which could be powerful. I hope it is. But ultimately it will fail, although it might last for months. Traders should have fun, but investors should see this as an opportunity to eventually get out. Let's examine why.

Secular bear market cycles are characterized by more frequent and more serious recessions than their bullish cousins. With each recession, investors become more disillusioned and more conservative. They become less willing to project earnings growth into the far future. By the end of the cycle, rather than looking out ten years, they are barely willing to look out ten months.

Typically, the bull cycles are driven by some innovation like railroads, electricity, computers, etc. which foster great optimism. "This time," investors think, "things are truly different." A period of growth and seeming stability becomes the order of the day. Normally sane men project this economic climate into the far future. Business builds too much capacity, then prices and profits drop, employment sags, and it takes a decade or two to work through the excesses of the boom. But those excesses always get worked through. There is no new bull market until the excesses are dealt with. When that happens, the base is formed for a new cycle that we call a secular bull market.

This boom-bust cycle has been occurring and recurring since the Medes were trading with the Persians. This optimism-depression syndrome seems to be part of our human genetic make-up.

With that background, let me posit the following scenario:

I believe we are in a Muddle Through Economy. This economy is currently dependent upon housing and consumer spending. That is not a bad thing, but it is not the engine of economic growth. Growth comes from (among other things) business investment and new jobs. We are seeing little (or no) growth in business investment and no (or negative) growth in jobs. (See below.)

Growth will be quite slow for some time, until some problem occurs, and then we slip into recession. What could be the trigger? It could be that housing slows down. We could see housing prices fall. Consumers could start saving and spending less. Consumers could decide they need to start paying down their debt and thus spend less. Consumers could come to the end of their ability to incur debt, and thus spend less. Unemployment could rise, as businesses increase lay-offs in an effort to increase earnings. Mortgage rates could stop falling or (gasp) even rise, thus killing a major stimulus to the economy. Deflation could rear its ugly head. The list of triggers is long.

Why then, with all these problems, do I see a Muddle Through Economy for our near future? Because we have had huge stimulus from a number of areas.

The Fed has been accommodating with lower rates and easy money. Foreign investors have been willing to buy our bonds and stocks with a very high dollar. The Bush tax cut has come at a very opportune time. Mortgage rates have in effect acted like another tax cut, as people pay less for their homes, and/or have taken equity out of their homes and spent it.

Thus, the two areas which are holding up the economy -housing and consumer spending-have had a lot of stimulus. The problem is that the patient is now hooked on these stimulus drugs. Housing needs ever lower rates, but I agree with Bill Gross of Pimco that there is only so much lower mortgage rates can go. 5% is probably close to the lower limit. Eventually, that stimulus goes away.

Eventually, the stimulus fails to work, and we slip into recession. Is that next year or 2004? I can make a cogent argument for either year. I have trouble thinking of how we can avoid another recession through 2004. The next one will take consumer spending, if not housing, with it and thus will be a serious recession, unlike the recent mild recession we had.

Many look at the economic pressures we face, and wonder why we do not slip into recession next week? I agree that we cannot avoid another recession. We will have to deal with our major debt problem, both corporate and consumer. The high dollar will have to come down. Housing will come back to trend, etc.

But the US economy and free market capitalism is much stronger than most stock market bears imagine. Just as we must remind ourselves that there is no connection between the value of the stock market and the economy, we must remember to do the reverse. Just because I think we are in a secular bear market and the Dow will be lucky to bottom out at 5,000 does not mean the economy will go into the tank and another Depression is around the corner.

The mistake most bulls make is to project the performance of the economy onto the stock market. The mistake many bears make is to project the performance of the stock market onto the economy. It is quite possible for the stock market to drop 50% and for the economy to muddle through.

While it is possible we could see a depression (primarily through government ineptness like increasing taxes or raising rates), it is far more likely we see a period like 1966-1982. We experienced four recessions and an ugly bear market in stocks, stagflation, a debacle in bond prices and much more. At the end of that period the US economy was far larger than at the beginning. Even in real, inflation adjusted terms it had doubled.

I noted at the beginning of this letter that there is no long-term connection between a growing economy and a growing stock market. There is, however, a connection between recessions and a falling stock market. The average recession drives the stock market down 43%.

It is my opinion that we will experience one and probably two recessions in the remainder of this decade. Historically, the bottom in the stock market will come after the latter one. But even with all that, the US economy will still be larger in 2010 than it was in 2000. While we will not grow anywhere near the pace we grew during the last 50 years, due to deflationary and global competitive pressures, we will still grow. It just won't feel like the 90's.

And that is why, Richard, I think it is perfectly reasonable to predict a Muddle Through Economy for the near future (and even for the overall decade, albeit with some serious bumps), and to also agree with you that we are in the Grandfather of all secular bear markets. (Richard Russell can be read at

Where is the Economy Headed?

While we may be in a muddle at the moment, the news is not particularly encouraging that we will remain so. Today I am going to come off the fence and begin to suggest we are in for a recession next year. Let's look at some of this week's economic data.

Today we read US housing starts were strong in September. This strength should continue until mortgage rates start to climb or unemployment starts to rise again. Since, as we will detail below, the rest of the economy is weak, it is likely the recent (and vicious) rise in interest rates will not stick, and thus I expect rates will eventually resume their downward trek. If they do not, then a recession will come sooner rather than the later I predict.

Inflation remains quite tame at 1.5%. The risk is that we slip into deflation. This is underscored by today's trade deficit numbers, which were (again) a record $38.5 billion. Imports rose by 2% to $120 billion and exports fell 1.3% to $81.9 billion. Because of the strong dollar, we are getting cheaper goods from abroad, and are having trouble selling our products. That is why so much of US business is showing decreasing earnings. They simply cannot sell their products at high enough prices in a global economy where the dollar is king.

China is Exhibit #1. There is no growth problem in China. Foreign businesses spent almost $50 billion in China in 2001 and are on pace to beat that in 2002. That is why Chinese exports grew at 25% over the last year. They (or their foreign partners) are building the factories to sell products to the rest of the world.

Here is the problem from a deflation point of view. China has a fixed exchange rate with the dollar. Because they can produce products at far lower prices (due primarily to labor costs), the US and the rest of the world has trouble competing on price. China has increased its share of Asian exports by 50% in just the last year. They are putting downward pressure on prices not just for US businesses, but for all businesses worldwide.

I just won a new putter at a golf tournament yesterday. (It was a raffle and not my golf prowess, I sadly admit.) It is the #1 putter on the ladies and senior PGA tours. It was made in China.

Until China begins to float its currency (let the market determine the price) rather than fix the exchange rate, this downward pricing pressure will continue unchecked. Since over 1/3 of our economy is global, then much of what we do has a downward price pressure.

But it is not just China. Japan is clearly creating a deflationary wind across the world. Hong Kong, Taiwan, Singapore and much of the rest of Asia is in deflation. Europe is slowing down. It is the result of too much production capacity and an addiction to the US consumer.

So what does business do to answer the problem? "If we cannot compete with Chinese products coming from Chinese factories, then we will build our own Chinese factories" seems to be the answer. In a perverse world, too much capacity has created a situation where only the low cost producer can survive. The only answer seems to be to create more capacity in the world's low cost producer to put even more pressure on prices on competitors elsewhere.

This forces country after country to devalue their currency against the dollar, so that they can compete for the American consumer. This keeps the dollar strong, just at a time when it would be convenient for it to weaken. This puts more pressure on American business, which must cuts costs (read lay-offs and less capital spending in the US - see below) in order to remain profitable. This causes deflation.

The trade deficit is now approaching 5% of GDP. As I have written before, this is historically when a currency begins to drop, sometimes rapidly. If the rest of the world continues to devalue their currency to keep attracting the American consumer, then we are in for deflation in the US, unless the Fed begins to seriously increase the money supply, which will create future problems of its own.

Consumer spending was up in August, and down in September. Wal-Mart tells us they are on track for a 2-4% sales growth, which looks impressive until you see that their numbers from last October were dismal. A trade organization for the office furniture industry predicts shipments will decline 20% this year to their lowest levels since 1993.

The Philadelphia Fed manufacturing survey fell through the floor this week. Their main index shows a negative number for manufacturing activity for October, for the second time in three months. Prices for finished goods fell (see above comments on China and deflation), inventories fell and back-orders fell.

In what Reuters characterized as a downbeat speech (no kidding!), Boston Federal Reserve Bank President Cathy Minehan said on Friday the U.S. economy remains fragile even without any new shocks, and consumer spending may be starting to wobble. "... how long can the consumer hold out? The risks here seem firmly on the downside," she said.

U.S. industrial output fell in September for the second month in a row, the Federal Reserve said on Thursday in a report underscoring the fragility of the manufacturing sector in the uneven U.S. recovery. Capacity Utilization is down to 75.9%. Experts normally say when capacity utilization is below 80% that companies are unable to increase prices or profits.

Honeywell, Sun, Motorola and scores of tech companies announced lay-offs this week, as they have too much capacity. Even the world of utilities is in trouble. S&P has downgraded 135 energy companies this year, almost 50% since July, and with nearly one-third of the major companies in the sector on watch for future downgrades, it appears the industry hasn't yet hit bottom.

And finally, as I wrote about early this year, the under funded pension problem is becoming a crisis. Last month, Merrill Lynch said that 98% of the 346 companies in the S&P 500 that offer defined benefit pension plans will find their plans under funded by the end of this year.

Fitch said the pension-funding gap for U.S. auto employers alone will rise to more than $30 billion at year's end, from $13.9 billion at the start of the year, with no immediate remedy in sight. When looking up the financials for GM and Ford on Yahoo I note that GM made almost $1.4 billion and Ford lost over $6 billion in the last 12 months. It will take them a few years of lower earnings to make up their part of that $30 billion.

Europe is a Sick Puppy

As one commentator put it, the whole of the European continent is sick. Instead of rebounding on the strength of cheap loans, low inflation and the combined spending power of 370 million people, Europe has seen its hopes of economic recovery unraveled by mass layoffs, chronically high unemployment, slumping stock markets and sky high tariffs. First France and then Germany announced that the agreement all the members of the European Union signed when they formed the EU must be ignored. Now even the head of the European Union, just a few years after the signing, today says the agreement is "stupid." This does not bode well for the euro (or the ability of the European governments to see the consequences of their actions) again at precisely the time when the world needs a strong euro.

The European Central Bank remains clueless. As if to perversely prove their independence, they refuse to lower rates or ease the money supply, even as the European economy slips ever closer into recession. Germany is complaining about deflation.

As I have written on Japan at length in past letters, let me simply say that recent reports from the Land of the Hidden Sun are in keeping with their being the most mismanaged government in the world. One of the great problems of Japan is that companies which are insolvent are kept on life support, selling products below cost and thus keeping all their competitors from being able to make reasonable profits. Japan simply has refused to deal with their huge bad loan problem

Michael Hewitt of HCM Capital calls it the vampire economy, as the undead prey upon the living, creating ever more undead. He tells us, "Goldman Sachs analyst David Atkinson's estimate [is that bad loans are] $1,957 billion, or approximately 40% of GDP." New loans are being created faster than they can write off the old loans.

As I reported a few weeks ago, this is approaching a crisis of biblical proportions. Even the Bank of Japan seems to finally be alarmed, as they announce they intend to "do something" about bad loans. Just as the world begins to get a hope they will finally drive a stake through their vampire companies, I read that the government is authorizing yet another ministry to make loans to defunct companies to help them survive. Which companies will get these loans? You can bet it will be the same ones who have gotten government loans in the past, and who make large "contributions" to the politicians.

Normally, one would not care what another country does, but the bad policy in the world's second largest economy - Japan - is severely hurting the rest of the world, and creating deflationary forces that are causing major problems both in Japan and elsewhere. Their recently announced "solution" will not solve the problem, but serve to make them worse. But it postpones the pain, which seems to be the only thing Japan can summon the political will to do.

And All This Means?

The US economy will probably grow less than 1% this quarter, barring some resurgence in business investing that is not now on the horizon. There is no help coming from the rest of the world. Lower interest rates from the Fed will not be any more stimulus to the economy, although it might help lower the dollar, and thus they should lower rates. It is unlikely we will get a tax cut, so that stimulus is out. When mortgage rates bottom out, that will be the last of stimulus from that source. We are running out of silver bullets.

With such slow growth, we find ourselves on the cusp of recession. It won't take much, as the Fed governor noted, to push us over. We can probably avoid an actual recession (Muddle Through) for another few quarters as long as we get no serious shocks in the meantime. But over time, a profitless recovery will take its toll. More and more companies will seek to increase earnings by lay-offs and holding the line on spending for new equipment and capacity, except where direct competitive pressure demands they do so. This means fewer new jobs at manufacturing companies and technology firms. This will all have a direct affect on consumer spending, and we will slowly roll over into recession.

The next recession will mean one more major leg down in the secular bear (stock) market. The Index that will get hit the most is the index that has already suffered the most, and that is the NASDAQ. You will see the NASDAQ fall below the S&P 500. You heard it here first. When the new accounting standards (expensing stock options, which will happen) are applied to technology companies, we will find that many of the NASDAQ 100 have no earnings.

My best guess, and it is just that, is that we will see an outright recession in the latter half of 2003. Given that the stock market is still at valuation levels higher than at the end of any previous bull market, this does not bode well. Could we see another 40% drop? Absolutely. Historically, that is the average drop in a recession. Since we have come from the biggest bubble in history, it makes a certain symmetry that we could see the biggest bear in history.

At the end of this year, you are going to hear a lot of cheerleaders telling you to buy stocks, because at no time has the stock market ever fallen four years in a row. "This year," you will be told, "is a lock for an up year."

If we enter recession, the only lock is for a fourth straight down year. Given the state of the economy above, I see no way we will go into a boom economy.

Absolute Returns

Are there any places that have the potential to make reasonable returns in this environment? Absolutely, in my opinion. I write a free monthly e-letter for accredited investors on hedge funds and private offerings, where I think there are pockets of solid opportunities. If you are an accredited investor (typically that means a net worth of at least $1,000,000), you can go to and sign up for the free letter. For current readers, the October letter is (finally) out.

Additionally, there are certain styles of investing that have the potential to do well. One doesn't have to go into a cave or into money markets for the remainder of the decade. Secular bear markets require a different strategy for success. Doing nothing is not a strategy.

New readers can go to to access all my web sites, including the web site for my book-in-progress called Absolute Returns, where I will offer my opinions on what investors should be doing this decade.

Last week, I was in New York, and stayed 100 yards from the World Trade Center site. It was my first visit back to the site, and it hit me pretty hard. Then I traveled to Washington DC, where you could feel the palpable tensions in the air from the fears of the snipers. It was very sad to listen to parents talk about the distress it is causing upon children.

All in all, I was glad to get back to Texas and my family and own bed. I will be staying home for a few weeks, and then will be in Santa Monica November 3-5 for the Endowments and Foundations Symposium, where I will be talking on the economy and leading sessions on investing in hedge funds. I will also be in New Orleans for the 29th annual New Orleans Investment conference ( on November 7-10. I will be glad to meet with clients and potential clients in both cities, and have some time available.

And with all the above gloomy news, don't forget that the source of your well-being is the grace of God, and that you get to work out your own future in a free world with lots of opportunities. Concentrate on what you can do and not on what you can't.

Your always seeing a boom around his corner analyst,

John Mauldin


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