TFTF

2002 Economic Forecast

January 4, 2002

My annual predictions letters for the last two years have been easy to write, and with one glaring exception, have been generally on target. I start with a basic premise - one key economic factor -- and work out from there. I look for the one thing I believe is going to affect the economy more than anything else in the coming year. If I am wrong on my basic premise, then everything else is likely to be wrong.

In 2000, it was the bursting of the bubble and in 2001, it was the coming recession. Both seemed obvious as I wrote about them then and hindsight has been kind to those prognostications as well.

Today it is not so obvious or easy, at least for me. I have spent a long time reading and thinking through the hundreds of pages of data and forecasts that are sent my way, many of them quite expensive indeed. To say there is more contradiction and disagreement than normal is an understatement. Well-respected experts look at the same data and come to quite different conclusions. Some see only "onward and upward" and others see the "end of the world as we know it."

Each group cites a mountain of economic data to support its position. The problem at hand is that we have never seen this combination of data before. Using history as a basis for prediction, as long time readers know I like to do, is fraught with problems. We are in uncharted waters. There is no historic parallel, so we are left to our own predictive devices.

On the Gripping Hand

It reminds me of the subject of one of my favorite science fiction books. The authors postulated a three-armed alien. Their third hand was called the "Gripping Hand". When in an argument with this clever species, they would come forth with three opinions. You would have to listen to: "On the one hand, on the other hand, and then on the Gripping Hand." I always thought they would have been ideal economists.

I think both those in the total doom and gloom fatigues and those in the cheerleader uniforms are wrong. We are going to try to "get a Gripping Hand" on the 2002 economy by looking at the data.

This letter is about twice as long as normal, but it is full of hopefully thoughtful research and predictions that you will find useful. You might want to read this when you have 15 minutes or so. Sorry it took a few extra days to get out, but there was just a mountain of data to weed through and assess.

For now, I'll give you the executive summary: I have come to the conclusion that the over-riding economic factor for the first half of 2002 will be deflation. "Imported" deflation is going to affect every area of our economy and investments. We will see a second half recovery in the economy, although it will be different in size and scope from previous recoveries, which are usually "V" shaped and quite robust.

Investing will be even trickier in 2002, as the Fed and world response to deflation, and the resulting problems that are created by their response, is anybody's guess. But the conventional wisdom of market cheerleaders (which passes for market knowledge) will be as wrong in 2002 as it was in 2000 and 2001.

This year we will have to keep our eye on several stats new to this letter. Could we see a return to inflation in the second half as the Fed continues to pump? Has Greenspan tightened for the last time in his career, as some very savvy analysts assert? We will explore all this and more as we look at 2002. Let's go to the numbers as I lead you through the economic minefield.

Deflation Comes to Our Shores

Deflation is not a new theme for this letter. I have been predicting it since late 1998. It now seems to be here. Has anyone noticed that for the last six months of data available (June through December) that the CPI (Consumer Price Index) actually dropped? Not by a lot, but at an annual rate of approximately -.3%, (give or take a tenth) which is unprecedented. The bond market certainly does not believe such numbers will last, as interest rates continue to climb as I write this.

However, the very reliable Bank Credit Analyst notes that their inflation predictor is at a very low point, showing almost no inflation in our future.

The Producer Price Index (PPI) is down 1.1% for the year and for the last six months is down 2.5% or an annualized rate of approximately 5%! The numbers are certainly at the lower end of the range and suggest that a further easing of prices in the CPI is in the future.

For the record, I understand the difference between monetary inflation and price inflation/deflation. We will explore later why we are seeing price deflation while the Fed is increasing the money supply at record levels (monetary inflation). As deflation is my basic theme for this year, we will go into it in a little more detail.

Importing Deflation

I am often asked how can a country export its inflation to another country? It is not a hard good or service which one country would willingly buy from another. Yet economists speak of "exporting deflation".

To begin with, let's look at Exhibit "A": Japan - the world's second largest economy. I have written at length about Japan in recent issues, so I will just summarize here.

The GDP (Gross Domestic Product) in Japan fell 5% last year and is now at the lowest level in 6 years. The GDP deflator (an obscure but important statistic) is now back at 1990 levels. Such trends have not been seen since the 1930's. (Bank Credit Analyst)

Japanese national debt is at 130% of GDP. If you add in the bad debt that the government will have to assume from the cascade of bank failures that will happen in the next few years, the debt load will increase to 160% (Morgan Stanley). That is huge. And that is debt that is on the books. Off-budget debt such as government guaranteed pensions in an aging country is not included and is staggering.

Japan is rapidly approaching the end of its rope. It is reasonable to worry about the economy imploding, as it will have severe effects on the world economy.

Japan has used "fiscal stimulus" for ten years to try and get their economy jump-started. They finance huge public building projects to keep the building contractors working. They spend and spend and spend. They have borrowed to the teeth to do so, and for little results.

Tax receipts are going down, and spending requirements are going up. But to raise taxes would drive the economy down further. To increase deficit spending would threaten Japanese bond ratings. S$amp;P has already lowered Japanese government ratings, which must be humiliating for the face-saving leaders of the second largest economy in the world.

As mentioned above, bad debts at all levels of banks are huge. Many of the country's largest banks are more than technically insolvent. The main reason that the Japanese economy has not rebounded since 1990 is the failure to simply close out bad bank loans.

Capital is being loaned to companies which are basically brain dead and have no chance of growth. Japanese banks continue to loan money in order to keep from recognizing that the companies they do business with are insolvent. This keeps smaller companies from being able to get access to loans, and finance companies that should be allowed to collapse. They continue to compete at a loss instead of getting out of the way of better managed firms.

Further, Japan depends upon exports for its very survival. But it now competes with the rest of Asia in a number of its key industries, especially for the attention and money of the US consumer.

Let's see if we can summarize: government debt and deficits that are too high; they can't raise taxes; exports are down to dangerously low levels; growth is negative and getting worse; deflation is ravaging the country; unemployment is at an all-time high; banks are collapsing left and right; the reforms which are needed are being fought tooth and nail. So, what's a government to do?

In a time honored tradition, Japan will monetize its debt and destroy its currency. Yes, you heard it here. Japan has decided that its only real option is to become a banana republic.

I have been telling you for months that the official policy of Japan is to now devalue its currency. The yen has dropped to 130. 130 is now the floor. Morgan Stanley analysts think it could go to 150. I agree, although we both may be optimists considering the nature of what Japanese leaders are contemplating.

Wasn't it just a few years ago that the yen was at 80? This means that if you are a Japanese consumer, it already takes 60% more yen to buy a dollar than just a few years ago, and your government is hell-bent on adding another 40% cost increase. But if you are buying Japanese goods with dollars, there are some bargains to be had.

What does this do for Japanese business? It means their products are cheaper outside of Japan. If the US steel industry thinks it has problems competing now, just wait till later this year. Japanese manufactured automobiles (like my daughter's new Lexus SUV) will be even better values within another few months. If you are GM or Ford, your worst nightmare is a loaded $30,000 Lexus luxury SUV selling against your $40,000+ models.

The plan seems to be to make Japanese products so cheap that everyone will want them and thus the Japanese economy takes off. Of course, that also means Japanese businesses will have less competition from abroad, and can improve their profits and their balance sheets at the expense of the Japanese consumer. The consumer, fearing prices might rise, might actually come out of their cocoon and buy something.

If this was just a problem for Japan, I might feel sorry for the Japanese consumer, but would not really care all that much. But it is far more.

By Japan making their products cheaper, that lowers prices of their products in the US. It makes US companies keep their prices and profits low. In fact, it means they will actually have to lower prices. This is deflationary.

But it gets worse. Much of the rest of Asia will not sit idly by and watch their competitive relationship vis-...-vis Japan deteriorate. They will also continue to devalue their currency in what will be a competitive devaluation policy. I have been writing about this for well over a year, and my prediction is that I will be writing about it for this next year as well.

When Korea, Thailand, Malaysia, Singapore, Taiwan and others drop their currency values in line with the yen, that not only keeps them competitive with the products for which they directly compete with Japan, but also the entire spectrum of their products.

US companies are going to face pricing pressure like they never have. More and more manufacturing jobs will leave the US, as companies are forced to either shut their doors or manufacture offshore.

But what if you are a company doing business in Asia? Your products now cost more to those consumers, so you sell less of them. Further, your profits as denominated in dollars are less, so your US balance sheet is weaker. UGLY, UGLY, UGLY.

In essence, Japan is exporting its deflation to us, and forcing its neighbors to follow suit. While this may be a relatively small portion of our economy (in the grand scheme of things) it will be significant enough that overall prices will drop.

More Deflationary Pressures

Monetary theory says that inflation is an increase in the money supply, and the Fed has certainly been doing that, although it is not evident in prices (yet). But we are also watching paper burn.

Let's take Enron. The loss of Enron stock is only a true loss for the economy to the extent of invested capital. If someone bought Enron for $50, someone also sold it for $50 and there was not a net difference to the over-all economy, although individuals feel the pain or gain.

But Enron is more than its stock. Bond holders are going to watch physical dollars disappear. Gone. Bye-Bye. As the dust settles, this could be upwards of $4-5 billion. JP Morgan may be out $2+ billion alone, depending upon whether their bond insurers have to pay up.

This paper burning is deflationary. Right now, companies are defaulting at record levels. So are consumers. Every dollar that disappears is deflationary. This allows the Fed to increase the money supply at higher than normal rates without bringing back inflation.

And it is not just companies. Argentina debt is going up in smoke as I write. I warned readers about Argentina almost two years ago when it seemed you could get a "safe" 16% return. Now investors will be lucky to get 16% of their principal. There is no free lunch.

Coupled with a slower velocity of money (see last issue), tighter bank lending standards and increased consumer savings (less spending puts less pressure on prices) and you have increasing deflationary pressure.

This deflationary environment is the back-drop for the rest of my 2002 predictions.

What are some of the effects? For starters, US corporations will continue to have difficulty raising prices. That means reduced profit margins and lower profits , which is precisely what we are seeing in the current data.

Lower profits mean lowered capital spending. Capital spending has been one of the main culprits in the current recession, and while we will see a rebound in the second half of 2002, it will not be robust. Tepid is the word that comes to mind. We are at decades long historic lows in capacity utilization. Typically, businesses do not buy products (capital spending) to increase capacity unless they see an increase in demand or a way to lower production costs for existing demand.

Lower profits mean more unemployment. The historic correlation is tight. Everyone acknowledges unemployment is going to at least 6% and some think 7% or more. I think 7% is quite possible, which (in the grand scheme of things) is not all that bad, unless you are in the 7%. It means that 93% of us are still working. The problem is that it is likely to linger for a while.

That means a continuing deterioration in credit card debt problems, bankruptcies and such. That is also not the environment for a consumer led recovery (see more below).

Lower profits and lower employment mean lower tax revenues and increased expenses at all levels of government. While the US government can run a deficit, states and cities cannot. That means the level of pain in state capitals this year will be at all-time highs. There have been major surpluses in many states for several years. This surplus was spent and budgets increased. Now the surpluses are gone, and state and local politicians are going to have to deal with the short-fall "cold turkey." You will see lots of headlines about this, and the level of negative rhetoric will increase. Prediction: in most places and for most people, your state and local taxes will increase, more than offsetting the peanut sized tax cut at the federal level.

Recovery? What Recovery?

Let me state up-front that I think we will "recover" in the latter half of the year. But for reasons I will now outline, the recovery will be weaker than normal.

The case that market cheerleaders (analysts, brokers and money managers) offer for a robust recovery is dependent upon historical precedent. The US has had 7 recessions since World War II. 6 of the 7 have seen dramatic rebounds in the 8 quarters after the recession was over. The one exception was in 1991, where the recovery was slow but sure.

On one hand, Douglas Lee, writing in Barron's, is typical of the cheerleader genre. Arguing that there is still a New Economy, he looks at several factors which will produce a stronger than usual recovery. He calls it a "Super-V". Of course, he mentions the Fed rate cuts and the huge increase in the money supply. Then the ".first stage of the recovery will be powered by a reversal of the inventory correction that helped push the economy into recession..The second stage of the Super-V recovery will be powered by both the fiscal stimulus already built into government policy and a resumption of capital spending.(One should not take the US consumer for granted, but consumer balance sheets are in excellent shape, confidence has been surprisingly resilient, energy prices are down, housing prices are stable and more tax breaks are on the way. These factors should offset the negatives from a soft labor market.)." (Barron's.)

And on the other hand we go to Dr. Kurt Richebacher, who sees no such recovery (Please remove sharp objects from your vicinity prior to reading further.):

"Manifestly, the economic and financial excesses that have built up in the U.S. economy during the past four to five boom years are the worst in history. The last time the U.S. economy experienced protracted weakness was from 1989 to 1993. Taking the actual credit expansion as a measure of excess, we note that during the second half of the 1980s, total credit (private nonfinancial and financial) in the United States had increased $3.4 trillion. In the second half of the 1990s, it expanded by more than $9 trillion.

"What is still normal in an economy with such an insane credit explosion? We presume, nothing. Looking only at the most obvious and the most spectacular, unsustainable imbalances is more than shocking, it is frightening: grossly overvalued equities, near-zero personal savings, the monstrous trade deficit, steeply rising trillions of foreign debts, a hugely overvalued dollar, badly weakened corporate balance sheets, the lowest corporate profitability in the whole postwar period, and a financial system that is founded on the most fantastic leverage.

"This is a virtual Pandora's box of interrelated and interdependent bubbles, and the one thing that is keeping all these bubbles afloat is the illusion of an imminent V-shaped recovery and blind faith in the magic of Mr. Greenspan.

"Who or which demand component could possibly lead the predicted U.S. economic recovery? Rising capital spending by debt-laden corporations confronted with collapsing profits? Or higher spending by the debt-laden consumer confronted with huge wealth losses in the stock market, rising employment and stagnating or shrinking disposable income? Nobody can say for sure what exactly is going to happen; yet one thing is beyond any doubt: the V-shaped U.S. economic recovery is impossible." (The Richebcher Letter, January 2002)

I think that pretty well sums up the bear case.

Let's look at the cheer-leader case. First, where is the evidence that rate cuts are making any difference? I distinctly remember Jim Cramer of TheStreet.com telling us to not fight the Fed last winter. Rate cuts, he said, will avoid the recession and explode the stock market. He was wrong. Anecdotally, my banker tells me the last 2% of rate cuts have done nothing for his business except make his CD customers mad at him as they roll over at 2% rates.

Rate cuts do matter, and are part of the reason why things did not get worse, but we need more than just rate cuts to stimulate growth. If it was that easy, we wouldn't need to guess about where the economy is going. Rate cuts are just one component of a very complex picture.

Secondly, the key problem for Greenspan and company is that long-term rates have mystifyingly (at least to me) not come down in tandem with short term rates. While short term interest rates are lower, bank lending is demonstrably tighter and thus not helping the economy. It is actually hurting those who are dependent upon CD's for income.

What little fiscal stimulus we have had is a drop in the bucket and is not of the type which would stimulate an economy. Majority leader Daschle, in a fit of pure partisanship, has postponed a real stimulus package. If one does get passed, it will be a case of too little, too late. It takes time for these things to work their way through to the economy.

Lee predicts an explosion in inventory re-building. But from what source? New sales are still less than inventory reductions. Further, much of the recent growth was supplied from technology investments. But the latest CIO (Chief Information Officer) poll from Dr. Ed Yardeni shows companies are cutting way back on tech expenditure growth. Most do not expect to see a rebound in tech expenditures until the second quarter or later. This is consistent with other polls from other industries I have seen. While this will inevitably change, in a just-in-time production world, inventories adjust to meet current sales levels. They do not "explode". Inventories may rise, but they will not go back to 2000 levels for a long time.

The world is in a synchronous recession. What country is going to kick-start the buying which propels inventories back to boom-time levels? The US will have to lead, of course. But we will be doing so with much lower profits. That is NOT a proper environment for an explosion in inventory rebuilding.

Further, simply because most past recession have had sharp recoveries does not mean we will have one this time.

Richebacher makes some very good points in that regard. He refers us to a watershed 1993 study by the Federal Reserve of New York in their Summer Quarterly Review. (I read Richebacher precisely because he finds studies like this one. He may be an unrepentant bear, but he does very good research.) The study shows that "V" shaped recoveries are always characterized by sharp increases in housing and business equipment investment. Increases in consumer spending lags the recovery. This is to be expected, I think, as unemployment is also a lagging factor and consumer spending and employment are closely tied together.

How can we have an explosion in residential building from levels that are already very high? Usually, housing drops off significantly during a recession. It did not do so this time. At the best, it seems to me, the most we can hope for is for this current level to be maintained for the year. The increased costs of mortgages, which are tied to the 10 year US bond, will serve as a further drag on new housing. Applications for re-financing is down 50% over the last month, and that will hurt new home sales as well.

The more likely scenario is for the housing market to continue its recent softening. Housing prices are down, as are new starts. I don't think we see a real drop-off, except in certain areas affected by higher than usual unemployment. In short, this is not an area which will stimulate a "V" or even a "U"!

(Long term, I am a fan of housing stocks and the industry in general, as demographics and the American love of a home are forces just too powerful to ignore.)

Business investment, the other major component in the study, is a direct function of rising business profits. As noted above, I don't see an explosion in profits either. So no help here.

One other significant component in past recoveries was the high growth in real disposable income. But these came as a result of significant increases in corporate profits. Again, not likely this time.

Muddle, Muddle, Toil and Trouble

But is it all that bad? Are we looking at a repeat of the deflationary 1930's and the Great Depression? I think the likelihood of that is only slightly higher than that we will see a "Super-V" recovery. My "Gripping Hand" analysis is that we muddle through. The differences between 1930 and now (or 1990 Japan and the US today) are significant. Here's why.

First and foremost, we are a market economy of the first order. US entrepreneurs will do what they have always done and adjust. Betting against American business is a losing proposition. While I do not believe in a "New Economy," the Old Economy principles work just fine, thank you. Contrasting the ability of US businesses, financial institutions or individuals to adjust in 1930 and today just falls short of realistic analogies.

That is not to diminish the very real problems we face. It is not a case of onward and upward. It is much more likely merely onward.

Secondly, there are pockets of real growth opportunities. While some technology will suffer, new technologies are in the wings which will offer significant growth potential. Biotechnology could explode. While much of the rest of the world is in a recession and seems determined to destroy their currencies, a strong dollar will allow us to buy productive foreign assets at fire sale prices. That may not add to bottom lines this year, but will make a difference in years to come.

There are still large amounts of willing investment capital for promising new ventures. Risk investors have not faded into the woodwork. A good sign is that silly dot.com ventures are not getting money which means that the new venture capital is being employed in pursuits which have a reasonable chance of success.

Finally, much of the economy is stable. While the banks and financial institutions are going to have to write off a lot of debt this year, they have the balance sheets to do so, unlike Japanese banks. Healthcare seems highly unlikely to fade. While the automotive sector may be weaker than usual, it will not go away. Unfortunately, government is likely to expand. We still need food and clothes and basic items. This just does not appear to me to be the environment for a lengthy, multi-year recession.

I should also point out that much of my "recovery scenario" is based upon the fact that the last half of 2001 was so very bad. We are coming off two really bad quarters. It is always easier to leap over a one foot hurdle, especially when you are jogging and not running.

Next year, I think GDP grows less than 1%, if at all. Corporate profits will show some growth in the second half, but overall growth will be in the small single digits if we see any. We may "technically" be out of recession in the second quarter by a smidgen (a technical economic term), but it won't feel like the return of the boom days.

If anything, my thought is that the "recovery" is more of an "L". If you look very closely at the "L", you will see the line at the bottom rising slightly at the end. (At least it is if you use a serif faced type like Garamond.) This is a slower version of the 1990-91 recovery. Also, it will not lead to a 9 year boom.

This is in keeping with my views on the longer stock and economic cycle. We are entering a 10-15 year period of slower than trend growth. This will just be the first of the recessions we see in this decade. I am going to put together a compilation of parts of half-a-dozen letters dealing with economic cycles and post the entire report on the web within two months. I promise.

Back at the Federal Reserve Ranch

Is Greenspan likely to sit back and watch deflation wash over our soil? I will admit that if the Fed sits back and does nothing, the likelihood of a serious deflationary recession becomes likely. But they will not sit and do nothing. They will continue to do what they have been doing, and that is pump the money supply like crazy.

If the money supply was growing at this rate in 1985, gold would be at $2,000 overnight. Today it can barely get to $280. Inflation would be raging in the teens. As mentioned above, it is almost gone.

In fact, the best evidence for deflation is that the Fed can pump the money supply with so little consequence in prices. Where is the money going? Why isn't it showing up as inflation?

As mentioned in past letters and above, debt destruction, a tighter lending policy at banks and a lower velocity of money have partially offset the money supply growth.

Plus, there is serious concern that the Fed is re-creating the stock market bubble. This Son-of-Bubble is not just a passing concern of bears, but even the normally staid Bank Credit Analyst. Just as the major money supply increase by the Fed in response to the Asian Crisis and Y2K is widely credited with creating the NASDAQ Bubble, there is concern that we are seeing the same phenomena.

In 2001, I used the analogy of a boxing match between History and Greenspan We have always had a recession one year after the appearance of a negative yield curve. Greenspan was fighting History with his rate cuts, and I bet on History. It was an uneven fight with Greenspan fighting out of his weight class.

Now Greenspan is fighting deflation. That is an opponent more suited to his strengths. He has a printing press and a demonstrated will to use it.

Will he win? Most likely. What round will he win in? Though it will be a late round TKO, I think we are already in the middle rounds.

And thus we have the real wild card in the prediction scenario. Can Greenspan create money faster than the world can destroy it? In theory, yes he can.

As Bill Bonner recently wrote, the Fed has a plan, but they have no clue.

Inflation comes back in our future. The real question is when, and to be very honest, I must tell you I have no clue either. Zip. Nada. None whatsoever. This is new territory for the Fed. You have many countries of the world intent upon making the dollar as strong as possible. You have a European Central Bank with no idea or focus who seems willing to go wherever the winds take it. You have paper assets disappearing (like Argentine bonds and other debt) at a prodigious rate and no end in sight. You have a market that is seriously over-valued by historic standards.

Print too much and they bring back inflation, high interest rates and a falling dollar, which would tank a budding, albeit tepid, recovery. Can you spell stagflation?

Print too little and you get real deflation, which would scare the markets out of their optimism, and would be a self-fulfilling prophecy for a major slow-down in the economy.

So, what do they do? They watch the NAPM index, (name change: now the ISM index), which finally turned back up yesterday. They look at capacity utilization, debt defaults and a dozen other items and try to fine-tune the economy back to 1-2% inflation, a somewhat weaker dollar and slow and steady growth.

I do not expect inflation to come roaring back but my expectation is based upon the ability of the Fed to not over-work their printing press.

They will not raise interest rates at all until late in 2002, if at all, unless inflation comes roaring back. I think the likelihood is that the Fed funds rate is lower or flat at the middle of the year, and probably stays there for the rest of the year. They will use the money supply to try and boost the economy and slow it down if necessary before they play the interest rate game.

Predictions:

The US Stock Market:

Last year, going into a recession, it was a lay-up to predict the markets would close lower for the second straight year. This year, I feel like I am shooting from 3-point range.

History has never - not once-- been kind on a long term basis to investors who invest at the level of P/E ratios we are at today. Short term? Can you spell m-o-m-e-n-t-u-m? If it feels like a bubble and quacks like a bubble maybe it is a bubble.

On the other hand, the Fed is pumping money into the economy and it is not going into higher prices for anything except stocks. How long can this mechanism work? The market can be irrational for a long time. Earnings are not likely to rise by 25% from 2001, which implies that at today's level the trailing P/E next year would be at least 30 if the market merely stayed where it is.

This is a market once again priced for perfection, and I don't see how anything can be perfect in 2002.

I think we should see a test of the market lows sometime this winter/early spring, on a pattern somewhat like 2000. Then will come the bounce. After that? It depends on a lot of factors, especially Fed money creation, which are just unknowable. How will the market react to flat earnings? Will they patiently wait at current levels for profits to catch up? Will they finally go somewhere else? But where?

Major bull markets do not begin when people are this optimistic about the markets. I think it is likely we work a trading range for the year. Earnings disappointments may be offset by Fed money creation. The broad indexes (DJIA and S$amp;P 500) should end up within 5% of where we started, and technology indexes (NASDAQ) will end up down, as they will disappoint on the earnings fronts and are now priced for a powerful earnings rebound.

Long time readers know that I am waiting for my "Three Amigos" (The NAPM index, capacity utilization and junk bonds) to turn positive to signal a return to the stock market. They are trying to get us there. When we do, I would suggest long-term investors and clients avoid most large cap stocks and stick with true small and mid-cap value stocks and funds.

Bank Credit Analyst is suggesting that the coming year is one in which market timing will work, which is an unusual posture for them. They think that we are entering a period like 1966 to 1972 where there were numerous market moves of 15-30% up and down. Those of you who are traders should have a lot of opportunities for profits.

The World Equity Markets

As usual, there will be a mix of results, but 90%+ of the world's markets are down this year in terms of the dollar. With a world recession picking up steam, it seems hard to figure out how that will change. There will be the usual outstanding markets, but do you really want to gamble on Russia or Finland or Romania? Stay away, at least for the first half of the year, until the dollar can start to get weaker.

The Bond Market

This is the one I blew in 2001. While predicting lower short-term rates was a no-brainer, I (and most of the world, including Alan Greenspan) expected long term rates to go down in 2001 as we entered recession. We end almost where we began, with a wild ride down, up and down again. My recommended leveraged long term bond fund is down about 2% for the year (American Century Target 2025: BTTRX).

For 2002, let's see if I can do better. Short term rates should rise slightly at the end of the year, unless we start getting real inflation signals. Long term rates should drop in the first half of the year, as inflation is increasingly seen as not a problem.

After that? I will have to wait until the middle of the year to make even a reasonable guess. I hate to be wishy-washy, and am not afraid to state my opinion. It is just that I do not have one after the middle of the year.

Currencies

As correctly predicted during the last year, once again I think the dollar will rise against Asian currencies and I think it will end up flat with the Euro. The Euro may be a special case, however, and we will have to look at the inflation picture in the middle of the year. If inflation stays benign, there will not be all that much movement. If US inflation comes back, you could see the Euro jump rapidly, as the perception of a fumbling European Central Bank which is not concerned about economic growth changes to that of a bank which is rightly worried about inflation.

Europe is between a rock and a hard place. Asian currencies will drop against the euro as rapidly as they do the dollar. That puts the same profit pressure on them. If they also see a 10-15% rise in the euro against the dollar, they are even further behind the curve. They are also entering recession and do not need to create more problems for their corporations.

Oil

I predicted lower oil prices last year. I also thought they would come down faster than they did due to OPEC cheating. Will the cheating develop this year?

Much of the rest of the world will still be mired in recession. This is not an environment in which oil makes a dramatic move up. If OPEC can get cooperation from Russia and keep a handle on cheating from some of its cash strapped members, you could see a slight rise to the mid-20's. If not, oil will stay in the recent trading range.

Gold

If you are Japanese or Asian, gold is already in a major bull market. Except for a few currencies, much of the world perceives a gold bull market.

It is hard to be a gold bull (in dollar terms) when I think deflation is the dominant factor. Couple that with central bank selling every time gold rises above $300 and it is even harder to get excited.

Gold will rise someday, probably when the dollar falls. But if all the crises we have seen in the world cannot get even a whimper of a bounce from gold, then I look elsewhere for my investment excitement. I continue to recommend a small percentage (less than 5%) in gold as a defensive play.

Looking Forward

This year we will be looking at the data on a weekly basis to tell us when the economy is ready to turn (I think it is close, even though it will take two quarters to egt back into the black), when and if inflation is coming back, and when it is time to get into junk bonds (in anticipation of a 40-50%+ run over 3 years). I will also start to recommend some dividend paying stocks and other income plays when the time is right. I will continue to review the works of Greg Weldon, Bank Credit Analyst and the dozens of economic publications I review each week, trying to keep you up on the ever turbulent markets.

Next week, we will look at the issues surrounding consumer and business credit. Is it time for a Day of Reckoning, or not an issue?

For my New Year's resolutions, I will make the same two I made last year, since they are still unused. I will lose weight and I will write a book on hedge funds. I will be posting chapters on the web site as they are done for comments. I will finish it in the first half of the year. This year I will really do both.

This e-letter is growing rapidly, much of it due to referrals from friends and readers. It is currently going to over 100,000 weekly. To those of you who have come on board in 2001, I hope you find it to be as useful as do many of my long-time readers. The price is right, but I hope the advice and information are worth more to you than the cost.

I should also mention that I do a privately circulated letter (also free) on private investments and hedge funds just for accredited investors. If you are an accredited investor ($1,000,000 net worth), and would like to get the letter, please simply reply and ask for the form to receive the letter. (I would love to open the letter to all readers but the SEC regulations do not allow me to write about certain topics to readers who are not accredited investors.)

I will be the key note luncheon speaker at the Global Alternative Investment conference on hedge funds and private investing in Boca Raton on January 28. I look forward to seeing current and potential clients while I am in south Florida.

Let me wish you a Happy and Prosperous New Year. This is the time we all make investment plans for the next year. May this be the year your investments work as well as your plans and goals.

Your Planning to Have His Best Year Ever Analyst,

John Mauldin

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