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Dear Chairman Greenspan - Part Deux

Last December I wrote you a letter telling you that those of us who fly in economy class were worried about a bumpy landing. We kept hearing about a soft landing, but the ride was getting rough. The passengers back here in coach class are getting real nervous. Now, we would just as soon forget about attempting to land. We would rather see the plane start to take off again.

I asked you back then to start cutting rates to help smooth things out. Since then, you have cut rates at the fastest pace in history. Thank you. Since you were so helpful the last time, I thought I would write again and ask one more favor.

At the recent Fed meeting, one governor actually voted against the latest cut, and presumably there is some sentiment on the Fed board to stop the rate cut process.

To that I politely say, "Ignore the cretins and please cut rates further and faster." While things may look fine to myopic economists in First Class seats, those of us in coach have jobs, investments, businesses and retirements on the line. Maybe its because we can't see as far forward, but the view out the side-window is scary.

There are just too many trends in place that suggest the worst is not yet behind us. Granted, the pace of decline has slowed in some areas, but we are still seeing declines. Further, there are a number of areas which are going to have negative impacts in the future, suggesting we need more stimulus, not less.

Let's look at a few of the problems.

First, the economy is still slowing. The June trade report made it almost certain that when 2nd quarter GDP numbers are finalized, that growth in the GDP will be flat. Zero. Nada. Not the weak growth of O.7% first estimated. Nothing. Both lead economists at CSFB and Morgan think so as well.

Of course, that was then and this is now. Today, it seems very likely the third quarter will post negative numbers. But what will happen is that economists will start telling us we are now in an official recession. They always notice recessions after the fact. Making the "R" word official could spook consumers as we go into the Christmas season.

Auto sales, which had been strong, have started to fall. K-Mart sales are down, as are sales everywhere. Retailers are pulling in their horns despite the rebate checks from the federal government. Housing markets have begun to cool in many areas of the country (more later).

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We read that department store buyers are planning for weak Christmas sales this year, as they fear getting stuck with inventory as they did last year. That also means less jobs will appear this Christmas.

Technology, which led the way in past years, is in free fall. Orders for semiconductors fell 26 percent in July and were down 56 percent from a year earlier. Orders for computers and related products fell 4.1 percent last month after falling 4.9 percent in June and were down 28 percent from July 2000. Don't even get me started about telecom.

Capacity utilization, which I know you pay attention to, is at its lowest in decades. The National Association of Purchasing Managers Index is also at its worst since the last recession. Durable goods orders are way down since last year. Companies are not spending to increase production capacity, and indeed are letting people go in an attempt to hold the line on profits.

And that brings up another worry: employment, or the lack thereof. Today, unemployment is at its highest level since 1992, and it clearly is going to get worse. Economists said the U.S. unemployment rate, currently at 4.5 percent, will rise to 4.9 percent by the fourth quarter. Now we all know business economists are an optimistic lot, and they generally err on the upside. That means unemployment will grow by at least 10% over the next few months, from where it is today. That is a pretty rapid increase, and will make even more people nervous.

Housing is starting to show signs of losing its luster. Yes, sales of existing homes nationwide in July were near the record pace set in March. But sales of $1-million-plus homes, which outpaced all other categories last year, sank 15% in the first five months of 2001. Supply is beginning to outstrip demand. The U.S. inventory of unsold homes, which fell steadily during the 1990s and reached a low of 1.4 million homes last year, has spiked upward for the first time in a decade, rising 23% since January, according to the National Realtors Association.

"A real estate slump 'could make this little recession we're having turn into something that's quite drawn out and serious,' says your friend, Yale economist Robert Shiller. It was the boom in housing, he argues, more than the Nasdaq's 175% runup in the 18 months leading up to March 2000, that made consumers feel so flush and spend so freely. Go back as far as 1975 and compare ebbs and flows in retail spending in all 50 U.S. states and 15 foreign countries, and it is clear housing markets directly affect consumer spending, while stock market fluctuations don't, he says." (Forbes)

It was not long ago that office occupancy rates were on a big upswing. Now, with a recession and an apparently over-built market, commercial rental rates are declining in all sectors in the US, and in some areas are starting to show severe decline. We wonder if this is a pre-cursor to a problem in the housing market? Can retail housing get over-built? How long can housing sales continue to boom as more people lose jobs?

Your rate cuts are just now beginning to affect long-term rates and mortgage rates. But we need more. Further cuts would presumably lower mortgage rates even further. This would have a dual effect. It would allow more people to refinance their mortgages, hopefully lowering their payments and giving families more monthly disposable income. It would also keep the current housing sales robust, helping a big part of the economy to keep growing.

We need housing sales to continue to be strong, because global trade is in outright recession. Pac-Rim exports to the US are down 13.3% year over year. Korean exports to the US are down 18.2%, Singapore's exports are down a whopping 27.0% and Taiwan's exports are down 20.1%. (Weldon)

US exports are decreasing and are at their lowest level of negative growth since the last recession. Germany is clearly slowing, as is the rest of Europe. Even England, which had been chugging along, is showing signs of an imminent recession. We don't even need to mention that Japan is quickly becoming a basket-case. If it were not for their trade surplus with the US, they would actually have a trade deficit. Their trade surplus with the US is not growing.

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You are getting no help from your central bank counterparts in Europe and Japan. Japan is clearly pushing on a string. Europe is showing a stubborn refusal to lower rates and stimulate demand, even as outright deflation is beginning to show up in parts of Europe. Yearly rates of inflation are slowing throughout Europe, and this month Germany will echo the US with outright deflation in their CPI.

To top it all off, the rest of the world is beginning to have doubts about us as well. The dollar has started to drop fast. While this may help a few US companies, it will not be good for our investment markets. Rate cuts will bolster the appearance that we are pro-growth and increase confidence in the future of our economy, and stop the deterioration of the dollar.

Speaking of deflation, and we keep hearing that word more and more, US companies seem to have no pricing power. Raw commodity prices are down on average, and some down significantly. Prices are dropping everywhere, which means lower profits. Lower profits mean lower new employment and lower growth. The latest CPI showed outright monthly deflation. It may happen again this month.

That means there is plenty of room to continue to expand the money supply and cut rates further. The rate cuts so far have been good, but they have found no traction. Things are still slipping.

Indeed, there is some mumbling back here in coach that you are just playing catch up with the market. When money market rates are lower than Fed rates, even after your last cut, it seems to some that you are behind the curve, and the economy is slowing faster than your rate cuts are helping. And while you are growing the money supply, the rate of growth (M-2) is 2/3 of what it was just last May.

Something clearly is different this time. Previous rate cuts of this depth had started to show signs of working by now. Admittedly, it has only been 8 months, but the troops are getting restless.

Rumor has it you are wanting to retire. Why not go out with a bang? Cut rates now. Cut them big. Everyone knows you are going to continue to cut rates as long as the economy is slowing, and now it looks like that will be right through the next three Fed meetings. Why not cut rates 50 or 75 basis points now and get it over with? Get ahead of the curve. Tell everyone that is all we need to get things moving.

Call your buddy Wim over in Europe and tell him to get with the program. If he doesn't understand, then take him to whatever serves as the woodshed for central bankers and explain to him how the central bank process works. He's still a little new at it, you know. You need some help in saving the world and stopping this deflation thing before it gets out of hand.

If things go well, you can retire as the most revered man of the last few decades. If growth doesn't appear, you can always come back and say that some new factor requires further cuts and start in again. Trust me, no one will mind if you cut some more if there is the need. The important thing is to maintain confidence that the economy will soon be rebounding. We all know falling consumer confidence could bring down the whole house of cards.

Things aren't that bad yet. In fact, there are a lot of areas of the economy that are doing fine, and the consumer has not yet thrown in the towel. But we need to keep it that way. If things keep dragging on and on, with more bad news and headlines talking about more job cuts, the mood could turn ugly. It could start to look like you are pushing on a string, just like the Japanese are. If that ever became the prevailing view, it would be disastrous for consumer confidence.

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Show us you care. Forget those who would caution you to do things slowly and with a deliberate pace. Their reputation is not on the line. Besides, they have high-paying guaranteed jobs. Having your job on the line helps clarify your viewpoint as those of us back here in coach can testify.

Just do it and get it over with.

Your impatiently waiting for his rate-cuts friend,

John Mauldin


Rate Cut Investing

OK, I know Greenspan is not going to cut rates all at once. But I believe he will cut rates at least 50 basis points and maybe 75 between now and the end of the year. And therein lies our opportunity.

I have to believe that will begin to have an effect on long-term bond rates. Rates are down, and bonds are up. In fact, bonds would have now been a better investment than the S&P 500 Index for the last three years. For that matter, it may not be long before we can say that about money market funds. So much for buy and hold.

Further, it seems there is starting to be an awareness that this market may still be a tad expensive. The Wall Street Journal's lead story last Tuesday showed that true P/E ratios, based on real accounting principles and not financial hocus-pocus, would be 36 for the S&P 500. Even taking out a one time problem for JDS Uniphase, the number would be over 31, which is twice as high as long term averages.

It seems that (shocker) some companies actually cook their books to make their earnings look better. I read today that Waste Management decided that painting their trucks was an unusual expense, and so did not include it in normal expenses, allowing the company to "beat" Wall Street analysts estimates by the usual penny. That gives a whole new meaning to "painting the tape".

Even more shocking, it seems that investment bank analysts let them get away with this charade. Could it be that their banking fees would influence their rationalization?

The P/E for the Dow is 27, the same as it was at its peak. The P/E for the S&P 500, using the company supplied cooked earnings numbers, is still 26, roughly where it was when the index was 25% higher.

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These are not the type of numbers that will inspire a long term rally. Either earnings have to improve or the markets will have to go lower in order to see a long term rally start. It will come as no surprise that I do not think earnings will improve this quarter, so I doubt the stock market will either. Not from these over-priced levels.

The stock market is up today, and is likely to stay that way through next week as mutual funds are working to keep their stocks up so they can post good month end numbers. Can they actually do that, you ask? You bet your sweet index they can. Not in the long run, but they can play short term games, especially when there are so many bears who are short and need to run for cover in a rally. The percentage of the market activity that is mutual funds is way up. But they will soon run out of cash, unless investors get generous.

Remember last August? The market peaked right before Labor Day. After Labor Day, the market headed south, eventually dropping 20%.

We are headed into earnings season, and early signs are that it could be ugly. The market was up today on Cisco's supposedly positive statement. But all Cisco really did was to confirm that things wouldn't be any worse than they thought a few weeks ago. That is, sales will be down 5% this quarter. Hardly something to rejoice about, as Cisco's P/E is already pushing 100.

All in all, a good rally to trade, good to sell into, but there is nothing that makes me want to leap back into this stock market.

Bonds? If you haven't got some in your portfolio, then I would encourage you to do so now. The next 2-3 rate cuts will be good for long bonds, in my opinion. The negative stock market environment for the next few months should also put some extra wind in bond sails. (Thanks to Greg Weldon for a lot of the data in the Greenspan letter.)

"Lonely Days, Lonely Nights, where would I be without my woman?"

---The Bee Gees

It is my wife's birthday next Wednesday. I have been putting the finishing touches on a major project, working too many nights, but am *almost* through. I am really looking forward to spending some time with her in Flippin, Arkansas next weekend. She has been very good in letting me work too late, and she deserves some special time.

We will be making some major announcements over the next few months. I will add a recommended advisor to our list, a firm that has been the #1 balanced fund manager for 20 out of the last 20 quarters. Hopefully, it will be well-timed to catch the next bounce in the stock market. Also, the list has been growing recently. There are a number of web sites that deem this letter worthy to post each week.

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A publishing firm may start sending this letter to their rather large list. I will keep you informed. But it has only happened because you have seen fit to read and recommend me to your friends and associates, demonstrating there is a demand for what I hope is thoughtful, realistic economic/investment analysis.

Thanks for making this possible,

Your hoping to be alive and Flippin soon analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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