Faith, Part II


I would have to count myself as a member of the Rick Nelson School of Writers. For the benefit of younger readers and at the risk of dating myself, Rick was the son of Ozzie and Harriet Nelson who went on to become a teen singing idol and one of my favorites as a kid.

But in the latter part of his career, people wanted to keep him in his old box. As I remember the story, he performed in a concert in Madison Square Garden. He was booed by the crowd for singing some of his new songs. They only wanted to hear the old Ricky Nelson. In frustration, he wrote a song called Garden Party (one of my favorite songs) which had the tag line: "since you can't please everyone, you might as well please yourself."

I am not sure what you could call my style of writing, but I write these e-letters as if they were a personal letter to long-time friends. I read scores of letters and reports and try to give you a summary of what I read. Some people like my style and look forward to each week's letter, as I look forward to writing to you. I hope you are one of them, and I trust my style is not too offensive. But, I do write to please myself, so I doubt I will change.

While I got some very kind compliments for last week's letter, after reading it again, I am not pleased with it. It just didn't come to a conclusion.

So this week, we are going to quickly review last week's main points, add a few more from the data we saw this week, and I promise I will try to come to a real conclusion today.

World Trade is Slowing Down

Last week we saw that world trade is slowing. Japan, Europe, Taiwan, Korea, Thailand and other main trading partners showed considerable slowing in their exports and imports. So did the United States.

This week we simply get more confirmation from these leading countries that things are slowing down. German Industrial Production fell almost 1% after dropping almost 3% in March.

Like their US counterparts, foreign companies are starting to warn about slowdowns and to complain about visibility. By visibility, they mean they can no longer see into the future and make reliable predictions about future sales. My kids would use the less kind word: "clueless."

Mexico, Japan and Switzerland are already in recessions of 2 quarters or longer, with numerous countries approaching recession "status."

Japan is particularly worrisome. Data this weeks shows bank lending is contracting by 3.8% from last year. 3.8% may not sound like much, but it is a big contraction, and continues the months-long trend downward. There is no reason to expect this to reverse soon.

Deposits in banks are actually up 1%, which means Japanese consumers are spending less. Export prices in Japan are down 1.5%, which means their companies are having to lower prices to compete, which of course will do nothing to help the already poor profit picture.

Further, the evidence continues to mount that Japan is in an outright deflationary spiral.

More Weak US Data

Last week we reviewed data which showed the US economy was slowing. This week we get more confirmation.

I have written on Greenspan's regular citation of increased US productivity as the reason he believes we have had such remarkable economic growth for the last decade and why he is comfortable with letting the economy grow at 3.5% or more without putting on the brakes. Oh, for the good old days of 2% growth.

Productivity was down 1.2% in the first quarter for the first time in 6 years. I know I worked my derriere off, but I guess some of you were goofing off. Just a year ago productivity was growing at over 5%!

Greg Weldon gives us these poor performance numbers from the Factory Orders report for April:

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New orders for primary metals were down 3.2%; for computers down 10.3%; for capital goods down a serious 6.3%. Even consumer goods were down 0.6%.

I keep hearing from the usual suspect cheerleading analysts about inventories going down. But while some individual companies may be working through inventories, the reality is that total inventories were up 0.1% and shipments of non-defense capital goods ... down 5.0% ... after falling 1.0% in March.

The following sectors each posted a third straight month of decline: durables, primary metals, machinery, computers, electrical equipment, furniture, construction materials, consumer goods. On a yr-yr basis, orders for non-defense capital goods is down a very worrisome 13.0%.

Aaah, you say, that is just manufacturing. That is not a big part of the economy anymore. The service sector will bring us out of this malaise.

Well, not yet. Without citing another long litany of numbers, the National Association of Purchasing Managers for Service Sectors told us last Wednesday that Employment, imports, exports, new orders and order backlogs were all down big. The main Index for the service sector is down 25% in just the last five months. That is HUGE.

Inflation Not a Problem

Greenspan told us this week that: "As best as we can see, there is little evidence of signs of emerging inflation. We see a lack of pricing power. Higher costs (ie: energy input) are not following through as pressure on prices."

Read that again. I would remind you that I have been saying that for over one year. Greenspan is growing the money supply at monster rates. In the past, we would be seeing serious signs of inflation at such levels.

Indeed, the bond vigilantes, those bond traders who sell bonds at the slightest hint of inflation, have been out in full force this year, driving bond prices down. But they are wrong, according to Chairman Greenspan.

The world is in a deflationary trend, for reasons I have written about in the past and will not belabor again. That is why Greenspan can grow the money supply at such huge rates. In fact, he must do so if he is to keep us out of our own deflationary problems.

He has to be frustrated that long rates have not come down more, as the lower long bond rates go, the more it stimulates the economy, especially home construction.

I believe we will see oil and gas prices come down this fall. I know, I wrote last year that they would be coming down in the spring. That is because I fully expected some parties in OPEC to begin cheating. I am surprised that they are holding the line as well as they have. But a slowing world economy should bring oil down, if cheating doesn't. When this happens, we will see inflation drop, possibly dramatically. It will give Greenspan even more room to cut rates.

By the way, don't think I am too hard on Greenspan. He is doing what he should be doing. I do think he should have cut rates beginning last fall, but now that he has started, he has put the pedal to the metal.

I will go into the investment implications of this in a minute.

Metals Telling us No Inflation

Copper is at a 22 month low. Palladium is down 40%. Zinc is way down. These and other metals are used in all manner of construction for homes, automobiles and so on. Demand for these metals is slowing and thus their prices are dropping. This is just one more sign of a slowing world economy.

I am not sure what gold is telling us. Typically, one would think that the low price of gold is telling us there is no inflation. And it may be. But it may also be telling us that the large gold producers and central banks simply want to sell their gold anytime the price of gold rises, which acts as an artificial drag on the price of gold. I don't feel comfortable relying upon the information I get from manipulated markets, and gold is a prime example of what may be an artificially low market.

By the way, that is not necessarily a conspiracy. It may mean no more than that central banks would like to sell their gold for cash and put the money into what they see as more productive assets.

The Battle of the Century

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And so we come the end of our "facts." For the past several weeks, and maybe months, I have paraded facts showing the economy to be slowing. We have detailed a half-dozen indicators which always -repeat always- have been followed by a recession. I keep saying that the average drop in the stock market during recessions is over 40%.

And yet, the S&P and the Dow do not go down, and even the NASDAQ rises 30% in the face of what I think is a coming recession. Inflation does not worry me or Alan Greenspan, and yet the bond market goes down, in spite of a historic precedent of long term government bond rates dropping in recession.

I go back to my boxing analogy. The Fed (Alan Greenspan) is in a death match fight with History. History tells us we should see a recession, lower stock market prices and higher bond market prices.

Those who back the view that Fighting the Fed is wrong believe that Alan Greenspan, with deep and quick interest rate cuts and with a monster growth in the money supply, can steer the US economy (not to mention the rest of the world) around the shoals of recession, barely touching the ground before he takes the plane back into the lofty regions of 3-4% growth next year.

They point out that stocks are typically up 15% or more one year after the third Fed rate cut. That also implies the economy will be coming out of recession one year later, hence justifying the optimism.

I must confess to being very uncomfortable fighting History. I must also acknowledge my fighter has been taking a serious beating for the past six months.

In a way, Greenspan is not so much fighting History as he is trying to change future History. If he pulls this off, he will become History. By that, I mean that in the future, we will look at the possibility of recessions from a new vantage point. Analysts such as myself will not be able to point to History and say when these 10 things happen, we have always had a recession. We will always have to acknowledge that the Fed can "change" History.

If he wins, in the future we will "know" that the Fed can indeed keep the economy from going into recession simply by pulling the twin levers of interest rates and money supply. Those who are buying stocks today will look back at we foolish bears and laugh at or pity us, because they will have been proven right.

I can only think that those who are buying stocks today when the S&P 500 is at a price to earnings (P/E) ratio of 28 (almost twice the historical average) are doing so on sheer faith in the ability of Alan Greenspan to avoid a recession, or at least to jump-start the economy so fast that we will not even notice this recent downdraft.

I had a long talk with Kevin Klombies last night. We discussed the nature of the markets. In my view, stock markets as a whole are neither rational or irrational. They simply are. They may reflect rational or irrational behavior on the part of investors, but what is rational and what is irrational is VERY SUBJECTIVE.

Those who invest today think they are being rational, and would think I am a foolish scaredy cat (is that how you spell scaredy?) I shake my head and marvel at their faith.

But faith is a real, substantive thing. It is, as Paul said, "the substance of things hoped for" Not only can it inspire great works and efforts, it can induce people to do very irrational and/or bad things. It can make them drink poison Kool-Aid, or strap on bombs and walk into Jewish night clubs.

Let me be blunt. I have placed my "Investment Faith" in History. So have many others. I have trouble in acting as if events and circumstances which have been reliable in the past will be so effected by Greenspan's actions as to literally change the course of future events in a way that has never been seen.

Those who have put their faith in the Fed are basically saying that one man, or at the most, 5-6 men, can effectively direct the entire course of human economic commerce. And that they can do it with very limited tools.

But again, my fighter History is taking a beating in the markets. While History has staying power, the market is being driven by a faith which has shown even more staying power. When Intel can announce their sales will be at the lower end of a lower range, and that they are not sure about the future and their stock goes up 10%, that is not a sign that History has much power. It tells me Faith and her twin sister Hope are driving the markets.

I think there are two courses we can see over the next few months. What History would tell us is that the markets should go down and bonds should go up. But Faith is powerful. If investors keep believing that Greenspan's rate cuts will shortly pull us out of our economic descent, then they may keep buying the dips. You could see the market drop 10% and then climb back up, drop, and then climb back up.

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What we have seen for the past six months could continue for as long as Faith remains, or until we are out of recession problems and earnings once again begin to grow.

Bonner often quotes John Keynes, and I can't find it now, but the gist of the quote is that the market can be irrational longer than you have the money to wait until it reflects your personal view of rational.

As I said three weeks ago, the trouble that many market timers are having is a reflection that investors are investing in patterns that are new. It seems they have really and truly bought into the mentality of buying the dips.

How long will this go on? Until they "grow weary in the faith". Until they get tired of up and down and decide to sit on the sidelines until things get "normal". But there is a lot of data, which I don't have room for here, which tells us that investors are truly acting in ways different than in the past. We have no History to guide us as to when, or even if, they will get "weary" and throw in the towel.

So, the question is: History or Greenspan? History has a parade of facts on his side. But Greenspan has the love of the markets. Will the crowd side with the establishment or the new sheriff?

I still will bet on History to ultimately win the match by a knockout. History is undefeated so far, and betting on the new guy, even if he is on a roll, is not where the smart money is going.

Frankly, I know that a recession will be bad for us. I don't want one, and neither does anyone else I know. But late at night, when things go bump in my worry closet, I wonder if I truly want a world in which one man can seemingly control the economic destiny of humanity, even if today it might be a good thing. I acknowledge there are men who have a great influence on our economic lives. But if Greenspan pulls this off he will be in a class unto himself.

So, I still think it is not safe to go back into the water, unless you are buying stocks of companies that truly represent value. That is NOT stocks with 25 P/E ratios that grow at 10% a year.

If you agree with me that we are on the verge of a recession, then you should consider putting some of your portfolio into long government bond fund such as those at American Century.

Commercial Break: For those who are considering using Don Peters of Central Plains (who is in the top 1% of all bond managers for the last 25 years) to manage a portion of your bond portfolio, and have been sent the information on his service, I think you should begin to act now. Do not procrastinate. His minimum is just $25,000. Long rates are getting very volatile. I think they may break out to the downside over the next few weeks or months, and you need to get positioned now. Feel free to call Wayne Anderson at 800-829-7273 at my office for information.

I seem to be traveling a lot lately, and am once again off to the airport for a long weekend with my bride in Puerto Vallarta (who has been there for the week - lucky her), and then next week for a day in Chicago looking at hedge funds for some clients. By the way, there is a stronger currency than the dollar. The strongest currency I have found in the world is now: The Mexican Peso! Go figure.

I notice that a spokesman for Boeing announced that (quote) "they have found some problems which are not normal." Some are calling it sabotage.

That makes me wonder, as I get on a Boeing plane, exactly what kind of problems do they consider "normal"? And does MY plane have these normal problems?

I am rushing out the door with no time to proof-read, so I hope there are not TOO many mistakes. Have a great weekend.

Your fresh guacamole loving analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

P.S. If you like my letters, you'll love reading Over My Shoulder with serious economic analysis from my global network, at a surprisingly affordable price. Click here to learn more.

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