How Low Can We Go?

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How Low Can We Go?

What a week. We have a lot of data to cover, as we try to see through the dark, cloudy glass of our economic future. I will try to clear up a few points, and give you something hard to hold on to.

The most important part of this letter, however, will be after my signature. Many of us have wondered how we can help our country in a tangible manner. I am going to share with you one very critical possibility. I have some good friends (and your fellow readers) who are once again going into Northern Afghanistan to bring food and medicine, just as many other relief agencies are leaving. It is an exciting, moving and very urgent story, and you can be a big part of the efforts to support our country and service men and women in that part of the world. More later.

Where Do We Go From Here?

We will begin with the economic consequences of last week's tragic events. First, we were already in a mild recession. I expected a relatively benign 6-9 month recession, with the stock market to hit bottom in October.

Now, for reasons we will go into below and over the next few weeks, I expect the recession will be longer and deeper. It could get ugly, but making predictions as to the extent of the damage today is very iffy. It all depends upon how seriously not just consumer confidence has been affected, but overall confidence/peace of mind has been affected.

Let me give just one of numerous possible examples. It is widely reported that the airlines industry accounts for 10% of the economy. I have not seen actual hard figures on that, (is it just airlines, or the aerospace industry as well?) but so many sources are using that number it seems probable.

Business air travel was already off 40% prior to September. It has fallen off the edge as of today. The airline industry has already planned for lay-offs in the 100,000 range. Unless there is a quick pick-up in travel, this will be just the beginning. Hotels are running at a fraction of the business they were a month ago. The entire travel and entertainment industry is in free fall.

Business air travel gets cut back for economic reasons in recessions. And we are in for a real recession.

Will it rebound? Yes. But to what level? It all depends upon how convenient and safe air travel becomes.

My business requires a certain amount of travel. I am speaking at three hedge fund conferences and attending a fourth in the next fours months. One is in Bermuda. I will now get to spend 4-5 extra hours per trip in airports, except to Bermuda, which will be much more as it is a connection. It also means I will have to travel a day early or later in some circumstances.

I have talked with numbers of fellow road warriors, and we all worry about how much time we will lose. Whereas last month I thought nothing of hopping on an airplane for a day trip for a meeting, now those trips will be a lot longer and more expensive.

If the travel related industry drops 20% over the next two quarters, which is a real possibility, that means GDP will drop about 2%.

Travel is just one industry. What about financial services? The only word that can be used is ugly. Insurance? Earnings are going to be hard to come by. Automotive? On the ropes. The list of industries that are dependent upon consumer confidence goes on and on.

And consumer confidence was at its lowest recent levels before last week. With announced lay-offs approaching the several hundred thousands, it will not get better.

Three Amigo Update

There is trouble in River City, my friends. And it begins with a CU. The latest Capacity Utilization numbers came out for August and they were down big. Greg Weldon reports that the worst forecast for last month was for down .7 and the actual number was down .8, worse than the most pessimistic forecaster.

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This number has been down for 11 straight months, which is the longest streak since 1960! Capacity utilization is 76.2%, and is now significantly below the worst numbers posted in the last 1990-91 recession. But with the details lie even worse news.

"On a year-year basis, output of Business Equipment (down a HUGE 6.9% yr) and Materials (down an equally HUGE 6.2% yr) rank as the two weakest Market Groups. This dynamic points to DEEPER declines in terms of corporate capital spending ... which ... points to WEAKER than has been believed GDP growth (and we use the word "growth" rhetorically)." -- Greg Weldon

The problem is that there is more to the economy than consumer spending. A large part is called capital expenditures. Basically, that is the money businesses invests in order to make products or produce services. If companies have plenty of capacity, they do not need to invest in more capacity. That means they buy less (or do not buy) new machines or computers.

Capital expenditures are supposed to be a big part of any recovery. It looks like such an increase could be a long time coming.

It also means that businesses have no pricing power: in fact, they may have to lower prices in order to keep factory lines moving. That is price deflationary, by the way.

I do not see how capacity utilization can increase this month. We will extend the streak to 12 months at least.

Junk Bonds

For the last month or so, our Three Amigo junk bonds have been trying to stabilize and start rising. After last Tuesday, that changed. We now see new lows in the mid-tier junk bond funds, some 40% below the highs of two years ago. By my quick calculation, yields are approaching the 14% range for some funds. That is close to the highs they got to last recession.

I get a lot of questions from readers wanting to know if now is the time to buy junk bonds mutual funds. You are getting tired of 3% money market returns. Stay away for now. Junk bonds are still well below any type of momentum based moving average program most professional timers would use as a basis to decide whether or not to get into a junk bond fund.

I have a program for clients which times junk bonds, and I think I can safely predict we will not be getting into junk bond funds any time soon. They will one day once again become high yield bonds, and we will want them in our portfolio, but not this month. As I have repeatedly said, the worse these funds get, the better it will be for us when they start to recover. Just to get back to where they were a few year ago would be a 70% recovery, not far from what happened in the early 90's. Patience.

The last of our Amigos, the NAPM Index, tried to get up off the ropes last month. We will have to wait for a few more weeks for the September number, but I cannot imagine that it, too, will not be on the mat and down for the long count.

Bluntly, any economic recovery, as measured by our Three Amigos, is at least two months off. I think it will be longer, but it doesn't matter what I think. We will let the numbers speak for themselves over the next few months. I hope I am wrong.

How Low Can We Go?

I have been writing for over two years that the market drops 43% in an average recession. I did not think it would do that this time, as investors have been trained to buy the dips. A mild recession would not be long enough to really build the necessary gloom to drop the broad market that much.

Now? I think we have to come to grips with the prospect that we could see worse than 40% drops. The S&P 500 closed at 965 today, which is down more than 35% from the all time highs. The Dow is off almost 30%. The Bubble created NASDAQ is down 70%.

I have been bearish on the market since last year at this time, as the inverted yield curve predicted a recession. I got more than a few letters from readers disagreeing with me, especially when Greenspan began to cut rates. But in the fight between Greenspan and History, I bet on History. History won. Again.

Do I think we would have gotten to where we are today without last week's tragedies? In my heart of hearts, no I didn't. I thought the S&P bottom would be above 1050 for this cycle. Could it now go much lower than 965? Possibly. Very possibly.

If reports are right, the problem with the markets does not yet stem from retail investors. The selling pressure is coming from institutional investors. John Bollinger, president of, pointed out there have been large numbers of block trades on the New York Stock Exchange since Monday. "This to me says that a lot of professionals, fund managers, hedge fund operators and proprietary traders have been very active on the sell side. It's my sense that individuals are not as panicked."

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I know that a few hedge funds I called this week had significantly less leverage than normal, and higher cash positions. A few quotes from other sources:

A researcher at Trim Tabs, which tracks mutual fund flows, said a total of $7.8 billion flowed out of U.S.-based mutual funds on Monday and Tuesday, compared with withdrawals of $8.5 billion Aug. 28 and 29.

According to John Babyak, portfolio manager at WHB/Wolverine Asset Management, margin calls on individual investors by brokerages are one of the reasons for the sharp drop in stocks since the market reopened on Monday. "I can guarantee it," Babyak said. "They're actually pricing customer portfolios on an intra-day basis -- which is unheard of -- and making margin maintenance calls based on those intra-day levels. They're giving people ultimatums." Traders at the major brokerages were not immediately available for comment. (

Investment accounts managed by professionals are at very high levels of cash. I have listened in on a few conference calls this week from managers, and they are getting very defensive.

So what does all this mean? The professionals are stepping aside, and as usual, the little guy is late to the party.

Right now, there seems to be a sentiment that selling is unpatriotic. If the market goes down much more, that sentiment will change. Right now, the market is going down because there is a lack of buyers. When individuals start selling as well, the market could go lower. Much Lower. When withdrawals from mutual funds are not much different today as compared to before last week, then we have not seen selling pressure from middle America. I cannot see how it won't come.

Last weekend, one of the more sanguine analysts, Dr. Ed Yardeni, lowered his earnings estimate for the S&P 500 this year to $40, although he is not ready to lower his estimates for 2002 below $55. He will. But this does not bode well for stocks.

For a variety of mathematical and historical reasons and over long periods of time, stock markets always go back to trend. Trend in the P/E ratio is around 15.

If we assume that earnings rise an unrealistic 25%, then the long-time trend value for the S&P would be 750. At a P/E ratio of 20, well above trend, the market is valued right where it should be today.

The correct question is not how low can the market go, but how low can earnings go? Earnings will drive this market. In a recession, earnings go down. What happens if earnings disappear in a number of industries? Not just for a quarter or two, but for a year or more? What happens when the cheerleaders can no longer get us to stand and applaud for the team, but like Dallas Cowboy fans in a losing game, we head for the exits early, trying to beat the crowd?

At some point, investors will start wanting to see earnings and not promises. At some point, reality will set in.

There are several ways to play this market. The most conservative way is to wait. Let things settle out for the next month. This is not 1998 when the market drop was followed by a strong and quick 34% rally. The economy was strong then. Now it is weak and getting weaker.

For those who are adventurous, there will be some stocks which are starting to be good value. You might get caught in another downdraft, but the stock will come back.

But I advise caution. We are going to get our opportunity, in stocks as well as junk bonds.

Long Term Government Bonds

My favorite long-term bond fund got creamed this week, down about 6% for the month after today, although it is still up since May.

Is this a pre-cursor or a buying opportunity? Historically, rates should go down in a recession. Today, bond investors are worried about inflation coming back due to the Fed putting more money into the system, the government having smaller surpluses and thus not buying bonds back as fast and are also worried that the dollar will go into free fall.

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There are very good analysts who will disagree with me, but I think rates are still headed lower. I have to tell you that there is more risk associated with this strategy than there was a few weeks ago.

My belief is based upon the fact that I do not see inflation in the pipeline. The Fed is getting very close to that dangerous phase of "pushing on a string". They have supplied huge amounts of money, and yet where is it going? The velocity of money is slowing down. World trade is dropping like a rock. The only place we are seeing real inflation is food prices (except for the grains).

Inflation is too much money chasing too few goods. I don't see too few goods today. That can change, of course, but we need the Three Amigos to tell us demand is increasing.

Before you write and ask, let me be very direct. If you think inflation is coming, then you should get out of long-term bonds. Period. Just because I have been right up until now does not mean that I will be right in the future. We are in new territory as far as money supply and consumer confidence are concerned.

If we start to see inflation in the economic pipeline, then I will have to change my position. But not now.


Is gold telling us there is inflation? I don't think so. If we were looking at just US dollar inflation, then gold should be rising in just dollar terms. Gold is rising in every currency, across the board, except in Yen. I think this recent rise is a flight to hard assets and away from paper assets. It is a reflection of uncertainty around the world. Weldon reports rumors that Asian banks are cutting credit lines to Middle Eastern companies. Reportedly they are moving to gold in response.

Without inflation, gold is not going back to its glory days. But you could see some strong rallies. Last week, a potential client told me he was going to send some money to me as soon as gold rose another $20 and he could sell. I laughed, as he is a long time gold bug. He will not sell, because as soon as gold rises $20, he will get excited and want to wait for another $20. He will wait until it goes back down to $260. It will be awhile before I manage his money.

I say this because gold is going to offer some of you with large positions a chance to get out with a nice profit in the future. Just a thought.


These last few weeks have been hard on every one. I have talked to more people this last week than in any one period of my life. There is a lot of pain, both personal and financial. Some of the stories I hear are very sad, as those who thought their retirement secure are no longer sure, as the drop in stocks has hit hard.

I am still working on an article which is going to deal with the Quest for Certainty in investing. I planned to do it today, but forgot that I had surgery scheduled this morning. They took a benign basil cell skin cancer off my shoulder. No big deal. But my wife once again reminded me, as I was taking calls in the doctors office and trading accounts that there are some things more important in life than dollars. My doctor, by they way, is named Bond. James Bond.

Finally, last week's e-letter triggered a huge response, running about 90% positive. I really appreciated all the kind remarks, even if I did not get to answer everyone. It did seem to touch some rather deep emotions. But not for everyone. I did get one reader who pointed out that:

"Surely, sir, you mean principles--not principals--in the sixth to last paragraph in your homily on Certainty. A voice crying in the wilderness should at least be philologically authentic."

Oh, well. At least Frank read to the sixth to last paragraph.

Please read the note on what you can do to personally help the situation in Afghanistan.

Your Philologically-challenged Analyst,

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John Mauldin

Please feel free to cut and paste the letter below and send it to your personal email lists. I hope we can get a chain letter going.


Dear friend,

During the last week of September, four brave Americans will be going to Northern Afghanistan to bring food and medicines to the women and children of the Northern Afghani tribes, who oppose the Taliban. They need our help.

Briefly, the northern part of Afghanistan is held by rebels who have been fighting the Taliban for years. They are poorly armed, but have continued a noble struggle. Sadly, there has been and is a serious food and medical shortage in the area. It is an area few international relief groups have been able to help.

My good friends Sir Ed Artis and Sir James Laws have been in Northern Afghanistan before, bringing much needed food and medicines to these people, even as bombs were going off in nearby fields. They have good relationships with the local people.

These men are Knights of Malta and are leaders of a group called Knightsbridge. They honor a long tradition of bringing aid to those who are in harm's way. Their exploits in helping those who are the hardest to help read like something from the movies, but they are for real.

They have been able to get food and medicine into areas where other groups have had difficulty or were unwilling to go. Now, Northern Afghani leaders have asked them to return. It will be difficult, but if anyone can get aid into this area, they can.

These don't take no for an answer men will travel to one of the bordering nations, buy rice, wheat and other staples, find trucks and transportation and begin the dangerous jobs of moving these supplies to where the people who need them live. The food and transportation are there if someone with money, ingenuity, and courage will show up to move them.

Artis, Laws and their friend Walt Ratterman have the courage and ingenuity. They need the money. They will take what they have, but the need is more than their current resources.

With all the needs in the world, why should you care about Northern Afghanistan?

Because that is likely where American troops will be going. The Afghan opposition will be our partners in fighting the Taliban. We need to show these brave men and women that the people of America support them and stands with them in their fight. They need to know that all of America stand with them, and not just our soldiers. We need to show we care for them as a people, and not as a means to get out a common enemy.

Sir Ed, Sir James and Walt (and an Oscar nominated film-maker Adrian Belic) will be risking their lives to help prepare the way for our troops. Can you risk a few dollars?

You can send a tax-deductible check directly to Knightsbridge (address below). But as you do, send an email to me at and let me know the amount. I will be in contact with the team by satellite phone. We can get money wired into the area, but advance knowledge of what they can buy helps them arrange for supplies.

For your donation, we will keep you in touch every week or so with reports as to what is happening, along with pictures and possibly even streaming video. For a donation of $100 or more, we will send you a video tape report of the mission upon their return.

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You can send your check to:

Knightsbridge International
P.O. Box 4394
West Hills, California 91308-4394
Web site: (Please be patient, the website is being updated to reflect this mission)

By the way, these men all serve at their own cost, and are paying their own way, in addition to buying food from their own pockets. No fancy offices or salaries. Just a calling and a spirit of service.

Please do what you can, and send this letter to others. If you are involved with an organization who would like to partner with Knightsbridge in raising money, contact me directly. And don't forget to pray for these men (and their wives). This is a very dangerous situation for them.

Helping those who go in our place,

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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