TFTF

One More for the Road

December 7, 2001

A lot of data has come out this week. I slice and dice it for you to help us figure out whether the economy is truly turning up, or is this just a head fake from the markets? Plus, we look at what some are calling a slam dunk investment. I agree it is as close as it comes to being a lock.

But first, I want to welcome the new readers from InvestorsInsight. I think you'll find this weekly e-letter to be extremely interesting and give you a perspective on the markets you don't find from the usual cheer-leader crowd. I read several hundred pages of information each week, from scores of sources. On Friday, I sit down and try to give you my impression of what's important and what's not. I look for ways we can turn that information into profitable action in our portfolios. So, with that small commercial, since we've got a lot to cover, let's jump right in.

why are rates going up so much?

The stock market has risen almost as dramatically in the face of bad news. Is the market telling us something, or are we seeing another premature bear market rally like last Spring?

Investors are clearly anticipating a quick and dramatic recovery: the classic "V" shaped boom is what they see right around the corner. When you look at the expectations in the market, as we will shortly, you have to call it a boom. No other word will do. But is there an economic boom in our near future? The data says no way. Let's start walking through the numbers.

I should note that there are real reasons in the data to think the economy will recover, albeit slowly, in the second half of 2002. But the data below shows that a 1st quarter recovery is just not in the cards.

Interesting Bets

There are several ways to invest (or bet) on the move of interest rates. You can buy or sell the actual bonds. One way large investors and hedge funds do so is by investing in the 3 month Euro-dollar futures. The forward curve for the December 2002 contract is now "pricing in" 200 basis points of Fed tightening in 2002. I think the forward curve is Wrong. Wrong. Wrong.

First, the Fed will cut rates next week. That takes the rate down to 1.75%. Then, just like the birthday spankings we give our kids, they are likely to give us "one more to grow on" at the next meeting. Here's why:

Inflation is not a problem in the near term.

The Fed is focused on recovery. They have never started to tighten rates back up until the unemployment rate peaks. Today we see unemployment at 5.7%. We have also seen more jobs lost in a two month period than any time since 1974. Many of the announced lay-offs have not yet taken place, so the rate of unemployment is going to rise for at least another quarter, and probably not begin to go back down until next summer.

37-year low and below the lowest reading during the severe 1982 recession

All this suggests to me that the earliest the Fed would start to raise rates would be next summer. The bond markets are therefore saying they will raise rates 2% in just 6 months!

Historically, they have done just that, and I believe the market is anticipating the Fed will repeat their historical pattern. But (I hesitate to say this), this time, things are truly different.

In fact, it has worked so well that now the concern in many circles is not inflation but deflation. That is consistent with our long held theme.

Paul McCulley, the managing director of PIMCO, the huge bond market mutual fund company, offers some astute observations:

One hundred and fifty basis points of Fed tightening in 2002, as the forward curve now discounts, would be a blatantly deflationary act.

"Taking Mr. Greenspan as a man of his word, recovery from the current recession is not something to be feared on the inflation front, but something to be cheered on the productivity front. He's still a New Age, pro-growth man. Indeed, he's a little too New Age for PIMCO thinking. But he is what he is, and he's got the data on his side. One hundred and fifty basis points of Fed tightening in 2002, as the forward curve now discounts, reflects very Old Age thinking. Greenspan ain't going to do it; read his lips (not the FOMC's)..

From an investment perspective, however, anticipating secular change is where the real money is made.

"With secular victory over inflation achieved, and with secular productivity promises to be pursued, Greenspan has tightened for the last time of his career."

I couldn't agree more, with the possible exception that McCulley seems to think Greenspan will retire before it is time to raise rates again. I think Bush and Co. beg him to stay.

Since Mcculley wrote those words, the forward markets have gotten worse. If 150 basis points of tightening would be deflationary, what would 200 points be?

Let's look at the data to see if we can see any evidence of a recovery next quarter.

Three Amigo Update

Long-time readers know I follow the NAPM (National Association of Purchasing Managers) numbers very closely. A rise in the base rate for two months during a recession is a very good sign that the economy is on the road to recovery 6 months out, and thus it is one of the three main indicators I look for in deciding when the economy is in a turn-around and it is time to increase allocation to stocks.

The NAPM number for November came out this week, and it rose substantially, although it is still not in growth territory. In general, the direction of most of the numbers are good. The one exception is the price index. It was down to a very ugly 31.6%, a decrease of 0.9 percentage point from October's 32.5%.

Why is this important? It means manufacturer's have no ability to increase prices. In fact, they are having to cut prices.

The worst problems are in technology. Capacity utilization rate for computer manufacturers is down to only 61% in October. Forward consensus expected earnings are down 94% from one year ago. Yardeni tells us analysts expect tech earnings to grow 14.% next year. Computer Hardware and Software earnings are expected to rise 1.7% and 7.6%, respectively, next year. Semiconductor earnings are expected to fall 1.0%. This would bring them back to about 1995 levels. Looking at the charts, the market is roughly double what it was in 1995. (More later.)

These numbers do not square with the analyst's projections, which are historically notoriously optimistic.

Even with dramatic cost-cutting, as is being done, these firms have little if any pricing power, as capacity is just too high. Capacity utilization below 80 is generally considered the point at which it becomes difficult to raise prices.

What these figures tell us is that one of two things is in the future: either we are going to see a lot of bankruptcies in technology to get rid of excess capacity, or earnings are going to be soft for a very long time-measured in years and not months. It will probably be a combination.

Technology is not going to lead us out of this recession any time soon.

record low for the second consecutive month, indicating very little inflationary pressure on non-manufacturing industries at the present time."

Inflation pressures? Hardly. As reported last week, the only two sources of real inflation in the US are medical costs and housing. But.

Housing Foundations Start to Crack

I have worried for months that forward looking indicators were telling us that housing, which has been strong and was a main reason the economy has been as strong as it has. Now, we read:

"The National Association of Home Builders latest Builders Economic Council Survey says four out of ten respondents said sales and traffic have declined since the Sept. 11 terrorist attacks. One in four said sales and traffic are off "significantly."

More data: "The latest NAHB survey shows that two-thirds of the builders queried saw their traffic decline from September to October and four in 10 said traffic slipped again between October and November. The falloff, moreover, was not confided to one region, a finding that surprises the builder group. 24% of the respondents said their cancellation rate is up - significantly for 7%."

So how do builders respond? More than half of those who start houses before they have buyers say they are cutting back on speculative building. Taking a clue from the auto industry, builders are resorting to sales incentives to boost sales. Twice the usual percentage are offering free options and upgrades, and four times the normal percentage are offering to buy down interest rates for buyers. I make the obvious note that this will not be good for profit margins.

the delinquency rate on FHA mortgage loans is up 0.57 to 11.36%!

Read that again! 11.36%! That means more than 10% of middle America (those who typically use FHA loans) are behind on their house payments.

No wonder housing is starting to get soft.

Consumer Confidence in What?

Consumer confidence numbers out this morning show confidence is up. That was certainly born out by spending and saving in October.

From analyst extraordinaire Greg Weldon:

"It does not take a rocket scientist to do the math. US Personal disposable income FELL 1.7% in October while US Personal consumption ROSE 2.9% in October.

This does not compute. In the four months prior to October, there was a cumulative 2.4% `net' plus in favor of savings over consumption. Then, in one-fell-swoop, it was blown to smithereens, with the negative 4.6% difference posted in October.

"In other words, the US savings situation is RIGHT BACK in the gutter, and in fact is WORSE than it was six months ago. This is also reflected in the dump in the Savings Rate, from September's 4.6% rate to October's lowly 0.2% rate. In fact, the 0.2% Personal Savings Rate is not only 'lowly' . it represents a NEW RECORD LOW."

Consumption on "non-durable" items only rose .5%. The rest of the rise was in "consumer durables". You can interpret that as automobiles, which accounted for almost all of the rise in spending.

In one sense, the consumer did in fact increase savings. If you were planning to buy a car within the next 3-4 months, and auto manufacturers offer to save you a bundle on the purchase, then spending now to save later is perfectly rational.

But what that means is that we borrowed from future savings in order to spend now. Therefore future consumption will be softer. We see that beginning to show up in November.

Just out this morning: "The outlook for the holiday season grew dimmer yesterday as major retailers, bruised by unseasonable weather and a sluggish job market, reported the weakest November results since 1990." (AP)

Numerous analysts point out that year-end bonuses are going to be much smaller than normal. These have always had a big effect upon consumer spending in January. This year the big effect may be down.

There is not enough time to go into credit card delinquencies, which are starting to get serious. Yet, my sister just got a credit card with 0% interest until August, 2002 and she gets to roll all her other credit debt onto the card. What a business model: no income and all risk for 8 months.

Consumer spending and housing have been the stalwarts in this economy. It appears both are softening. This does not bode well for a 1st quarter recovery.

One More for the Road?

Warren Buffet tells us: ".the mistake that investors repeatedly make: [they] are habitually guided by the rear-view mirror and, for the most part, by the vistas immediately behind them." (see his important Must Read article in the December 10 issue of Fortune. Go to www.fortune.com, click on current issue, and scroll down to his article.)

Are investors once again driving forward while looking in the rear-view mirror? Is it Springtime, 2001, all over again? Remember as interest rates sky-rocketed along with the stock market, then retreated to find new lows?

Just as drunk drivers are not safe on the roads, the question I mull over is: are investors still intoxicated with the hope for one more run in the market? "This time, I promise to get out at the top!"

TheStreet.com did an excellent interview with Lakshman Achuthan of the influential Economic Cycle Research Institute. Conclusion: determining the likelihood of a rebound doesn't need to be a gut-level guessing game. ECRI has become very good at weighing a variety of metrics to determine the timing of the business cycle. Summing up the article:

Today Acuthan says facts and figures still line up powerfully against investors' hopes for an early 2002 recovery. In fact, he doesn't see the likelihood of a rebound before July.

While he sees three positive factors in rising equity prices, a decline in energy prices and an explosion in the money supply, he cautions that equity prices can be deceiving. The bad news is that most people seem to think that the typical lead is six months, but Achuthan says that 50% of the time since World War II the lead has been four months, 25% of the time it's been five months and 25% of the time it's been three months. So if you believe that the September low was the real thing, then the economic rebound has to start in December, January or February. The data cited above says not likely.

Among the economists I read and respect, from the National Bureau of Economic Research to ECRI to Morgan, etc., most are saying July 2002 is the likely date of a beginning recovery, and one which will be soft. If you date the stock recovery back three to five months from then, you would expect a cyclical market low -- that is, prices below the September 2001 low -- between February and April 2002. Achuthan notes that his percentages are facts, not guesses, which encompass all cycles in the postwar era. "It's possible we'll get a longer lead this time," he said, "but given our experience, it's not likely."

As negatives, he see rising initial claims for unemployment insurance, falling building permits (see above), flat and falling commodity prices (with the exception of copper), wide bond quality spreads, two-decade lows in new factory orders, and a global recession, among a longer list.

John Markham of MSN MoneyCentral concludes: "In short, Achuthan warns that stocks may have once again forecast a `false dawn.' He knows, and I know, and you know, that eventually the United States and the world will experience a full and complete economic recovery. But it is critical for investors to think for themselves and get the timing right -- and not to simply hope that the market has gotten the timing right."

Son of Bubble

If it is a false dawn, it is a very bright fire lit by a huge increase in the money supply. There has been an enormous increase in liquidity as measured by MZM-M1, savings deposits, and money market mutual funds. It currently stands at a record $5.6 trillion, up 21% or $976 billion from a year ago.

These are growth numbers reminiscent of 1998 and 1999, as Greenspan pumped the money supply because of the Asian crisis and concerns about Y2K. It created a stock market bubble, especially in the NASDAQ.

This money growth appears to be having the same affect today. The tech-heavy NASDAQ once again is selling at 50 times forward 2002 earnings -- identical to the valuation excess hit at Nasdaq 5,000.

"If it looks like a bubble, feels like a bubble, and acts like a bubble, maybe it actually is one ... again."

Some Conclusions

A "V" shaped recovery starting in the 1st quarter is very unlikely. As noted above, this suggests that we will see a re-test of the recent stock market lows. That is what should happen. However, if there are enough buyers who keep looking over the valley, perhaps the broad markets (the DOW and the S&P 500) will stay up. I would not want to bet my future retirement on that.

I think short-term traders should take some profits, especially in technology, and long-term investors should wait until the Three Amigos of the NAPM Index, capacity utilization and junk bonds tell us a recovery is in our future. The reason to wait is that you want to be able to make long term investments when the wind is at your back. Fighting the economy and a bubble as we have the past two years is not fun.

The good news is that two of these numbers (the NAPM index and junk bonds) have finally turned up this month. I think we will see these numbers give us an all-clear sometime in the 1st quarter, with a turn-around happening next summer (barring some extra-ordinary event).

For new readers, this means we will get back into the market buying deep value and special situation stocks. Technology still looks like a bubble.

Once Again, Bonds are a Great Opportunity

In October, my bond call for this year looked prescient. Today it looks boring or bad, depending upon when you got in, as we are slightly below where we were at the beginning of the year. The market is pricing in a dramatic recovery. I just don't see it. I think long and mid-term rates will come down from here big time over the next few months and those of you who have not bought bond funds can get in. If I am right, we will make up what we have given back and more.

Aggressive investors can look at the Dec '02 3 month Eurodollar contracts on the CME. If you don't know what that means, you probably shouldn't make the trade, as it can be VERY volatile. Only the iron stomachs need apply.

The "Bond Vigilantes," those investors who are always looking for signs of inflation, are going to be disappointed. Deflation is sweeping the world. Even the Swiss central bank cut rates yesterday to 1.75%, citing low inflation projections. Many countries, like Japan, are in outright deflation. When was the last time you heard of Mexico having little or no inflation?

Mcculley may be right on target. Greenspan has raised rates for the last time in his career. He may pull a Kissinger by declaring victory and going home once the economy rebounds. Let someone else catch hell for raising rates in the face of a slow recovery.

Time for junk bonds? It is getting closer as recovery gets nearer.

***************

I will be writing one more letter this year, and then my bride and I are off to the Pacific Coast of Costa Rica for a well-deserved vacation (a little golf and drinks with umbrellas in them). I will be thinking about my 2002 predictions, and expect to write them between Christmas and New Year's. As last year, I will present the optimistic case, the doom and gloom scenario and what I think is likely. Last year, we got more than a few predictions right. I am still waiting for my long-term bonds to behave and reward us, however.

I hope you got to watch the recent National Geographic special on Afghanistan. They featured my good friend, Sir Ed Artis of Knightsbridge, giving away the food and blankets many of you helped pay for. I will tell you more next week about how you can help the relief effort this Christmas, as Ed prepares to go back in a week or so. Do not think the US government is taking care of everything. There is a disaster brewing in the small, remote villages. Children will live because you help.

For new readers, I always read comments and try to answer if I have the time. Have a great week, and remember to enjoy this Season of Love, Peace and Family.

Your ready for a week off analyst,

John Mauldin

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