Recession Blues

I laugh in the face of superstition over Friday the 13th. Nothing can be as scary or unpredictable as the stock market has been lately. Following these markets on a daily basis makes Jason seem tame. If you really want to see blood, you need to spend some time reading the recent economic reports.

There has been a lot of news of late that merits our attention. After reviewing, we will step back and see what it means for the economy and the markets.

The evidence continues to mount that we are in a recession and that we have not yet seen the bottom. Of course, there are those who disagree. This found its way to my computer on Thursday as the market was rallying sharply.

Post-mortem on the Bear Market?

"The bear is dead," said Alfred Goldman, chief market strategist at A.G. Edwards. "The fuel for bearish sentiment has been lousy corporate earnings, but that's antique news now. And anyone that hasn't discounted the likelihood of poor earnings has been in a coma for the last three months."

Hmmmm. This sounds suspiciously like the statements from market strategists and analysts we read three months ago as the market rallied. "We have seen the bottom," we were told. "Corporate earnings are on their way back up."

I read the above statement and at first just smiled. But the more I thought about it, the more annoyed I got. This is cheerleading of the worst sort. It is not just that those of us who are worried about the markets might be overly concerned. He implies that those who have many sound historical reasons to be bearish are brain dead, and no intelligent investor would want to be caught in company with them.

I should also point out that fewer stock buyers means lower earnings and year-end bonuses for investment bankers. But I am sure there is no connection.

For the last 12 months, analysts have consistently lowered corporate earning projections each quarter. This quarter is no exception. There is no reason, from the data we will see below, that next quarter will break the trend.

So as I read Mr. Goldman's statement, I wonder why I should discount "lousy corporate earnings"? I will bet you dollars to donuts that during the bull market Mr. Goldman, like every investment analyst, told his clients that earnings are the driver for the stock market. Therefore, buy companies which have solid earnings growth potential.

Then why should we discount lousy earnings now? Why should we buy companies with lousy earnings growth potential? Why should we believe future earnings projections from cheer-leading analysts that have been consistently high and consistently wrong? Especially from analysts who get paid by companies who are trying to sell us stock?

Getting Comatose

OK, let's pretend I have been in a coma for the last three months. Much like some of the buy and hold clients of AG Edwards. (Ouch - Did I write that?)

I wake up today and review the last week's news. This is what I read.

*US wholesale inventories rose more in May than at any time in the last six months as sales fell, the largest increase since November.

* Second Quarter demand for US goods and services was the weakest since the economy was emerging from the last recession in 1991

* Scores of companies like NCR and EMC are telling us that sales are down as customers postpone purchases.

*Capital Spending (the spending companies do when they invest in new production equipment and capacity) is falling. The widely followed index of the National Association of Business Economists is in negative territory, again the lowest reading since 1991.

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*Employment is falling. The NABE employment index is now negative, and the lowest since 1993. The unemployment rate continued to rise. Manufacturing payrolls dropped for the 11th straight month. "More troubling was that the service sector failed to add new jobs in the second quarter for the first time in four decades...That tells us weakness so concentrated in manufacturing is now spreading." (

That last quote is VERY important The Service sector is the largest part of our economy. To learn that it is visibly slowing down is not good for those of us coming out of a three month coma.

Company after company announces payroll cuts. Motorola announces it will lay off another 3% and its stock rises. Initial jobless claims report from the Labor Department rose by 42,000 to 445,000 in the week that ended July 7 - the highest level in nine years.

By the way, the huge numbers of lay-offs announced this last month have not yet shown up in the unemployment figures. Those numbers will start to show up next month. It takes time for Nortel to lay off 10,000 more people in addition to the 20,000 already announced.

*Consumers are starting to show signs of slowing down. An NABE index showing consumer demand was the lowest since -- you guessed it - 1991.

Consumer spending has been the backbone of the economy, and has kept us from falling into outright recession. Without repeating numbers from previous letters, consumers have clearly been borrowing and dipping into savings to maintain lifestyles. My question a few weeks ago was how long could that trend last? It appears that it may not be that long, as consumer borrowing, though still growing, is not growing as fast.

As I have repeatedly said, if consumers spending slows, look out below.

* Aaron Trask writes: "Goldman Sachs' global economic research department estimated U.S. technology spending will be down 24% on an annualized basis in the second quarter after a 19% decline in the first quarter. The good news is Goldman expects tech spending to return to positive growth on a quarterly basis in early 2002 and on an annual basis in the middle of next year."

Aaron, why is that good news? When in the last year has Goldman Sachs been right about future tech spending? The way I read it, that means spending will still be way down for the rest of the year, contributing to more earnings problems. (By the way, in case he reads this, I like Trask's writing.)

* Trimtabs tells us that the huge horde of cash everyone keeps talking about that is waiting on the sidelines to drive the market up may not actually be there. The actual percentage cash in US equity funds is DOWN to only 5%. But haven't money market funds grown by 14%? Yes, if you include institutional money. But retail money funds have received all of $32 billion in new cash this year, after losing $8 billion the past fortnight. That means retail funds have grown by all of 3.5% so far this year. $32 billion could get absorbed overnight.

OK. I will stop about US problems. There are many more, but any more and I might go into a coma. But we should address the world situation before moving on.

Exports account for 11% of the US economic Gross Domestic Product (GDP). It also accounts for a much bigger share of corporate profits, as many multi-national companies produce products in other countries but in theory their profits come back here. These are called "affiliate sales". They are roughly 2.5 times exports, so they contribute a considerable amount to our national corporate bottom line.

There is considerable doubt that the profits from affiliate sales will be anywhere near what they have been in the past. They are visibly disappearing at many companies.

The problem US companies face is three fold. First, as the world slows down, that means they buy less from us. A 10% drop in exports translates into a 1% drop in GDP. Singapore announced this week it is in recession. It will just be the first of many Asian countries to do so in the next few months. Almost without exception, they are all reeling.

That means they buy less from us. But the strong dollar makes the problem worse. The dollar, now stronger than it has been since 1986, makes our products more expensive to foreign buyers. They can afford less of our products, if they even have the money. Further, it means that other manufacturers in other parts of the world can undersell us without having to lower their prices in terms of their own currencies. It becomes a vicious circle.

Crying for Argentina

Sadly it is the same song, second verse for Argentina.Where is Evita when we need her?

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Argentina is collapsing. Years ago, in an effort to stabilize their currency from terrible inflation, they decided to go onto a dollar standard. One Argentine peso, they said, would be equal to one dollar. And it worked. Up until lately.

With the dollar getting so strong, it also means the Argentine Peso was getting strong as well. But their main competitors and the markets they sell to, Brazil and Chile, have seen their currencies drop like rocks, especially Brazil. This has seriously hurt Argentina's ability to profitably sell products outside of their country. Further, they had huge government owned industries which are typically inefficient and have been losing enormous sums of money. Unlike the US, they cannot run trade deficits of 4% of GDP.

Money flowed out of Argentina but little has been flowed back. My favorite analyst, Greg Weldon, did a lengthy write-up on Argentina today. There were a number of quotes from opposition leaders, as you would expect, decrying the situation and blaming the government. But what struck me was the rhetoric from within the leading party criticizing the national leaders. This is a situation which is going to get ugly.

I love Argentina. It is a beautiful country with wonderful people. But I fear they are in for a very bumpy ride. Instead of leaders coming together in what is clearly a crisis, they are falling apart and getting into shrill shouting matches. Not a prescription for making the necessary hard decisions possible.

As I predicted last year, Argentina will soon devalue its currency. I warned you about Argentine debt, while others were talking of the high rates of return which were safe because the Argentine government would not devalue their currency. When a government gets its back to the wall, they will do whatever it takes. Their problems were clear last year, and their was no political resolve to solve them.

The entire region will suffer for Argentina's inability to solve its problems. They are going to lead the region into a serious recession. With Mexico already in recession, Columbia and Venezuela fighting guerilla wars and watching their economies deteriorate, it is hard to see where US companies are going to maintain exports, let alone see them grow, South of the Border.

The Devaluation Raceway

Greg Weldon has been watching the currency devaluation in the Asian tigers. He likes to refer to the current situation as a NASCAR race. Each country is trying to lower the value of their currency so they can sell more products to the US and so they will have a competitive advantage against each other. Taiwan, Korea and Thailand are all neck and neck, making new recent lows almost simultaneously this week.

Quote: "Indeed, backing up our theme, we note the partial list of other currencies setting new multi-year and/or all-time lows against the USD in the last 24 hours include ...Chilean Peso, the African Rand, the Indian Rupee, the Argentine Peso (NDF market), and the Venezuelan Bolivar."

(Weldon does more or less 4 powerhouse newsletters a day, starting at 2 am. You can subscribe for $400 per month. For a free sample write .)

The Japanese Yen is close to a recent low, and the Euro is lounging around 85 cents, only slightly above its lows.

Space prohibits me from starting another long list of woes from overseas, especially Europe and Japan.

Comatose Investors

Chartist Kevin Klombies tells us: "When people start out on a trip, they generally know where they are going and how they are going to get there (with the exception of most men, of course). When they arrive at their destination they are seldom too surprised by the weather and have packed accordingly. Yet, when it comes to investing...even seasoned pros often have no idea what they are doing or why they are doing it. 'Value' is often another term for 'this dog is lower than I thought possible', 'diversification' means 'I have no idea', and 'long-term' was thought up by someone in the mutual fund business and means 'cash flow'.

The cheerleaders and analysts in the investment banking world are watching their cash flow deteriorate right before their eyes. They want you to stay the course, so their cash flows will not deteriorate any more.

I have been warning about a recession since last September when the yield curve went negative and the S&P was at 1500. I now think we are in one, and the third quarter, as I predicted, will show negative growth.

Investors, it seems, are right now more inclined to hear and believe statements like Goldman's. They want to hear everything is going to be all right. But how long will they listen as it becomes evident that things are not all right?

Will the market drop sharply (over 40%) as it usually does during recessions? History says it will, but this is not like any other historical market. I was talking with representatives of one of the largest and most successful hedge funds in the world yesterday. They specialize in short-term trading. They manage billions. Up until this year, they had consistently turned out 30-40% annual returns with only 2 losing months in the last 5 years.

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But since January, they are flat. No big losses, but no big gains. Down .1%, up .3%, down .2%, etc (Yes, that is tenths of a percent). In quizzing them, they tell me the last five months have been like no others they have ever seen. Trading patterns have been non-existent, and profit opportunities are just not there. They see the problem as a change in the nature of volatility. While it is technical, the nature and patterns of volatility have changed.

They believe, and I agree, that this cannot continue. Something is going to break.

I talk to more and more investors who are in a "forget the cheese, get me out of the trap" mood. As this recession begins to become evident, I believe an increasing number of investors are going to throw in the towel and decide to "wait it out".

Stock prices are made "on the margin". If there are 100 people who own a stock, but only 3 people wanting to sell, those who are selling set the price. That is, assuming there are at least three buyers; if there is only one buyer, it is the buyer who gets to set the price.

While it may sound simplistic, markets go up when there are more buyers than sellers, and vice versa markets go down when there are more sellers.

The fact that a large portion of the stock market is in "steady hands" makes little difference to the price of stocks in a bear market. The price is set by those wanting to sell. Today, there are still large numbers of investors who are trained to "buy the dips". But their numbers are dwindling. That is why each rally stops at a lower "high". That is the nature of bear markets. Each rally finds a few more investors deciding to get out of the trap.

At some point, confidence collapses and so will prices. Unless we are in a sustained multi-year recession like 1973-74, which I do not think we will see, that will be precisely the time to buy. (Please note that I am NOT suggesting you sell stocks which are already at good values.)

The Glue that Bonds

Our long term bonds have done nicely this last week, moving up steadily. Inflation is not the worry, and as that becomes more apparent, bonds should do even better.

I know that many are worried that the recent growth in the money supply will result in inflation. I and others have speculated that it is the increase in the money supply that is holding up the stock market. Growth in the money supply is a signal to some that inflation is around the corner.

But Weldon points out that the rate of change in the growth of the money supply has been slowing the last few weeks. If that trend continues, it will be good for bonds. If, as I think, much of the growth in the money supply shows up in the stock market, that will NOT be good for stocks. We will keep a sharp eye on these figures.

In short, the rallies of Thursday and Friday were classic bear market rallies. Bear markets do not go down in a smooth line. Bulls do not surrender their prices without a fight.

That being said, the trend is still downward. It is not safe to go back in the stock market forest. There are bears lurking, waiting for fresh beef.

Summing Up

Is Goldman right? Are we in a coma because we refuse to ignore repeated earnings breakdown? Should we assume that the worst is behind us? Has all the bad news been factored into stock prices?

I don't think so. Not at P/E (Price to Earnings) ratios well north of 20 for this market. Not until I start seeing some sustained good news. Not until I start to see signs of a turn-around. Waking up and reading the last week's news did not do anything to make me believe this quarter is going to better than last quarter.

To illustrate my point that each rally and fall turns a few more bulls into bears, I note in passing that Joe Cowdin, an analyst whom I read and who has been quite bullish, turned bearish this week. Another one bites the dust. There will be many who follow him.

That's enough for this week. Thank you for your letters and many kind words. They give me real pleasure.

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Last week at San Antonio and Sea World was great. I am always amazed at the killer whales. If only we could get our governments to respond as predictably.

Your wondering who's really in a coma 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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