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Some Additional Firming?

Are we in for a soft or a hard landing? Did retail sales slow, as the data suggest, or is the underlying data quite bullish? We will look at the arguments, and then look at the most reliable of all economic indicators to see if we can get an idea as to which view is right.

But first, I want to announce a new addition to my free information services. In addition to this letter, I send out a free newsletter every Monday evening called Outside the Box, where I feature the work of another analyst or writer, often looking for thought-provoking views which disagree with my own. Yesterday, I sent you a special Outside the Box highlighting an essay by George Friedman of Stratfor on the problem the US faces because of our military being stretched.

I see about 3-4 Stratfor letters each day, with thoughtful analysis and up-to-the-date lists of major geopolitical events. I am very pleased to announce that George is going to let me choose one of these essays every two weeks to send to you. You can of course opt out if you like, but I really think you are going to like the additional insight and information. I find the work they do to be of the highest quality and quite useful as I think about how everything "fits" together in a rapidly changing world.

If you missed it, you can click on the following link and read the essay from yesterday.

"Some Additional Firming May Yet Be Necessary"

Yet another Fed official tells us that inflation is not yet dead and the Fed is not ready to move to an easing stance. Chicago Fed President Michael Moskow said that there is still "substantial inflation risk" to the economy. He could not have been clearer that if inflation does not come down, he will be prepared to raise rates. He also echoed the "we are now data-dependent" theme. Quoting:

"My current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook."

By my count this is five Fed officials in just the last few weeks that have gone on record stating that they are uncomfortable with the current level of inflation. Is it just Fed posturing, as some argue? If it was just Bernanke or Kohn, one could maybe surmise that. But this is a theme that seems to become more and more prevalent with each week. Moskow's opinion matters. He votes on the FOMC.

Adding to this view was the release of the minutes from the September 20 FOMC meeting. Reading them you come away with the sense that Fed governors feel that inflation concerns are still very much on their mind. In August, they seemed hopeful that a slowing economy would rein in inflation. At the September meeting, "members continued to see a substantial risk that inflation would not decline as anticipated by the Committee."

There seems to be a consensus that core PCE, their favorite measure of inflation, is not low enough to be consistent with price stability, and this would thus make future low inflation expectations somewhat of a risk. Inflation expectations are very important to the Fed. If you did not read my letter last week, I suggest going to that letter ( or to Paul McCulley's recent essay at to understand why the Fed is so concerned about expectations.

The inflation numbers we get next week are going to be very important. As noted below, it looks like the economy did slow some in September, as both retail sales and new jobs were down significantly. If inflation did not also slow, then there may be a worrisome disconnect between a slowing economy and inflation. The Fed is counting on a slowing economy to slow down inflation. If that is not happening, then some of the Fed governors will start to publicly reconsider the current pause in the rate-hike cycle. Nothing will happen at the October meeting or even in December, but the January meeting becomes more interesting.

Consumer Spending Weakens, Or Did It?

September retail sales posted a rather weak headline number. Expectations were for a rise of 0.3%. Mostly, the high expectations were because of the drop in gasoline prices. Economists assumed consumers would spend their energy "savings" on other items. The actual number was down 0.4%; and just as important, August sales were revised downward from 0.2% to a final 0.1%. It is important to pay attention to the direction of the revisions, as they will sometimes be a harbinger of trends.

So, are we finally starting to see a slowdown? Not if we look at the action of the stock market, which is again posting new 52-week highs as I write. Dow 12,000, here we come! And why can the market shrug off slowing consumption? Because the immediate spin was that the underlying data was really quite strong.

Typical of this line of thinking is Peter Possing Andersen of Danskebank. Quoting:

"The September retail sales report posted a disappointing headline reading that showed total retail sales dropped by 0.4% m/m and ex. autos sales dropped by 0.5%. However, these rather weak headlines were heavily distorted by the effect of lower gasoline prices, which subtracted almost 1.0 percentage point from total retail sales growth. Adjusting for gasoline, retail sales actually look very strong, gaining 0.6% m/m ex. gasoline and 0.8% m/m ex. gasoline and cars (core retail sales).

"It is very important to emphasize that the gasoline effect is purely nominal and hence not a reflection of low turnover measured by volume. The retail sales data now reflect that the positive effect from lower energy prices is beginning to feed into spending. Core sales (ex. energy and autos) have risen by 7.2% AR over the past three months, significantly up from the low of 2.5% AR in June. This bodes well for consumption heading into Q4.

"... Bottom line, consumption growth should be picking up as the full effect of lower energy prices feeds through into the economy during the coming three-six months." (

This is in the same camp of thinking that says that if you take out food and energy, inflation isn't all that bad. It is what Barry Ritholtz calls the inflation ex-inflation school of thought. And he does a good job of looking at the other side of the retails sales picture. Quoting:

"...Now for the fun part: Retail Sales can get reported in a variety of 'EXes;' Ex-autos, and Ex-gasoline are two more common versions. Ex-gas retailers, and sales were up 0.6%; Ex-autos, and sales were down 0.5%. Excluding both autos AND gasoline, all other retail sales increased 0.8% in September.

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"What can we learn from this? Quite simply, despite the huge drop in gasoline prices, total sales were still off nearly half a percentage point in September. (I'll mercifully spare you any further zero-sum discussion).

"One might have thought that, given all of the dollar savings at the pump, at least an equivalent amount of dollars would have been plowed back into the economy. Indeed, the new-found energy savings could have led to a wealth effect, leading to more big ticket items -- including cars.

"Nope. But taking a page from the school of inflation ex-inflation , if we removed the items that went down in sales, we can reach the conclusion that sales were not punk."

Last week we had a very poor jobs report, with the exception of this very odd and huge revision of 850,000 new jobs last March. However, the latest monthly number was definitely weak. The spin was that the revisions showed a strong economy. (Remember, employment is a lagging indicator.) Which goes to show, if you want to, you can make the numbers mean whatever you want them to say. There are lies, damn lies, and statistics.

The Best Economic Activity Indicator of All

As Dennis Gartman reminds me from time to time, tax receipts are a very reliable indicator of economic activity. Nobody pays more taxes than they have to. Income tax receipts have been high and rising. Capital gains tax receipts are higher than ever, despite an almost 50% cut in rates by George Bush. Imagine that. Tax cuts worked by increasing tax receipts. And where has the largest increase in tax receipts come from? High-income tax payers, who are now paying a larger percentage of total taxes than ever. So much for the "tax cut for the rich." Now if Republicans in Congress had just held the line on spending we would have a balanced budget.

(Sidebar: If the GOP wants to know why the rank and file gets discouraged, it is because they thought that electing Republicans to office would result in more fiscal responsibility. Now they are in real danger of losing the House or Senate or both. Can you say gridlock, boys and girls?)

So, what do taxes tell us about the retail sales numbers? We can't look to income taxes, but we can look at sales taxes. And they confirm that consumer spending is indeed slowing. Philippa Dunne and Doug Henwood at The Liscio Report track sales tax receipts in the various states. This week they write:

"State sales tax collections continue to fall relative to budgetary projections. In September, just 37% of the states in our survey met their forecasted sales tax collections, down from 51% in August. A few contacts reported exceeding their projected collections by 1-2%. The majority, however, reported wide misses, the worst of these coming in 7-8% below where they thought they would be. Large states on both coasts reported year-over-year declines of around 2%, and in the Midwest, where results were weakest, collections in one state fell 11% over the year. Collections in three states in the "made it" column are hovering at the very low end of the tolerable range.

"Only one contact suggested a calendar issue explained the miss in his state. We, of course, have our perennial calendar issue, the lag between sales activity and collection due dates; gas prices continued to fall in late September, and if consumers spent the extra cash on other items, those purchases would not be fully reflected in September sales tax collections. We believe the important story is the continuing slide in sales tax collections. In the graph below, we show the last three years January to December, leaving in the monthly noise factors. There are some big switchbacks, like the nasty fall in February 2005, which our contacts believed to be calendar related as we reported at the time. What does not appear to be related to anything but a growing weakening in consumer spending is the slide this year that began in January and, outside the April fall (which our contacts thought was exaggerated) has continued since.


"And our contacts believe it's real; some have lowered their growth projections for the coming year, others are close to making that decision, and some have recently decided against raising projections. The states with previously hot housing markets see ample reason to believe they have their culprit. Local reports indicate slowing sales and falling prices. Our contacts in these states also pointed out reports of people walking away from their down-payments, and wondered how many aren't putting their houses on the market because they would basically have to bring a check to the closing. (A contact of ours who's a mortgage banker in the formerly hot South Florida market reports: 'The market has evaporated. Even the affordable stuff can't be given away. The Desperation among developers, bankers, and speculators is palpable.')

"Drops in building materials can have dramatic effects: one contact computed that much of a recent miss could be explained by lumber's move from y/y growth of 10% to flat. And collateral damage remains an unknown."

Truth in Lending, Home Style

How much of the slowdown in consumer spending is due to the housing market decline? How much of a problem could that be in the next few quarters? The connection between consumer confidence, consumer spending, and housing prices is well known. But how great a connection has been a matter of contention. Some recent economic papers are suggesting the connection is stronger than we had previously thought.

In a very interesting article in the latest Economist , they ask the pertinent question of whether Americans treat their home equity as a nest egg or as credit card. The evidence is that the answer is changing over time. Look at the chart below. Home equity withdrawal was quite low, or even negative, less than 15 years ago. But then there was not a finance industry geared to make home equity loans. Now the competition for such loans is fierce.


But the evidence is that mortgage equity withdrawal (MEW) is slowing dramatically. MEW has been shown to be responsible for as much as 1.5% of recent economic growth. From the article in The Economist:

More Than a Roof Over Your Head

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"The stakes in this debate are high, because the behaviour of consumers will largely determine whether America's economy tumbles into recession or merely slows down. Unfortunately, there is no simple answer. Economic theory tends to support the optimists. Rational consumers should adjust their long-term spending in response to changes in their wealth, not the ease with which they can tap it. But there are several reasons why the wealth effect from housing could differ from that of shares and bonds. People have to live somewhere, and as the price of property goes up the notional cost of housing rises with it, even for owner-occupiers. That means rising property prices do not create aggregate gains in the way that higher share prices do. Housing's effect on overall spending should therefore be smaller than that of financial wealth. On the other hand, more people own homes than own financial assets. Since poorer people tend to save less than richer ones, higher house prices ought to boost spending more than rising share prices.

"Empirically, economists have long had trouble pinning down the wealth effect from housing. Two decades ago, it was considered to be non-existent. Then studies found that changes in property values did affect spending, but by less than changes in share prices did. However, the latest research suggests that, in America at least, housing wealth has a bigger influence on consumption than financial assets, and the effect is increasing.

"A new study by Christopher Carroll, Misuzu Otsuka and Jirka Slacalek estimates that an increase in housing wealth of $100 in America eventually boosts spending by $9. A similar increase in stock market wealth would produce only $4 more spending. That ties in with a new microeconomic analysis of individuals' wealth and spending habits by Raphael Bostic, Stuart Gabriel and Gary Painter, which estimates that the wealth effect from housing is around three times bigger than that of financial assets. A study by Karl Case, John Quigley and Robert Shiller also found the wealth effect from housing to be more significant than that from shares." (Full article at

The total value of US residential property is now around $19 trillion, according to the Joint Center for Housing Studies at Harvard University. Housing values have increased by 60% over the last five years, or around $7 trillion (rounding off). If the above research is correct, that means around $600 billion in increased spending was a result, or about $120 billion a year on average, with the number rising each year. In a $12 trillion dollar economy, that is not much. But is means a lot of the actual growth in the economy, at least 1%, was directly related to home price increases, which is something that we can empirically observe. Take that away and the economy is markedly slower.

Take off that growth in home values and you see an economic slowdown in the making, which is precisely what retail sales and the sales tax receipts are beginning to show. And that is on top of what could be a real cutback in jobs in the home construction market.

Much of the current home construction employment is due to homes started last spring. It takes 9 to 12 months to build a home (unless it is the townhome down my street which has taken two years, but no one actually seems to be working there). We are watching new home permits drop, which is going to mean housing employment will suffer. Professor Nouriel Roubini estimates that construction jobs could fall as much as 40-50,000 per month with a few months, as the lagging effect on home building takes its toll.

And while we are talking about Nouriel's work, let's close with a few paragraphs from his recent posting. Many are suggesting that the recent drop in oil and commodity prices is bullish for the economy. Not so, he argues.

The first paragraph is a quote from the Financial Times , and the rest are his comments:

" '...The reduction in prices we see today is the result of expectations of weaker demand rather than of improvements in supply. This makes the fall much more worrying than it may initially seem. If the decline in prices were to continue, it would be an indication of continued weakness in global demand. Worse, it would also undermine the price stability needed for investment in both increased supply and more efficient use of the world's scarce energy resources. Do not cheer too soon. This good news may yet turn out quite bad.'

"In conclusion, the soft-landing bulls are getting it wrong and are altogether confusing cause and effect when they argue that lower oil prices are good news and good signals for future economic activity in the US: oil and commodity prices are exactly falling because we are now experiencing a US and global economic slowdown; so such price action should be interpreted as bad news rather than good news. This is the typical fallacy of non-economists that take a partial equilibrium - rather than a general equilibrium - approach to analyzing data; an economist would ask himself or herself: why are oil and commodity prices falling at the same time? What is the cause of it?

"There is only one clear and consistent explanation of this generalized price fall: the US is sharply slowing down, dragging with itself the global economy. So, paradoxically, falling oil prices are bad news for the economy: they are the proverbial canary in the mine warning us of the recession risks ahead. Indeed, what both the oil and commodity markets and the bond markets and the housing market are telling us - or screaming at us - is: slowdown and recession risks ahead!

"The fact that the stock market is allegedly now providing a signal that is different from the bond market and the oil and commodity markets can be then interpreted - as I have since August - as the typical suckers' rally that accompanies slowdowns where the Fed is expected to come to the rescue of the market and the economy. Remember that in 2001 95% of all economic forecasters predicted in March 2001 no recession that year; too bad that the economy had already entered into a recession by March 2001. The wishful hope of forecasters and markets was that the Fed easing would rescue the economy and that the economy would experience a second-half rebound.

"Indeed, in typical suckers' rally mode the S&P index rallied a whopping 18% in April and May 2001. It was only in June 2001 when even more severe signs of a recession clearly emerged that the stock market started to rapidly tank into a free fall. So, such stock market suckers' rallies are very common at the outset of the recession. The reality is that stock markets are often wrong: sometimes they predict recessions that do not occur but, at times like in 2001, they fail to predict recessions that are already ongoing."

I think less than 5% of economists are predicting a recession today. Take no comfort in the consensus view.

New Orleans, a Special Offer, and More

I have finally written a new Accredited Investor E-Letter. It is being sent out by my various partners around the world. I work with a few very select firms around the world to help such investors find private offerings, hedge funds, and commodity funds that might be suitable for their portfolios. If you are an accredited investor (generally $1.5 million net worth or more), you can subscribe for free. This week, we made a special offer of a link to a speech Louis-Vincent Gave delivered at my annual Accredited Investor Conference last spring (co-hosted by my US partners at Altegris Investments). It was well received. If you did not see that offer, you can click on the following link to learn more about it and subscribe to my free letter. (In this regard, I am president and a registered representative of Millennium Wave Securities, member NASD.)

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I should note that sometime in the next few months, I will finally be announcing a new program to work with "non-accredited" investors. It has taken a long time to get to where we can do this and do it right. I hate differentiating among potential clients because of net worth, but the rules are the rules. Look for an announcement soon.

I will be speaking at the New Orleans Investment Conference November 15-19. In addition to yours truly, they have lined up Steve Forbes, Jim Rogers, Marc Faber, Dennis Gartman, and Newt Gingrich, plus scores of other well-known speakers, workshops, and private sessions. I hope to see you there. Click on the link for more information and to register.

My friends at Altegris Investments will be hosting a special dinner for high-net-worth clients and prospects in New Orleans, and we will be arranging private meetings during that week. Drop me a note if you would like to attend that dinner or meet in New Orleans! I hope to see you there!

It is time to hit the send button. It has been a long and interesting week. I am ready for the weekend. I was talking with my daughter Tiffani, who has worked with me for nine years, the other day. We both agree we need to take some short vacations over long weekends and re-charge. Now if I can just find the time!

Have a great week.

Your waiting for the Dow to go over 12,000 analyst (sigh),

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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