TFTF

Sucker Rally or New Bull?

November 22, 2002

Today we are going to look at the world economy, muse on why the dollar is holding its own and when and why it will drop. Then I make a few comments on the current stock market rally. Finally, in a departure from the normal letter, I am going to close the regular e-letter, but add a PS in the form of an essay on the risk of derivatives for those who find the subject interesting.

The US Muddles Through

The world economy is clearly not healthy. Let's look at the US, and then we will go around the world. The US economy grew at 3.1% for the last quarter, which ahs been loudly trumpeted by the cheerleaders on Wall Street. But digging down into the details, we find that if you take out the explosive growth in automobile sales caused by 0% financing, the growth was only 1.5%. The predictions are for a weak holiday buying season. Car sales are now down. Housing was down 11.4% in October, capacity utilization is almost back down to recession lows and the trade deficit widens. Retail store sales are slightly down.

Still, the economy is not likely to fall into outright recession for the next few quarters. As I have maintained all year, this is a period of slow growth. The Index of Leading Economic Indicators, after falling for four months in a row, finally turned back up. Unemployment claims dropped slightly this week. There are parts of the economy that are doing just fine, and some businesses that are having banner years. There is a lot of stimulus from the Fed and the government, tax cuts last year and the likelihood of even more tax cuts and stimulus in the future. Greenspan has not made his last rate cut.

While some would argue that interest rate and tax cuts have not helped, I would like to suggest another view. They have been helpful, in much the same way that Advil will help a major hangover. It serves to lessen the pain, but does not get rid of the problem. The US and the world had a huge hangover from the stock market bubble, and it is a wonder to me and many observers that we did not have a major recession. We have certainly not dealt with all the excesses. Something is holding the economy up, if ever so tenuously.

But given all the problems cited above, along with the huge trade deficit, why would the dollar be holding up so well?

While Europe Falls Behind

The problem is that the rest of the world does not look good by comparison. The London Financial Times notes that France grew at an anemic 0.2% this last quarter. Germany and Italy grew at an only slightly better 0.3%. Various authorities project that the fourth quarter will be weaker. It is hard to picture a weaker quarter without these countries falling into recession.

Goldman Sachs warned last week that 30% of the 118 German life insurance companies could disappear within five years. The following day, Fitch said 39 of 75 insurers it surveyed had "weak" capital bases. Insiders say this may be the tip of the iceberg.

Germany is in open defiance of the European Union agreement on deficits, planning to run government deficits in excess of 3% of GDP. France is making rumblings. This does not bode well for peace among the members of the European house.

The Central Bank of Europe has ignored calls to ease interest rates, thus threatening to help push the continent into recession. Most European countries have the same age demographic profile that Japan does, and this is slowly creating a more deflationary prone environment.

Japan is in an outright deflationary recession, and has been so for some time. The Koizumi government is proposing either the 47th or 48th (I lose count) solution to the national banking crisis. This one might fly, though, as it gives a lot more tax dollars to the banks and big business, which is the Japanese model. Of course, it will create even more government debt, which is not going to help its credit rating, which was recently down-graded again (this time by Fitch).

Thus, the three largest economies in the world are all weak at the same time for the first time in history. There is no engine for growth.

Given such an environment, who is to blame international investors for being confused as to which weak sister deserves his money?

Which way will the dollar break? The following quote is from Andrew Kashdan of Apogee Research:

"Stephen L. Jen and FatihYilmaz both agree with Morgan Stanley colleague Stephen Roach that the U.S. dollar is overvalued. However, in the grand scheme of things, it hasn't been clearly overpriced for all that long, they say. By Yilmaz' reckoning, the dollar has only been overvalued since the third quarter of 2000 based on cumulative imbalances -- i.e., the U.S. net foreign asset position resulting from its current account deficits. But both Jen and Yilmaz seem to agree that the dollar will only decline once the U.S. and global economies recover.

"In a weak economic environment, the pair points out, the U.S. tends to receive 'fear-motivated capital flows.' And, in fact, because of the 'hegemonic' status of the United States, the dollar 'will be supported in periods of extreme greed or extreme fear, regardless of valuation.' The problem will come when yields finally bottom, according to Jen and Yilmaz. We would add that higher-than-expected inflation, something that is obviously off the radar screen right now, will only exacerbate the trend once it gets going.

"But the dollar's downfall could come even sooner than that. Currency forecasting is always a dicey proposition, but there are complications, including the consequences of a war with Iraq, that may speed the process. For example, Yilmaz points out that 'the reluctant support from the U.N., plus a lack of visibility on the potential petrodollar flows, also works against the traditional 'war premium' arguments." Jen, who expects the U.S. economy to double dip, adds that "if I am wrong ... then [the recent dollar weakness] we are witnessing could indeed be the beginning of a structural correction." Either way, to put it bluntly, the dollar is screwed, says Kashdan.

China and the Fall of the Dollar

My personal views? I continue to think the dollar will get weaker against the euro, but slowly and over time. Japan has publicly declared its intention to weaken its currency against the dollar, and almost every Asian country has exhibited a willingness to devalue their currency against the dollar in order to stay competitive with each other and especially China.

The dollar may not significantly crack until China decides to let their currency rise against the dollar. When do they do that? When they think their internal structural problems are sufficiently dealt with and they have the beginnings of a real consumer market within China.

China is the key. One headline this week says that Japan is increasingly moving its production to China. Mexico (I swear this is true -- I couldn't make this up in my wildest dreams!) is actually importing Mexican sombreros from China for the tourist trade. Every nation feels forced to keep their currency competitive with China in order to sell to the US.

With the huge trade surpluses China is currently running, at some point in the future, they will decide they have enough US paper, and want more dollars for their labor and goods. When they feel secure in their international competitive advantage, they will pull away from the fixed dollar link, and that will be the beginning of the fall of the dollar that so many have predicted. Until then, the dollar is likely to go sideways to down, with rallies from time to time.

And yes, this is quite bullish for gold over the long term.

Bear Market Rallies

This is now the third time the S&P 500 has rallied by over 21% since the beginning of the bear market in 2000. Each time, we are told that the economy is turning and the stock market is leading the way, predicting the turn-around in advance. The cheerleaders and the stock market will be wrong for the third straight time. This quarter's GDP growth is likely to be below 1%. Such anemia is not the stuff of which roaring and long lasting bull markets are made.

While I noted above that Fed and government policy is appropriately stimulative, it is also having trouble getting traction in the three areas where such stimulus would normally have the most affect: housing, consumer spending and business investment. Each of these areas is not rising as they all have their own issues. It is hard, in the case of housing and consumer spending, to get an increase from a level which is already historically high. It is difficult to get business to invest in more capacity when they have too much capacity already. Thus, while stimulus policies (tax and rate cuts) have historically resulted in significant growth, we languish, slip sliding away down the slope of the last bubble. I agree with Stephen Roach of Morgan Stanley who writes: "The model of the post-bubble business cycle allows for precisely this type of muted response to policy actions, as the authorities get increasingly frustrated by 'pushing on a string.'"

Thus, those looking for the economy to bring forth a new bull market will be disappointed, and the market will at some point resume its downward lurch. The question for traders is, when is the next top?

Bear market rallies can evaporate quickly, or draw out for long periods. There is no real pattern. Discerning the pattern and reading the tape takes a seasoned pro. To that I defer to the genius of Richard Russell. (www.dowtheoryletters.com)

The best stock market call I have made this year was to tell anyone who wanted to trade bear market rallies to pony up $250 and subscribe to Russell's now daily Dow Theory Letter. He has been the blisteringly hot hand of late. He has been writing the letter for 44 years, has always been insightful (and usually right on target), and never more so than in the last few years. This secular bear market will have lots of opportunities to trade into a bear market rally over the next few years. Russell is one of the analysts who has the potential to recognize them as they happen.

Home Again, Home Again

It is good to be home again with my family and to start to catch up on my work and writing. Those who get my free Accredited Investor E-letter will get a new issue next week. It is being reviewed by the legal types as I write. If you are an accredited investor (typically a net worth of $1,000,000 or more), and would like to get my monthly (more or less) letter on hedge funds and private offerings, you can find out more about the letter by going to www.accreditedinvestor.ws.)

Thanksgiving is next week, and it is one of my favorite days of the year. I really look forward to my family getting together. And, admittedly, the food is also fun. We all have much for which to be thankful, and me more than most. This year, I will also get to spend some time with friends over the weekend. All in all, this looks to be a special Thanksgiving.

Following this letter is an essay on the issue of derivatives for those interested in the topic. And thanks for all the comments on last week's letter on retirement. I did read them all.

Your blessed beyond what he could ever hope to deserve analyst,

John Mauldin

A Word on Derivatives

Much has been made of the fact of the British Bankers Association recent report that the notional value of derivatives has increased from $180 billion only five years ago to over $2 trillion today. Some articles border on hysteria, warning of a spiraling implosion of derivative debt obligations which will result in the collapse of the world economy. As near as I can tell the argument rests on the premise that the increase in derivatives in and of itself is bad and the people using them are probably stupid or have some sinister motive, or both.

Others wax eloquent about how the growth of these financial instruments is going to take us into a new world where risks are spread throughout the economy, thus promoting a new and safer world where the cycle of bank losses which produce credit crunches and recessions is forever banished.

We are going to briefly look at derivatives today because a basic understanding of derivatives is essential to understanding how modern world economies and global businesses work. My view is that derivatives are wonderful things, but. There is always a but, it seems. We will first look at why derivatives are good things, and then examine the "but," coming to a conclusion on the dangers of derivatives different than you will normally read.

First, what is a derivative? You can go to www.margrabe.com/Dictionary.html and get the classic definition, along with the definition of hundreds of various types of derivatives. (This site also has a wealth of information on derivatives and risk management, hedging and is a good place to go to learn about these topics in a fun and understandable manner.)

derivative product or derivative(s): A financial contract whose value depends on a risk factor, such as the price of a bond, commodity, currency, share, etc. a yield or rate of interest an index of prices or yields weather data, such as inches of rainfall or heating-degree-days, insurance data, such as claims paid for a disastrous earthquake or flood, etc.

In short, a derivative is a financial instrument whose value is derived from something else. A stock option is a derivative. It is not the stock itself. The value of the option is dependent on (derived from) the value of the stock. Wheat futures used by farmers to hedge their operations are derivatives. Exchange Traded Funds (ETFs), which have only recently come in to existence, are derivatives. When you buy a Spyder, which is a stock listed on the AMEX and is basically an S&P 500 index fund, you are buying a derivative.

You can now buy as an ETF almost any country stock index immediately, rather than waiting to the close of the day to buy an international mutual fund. (Can we say arbitrage potential, boys and girls?)

If I want to sell my widgets in Europe, but don't want to take the currency risk of taking euros in 6 months, I can do a swap with a counter-party in Europe who wants euros and not dollars. Typically, some intermediary (like an investment bank) will facilitate the transaction for a small fee, guaranteeing payment in full.

If you buy a government TIPs bonds to hedge out inflation risk, you are buying a derivative. If you hedge out your weather or earthquake risk, somewhere there is a derivative.

One of the books which I highly recommend is Against The Gods by Peter Bernstein. This exceptionally well written book tells the fascinating story of how risk has been dealt with through the centuries.

The growth and wealth of nations and commerce has always and everywhere been accompanied by an increase in the ability of businessmen to control risk. When men are able to control their risk, they are ironically in a greater position to take risk.

It is hard to understand now, but any fourth grade student of math who was shipped back to 10th century Europe would soon be rich. Back then, there was no understanding of something as simple as the odds on the roll of a dice. You could get the same bet on rolls with substantially different potential outcomes. Risk and rewards were determined by fate. The gods themselves determined who would win or lose.

The development of mathematical and analytical tools to predict the odds of certain events was a major factor in the growth of commerce.

For instance, let's say you are a ship merchant. Experience tells you that 1 in every 10 of your ships will not come back. You also know that you could have a period of bad luck where you lose three ships in a row. If you bet 1/3 of your wealth on each ship, you could lose everything if you had a run of bad luck. So you very cautiously invest your capital, wanting to make sure you will be able to stay in business.

But what if you could find a group of men willing to take the risk of your ship returning? You could pay them a fee, and then not worry about losing three ships in a row and being wiped out. Of course, your profits on any one venture might be less, as you are paying for insurance. But now you can confidently invest more in shipping, knowing that even if three ships in a row do not come back, you will still be in business. Your overall profits increase, and the entire economy is better off.

That is exactly what happened in London. Edward Lloyd, who opened a coffeehouse in London in 1687, began to compile data on risk, shipping, ports and the conditions abroad, which was used by investors to assess risk, buy ships, organize trade, etc. Of course, it became Lloyd's of London. It was at the vortex of an explosion of shipping and prosperity, and it grew because of an early form of derivatives.

Without derivatives, insurance and risk management, it is impossible to imagine a modern commercial society. These are crucial to our economic health. The wheels of commerce and investment would grind to a very slow pace if businesses and individuals could not control risk or take risk.

Every one of a variety of Spyders, Webs, Oats, Cubs (created by Bear Stearns), Steers (created by Merrill Lynch), Suns, strips, options, futures, swaps, CMOs, CBOs, and a hundred other acronyms for a contract which trades risk between two parties are fundamentally necessary in our economic world.

Could we live without them? Of course, but then we can live without a lot of things. But most people would be surprised at how much the very food we eat, the clothes we wear and the goods we use depend upon derivatives.

All of these types of derivative transaction are growing by leaps and bounds. But the real growth explosion is in credit risk derivatives. If you are a bank or a creditor, you can now buy credit insurance on the loans you have made. That can be a good thing, as banks lose less money and thus are more solvent after a recession than normal. But........,

And now, after my breathless ode to the glories of derivatives, we come to the dark side.

The problem with derivatives is that while one party is hedging his risk, another party is taking a risk. Sometimes, as in the instance of two groups swapping currency risk, this is benign. At other times, if one party underestimates the nature of the risk, there can be significant losses involved. Much of the losses of various insurance firms and investment banks in recent months have been on the sale of insurance risks on loans. Insurance companies and others have sold such insurance, using models that they now find didn't adequately address the risk.

Let's look at two spectacular instances of problems caused by derivatives.

Roger Lowenstein wrote a great book called When Genius Failed about the collapse of Long Term Capital Management. LTCM was run by the smartest and brightest of financial minds: two Nobel winners and a host of similar worthies. They specialized in "convergence" trading on bonds, and clocked along making huge sums. They thought they were diversified by investing in the debt of many countries. In fact, they were making the same bet everywhere, and country diversification did not help when the Russian debt default threw the world into crisis. They were leveraged as much as 80 to 1, and even small movements were disasters for them. Once wind of their predicament hit the street, funds and traders on the other side of the trade lined up to take advantage.

LTCM used derivatives to build up such a leveraged portfolio. They would let no one look at their books. If an investment bank wanted to see their total portfolio as a condition of doing business, they said no. Since they were generating huge fees for these banks, everyone assumed these smart people knew what they were doing and continued to do business.

While each investment bank knew the exposure they had to LTCM, no one had the total picture, which was staggering. No bank would have done business with LTCM if they knew the true picture. The situation did indeed threaten to collapse the world financial markets.

In the end, the New York US Federal Reserve Bank President had to call the chairmen of the banks which had exposure to LTCM and say, in effect, "Be in my office tomorrow morning. Don't send your subordinates. Bring your checkbook." Disaster was averted, but the various banks took some huge hits. There were a lot of very unhappy bankers. Contrary to some reports, no tax dollars were used.

This pain brought about a new fetish for transparency from their clients upon the part of banks. Investment banks now want to know what the total exposure of a client is, and will walk away from business if they cannot get it. It also helped spark an increase in credit insurance, as more and more groups wanted to hedge their exposure.

A second spectacular failure was Barings Bank. Here the stories would have you believe a hundred year plus old bank was brought down by a "rogue trader" named Nick Leeson. Leeson bet on yen futures, and wiped out the total capital of one of the largest banks in the world. ING came in, bought up the pieces, and the shareholders were wiped out.

It is my contention that Barings was brought down by management failure, and not by Leeson. They simply did not have proper risk controls and they and their shareholders paid the price. Other banks have taken note, and now more risk controls are in place.

And thus, my view on the topic is a derivative from the old mantra of the gun control debate: "Guns don't kill people. People kill people."

Therefore, we come to, "Derivatives don't cause financial disasters. People (bad risk managers) do."

In every case of problems stemming from derivatives, someone lost money. But that is the free market. No one would think of getting rid of cars or planes because people die in them. Everyone works to make them safer.

Getting rid of derivatives is not an option. While some call for more government oversight, that is not going to be much help. The real control on derivative problems is the threat of loss. The example of LTMC and Barings woke up a lot of people.

Every time a hedge fund blows up, or a company goes bankrupt, investors start to try and avoid those types of risk. The reality today is that many hedge funds provide a lot more transparency than do mutual funds. You don't know what your mutual fund is investing in today, or what risks they are taking. You only see their portfolios twice a year, and then long after the fact. You are making an assumption that the management of those funds have risk management controls, to keep a "rogue manager" from investing in ways other than they agreed to in their prospectus.

For many hedge funds, clients demand to see their portfolios on a regular, real-time basis. Investment banks, who have derivative exposure to them, know where their money is. They do this because they have been burned before. The pain of loss is a wonderful stimulant for risk controls.

Could we have another situation like the LTCM debacle? Probably not. We know about that one, and everyone is looking for it. Could we have a problem that is equal in size and proportion, but different in nature? Absolutely. I can almost guarantee it. (In fact, if you want to hedge against such a risk, I have a derivative for you.)

LTCM, left to itself, would have been a global disaster. It came close to being a financial market meltdown. Each of the various investment banks were fighting and jockeying to save themselves at the expense of the others. It took the playground monitor (The New York Fed) to get everyone together and point out that it was in everyone's best interest to "play nice."

The point is that even in the face of one of the greatest potential financial disaster in the last century, the markets and the system worked. Most problems will be solved by one or more parties going under. That is sad for them and for their shareholders, but it is the nature of the beast. Some will be solved by some authority stepping in to force a solution. Even then, there are winners and losers. But that is the price one pays when you enter the game of market risk. Without that element of risk, a free market economy is not possible.

I find it ironic that some of the most vocal proponents of the free market are those who most want to see the "derivatives problem" brought under government control. The current explosion of credit derivatives has already caused a great deal of loss for some groups, and will undoubtedly cause more. Did the availability of credit derivatives encourage some of the last credit bubbles? Absolutely.

Did it create an imbalance? Will it create losses? Of course. But the reality is those losses are good. (Unless of course, they are yours.) Those losses are the best "insurance" that the buying and selling of credit derivatives will be more rational in the future. I am sure some of the first few intrepid investors who sold shipping insurance made mistakes. They went bankrupt, and others noted their mistakes. That process made, and will continue to make, the world a better place.

If Morgan or Goldman Sachs, or whatever bank is the problem bank du jour, has too much of the wrong kind of derivative exposure (gold is the current theme), they will lose money or go bankrupt. If they managers of a company allow it to take more risk than their capital should allow, they deserve to go belly up.

Long time readers know I worry about lot of things. The risk of various blow-ups caused by derivatives is real, but I think the results will be the same as past blow-ups. The world markets absorb the shock and keep on going. The real economic and financial problems in this world, which do worry me, are not the ones represented by derivatives, but by major macro-economic and demographic forces like deflation, trade deficits, retirement, bear markets, etc.

In fact, it is the very nature of the risks that these forces present that become the driving force for the growth of derivatives, hedge funds and other risk adjusted investments, as businessmen and investors seek for ways to lessen the risk of market exposure. Rational men always and everywhere seek to minimize risk. History shows that while there are those who do not do a good job of analyzing risk, the large majority of business does a pretty god job. The free market works, and that is why the world is richer at the beginning of this century than at the last. That is why, in spite of all the problems I continually write about, that I fundamentally believe the world will be a better place 100 years from now for the average man. The free market is a flawed system, full of creative destruction, but better than any alternative.

I would argue that it is the proper use of financial derivatives that will help businessmen and investors find safer, less risky investment returns. Just like those early sea captains, the ability to control risk will make for more wealth for us all. Yes, there will be losses, but hopefully for the benefit of their shareholders, those who are taking the risk have calculated the cost.

John Mauldin

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