TFTF

The Muddle Through Economy

January 25, 2002

The task I face every week as I begin this column is to interpret the tea leaves so we can get some glimpse into the future of the economy, and thereby get an idea of how to invest our hard-earned money. In theory, the direction of the economy (both local and global) will have a direct influence on stocks, bonds and other investments.

The tea leaves I read are the hundreds of pages of data, stories, articles and reports I sort through each week, letting them swirl around in my mind and seeing what settles out. This week I am going to focus on what I see as a growing disconnect between consumer and investor expectations on the one hand and the historical ability of the economy (and the markets) to actually meet those expectations. Let's look at half a dozen key facts and then see what conclusions we can draw.

For new readers (and there are many of you as the letter is growing because loyal readers keep forwarding it to friends and they subscribe!), let me quickly go over a few broad themes.

I believe we are in the year of the Muddle-Through Economy. No big drop off the cliffs but no rocket rides to recovery either. Deflation and over-capacity will hold down corporate profits and thus capital spending and income growth will be smaller than normal in a recovery. We are in one of the strangest recessions in history, and the recovery phase will be no less odd. Let's go to the data.

Greenspan Puts on the Brakes?

Everyone (including me) has been writing about the extremely high growth rate of the money supply being pumped into the economy by Greenspan and Company. But good buddy and fav analyst Greg Weldon has noted a potentially disturbing new trend. Greenspan may be slowing the rate of growth in the money supply. I quote Greg at length because this is important.

"More evidence of tightening liquidity can be found within last night's US Money Supply data released by the Fed. We have spotlighted this dynamic before, and will again today, as the longer-term rate-of-change indicators still exhibit expansive growth rate. . . BUT . . . the near-term readings have signaled a significant shift. Last night's data continues that 'trend-change' ---

M-3 expanded $27.1 bln in the week . . . while M-1 fell by $6.7 bln. Two-week Daily Average Free Reserves . . . down $300 million from the previous two-week period. Excess Reserves Daily Average . . . down nearly $400 million Monetary Base . . .down $3.1 billion Currency in Circulation . . . down $779 million 3-Month ROC (Rate Of Change) of M-1 . . . minus-7.7%, steepening the contraction versus last week's minus-7.4% rate.

--- M-3 ROC's as follows. . .

3-Month ROC at 10%, down from 12.0% (last week) 6-Month ROC at 10.4%, down from 11.6% 12-Month ROC at 12.8%, down from 13.5%

"The addict needs a CONSTANT mainline stream . . . NOT a supplier that cuts off the source, just when the feeling gets good. The global-eco-addict will eventually go through withdrawal, as liquidity continues to tighten."

To me, this is something new. Numerous observers, including yours truly, believe that the current Son of Bubble in the stock market is the result of large Fed increases in the money supply. The new money has certainly not resulted in inflation, which would be the normal case.

When Greenspan increased the money supply dramatically in late 1998 because of the Asian crisis and in 2000 because of Y2K, it went directly into the stock market. When he slowed the growth of the money supply in early 2000, the stock market tanked a few months later.

Now, money growth is still high. As of yet, the current policy certainly could not be called tight. It may be that Greenspan is deciding to simply slow the rate of money growth to merely aggressive from the outrageous levels it has been.

This new trend bears close watching. If this slower growth continues, it does not bode well for the stock market. I think it could also translate into further deflation. This could cause (finally) long term rates to drop, something which Greenspan truly wants.

The $600 Billion Gorilla

A drug addict is often said to have "a monkey on his back". The US economy may have a gorilla on its back. Are we strong enough to carry around a little more weight, or will we collapse?

What I am referring to is a recent study by Morgan Stanley that the "America's current-account deficit should hit 6.2% of nominal GDP in the second half of 2003, in excess of $660 billion. In dollar terms, this would break all global records. It does the same in percentage terms for the modern-day US economy." That means we will be buying about $600 billion more from the world than we sell.

In 1987, the last record year, the percentage was 3.4%. Back then, we needed about $160 billion to finance our deficits. The rest of the world did not give us the required money, and the dollar dropped 50% in about 2 years.

Today, with our record deficits, the rest of the world finances our excess buying binge by using dollars to invest in US companies, buying our stocks and bonds and buying products and services from the US. The dollar has become the de facto store of value for the world. Nowhere is this more starkly illustrated than in the year-end letter from Blanchard and Company. Blanchard was started decades ago by Jim Blanchard, and was one of the premier gold bullion dealers. Jim was a good friend and business associate, and I miss him as he is now walking streets of gold rather than selling them.

But Bill Bonner tells me that his old company wrote the following: "Effective as of January 1, 2002, Blanchard and Company is changing its business practices and policies in order to limit its exposure to falling gold prices, and recommends to its clients that they do the same. As of that date Blanchard will not maintain inventories of gold bullion or gold bullion products, nor will it market gold to, or solicit gold sales to, Blanchard clients.

"Gold is no longer a hedge against inflation, devaluation of the dollar or falling stock prices," continues the mailing from Jim's old company. "It is no longer a store of value. The very idea of gold's intrinsic value - value that is not dependent upon the actions or promises of any government - is publicly questioned by senior central bankers, and by the heads of major financial institutions."

The irony is huge. Jim fervently believed in a gold standard, and now his namesake company no longer believes gold is a store of value. ("Say it ain't so, Joe" comes to mind.)

But that is typical of companies and central banks around the world. That is why gold does not rise even as the money supply does. Central bankers simply do not want the barbarous relic and look to sell any time they can get a good price. In my mind, it is not a conspiracy as such, although many of my readers have sent me reams of material from GATA attempting to show it is.

I think it is simply that central bankers agree with Blanchard and Company. They do not think gold is a store of value and so look to sell. This selling pressure has kept gold down for years.

Now, stay with me, because I am going to write something that is long-term bullish for gold for the first time in years and years - maybe a decade or longer. I turned bearish on gold as an investment in the mid-80's and have been so ever since.

Gold May Be Ready to Rise (Finally)

I once visited Maputo, Mozambique on my way to Luanda, Angola (l-o-n-g story). Having a day layover, I went into town into the local market, just to look around. An unusual experience happened to me. I looked around and noticed that I was about a head taller than everyone else. I am only 6', so I am average in a crowd in the US.

But the local population was much shorter on average. I felt tall for the first time in my life. It must be what my 6'10" friend Greg Weldon feels like.

In the Land of Pygmies

I have frequently written about the rest of the world trying to lower their currencies against the dollar in order to make their products attractive to US businesses and consumers.

This week, the Bank of Japan executive director bluntly (for a central banker) stated that China should stop griping about the weakening yen because the Chinese currency is too weak and needs to be stronger. New studies surfaced this week which show Asian growth slowing dramatically as a result of the weaker yen.

This will set off a new round of currency wars as each country tries to lower their currency against the dollar. Remember me quoting even the Swiss central banker complaining about how strong the Swiss franc was?

The dollar is once again gaining strength against the Euro, and this is the main force pushing gold once again down to the $260 level. Dollar strength is gold weakness. Until the dollar drops, gold is going nowhere except the trading range it has been in for years.

There are two major problems over the horizon. The first is that not everyone can have the lowest currency against the dollar. This current round of "beggar thy neighbor" has to end sometime. It won't be next week or next month or next quarter, but eventually it will have to stop.

Countries are going to have to figure out how to compete on even terms rather than trying to simply lower exchange rates. Until that happens, we will not see sustained world growth of anything like recent periods. Destroying your currency is not a sound model for real growth.

If Japan wants to sell us a $10,000 Lexus or Korea a $5,000 Kia (as an extreme example), then Americans will buy them. But what can Korea buy for $5,000 if everything from the US costs so much to them? Why will they want dollars if there is nothing cheap in the US in terms of their buying power? It seems to me the current trend is unsustainable over the long term.

That brings up the second problem of the trade deficit. At $600 billion, we will need almost $2 billion a day to sustain our buying binge. As Stanley Roach points out, "We tend to treat this as America's problem, symptomatic of a nation that has long lived beyond its means. While that point is well taken, there's an even deeper issue at the core of this problem. America's gaping current-account deficit is also symptomatic of an increasingly unbalanced world that has become hooked on the US growth engine as a key source of economic vitality. And that's the real point of tension that I believe is likely to be critical to the global economy in the years ahead. A resolution of America's current-account problem will not be easy for the rest of the world. The global economy may well have to figure out how to grow on its own."

Morgan Stanley sees the dollar dropping by 20%. That should make gold rise 20% to the $340 level and maybe higher. That may be a few years off, but it is the first time I think we could see a sustained rise in gold in a decade.

In the land of pygmy currencies, the dollar is tall. But is it truly tall like my 6'10" friend Greg? Or does it only seem tall because the local market is so short?

How can we see $600 billion a year come into the US if every currency continues to get weaker and weaker? Where will it come from? Where will it go?

The answer is, of course, that the $600 billion level is simply unsustainable with the dollar as strong as it is. Either the dollar will drop or consumer spending will. Based on current trends, it will be the dollar first. As it falls in value, so will consumer demand.

The business cycles between recession and growth will no longer be one recession every ten years, but every 3-4 years as in the 1966-1982 period. This is a classic formula for a long-term sideways stock market, with lots of gut-wrenching ups and downs.

By the way, many economists are scratching their heads as this recession has not cleared up all the credit, investment, loan, inventory and other imbalances. They shouldn't worry too much. The next one will. Until then, we will muddle through.

Interest rates? You tell me how fast the money supply will grow in that environment and I will predict interest rates. But my current prediction for the first half of this year, with short term rates flat to slightly up and long term rates down, still stands.

I Want Whatever Abby is Smoking

Finally, the Mistress of the Bull Ring, Abby Joseph Cohen, surprised everyone by actually lowering a forecast target. Cohen lowered (I swear I am not making this up) her 2001 profit estimate from $47 to $34 per share for the S&P 500. That is for LAST year.

How in God's green earth can you do that with a straight face? However, since it worked for her, and in the spirit of revising forecasts, I would like to change my 2001 forecast on long term rates to flat instead of down. Now, that should make all of you who invested in long term bonds feel much better.

Yardeni tells us that real 2001 earnings were actually $25 share. Cohen now thinks operating earnings will be $42 in 2002, down from an earlier prediction of $52.

She still thinks the S&P 500 will be at 1300 to 1425 by the end of the year. To get to that number, she assumes that 2003 will be an even bigger growth year, and that investors will factor that into stock prices. In other words, she thinks the S&P 500 will somehow be around a P/E ratio of 33, and that is if her companies meet her optimistic earnings target.

Maybe it will. One year price movements in the stock market are more or less random. But longer term movements are not. I have written at length on the fact that the market always returns to trend. 100% of the time. Without fail. Bank on it.

There are several huge holes in her projections. First, earnings are likely to grow at much less than robust 5% from a low base. (Due to deflation and little pricing power.) Ed Yardeni (chief economist at DeutscheBank) says, "What are the prospects for this decade? A reasonable assumption is that profits will grow 7% per year over this period. However, this might be a bit too optimistic if deflationary pressures intensify as I predict they might. A more realistic assumption is 5% per year. This would also be the annual average return from stocks if the valuation multiple remains unchanged at current levels."

The Enron Factor

Further, we are going to see a revolution in accounting this year, due to the foibles at Enron.

Enron is not the only company to use off the books partnerships to smooth out their earnings curve and manage taxes. You can bet your accounting dollar that we are going to find out about more of these partnerships this year. How will we find out?

Because accounting firms will start to note them on their audits. They will not want to risk becoming the next Arthur Andersen. Congress is likely to reform the accounting trade, divorcing consulting and accounting, making the auditor more independent (which is long overdue).

When these revelations come to light, rather than face tough scrutiny and hard questions from investors, companies are simply going to shut them down or fully disclose them. This will result in more write-offs this year, and closer scrutiny by the IRS into aggressive tax accounting. There will be pressure to close the tax loopholes, especially with the government in deficit. Corporations will be easy tax targets. Increased taxes will lower earnings.

Just as earnings this year for the S&P 500 were adjusted by $20 for "non-recurring items", we will see a similar write-off this year as companies, far more than most analysts project, as companies rush to be able to boast about "full disclosure".

Enron is going to act as a huge re-set button in accounting practices all over the world. Companies are going to use this as an excuse to clean up every problem remaining in their balance sheets.

Plus, you are hearing calls for the SEC to require more disclosure and less use of aggressive pro forma earnings. With independent auditors, there will be less allowing of write-offs on a one-time basis, and thus more pressure on reported earnings.

The combination of a very slow growth economy with tough accounting reforms does not bode well for a significant increase in earnings, let alone the 25% growth projected by Cohen.

This theme is repeated by Stephen Roach.(He has been on a roll for the last few weeks, with some great analysis.) He writes, "The US stock market is also in denial, in my view. How else can you explain the power of the tech-led rally since 21 September? As Steve Galbraith has stressed repeatedly, tech stocks ended 2001 at 50 times forward 2002 earnings -- hitting bubble-like valuation excesses last seen in March 2000. Joe Mezrich notes that this bet has an extremely long tail; his work shows that tech stocks are still priced for five-year earnings growth of about 35% -- an outcome that has never been achieved in recorded history. In my opinion, there's only one way to interpret this bet: Investors truly believe that a replay of the tech-led resurgence in US and global economic growth of the late 1990s is a distinct possibility. The extraordinary shakeout in the technology business has done literally nothing to dispel that deep-seated conviction."

Roach thinks the S&P 500 drops to 900 by the end of this year. I wonder, though, if investors can lose their enthusiasm for stocks in just one year. Past bear markets have taken years to reach bottom. I think it is quite possible for the stock market to mirror the economy: The Muddle-Through Market. Trading around a range for the entire year, as investors are constantly told that a boom recovery is only two quarters away. It will take awhile for the reality to hit that a boom is unlikely. Then we could see a drop, or a continued sideways lurching as the market waits for earnings to catch up with stock prices.

Either way, the ONLY way to invest in this market is value, value, value.

Modern Portfolio Fallacies

On Monday, I speak to the Global Alternative Investment Management conference on the topic: The Fallacy of Modern Portfolio Theory. The speech will be part of a chapter in my next book, Absolute Returns , which will be on why and how to invest in hedge funds. I hope to start posting chapters some time next month, and this will be one of the first.

The conference is in Boca Raton and is over on Wednesday. I still have some free time available to meet with clients and potential clients. Contact my office at 800-829-7273 to arrange a meeting.

I will be writing soon about a new manager I have been following who is an excellent timer of high yield bonds, plus I am exploring ways for you to invest in foreign currencies in a low risk manner in the US. I will report in a few weeks.

I do read all your emails, and try to answer as many as possible. I appreciate you letting me come into your home/office, and do my best to make the time you spend reading worthwhile.

I will try to get onto a golf course while in Florida, and maybe this time I can figure out how to hit them as straight as I talk.

Your seeing too many airports lately analyst,

John Mauldin

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