Tiny Bubbles?

This week I want to welcome 500 or so new readers, many at the suggestion of my old friend and sushi partner, Tony Sagami. Lately we have been getting a lot of referrals from readers and other investment writers, and I am grateful for the growth. I do spend a lot of time researching and writing this letter. It is nice to have someone recommend my writing to a friend or colleague.

And to all readers, as the letter is free, if you find it of value, please feel free to recommend it to a friend. Simply send us an email and we will add them to our list.

Hedge Funds 100, Market Timers 0

What a difference a week makes! Last week I was in Denver at a convention of professional market timers and asset allocators. This week I was in New York speaking at a hedge fund conference. There was such a stark contrast between the two groups. The first group had very few smiles. In a period where market timers should be shining, there were few clear winners. The huge majority of market timers have been hurting, and some have simply been crushed.

At the hedge fund conference, there were lots of smiles. Of course, there were a few problem kids, but most of the hedge fund managers I talked with were experiencing banner years - the kind of years that make your reputation.

I interviewed a few hedge fund managers for a project I am doing for some clients. One convertible arbitrage manager practically apologized for his good numbers. Last year they did almost double their targets, which is around 15%. By the way, they post positive monthly numbers 90% of the time. (Convertible arbitrage is a class of hedge funds which deal primarily with convertible bonds. They use certain hedges and techniques to try to tame the volatility of these bonds and extract steadier earnings.)

I interviewed another technology hedge fund. Their style is called long-short. That means they will be long some stocks and short others. Today, they are about 5% net long. Last year was their best year ever. They were up over 100% with no losing months, and are having a great year so far.

The difference? Many classical hedge funds use some type of strategy to control risk and benefit from volatility. Most market timers use some type of technical program or pattern recognition system to predict the direction of the market and do not have risk controls beyond stop loss exit triggers, if they have those. Volatile markets are the bane of most market timers.

The problem is that for the last few months especially, investors have not been behaving as they have in the past. It makes life difficult for timers. More below.

Interestingly, most of the hedge fund managers I talked with this week do not believe the economy is in a recovery mode, and they expect things to get worse. More on that below.

This week has underscored my belief that smaller investors should be allowed access to hedge funds. Small investors are considered smart enough to be allowed to day trade, use margins, invest in wild and woolly mutual funds which can lose 70-80%, buy options and futures on huge leverage. But small investors are not considered smart enough to be able to evaluate hedge funds and are thus precluded from investing in some hedge funds which are to me, at least, considerably less risky than Janus 20 or other technology funds..

As I wrote last week, I will be doing a monthly e-letter on hedge funds and private placements. If you are an accredited investor (that means you have a net worth of over $1,000,000, including home and real estate), you should email me and get on that list.

Is Son of Bubble Busting?

There is so much information this week, I am having trouble digesting it in only two days. Last week, I took the position that the increase in the money supply is showing up in the stock market creating another potential bubble. Investors can fight the Fed and be short or fight history and be long. So far Alan Greenspan's Magic Recovery Elixir of more and cheaper money is winning the fight. But history is a mighty big opponent.

As if on cue, Ed Yardeni sent me his letter, written about the same time, that he too thinks that we could be seeing a bubble brought on by the Fed's dramatic increases in the money supply. I love it when someone agrees with me. By the way, a number of hedge fund managers I met with this week either independently think that way, or agreed with my analysis. Yardeni points out that we are only 5% away from the stock market being as over-valued as we were in 1987 prior to the crash. Of course, we went way beyond that in early 2000, but I doubt we will ever see in our lifetimes a repeat of that magnitude of gross over-valuation.

Apparently, many investors believe the worst is over, and recovery is around the corner. Otherwise, why would Cypress Semiconductor point out that order cancellations basically equaled new orders in the first quarter and yet their stock rises 40% in April? Amazing.

Manufacturing profits are slowing down. The US commerce Department just released figures showing corporate profits in the fourth quarter of last year. Dr. Kurt Richebacher writes: "Worst hit, though, is manufacturing, with fourth quarter profits down from $192.1 billion to $152.4 billion. At this level, U.S. manufacturing has been earning substantially less than the $166.1 billion in 1995. Listening to proliferating CEO warnings about revenues and profits, it's clear that the worst has hardly started.

"And how did the economists, analysts and markets respond to these dreadful profit figures? In brief, they attracted zero attention. Considering that just two days earlier Wall Street had soared in reaction to the news of an eight-point rise in the Conference Board's consumer confidence index, to 117, one can only wonder about the intelligence and integrity of those who are supposed to carefully analyze and comment on economic developments."

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Profits will not be better in the first two quarters of this year. It is interesting to read the many analysts who six months ago predicted a recovery in the third quarter of this year are now starting to tell us the recovery will now begin in the 4th quarter. Wait until this summer. They will be telling us that the recovery is right around the corner in the beginning of 2002.

Maybe we will see recovery late this year, but we still have problems to work through first.

There are some statistics that I think are important, and I watch them closely. We need to see capacity utilization increase. Capacity utilization is the percentage of products that we actually manufacture of what it is possible for us to make. Right now, we are at 77%, which is the lowest since August 1980. The utilization rate in the chemical sector was 73.8% in April, the lowest since February 1983. It is even worse in many overseas countries. That means we can make a lot more goods than we can sell.

The orders to US factories for durable goods plunged by 5% in April. I doubt that will increase capacity utilization in the coming months.

If we have too much spare capacity to make products, competition will make it hard to raise prices. That is one reason why Greenspan can raise the money supply so much and not get serious inflation. If this were 1984, and Greenspan was growing the money supply at the current levels, we would be back to 15% inflation and $800 gold in a heartbeat. Today, we shrug it off. It is difficult to see how we could get an improvement in the overall profit picture until we see capacity utilization increase.

A reader sent me a very excellent report from Stocks at the Bottom. (Thanks, Steve) Let me run through a few notes. By the way, these guys end up by saying they are optimistic.

We have seen the first quarterly drop in business investment since 1992 last year and another drop last quarter.

The economy lost another 223,000 jobs in April. Unemployment is at 4.5% and rising. GDP The original estimate of 1.98% GDP growth has been lowered today to 1.3%. My bet is that it will be lowered again until it gets closer to the anemic 1% of the fourth quarter, down from 8.25% in the 4th quarter of 1999. I hope I wrote for the record that I didn't believe that first number when it came out, because I didn't.

I can tell from some of the articles you send me that I have a few conspiracy theory advocates among my readers. Let me give you a thought. Why did the government miss the GDP number by so much on the upside? Did they want to keep from tanking the stock market when it was vulnerable a few months ago? Are we being fed artificially high and false numbers to keep up consumer and investor confidence? Naah, not from the Bush administration. They just made an honest mistake.

Over the last ten years, consumers have gone from saving 8-9% to saving a -1%. This last quarter they have been taking from savings or going into debt to keep up expenditures. Today we are seeing a profit recession. If consumers slow up to start saving and paying down debt, we will see a real recession.

The trade deficit is soaring to record levels as our national exports are falling. Fortress Europe, we read this week, is starting to show signs of slowing down. In fact, the entire world, with a few exceptions, seems to be winding down. This is worrisome, as we need them to buy our goods and services.

The dollar is amazingly strong. As you know, I am not one of those who think the dollar is going into the tank in the near future. But I am amazed at how strong it is. A strong dollar makes our products cost more to foreign buyers, hurts our profits and is hard on US companies as they must compete with foreign companies with cheaper products and costs, in terms of dollars. I have written a lot on how many countries are devaluing their currencies so they can sell more to the US, and better compete with our companies.. I will not repeat that argument again, but this has been going on for a long time.

Dr. Hans Sennholz writes a very good essay on the euro for the Mises Institute at http://www.mises.org/fullstory.asp?control=686 .

In summary, he says the current strength of the dollar verses the euro is being aided by a curious event in Europe. At the beginning of next year, all those who hold European currencies will need to exchange them for newly minted euros in just two months. The current cash currency will become worthless after march1, 2002. The only way to get a physical euro is to go to an official bank. Banks have been deputized to inform the governments of any suspiciously large cash transaction. They are trying to find people who have been using cash to avoid taxes. The underground economy is huge in Europe, and these countries are trying to find the "tax-cheaters". The Italians must be really nervous, as tax cheating there is a national sport.

As a way to avoid getting caught, people are converting their marks, francs, liras or pesos into dollars today trying to avoid showing how much they have. "This is a huge market. The black-market economy of the euro-zone has been estimated at some 16 percent of official gross domestic product (GDP). As it cannot use the banking system and is forced to use cash only, its stock of cash is bound to be way above the 16 percent of illegal GDP. If we assume it to be only 25 percent, with some 256 billion euros of bank notes presently in circulation (European Central Bank, Monthly Bulletin, April 2001), some 64 billion euros are serving the black market. A flight into dollars of such amounts alone would depress the euro."

That may be small compared to what is outside of Europe. I remember traveling in Africa and going to exchange currencies in the local markets. (There are very few African countries where you would use the local banks, as the official exchange rates were basically government sponsored theft.) The local "mamas" would sit on the sidewalk and take your dollars, marks, francs or whatever. There are huge hordes of European cash in Africa and Eastern Europe. All that cash will have to be converted or it will become worthless. The locals will not be able to go into a bank and do the conversion, as they wold be subject to tax, bad conversion rates and worse.

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You watch. There will be a black market in dollars develop later this year. You will see it on TV and read about it in the papers. Cash European currencies will trade at a significant discount to the dollar.

Want to have a great cheap vacation? Plan to go to Europe late this year or early next. Take LOTS of cash dollars or travelers checks. Then buy the old German marks or French francs at a discount with your dollars, pay for your hotel and food, etc. with them before March 1, 2002.

I bet the discount for cash dollars gets to 15-20% this winter. The black market will want to stay black and underground.

Housing Drops

Today, we find that housing sales are dropping. Existing home sales are down 4.2% in April and new home sales are down a big 9.5%. I think that is because mortgage rates are going up, but slowdowns of this magnitude in such an important sector are definitely not good for the economy.

Kevin Klombies reports that "...an IMRA subscriber emailed us yesterday from Austin, Texas. He commented anecdotally that it appeared that those people involved in the initial stages of construction projects in Austin were finding work difficult to come by while those involved in the finishing end were still swamped. Monetary policy might work with a lag but so do the forces that lead into a recession, it appears."

Excellent point, Kevin. That last sentence is the crux of the problem.

For the new readers, let me briefly repeat a theme of mine. The negative yield curve has preceded and predicted every recession for the last 40 years. Analysis by Federal Reserve economists suggest the recession should not start until the third quarter of this year. If we are in a recession now, it would be historically early.

Yet most mainstream economists predict a recovery in the 3rd quarter or the 4th quarter at then latest. They are betting the magic of serious rate cuts and increased money supply will spur things on.

If we are going to avoid a recession we need to start seeing unemployment and housing pick back up, capacity utilization increase, exports increase, etc. As these areas get worse, it will continue to affect corporate profits and force more lay-offs and curtail capital spending. That is how recessions begin. It is like getting nibbled to death by ducks. They are slow and painful. And as a reminder, the stock market drops an average 43% during recessions.

Will Greenspan keep the money supply going up? Will it keep the stock market propped up and trading in a sideways manner until the economy eventually recovers?

That is the game Greenspan is playing. He will keep goosing the stock market with more money in an effort to keep consumer confidence and the wealth effect from collapsing until the economy is back on a growth cycle.

I hope he does it. If he does, it will be the first time in history anyone ever has.


Long term rates have lately been going up, not down. For those of us who hold bonds, this is annoying, especially for the instant gratification crowd. But for those who believe we are headed for recession, I think it is a great time to invest in long term government bonds. If we do have a recession, long term rates are going much lower.

I will write more on bonds soon, I promise. But the above economic data tells me we are closer to going into a recession than coming out of a slowdown. That is a good time for bonds.

No travel this week! I am glad to be at home and enjoy the family. I know a lot of you will be going to see the new movie Pearl Harbor. On Memorial Day, it is good to remember those who paid the price so we can live and invest in a free country. Let me thank those who are veterans among my readers.

I would suggest, though, that you take your kids or borrow someone's and go see "Shrek", the cartoon movie that makes fun of every fairy tale we grew up with. I cannot remember when I have laughed as much. It can be a little rude, as it seems no one refrain from some bathroom humor these days, but it IS funny.

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Next week, I will be in Washington, DC to speak at yet another conference. It seems they come in bunches. I will be glad to meet with clients or prospective clients, if you are interested. (For new readers, I am a Registered Investment Advisor, though lately I seem to spend a lot of time writing and speaking.)

Your still waiting for the recovery advisor,

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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