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Truth in Advertising: The Fed Fails the Test

This week I had the pleasure of talking with Nobel Prize economist Dr. Harry Markowitz. We discuss that conversation, and how it ties in with my continued unease with deflation, Paul McCulley's recent essay, the lack of candor from the Federal Reserve, the implications of the dollar bear market, Iraq and more. It will make for a fast-paced e-letter this week, so let's jump right in.

Markowitz received his Nobel prize for a 1952 essay which marked the beginning of Modern Portfolio Theory. Very simplistically, he said you can reduce the overall volatility of your portfolio by diversifying your investments among a group of non-correlating asset classes. When one asset class (such as stocks) was going down, your diversification into bonds and real estate would help hold the value of your portfolio steady.

He spoke at the Global Alternative Investment Management (GAIM) conference, which is a rather large conference focused primarily on hedge funds. I took away two important insights which I pass on to you. Stay with me, because this will bring us to a very important point.

Last year, I gave the keynote luncheon address, where I argued that Modern Portfolio Theory has been misused by Wall Street to persuade retail investors and large institutions alike to remain in poorly performing assets. The argument that you must always stay invested in stocks because they always go up in the long run is a demonstrably false premise, Jeremy Siegel's best-selling book notwithstanding. It is one of those economic arguments that work fine in theory, but in practice is a prescription for disaster for investors.

The first insight came during his presentation. Markowitz gave a reprise of a speech he gave last year on the 50th anniversary of the publication of his paper. He went through the history of how Modern Portfolio Theory came to be. Buried in the slide on the discussion on non-correlation was the point that in the 1980's the world assumed that there was no correlation between the US and international stock markets. International stock markets were considered a separate asset class and were marketed as such.

Now we know that the correlation between the two stock market classes is quite high. The diversification "protection" an investor got from investing offshore in 1980 has disappeared, as world markets have all tanked at the same time in the past few years. Markowitz's point was that if you attempt to diversify, it is important that the markets you diversify into don't actually move together.

That was what caused the spectacular failure of Long Term Capital in 1998. That fund, led by Nobel prize economists, profited for years by making a highly leveraged bet that the interest rates on bonds would converge. In 99 out of 100 years, that is the case. They believed they were diversified because they held bonds in scores of different nations. Their theory was that even if the 100 year flood happened in Norway, if you only had a small amount of your capital in Norway, you were protected.

What they discovered too late was that in times of stress the world had become so connected that there was no benefit to diversifying among countries. They went down in flames, drowning in the flood in Norway and the rest of the world.

Markowitz, in his work, allowed for correlations to change over time. When Wall Street uses the theory it does not. Wall Street does not want to be involved in "market timing." They simply say use such and such a fixed correlation portfolio, and over time things will even out. They wait for their correlation studies to become fatally flawed, and then change them after the fact. By then customers have lost their shirts.

It's all About Assumptions

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The second insight comes from a private conversation I had with Dr. Markowitz in the lobby of the PGA National Resort. There was more than one eye raised in the lobby as this very charming elder statesman and educator, deprived of his chalkboard, enthusiastically began to draw graphs in the air to illustrate his answers. He was kind enough to draw the graphs backwards, so that they could be "viewed" correctly from my position. (I must admit to not following the differential equations he jotted in the air.) I would have loved to have sat in his class in college.

I then asked a question about his views on how Wall Street has used his theory. He replied that he thought they had done a reasonable job for helping institutions diversify. I brought up the point that Wall Street had used his work to justify buy and hold policies which were not helping small investors.

"Aahh," he replied, "It all depends upon what assumptions about future returns that you use."

And therein lies the rub. Wall Street and mutual funds use various studies to show rather large returns for the stock market. Stay fully invested and you can eventually grow rich. Many pension funds assume 9% to 10% returns on their total investment portfolios. Since 30% or more of their funds are in bonds, this means they assume they will be getting at least 12% or more each year from stocks.

Lies, Damned Lies and Statistics

As the saying go, there are lies, damned lies and statistics. Using past performance as a guide, what your return over the next decade will be all depends upon when you start and when you end your study. Using a 70 year study (such as the flawed Ibbotson study) to predict future returns for is worthless, as none of us will ever invest in an index fund for 70 years. Further, it is misleading to suggest such a statistical relationship for any given ten year future period.

One of the nice things about having 1.5 million readers is that a lot of you send me some very interesting work. John Reiser sends us this note:

"A very interesting thing happens when you start comparing 'apples to apples': Take any two dates for the Dow, 20 or more years apart, from the last 100 years, but they have to have a similar P/E ratio for the Dow, and then look at the annual returns."

His results show numbers that are all over the board, but nothing ever approaches 10%. If you start in 1908 when P/E ratios are 12.5 and then go to 1986 when P/E ratios are 12.38, the returns over that period average about 4.75%. Multi-decade periods within that time, but having the same P/E ratio from start to end of the period, produce a range of returns from 5.5% to 3.29%.

As you look at the data, the overwhelming fact that jumps out is the most important single factor about your future investment returns is the point from which you start. If you start during a period when P/E ratios are dropping (secular bear markets) your return for at least the next decade is going to be flat at best . If you start when P/E ratios are rising, your returns are going to be very good. They can very well be in the 10% plus range for long periods of time.

Sadly, we are now in a period of where P/E ratios are going to go down. This is a process that will take many years to finally complete. That means investors cannot use the investment strategies which worked during the last two decades. You cannot use relative return buy and hold index funds and most stock mutual funds and expect to make progress. You must seek absolute return investments.

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This means your investment portfolios are going to grow slower than most of you would like. The era of 12-15% is over. Done. Gone. To try and grow them faster implies you will be taking more risk. This is not a decade for risk talking. It is a decade for risk avoidance.

It's Worse Than I Thought

A few weeks ago, I quoted a hedge fund study which said: "...their work shows that real (inflation adjusted) S&P earnings have grown on average about 1.8% per year since 1889."

Institutional money manager Rob Arnott wrote me and noted, "This is probably through 2000, a peak year. Through 2002, it's already down to 1.4%. Also, I don't like end-point problems (peak vs. trough comparisons), so I prefer the slope of a best-fit line, which is 1.5% all the way back to 1871 (for dividends, it's 1.1% back to 1802). Not much difference, but over 115-130 years even 0.3% or 0.4% matters. Also, it's 0.3-0.4% out of 1.8%, or a 20% drop in growth."

(Arnott has just been named the editor for the Financial Analysts Journal. Long time readers know I cite his brilliant work regularly. While this a significant and richly deserved honor, I wish he had turned them down and written a book on his studies of the effect of demographics on the economy. My bet is he will bring a little more of a much needed real world view to the Journal.)

The point is that stock investments grow over long periods of time by earnings plus inflation plus dividends. In periods where P/E ratios are dropping, the value that investors put on those earnings (or the price of the stock) will drop as earnings and inflation slowly rise. It is a grinding process which takes years. I invite you to go to and click on Stock Market Return Graphs. The chart shows what type of returns an investor received from any given year going forward for the last 100 years. The numbers in white are periods of dropping P/E ratios. There you can see how long it takes for these periods to work to their eventual end, and how poor stock returns over those decade plus long periods are. (You will need Adobe Acrobat to view the charts.)

How Low Will the Dollar Go?

Now that we have had our statistics class, let's move on to currency class. The Financial Times notes, "Research by Deutsche Bank of the three most recent reversals in the dollar - the dollar's rise after 1980, its fall after 1985 and its resurgence after 1995 - provides a reminder that turns in the dollar have tended to be big and violent.

"On average, the dollar moved by 30% against the German mark in the first year and 12% in the second year. If history repeats itself, this would leave the euro at $1.25 by February 2004." These are not short term affairs. They note that on average, these dollar cycles have averaged 7 years.

Here's the problem: The US has a trade deficit that is $500 billion and rising. That means foreign nations and investors have to lend us $1.5 billion per day. As I have written for the past year, this is now at the point where of being unsustainable.

But as noted a few weeks ago, the dollar has not dropped as much as most people think. Yes, we are down about 20% year over year against the euro, but we are flat or better with many of the currencies of our major trading partners. The Fed tells us that we are only down about 5% on a trade weighted basis, with the large bulk of that being European currencies.

According to Fed calculations, a 10 % trade-weighted fall in the dollar is needed to produce a fall in the current account deficit of 1 per cent of GDP. To bring the US deficit back to a sustainable level of about 3% of GDP from the current 5% of GDP may require a 20% trade-weighted fall. (FT)

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I have written at length about why the dollar is going to go lower. It needs to, for a lot of reasons. This does not alarm me, nor is it some gloom and doom scenario. The dollar dropped 40% from 1985 to 1991, and the country grew and prospered.

The problem I see on the horizon is: lower against what? I continue to ask myself "What If They Gave a Dollar Devaluation Party and No One Came?" This troubles me greatly, as I see irresistible forces coming against immovable objects.

This week Japan has gone into the currency markets to try and weaken the yen in an effort to help their exports. They have explicitly targeted a currency anywhere from 130 to 160, depending upon which politician you listen to. (It is at 118 today.)

The unemployment rate in Japan is 5.5% and rising, consumer sales are dropping rapidly. Japan is a country with a huge government deficit, deepening recessions, severe deflation and a government debt that is 140% of GDP. That is almost triple our national debt on a comparative basis. They are going into ever deeper debt. Bond sales, required to fill the widening gap between spending and revenue, will amount to half of the budget for fiscal 2006, the finance ministry said in the report to the ruling Liberal Democratic Party.

Think about that. In just three years, the Japanese government will have to finance their spending by selling bonds equal to 50% of their budget. That would be the US equivalent of a trillion dollar deficit. And even with this huge government created currency, they seemingly cannot create inflation.

This is the third largest economy in the world. While the Japanese consumer has saved and avoided debt, the government has not. How is the yen to drop 20% against the dollar with such a negative economic back-drop and a government with an announced policy of destroying their currency?

Other Asian countries are working hard to keep their currencies competitive with China and Japan. As I survey country after country in the Pacific Rim, I ask myself, will this country let the dollar drop 20% or more if China does not re-value? There are not many candidates.

The euro has already dropped 20%, yet the trade weighted dollar has dropped just 5%. Assuming the Fed is right (work with me here -suspend your skepticism) and that a 3% trade deficit is sustainable, then would a 20% correction mean an additional 60% dollar correction against the euro? Is the euro going to $1.80 as some alarmists project? (Chuck Butler, currency trader at Everbank, is hyperventilating while reading this.)

No, it is not. Let's look at the landscape. First, Europe is on the verge of recession. France and Germany have 10% unemployment. Both are optimistically slated to grow 1% this year. Rising oil prices do significant damage to their economies. A rising euro makes their exports more expensive, and thus hurts their sales and corporate profits. Europe cannot afford to let their currency rise much beyond the $1.20 range without severe political repercussions. This will increase unemployment and push the continent into recession. Politicians hate repercussions.

They simply cannot allow the euro to go down more than, say, another 20% (my guess) without throwing their continent into recession. They will soon be legitimately asking, "Why should we bear the brunt of the drop in the dollar? Why are we suffering when China, Asia and Japan refuse to do so?"

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The answer would be easy if China would allow their currency to float. But there are no indications that is in the cards. At the World Economic Conference in Davos, where the powerful and connected consul (my invitation was apparently lost in the mail), the mood was gloomy, with much concern about China from delegates of emerging countries like Mexico and India, as they see their markets eroding and China getting more and more business they once commanded.

The immovable object is China and the irresistible force is world deflation.

Sidebar problem: Bush paradoxically needs Germany and France to grow economically, as they are major trading partners. A recession in Europe hurts our economy, and makes it harder for us to continue to Muddle Through.

Truth in Advertising: The Fed Fails the Test

Thus we come to the Fed. Art Cashin of CNBC fame once again does the hard work of slogging through Federal Reserve meeting minutes. Quote:

"Okay! I Know You Think I'm Obsessed But Words Do Have Meaning - Or - Look What The Fed Said - At 2:15 the FOMC, as expected, left rates unchanged and issued a kind of blah, neutral statement. But the media began referring to the statement as "reassuring" or "upbeat" or "optimistic". Does anyone read English?

"The FOMC statement was a terse four-paragraph thing. Paragraph 1 said, in one sentence they we're leaving rates unchanged. The last paragraph simply lists those who voted. We offer you the two essential paragraphs for your consideration.

Oil price premiums and other aspects of geo-political risks have reportedly fostered continued restraint on spending and hiring by businesses. However, the Committee believes that as those risks lift, as most analysts expect, the accommodative stance of monetary policy, coupled with ongoing growth in productivity, will provide support to an improving economic climate over time.

In these circumstances, the Committee believes that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals for the foreseeable future.

"You will note that the Fed does not say that they see things weakening nor improving nor stabilizing. They do not report on conditions at all. They say high oil prices and geo-political risks "reportedly" are holding things up. (Translation - we hear this is the problem.) They then say - "that as those risks lift as most analysts expect" (they do not say as we expect). In fact, the whole comment appears anecdotal rather than fact or data based. It also looks like crossed fingers. But, I guess my English is faulty."

That was on Thursday, today he notes that the Fed released the December 10 meeting notes. The news release of the meeting was designed to reassure the public after a 50 basis point cut. It was a lot like the above quotes.

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But the actual minutes of the meeting were quite different. Quoting Art again: "In the 12/10 minutes, the FOMC uses lots of downbeat terminology. ".....economic growth....sluggish....since midsummer."..."Business fixed investment was still in the doldrums and consumer spending had flagged."

"They saw strength in housing market but that was about it. For two-thirds of the minutes, we see paragraphs peppered with phrases like "persisting concerns", "renewed weakness" and the like.

"But as they were ending they focused again and again on the only ray of hope outside of housing. It was "the better tone of the financial markets...." Yes, boys and girls, the Fed, who has repeatedly suggested that it doesn't target or react to the stock market seems to have used the post October rally to decide that risks were balanced."

Their press release does not mention the markets nor refer to any of the rather negative climate they discussed.

I should only note that if I advertised in the same manner as the Federal Reserve, the NASD would pull my license and the SEC would bring me up (justifiably) on misrepresentation charges.

Exactly Where are Those Printing Press Keys?

And that brings us to today's final lesson: We will look at Paul McCulley's thought provoking essay on Federal Reserve policy. McCulley is one of the more thoughtful strategists I read (coupled with a delightful style), and since he sits (along with Bill Gross) on the largest pile of bonds in the world, it is incumbent to pay attention to what he says about interest rates and Fed policy.

Again, this is important for investors to understand. Let me quote from his essay [comments within brackets are mine]: "In 1981, Tom Sargent (a father of the "rational expectations" school of theoretical economic thought) and Neal Wallace wrote a seminal academic article on this question: Some Unpleasant Monetarist Arithmetic, published in the Minneapolis Fed Quarterly Review. I'll never forget when I first read their theoretically powerful, yet easy to read, essay on the nature of the fiscal/monetary policy framework.

I quickly grasped (as a young man without the baggage of a career of public views!) the essence of Sargent and Wallace's work: the 'sustainability' of any monetary/fiscal policy mix comes down to the arithmetic relationships between three variables.

The level for short-term real interest rates maintained by the monetary authority [The Fed]. The real growth rate of the economy. The growth path for the real stock of debt incurred by the fiscal authority {the US government], as determined by real fiscal deficits as a share of real GDP.

[McCulley then explains that essentially there is a contest of wills over who will drive policy. In the years prior to 1981, a government unrestrained by Fed policy had allowed inflation to reach very high levels.]

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"....Recall, the context for Sargent and Wallace's work was 1981, with Paul Volcker running monetary policy, and President Reagan running fiscal policy. The monetary and fiscal authorities were playing a grand game of chicken: who would discipline whom?"

"As secular time unfolded over the 1980s and 1990s, Sargent and Wallace's question was answered: the [Federal Reserve] sustained its secular course of "opportunistic disinflation' and the [US Government] blinked."

McCulley now says that the Fed has done its work, and that Greenspan must give up control in these colorful paragraphs: "...why doesn't Mr. Greenspan - the Maestro, remember? - read [Bernanke's speech], and surrender some of his hegemony in the Beltway to the fiscal authority? Why do fiscal authorities continue to genuflect to Mr. Greenspan, a man who achieved much for his country by grasping power, but who doesn't know how to let go? Why, why, why?

"I don't know. But what I do know is that until the monetary/fiscal policy mix is structurally changed to restore the preeminence of the fiscal authority, monetary policy promises to address deflationary risks, and to reverse deflationary realities, are a frankfurter without onions, smothered with dividend tax-cut brie, chased with a flat chardonnay spritzer, served in a dirty beer cup."

McCulley is a Keynesian. He sees the problem from a different perspective than do I. In essence, if I understand him, he is calling for active Fed and US government intervention to stave off deflation now rather than waiting for deflation to appear at the door. It is a doctrine of pre-emptive war against deflation. That he calls for such action presumes he thinks there is no such serious activity now.

As I wrote a few weeks ago, I also do not see the actions following the recent statements that the Fed had deflation under control. I see a Fed talking the deflation fight, but still seemingly focused ion inflation. (Read yesterday's Fed release: "...goals of price stability") While I agree in theory they should be able to do something, theory not put into practice does not work.

The real question, in my mind, is whether or not it is in the Fed and US government power to unilaterally combat deflation. I am not altogether persuaded that any reasonably limited action will have positive results absent a coordinated world effort to deal with the deflationary pressures that are present in the world today. Without such coordinated effort, we (the Fed and the US) could end up pushing on a string, hoping to stimulate the economy and failing. Our problems are not the same as those of Japan, but the results could be the same if deflation is allowed to get a hold of our economy.

(What I mean by "reasonably limited action" is modest monetary growth, which does not have to reach deep into the yield curve to hold down rates and create money without spooking the bond markets with concerns about deflation. The longer the Fed waits, the more aggressive they will ultimately have to be, in my opinion.)

Without a coordinated world-wide effort on deflation, the Fed and the US government would have to pursue policies of aggressive monetization that in my opinion would bring about the serious risk of a longer stagflation. And this requires the cooperation of China, Europe and Japan, as well as the rest of the world. It is in everyone's interest to cooperate, as a weakening US economy will bring about a serious world recession.

My concern is that I see a Fed that is not candid with its constituents (that would be you and me), and seems to be looking for the path of least resistance. I see no major figure on the world platform aggressively taking China to task for not floating their currency. I see a world not willing to deal with deflation, and one in which an increasingly large and artificially sustained US trade deficit is throwing normal financial market relationships out of kilter.

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And that brings us full circle back to Markowitz. You see, correlations do matter. Unfortunately, they change over time and change differently because of different circumstances. You cannot assume fixed correlations. Given the extraordinary pressures in the world markets, one should not assume that the normal relationships between monetary policy and inflation/deflation will produce a specifically defined and desired result. Perhaps it will, but we have no data set (or experience given our unique circumstances) upon which to base such a prediction.

As McCulley notes, the US government has abdicated policy to Greenspan. Yet we are at a time when monetary policy is having less and less influence precisely because the forces that they control (US money supplies and interest rate) are not the real problems. They are band aids when we need real medicine.

You can read McCulley's essay (and I suggest you do so) at

The All Iraq Economy

This is just one more reason we need to get Iraq behind us so we can get on with other problems. That will happen soon. Next week, I will discuss the US economy, and show why we are still in a Muddle Through world. The problems discussed above are not imminent, but they are on the radar screen. There is time to mitigate the consequences, but someone at senior levels needs to focus on them with the same resolve we are exhibiting in Iraq.

I get letters from readers suggesting that we are going to war with Iraq simply to gain control of Iraqi oil. There is an oil connection, and it is French, German and Russian. The French especially have a stake in the status quo. Read Dan Denning's expose where he shows where the oil interests really lie at It is in the archives under 1/31/03. Scroll down halfway where his work begins.

Texoma Weekend

Thanks for your letters and comments. 99% of my readers write thoughtful and interesting letters, which I enjoy whether or not you agree with me. Just for the record, I read every one of them, although I cannot answer them all any more.

This weekend I take my wife to Lake Texoma for a little R&R. Next Wednesday the doctor gets to cut on my shoulder for a skin cancer. This one has come back, so they are going to get serious with it this time. I am told it will take at least four hours and I will not enjoy the next few days. The good news is that I will get the time to catch up on my reading. It is not life threatening, just life annoying. I hope to be able to write next week, but we will see if I am up to it.

Until next time, remember that you are in control of your life and destiny. It is not the markets or the economy, but what you do and how you live, that is important.

Have a great week,

Your looking forward to a few days just to read analyst,

John Mauldin Thoughts from the Frontline
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