Thoughts from the Frontline

Sadly, I find myself with more than enough time to compose yet another Thoughts from the Frontline in an airport, as a flight booking error has me at JFK for six hours instead of fishing in Maine. Details for those interested or amused at the end. But it does allow me to offer you a peek into a very sobering report on how badly underfunded public pension are. The situation is worse than you think. Then we will close with a eye-opening report on China from the gracious Simon Hunt, who is allowing me to reprint his latest missive in toto. You really want to read this one. And we start with this rumor from Reuters, just in. Read this and weep. It comes from James Pethokoukis.

"...[this economic condition] has been brought about by policies which the majority of economists recommended and even urged governments to pursue. We have indeed at the moment little cause for pride: as a profession we have made a mess of things." —Friedrich August von Hayek, Nobel Speech 2010 1974 Those of us who have taken young children on long road trips to somewhere they wanted to go are familiar with the plaintive question "Are We There Yet?" As a nation and indeed the developed world, it is not unreasonable to be asking "Are We There Yet?" about the road to recovery. The NBER, those self-appointed economists who are the official keepers of the score sheet of recessions and recoveries, have yet to tell us we are out of recession. Yet the economy is growing. Kind of. Today we look at the most recent data on second-quarter US GDPÊ (which came out this morning), and even though it is backward-looking data, we'll see what we can discern that might help us chart the direction of the future. And then, if there is time, I'll highlight what is a very serious and growing problem for our state and local governments. There is a lot to cover and so, with no "but firsts," let's dive in.

The debate over whether we are in for inflation or deflation was alive and well at the Agora Symposium in Vancouver this this week. It seems that not everyone is ready to join the deflation-first, then-inflation camp I am currently resident in. So in this week's letter we look at some of the causes of deflation, the elements of deflation, if you will, and see if they are in ascendancy. For equity investors, this is an important question because, historically, periods of deflation have not been kind to stock markets. Let's come at this week's letter from the side, and see if we can sneak up on some answers. Even on the road (and maybe especially on the road, as I get more free time on airplanes) I keep up with my rather large reading habit. This week, the theme in various publications was the lack of available credit for small businesses, with plenty of anecdotal evidence. This goes along with the surveys by the National Federation of Independent Businesses, which continue to show a difficult credit market. Businesses are being forced to scramble for needed investments, generally having to make do with cash flow and working out of profits. This is an interesting quandary for government policy makers, as 75% of the "rich" that will see the Bush tax cuts go away are small businesses. There was a great graphic (that I now cannot find) showing that all net new jobs of the past two decades have come from small businesses and start-ups. And yet as of now, when structural employment is over 10% (if you count those who were considered to be in the work force just a few months ago), we want to reduce the availability of revenues to the very people we want to be hiring new workers, and who are cash-starved as it is. It is not just that taxes will go from 35% to just under 40%. It is the increase in Medicare taxes coming down the pike, too. We are taking money from private hands, where it has the potential to increase productivity, and putting it into government hands, where it will do nothing for growth of the economy. There is no multiplier for government spending. And tax increases reduce potential GDP by a multiplier of at least 1 and maybe 3, depending on which study you want to cite. I understand that taxes have to go up. I get it. But we would be better off having a discussion of where we want to tax dollars to come from before we risk hurting an economy that will barely be growing at 2% in the 4th quarter, and may be well below that. It is the increase in taxes that has me concerned about a double-dip recession. That being said, the announcement by several prominent Democratic senators that they think we should extend the Bush tax cuts is significant. As I said a few weeks ago, we should not experience a double-dip recession absent policy mistakes. A slow-growth world, yes. But an actual double dip is rare. If Congress were to extend the Bush tax cuts for at least a year, until the presidential commission on taxes is done with its work and THEN have the debate, it would make me far more optimistic. And it would be quite bullish for stocks, I think. Businesses would know how to plan, at least, for a year, and the economy would be given more time to actually recover. I am not ready to channel my inner Larry Kudlow, but from what we see this summer it would make me more optimistic and reduce the chances of a double-dip recession significantly.

I have been writing about The End Game for some time now. And writing a book of the same title. Consequently, I have been thinking a lot about how the credit crisis evolved into the sovereign debt crisis, and how it all ends. Today we explore a few musings I have had of late, while we look at some very interesting research. What will a world look like as a variety of nations have to deal with the end of their Debt Supercycle. We'll jump right in with no "but first's" this week. Part of this week's writing is colored by my next conference. Next week I go to Vancouver to speak at the Agora Investment Symposium. I have a number of very good friends who will be there, both speaking and attending. This is generally a "hard money," gold-bug-type crowd (and a very large conference). Some (but not all) of the speakers believe that all fiat currencies, including the US dollar, will default in one way or another, either outright or through inflation, as mounting debts and out-of-control entitlement obligations force large-scale monetization, leading to high inflation if not hyperinflation. There are a couple of panels and debates that I presume I will be involved in, and I have been meditating on how the panels will go. Bill Bonner, founder of Agora and a book-writing machine, has a steel-trap mind with an ability to turn a phrase that is way beyond that of your humble analyst. The preponderance of the panel members will likely be in the soft-depression camp, and most of us will card-carrying members of the Often Wrong but Seldom in Doubt school of economics and investing (the Latin for which, I am told, is "Saepe mendosus, nunquam dubius.") And yet, I am not quite there with most of that thinking, so the debates will be lively. Understand, I started in the newsletter business back in 1981 or so, working with Dr. Gary North (also known as "Scary Gary"). Gary is an Austrian, and although I took a lot of economics courses at Rice, I had never read anything even remotely close to the Austrian school. I caught up rather quickly, and in the mid-1980s even wrote my own gold-stock newsletter (although I must admit I know next to nothing of the current gold-stock world). I was mostly limited to books, newsletters, and journals for reading material. Then came the mid '90s and the internet, and the world opened up. I became incurably addicted to information and read widely and deeply. At some point the small lens of Austrian thought became difficult to continue to peer through, as I looked for perspectives on the larger world. I now worship at a number of economic altars, in the ongoing effort to understand what is happening in the real world, not just in the world of theory or the world of what we would like to be. So, with that background, let's look at The End Game.

Just how dynamic is the US job market? If I told you we created over 4 million jobs in April, would you believe me? I had a long conversation with Mohamed El-Erian of PIMCO yesterday. He is openly speculating that employment may no longer be just a lagging indicator but may also be predictive. It is an interesting insight, which we will explore as we take a very deep look at US employment. And I answer a few questions about my thought that there is a 60% chance for a recession in 2011, and why there is a 40% chance we won't. What could change those numbers? We explore that and more, while I suffer from the injustice that LeBron will play with Wade and Bosh. Where's a nonproliferation treaty when you need it? First a quick commercial note. I want to let Conversations subscribers know that we will post on Monday a Conversation I recently did with Rick Rule and Marin Katusa. Rick is a decades-long friend and maybe the smartest and most successful resource investor I know of. Katusa writes a resource letter for Casey Research and is wicked smart on energy. This is a very good piece that you don't want to miss, as Katusa identifies what he thinks are some of the really great new energy plays. A month or so ago we also posted a Conversation with two noted hedge-fund managers, Kyle Bass of Hayman Advisors (and his staff) here in Dallas and Hugh Hendry of the Eclectica Fund in London. Our discussion centered on what we all think has the potential to be the next Greece, but on a far more serious level (that would be Japan). That garnered a lot of positive response. Herb wrote, "Wow. What a great discussion. What smart guests, how little BS. Congratulations. It's the best of your Conversations that I've listened to." And ACK wrote: "Wow!! Just the most important discussion I have been treated to as an investor and fund manager this year or last. Your product is dreadfully underpriced, as it delivers more value and education than almost any other subscription that I have... Thanks so much... This particular conversation was just mind-blowing!" Actually, we get that last comment almost every issue, as we somehow seem to connect the dots for different listeners. When we started, I promised to do 6-8 a year, and we have already posted 6 timely Conversations in the first 6 months of this year, including my special Biotech Series as well as the Geopolitical Series with George Friedman. For new readers, Conversations with John Mauldin is my one subscription service. While this letter will always be free, we have created a way for you to "listen in" on my conversations (or read the transcripts) with some of my friends, many of whom you will recognize and some whom you will want to know after you hear our conversations. Basically, I call one or two friends every now and then, and just as we do at dinner or at meetings, we talk about the issues of the day, back and forth, with give and take and friendly debate. I think you will find it enlightening and thought-provoking and a real contribution to your education as an investor.

There's a reason economics is called the dismal science, and weeks like this just give it further meaning. In economics, there is what you see and what you don't. This week we are going to examine the headline data we all see and then take a look for what most observers do not see. Then we'll try to think about what it all really means. With employment, housing, and the ISM numbers, there is a lot to cover. And this letter will print out longer than usual, as there are a lot of charts. Warning: remove sharp objects from the vicinity and pour yourself your favorite adult beverage. This does not make for fun reading. But first, a very quick three-paragraph commercial. In the current market environment, there are money managers who have not done well and then there are managers who have done very well. My partners around the world would be happy to show you some of the managers they have on their platforms that we think are appropriate for the current environment. If you are an accredited investor (basically a net worth over $1.5 million) and would like to look at hedge-fund and other alternative-fund managers (such as commodity traders), I suggest you go to www.accreditedinvestor.ws and sign up - and someone from Altegris Investments in La Jolla will call you if you are a US citizen. Or you'll get a call from Absolute Return Partners in London if you are in Europe (they also work with non-accredited investors). If you are in South Africa, then someone from Plexus Asset Management will ring. And in Canada it is Nicola Wealth Management. And Fynn Capital Management in South America. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) If you are not an accredited investor, I work with CMG in Philadelphia. We have created a platform of money managers who specialize in the alternative management space. By this I mean they do not need a bull or bear market in order to have the potential for profits. (Past performance is not indicative of future results.) You can go to http://www.cmgfunds.net/public/mauldin_questionnaire.asp and quickly read about the past performance of a manager we recently added to the platform, and then sign up to get more information.

We are halfway through the year (where did the time go?) and it is time to make some predictions about the last half of the year. This week we look at what the leading indicators are telling us, size up a new indicator, drop in on banking data, and do a whole lot more. Quickly, I will be on Larry Kudlow's show next Tuesday, which is at 7 pm Eastern. Larry has promised that we will spend some quality time on some of the current issues facing us. See you there! And now, let's jump in. I am on record as saying I think there is a 50-50 chance we slip back into recession in 2011, as I think the economy will soften in the latter half of the year and a large tax increase in 2011 (from the expiring Bush tax cuts) will tip us into recession. This was not based on data, but rather on research which shows that tax cuts or tax increases have as much as a 3-times multiplier effect on the economy. If you cut taxes by 1% of GDP then you get as much as a 3% boost in the economy. The reverse is true for tax increases. Christina Romer, Obama's head of the Council of Economic Advisors, did the research along with her husband, so this is not a Republican conclusion. If the economy is growing at less than 2% by the end of the year, then a tax increase of more than 1% of GDP could and probably would be the tipping point. Add in an almost equal amount of state and local tax increases (and spending cuts) and you have the recipe for a full-blown recession - at least the way I see it. I was asked at my recent speech in Milan, what sorts of things could make me wrong? There are a few. First, it could be that tax increases and cuts don't matter. Some very smart people (like Paul McCulley) feel that tax increases on the wealthy don't really figure into Romer's analysis.

"Everyone" is upset with the level of fiscal deficits being run by nearly every developed country. And with much justification. The levels of fiscal deficits are unsustainable and threaten to bring many countries to the desperate situation that Greece now finds itself in. We must balance the budget is the cry of fiscal conservatives. But there are unseen consequences in moving both too fast or too slow in the effort to get the deficits under control. Today we look at them as we explore what a fine mess we have gotten ourselves into. (I am working without internet today so the letter will be shorter with fewer references than normal.) We have discussed the above equation before, but let's look at it again from a different angle. Basically, the equation is another accounting identity. GDP (Gross Domestic Product) for a given country is the total of Consumption (personal and business) plus Investments plus Government spending plus exports minus imports. The Keynesians argue that when there is a drop in C due to a recession that the G must rise to offset the drop. That was at the heart of the argument for stimulus packages in so many countries. And there is no doubt that stimulus did help keep a very deep recession from turning into an even deeper depression. One can legitimately argue about the size of the stimulus, or about the nature of the spending, but it is difficult to argue that it did not have an effect. Now, of course, the hope is that a recovery will allow C to begin to rise so that there is no more need for government deficits. Keynes argued that governments should run surpluses in good times, which is conveniently forgotten by most government spending types. The problem is that we are still running massive deficits. Tax receipts are way down (10% unemployment will do that to you!) and show no sign of turning back up soon all over the developed world. If you reduce government spending, that also has a negative effect on GDP in the short run. But in past recoveries the growth of the private sector has overcome that negative effect. Normally at this time in a recovery growth is in the 7% range. This is a very tepid recovery in the US and the developed world.

Tonight I am in Venice, but I have arranged for a special edition of Thoughts from the Frontline, written by Jonathan Tepper of Variant Perception, a research firm in London. I have been corresponding with Jonathan for some time, and we have had some solid, and lately quite frequent, conversations. I am very impressed with this young man, whose perceptions and insights I find quite thoughtful. We are working hard together to finish a book that will be called The End Game, which we hope to have out this fall. It deals with the end of the debt supercycle in the developed world and the consequences for economies around the globe. Depending on where you live, the investment implications can be very different. The book will be very global in scope, and our intention is to make it so simple even a politician can understand. In countries all over the world, difficult choices lie ahead. We hope to give people a framework for making those choices and understanding the consequences. Our situation is not pretty, but ignoring those choices would be the worst choice of all. But first, and quickly, a number of people have written to see if I can get the publishers of Breakthrough Technology Alert to extend their offer of the current price before they double it. They have agreed to do so through next Wednesday. As I have said, this is one of my favourite sources for information on biotech stocks, and I have been very pleased with Patrick Cox's analysis and suggestions. You can read his latest piece, which I used as an Outside the Box a few weeks ago, by clicking here. And now let's turn the letter over to Jonathan. "My best guess is that we'll have a continued recovery, but it won't feel terrific. Even though technically we'll be in recovery and the economy will be growing, unemployment will still be high for a while and that means that a lot of people will be under financial stress," Benjamin Bernanke, Chairman of the Federal Reserve in a Q&A at the Woodrow Wilson International Center for Scholars After the dot com bust, John Mauldin wrote frequently about "the Muddle Through Economy," where the economy would indeed be growing, but that growth would be below the long-term trend. The Muddle Through Economy would be more susceptible to recession. It would be an economy that would move forward burdened with the heavy baggage of old problems while facing the strong headwinds of new challenges. Mauldin's description of the world was accurate then, and it is even more accurate now. The current recovery from the Great Recession has surprised to the upside, given the extremely negative estimates that analysts had last year, when almost everyone was predicting the Apocalypse. Since then GDP has been robust, industrial production has shot up, retail sales have bounced back, and the stock market has rebounded strongly. However, compared to previous recoveries, growth does not look that great and people don't "feel" the recovery. This is unlikely to change. The Muddle Through Economy is the product of several major structural breaks in the economy, which have important implications for growth, jobs, and the timing of a future recession.

Sometimes I feel so low-down and disgustedCan't help but wonder what's happenin' to my companions,Are they lost or are they found, have they counted the cost it'll take to bring downAll their earthly principles they're gonna have to abandon?There's a slow, slow train comin' up around the bend. - Bob Dylan The question before the jury is a simple one, but the answer is complex. Is the US in a "V"-shaped recovery? Are we returning to the old normal? A great deal hinges on the answer, and this week we look at some of the evidence before us. But first, a follow-up thought to last week's letter. I wrote about why countries can reduce their private debt, reduce their public debt, or run a trade deficit, but not all three at the same time. If a country wants to see its government run a fiscal surplus (or small deficit) and at the same time its private citizens want to reduce their leverage (common desires throughout the developed world), it must run a trade surplus. That's a simple accounting statement. If you did not read last week's letter, you can get to it by going here. That brings up the deepwater gusher in the Gulf. That it is an unmitigated disaster is an understatement. There is the possibility of the oil getting into the Gulf Stream and going around Florida and landing upon the Atlantic coast. We will be cleaning this up for years. I am at the moment on a plane to Italy, but if memory serves me right, we run about a $300-billion-dollar trade deficit just in energy purchases. Our trade deficit has been coming down in most other categories but is fairly steady with respect to oil. And as noted above, if we want to get to a place where we are in control of our government deficit, we must reduce that trade deficit. Bluntly, we cannot hope to balance the fiscal budget without getting a handle on our energy policy (unless consumers and business elect to go into more debt against the current trend - there must be an accounting balance!)

Alice laughed. "There's no use trying," she said "One can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for half-an-hour a day. Why, sometimes I've believed as many as six impossible things before breakfast." —From Through the Looking Glass by Lewis Carroll Economists and policy makers seem to want to believe impossible things in regards to the current debt crisis percolating throughout the world. And believing in them, they are adopting policies that will result in, well, tragedy. Today we address what passes for wisdom among the political crowd and see where we are headed, especially in Europe. I am reminded of the great line from the movie, The Princess Bride. Vizzini is the short bad guy who is trying to get away from Westley and every thing he attempts does not work. Westley just keeps on coming. At each failed attempt, Vizzini mutters, "Inconceivable." Finally, Vizzini has just cut the rope and The Dread Pirate Roberts (Westley) is still climbing up the cliff. Vizzini : HE DIDN'T FALL? INCONCEIVABLE. Inigo Montoya : You keep using that word. I do not think it means what you think it means. European leaders keep telling us that the break-up of the eurozone is inconceivable. I do not think they know what that word really means. Let's see if I can explain the problem so that even a politician can understand. But first, and quickly. We have transcribed the speeches from my recent 7th Annual Strategic Investment Conference I put on with my US partners Altegris Investments. To say they were awesome is somewhat of an understatement. If you have registered for my free accredited investment letter, you should already have gotten a link or will get one soon to the speeches. David Rosenberg, Dr. Lacy Hunt, Paul McCulley, Niall Ferguson, Jon Sundt, Jason Cummins, Gary Shilling and your humble analyst. That is a world class line-up. If you are an accredited investor (basically $1.5 million net worth) and have not yet signed up for my letter, then go to www.accreditedinvestor.ws and do so now. One of my partners from around the world will get in touch with you and make sure you get access to the speeches. They will also show you a world class line-up of funds and investment managers that have the potential to help your portfolio weather these tumultuous times. You really owe it to yourself to take a look. (If you are a non-US investor, there is a button on the top of the home page.) In this regard, I am a registered representative of and president of Millennium Wave Securities, LLC, member FINRA.

Everywhere there are arguments that we are in a "V"-shaped recovery. And there are signs that in fact that is the case. Today we will look at some of those, and then take up the topic of when the Fed will raise rates. We open the case and look at the evidence. Is there enough to come to a real conviction? I think there is. (And at the end of the letter I mention two conferences I am speaking at in the next few months, in Vancouver and San Francisco.) But first, a little housekeeping. The delivery rate for this letter has not been good for some time now and we are aware of it. We get tons of letters and calls from long-time readers who want to know why we have dropped them from the list. They keep resubscribing but not getting the letter. It is a problem. I was not getting delivery on my own personal accounts from well-known email providers. We apologize for any inconvenience. Please know that we do not drop anyone from the list unless they request it or we get hard bounces or undeliverable messages. Hopefully that has all changed with this letter. The problem has been that the list is so large that it is blocked long before the letter ever hits your inbox. The computers at service providers just assume anything this large can't be for real. We are now using a service that is a third-party verification of our letter, which hopefully will fix the problem (not a cheap solution, by the way!). So, there may be a lot of you for whom this letter is (hopefully) a pleasant surprise after not getting it for some time. If that is the case, we would like to know. If you have the time, drop me a response that says "got it" in the subject line. And of course, if you don't want to get the letter you can hit the unsubscribe button at the bottom. But even better, why not forward this to a friend and tell them to subscribe? For the record, we are working on a MAJOR revision of the website and the letter. There will be a lot more ways for you to interact with me and each other. A lot more information and capabilities. We are excited. It should be here by the fall. Tiffani and I think you are really going to like it. And now to the letter.