2003 Forecast

John Mauldin | Thoughts from the Frontline
January 11, 2003

We cover the globe, currencies, the US economy, bonds, stocks, deflation, inflation, gold, oil and more!

For the last three years, making annual predictions has been relatively easy, at least as compared to this year. You try to discern the dominant theme for the year and then everything else usually flows from there. In 2000, it was an over-valued stock market. In August of 2000, the interest rate yield curve went negative, and as I wrote at length at the time, Federal Reserve studies (among others) showed that a recession always followed a negative curve by about 12 months. I saw no reason for that not to be the case this time. I suggested strongly to readers that the safe move was to get out of the stock market entirely at that time.

Thus, coming to January of 2001, a second half recession was the dominant theme of 2001, and the general slowdown throughout the world provided a back-drop for a very bearish picture. I began to write that year that we were beginning a probable decade long (at least) secular bear market. Last year, the theme was the arrival of deflation, a less than robust recovery and the development of my view that we are in a Muddle Through Economy. (I should point out that I first wrote about deflation in the fall of 1998 and strongly suggested readers consider long term zero coupon Treasury bonds at that time. That has been a very good trade. Later we will consider whether it will be so in the future.) In March of 2002 I turned bullish on gold and bearish on the dollar.

All in all, it has been a reasonably good track record, with of course the usual bumps here and there. Long term bonds were not a winner in 2001, although they did very well in 2000 and last year. Stocks have had some tradable rallies, but the trend has been down.

I have been meditating for over a month what the main themes for this year's forecast should be. The problem is that there are no obvious over-riding themes, in my opinion, that control the rest of the picture. As I have thought about it, this is the year of Transition and Surprise. As we examine our portfolios and look to what might unfold in 2003, we will want to keep these two words in the front of our minds.

Please keep in mind these are predictions and not prophecies. I did not receive them on stone tablets shoved under my office door. They are my best take after reading hundreds of pages of economic analysis form scores of services. They are my opinions, and are not guaranteed. The one prediction I can confidently make is that I will change my opinion on at least a few of these thoughts sometime in the year. That being said, let's look at 2003: Transition and Surprise.

On the Gripping Hand

To the usual economic essay that starts "On the one hand..." and continues "On the other hand..," in my past annual forecasts I have added a third possibility, "on the gripping hand." This comes from Larry Niven & Jerry Pournelle's masterful 1993 science fiction novel "The Gripping Hand" which involved a species of aliens with three arms. Since economists are about as alien a species as we have on earth, and because we are indeed trying to "get a grip" on our finances, it seems appropriate. As we examine each economic arena and market, we shall look at both sides of the issue and try to come away with some idea (the gripping hand) of what might really happen.

(Because of the rather large range of topics we will be discussing, I am not going to provide my usual lengthy analysis of each individual market. I will cover in future letters those areas which beg for more in-depth analysis.)

A World of Hurt

Before we look at the US economy, let's quickly review how the rest of the world is doing. Europe is on the verge of a recession, if not already there. Incredibly, even Chancellor Gerhard Schroeder's own optimistic economists (called for some reason the "Five Wise Men") openly bring into question his proposed tax increases, saying they may prevent Germany's economy from growing at the anemic 1% rate they forecast for this year. Italy is not well, France is doing somewhat better, but it is only in relationship to Germany that you would use the word better. (Bloomberg)

Incredibly, while deflationary forces sweep the world, the European Central Bank is still fighting the last war. They are so afraid of inflation they provided only one measly interest rate cut last year. They seem to be waiting until the patient becomes comatose before providing blood. My take is they will cut rates again this year, but only grudgingly and not soon enough or deep enough to have any real influence prior to a recession starting. Even though the dollar is falling, Europe is not going to be a source of significant export growth until it works through its current malaise.

I have lost count of how many final stimulus packages have been proposed or enacted in Japan. Japan redefines the meaning of futility. The country is mired in long term deflation and recession. A large chorus of national leaders calls for the yen to drop to a value of at least 130 against the dollar and some say the Bank of Japan should target 150-160 from the current 118. This of course would make Japanese exports cheaper and therefore more affordable to US consumers, help Japanese exports rise and allow them to continue to export their deflation to the US and the rest of the world.

There will be a new counterpart to Alan Greenspan at the Bank of Japan this year. He will probably be from the school of thought which says Japan should develop a specific inflation target. I agree they should, but doubt very seriously whether they will be able to do so without serious structural reform to their banking system. The Bank of Japan in combination with the government is the only management team which makes Wall Street analysts look competent.

Look for the yen to drop with the appointment of a new BOJ chairman, as there will be lots of speeches calling for a drop in the yen among government circles. Then as no action actually follows the rhetoric, the yen will probably drift back up. You are pretty much a failure as a central banker when you cannot destroy your own currency. Maybe this year the leopard will change its spots, but I am skeptical.

The rest of Asia, and especially China, continues to grow. The trade surpluses of these countries continue to rise, especially with the US. Latin America struggles as Argentina is a basket case and Brazil has seen its currency drop 30% in the last year.

King Dollar and the Guillotine

The US trade deficit continues to rise. It is well over 5% of GDP and going to 6%, and such levels normally mean a serious correction in the value of a currency. While the dollar has dropped, especially against the euro, it has not dropped as much as you might think on a trade weighted basis. (I have done extensive analysis of this problem in previous letters, under the theme "What if they gave a dollar devaluation party and no on came?")

The dollar is doing better than it should because China has fixed the currency to the dollar, and the rest of Asia is in a competitive currency devaluation race (Greg Weldon's terminology) to see who can make their currency lower in order to attract US consumers. The world and especially Asia will continue to be addicted to the US consumer. They sell us their products for electronic dollars, and then buy our government paper and stock. The world either owns 35% (BCA Research) or 42% (Morgan Stanley) of our Treasury debt. Morgan Stanley also reports foreign investors own 18% of US long term securities and stocks.

Why would foreign central banks continue to buy and hold large positions of dollar denominated US assets when it is clear the dollar is over-priced? Because they have a Hobson's choice. They can take pain now or take it later. Politicians are the same all over the world. They prefer to take their pain later, even if it will be more severe.

If a country stops taking dollars and buying US assets, then their currency will rise and make their products less attractive to our consumers. In export driven economies, this is a disaster, especially for the politicians, as it assures a recession at the very least. Thus they continue to support our spending habit.

Canada, Mexico, China and Japan account for 47% of the trade weighted currencies. The Canuck is flat for the year, the peso is actually down 10% and the yen is down more than 10% for the year, much to the consternation of the Bank of Japan, as noted above. The Chinese currency is pegged to the dollar, so there has been no movement. (These and other currency figures cited are from A. Gary Shilling's INSIGHT newsletter)

Thus the drop in the euro is the single major reason the dollar has dropped slightly on a trade weighted basis, when seen on multi-decade chart.

Is there a limit to this? Of course. We can't sell more than 100% of our assets, and we are now selling $500 billion a year. At this rate, the rest of the world will own 100% of our government debt in ten years, even as we grow the deficits. Clearly this is not sustainable. When does the pain of taking over-valued dollars become more than the pain of selling less to the US? I think it is when China allows their currency to float. Asian countries do not necessarily want an over-priced dollar; they simply want the price of their currency to be favorable in relation to their neighbors. The gorilla in this process is China, and when they allow the renminbi to rise, that will be the real end of the dollar as the rest of Asia will feel comfortable inletting their currencies rise as well.

There is an increasing call from many corners of the world for the Chinese to allow the renminbi to float. They have not responded to the pressure, but as do all countries will act when they feel it is in their own best interests. That will probably be when they think their own consumer demand is growing and solid, and thus can sustain a possible slowing of sales to the US. When that will be is anyone's guess, so the dollar could be surprisingly strong even when by all rights it should drop. But China could be the surprise move which sets this set of dominoes in motion. This is one area we will watch closely this year, as it will be a surprise and will be the transition to a much lower dollar fairly quickly.

(Sidebar surprise question: which country has the third largest trade surplus behind Japan and Germany? Answer a few paragraphs below.)

By the way, this is not the end of the world, as some would have you think. The dollar dropped by over 1/3 against all currencies in the 80's and early 90's, and the US seemed to move along just fine. Inflation dropped during that time and the economy grew. A falling dollar will help our exports, of course. I expect the Bush administration to tacitly approve a weak dollar policy while continuing to say the market should determine prices.

The one real exception is the euro, as the European Central Bank seems quite content to let the dollar drop. Even with the weakness in Europe, I think it is likely the dollar will continue to drop against the euro. In 2002, I predicted the euro would rise to parity by year end, and it has gone decisively past that point, to $1.05. Those readers who opened euro denominated bank accounts at Everbank are happy today. The "natural" target of the next 12-18 months, if not sooner, is around $1.17, which is where the euro started about four years ago. You can buy a euro denominated CD from Everbank by calling Chuck Butler: 314-984-0892, ext 102. (Full disclosure: Everbank has a business relationship with my publisher. I know of no other US based bank from which you can buy CD's denominated in foreign currencies. If you know of one, I will be glad to add them to the list.)

I believe Europe will resist a drop much further than $1.17 until China starts the dollar tumbling down the hill so they can stay competitive as well. It is truly every country for themselves in the currency markets.

(The answer to the question above is that bastion of capitalism: Russia. Their trade surplus in 2002 was $44 billion. They also have the lowest taxes of any major country. Khrushchev loses. Reagan wins. And the biggest winners are the Russian people.)

This naturally brings us to that international currency: gold.

Gold Has a Lot More Glitter to Come

Gold has finally gotten off the floor, and has become the hot investment of the year, up around 35% or more, depending upon which day you look. I think it has more room on the upside.

First, gold finally broke through the $325 barrier. Dennis Gartman tells us that the reason is that the Bank of Canada finally finished selling all the gold it wanted to at that level. There now seems to be someone major selling in the $355 area. When that supply is worked through, the next level of resistance is $385 per one of my favorite gold technicians Ian McAvity.

Central banks are not in some vast conspiracy to hold down the price of gold. They simply want to sell what they have. They do not understand the yellow stuff, and don't want to own it. As gold rises, they will sell more. The prefer electrons to hard metal, which in theory can earn interest. (The lease rates on the gold they lend to banks and dealers are quite small, which is the way they make something on their gold holdings.)

My long held belief is that gold acts like a currency, and if the dollar drops another 10% against the euro, you could easily see another 10% rise in gold. Because gold is so thin a market, it could rise much further fairly quickly, if central banks decide to limit their sales.

And as Paul McCulley of Pimco points out, gold needs to rise as a sign that the world is dealing with its deflationary problems. For a very fascinating and well written historical study of the relationship of gold to inflation/deflation see his January essay at www.pimco.com.

When the need of central bankers coincides with the direction of the market, we should pay attention. Thus, I continue to be a long term fan of gold and gold stocks (at least since March of 2001).

The Muddle Through Economy, Part 2003

Economists throughout the country are predicting that this year we will see a resurge in capital spending, and this will be the trigger for a return to the boom years with 4% growth. I think not.

First, let's look at my Three Amigo Economic Indicators: the ISM numbers, capacity utilization and junk bonds. The ISM number is the old NAPM (National Association of Purchasing Managers) and is a very accurate independent measure of the level of purchasing and business activity. It has recently turned modestly positive, which means business is finally doing better, but not great. Capacity utilization stinks. This is a measure of how much of your potential production you are actually using. It now hovers around 76%, which means that business has no pricing power, and if you can produce all you can sell and then some, what reason is there to increase capacity by spending money on more factories and production capacity? Better to use the money to pare down debt.

As the level of business loans as a percentage of GDP is still dropping, that suggests business is not borrowing to increase capacity. That suggests the resurgence of capital spending mentioned above is still beyond the horizon.

Finally, junk bonds have improved somewhat over the past few months, but not a lot. When the economy starts to roll after a recession, junk bonds ceased to be treated as nuclear waste and earn the respectable title of high yield bonds. They show a real jump in value. After the recession in 1991, we saw junk bond funds rise 70% in the next three years. Interest rate returns and spreads over treasury bonds are still very high, but sl-o-o-o-wly coming down. This also suggests that the economy is improving, but still quite soft.

There are three main components which normally lead a recovery in the economy: consumer spending, housing and capital spending by business. We saw weak consumer spending in the holiday season. While overall it did not fall out of bed, the "growth" was anemic, and moved down the food chain from upscale stores to Wal-Mart and Target. Even so, they performed below earlier projections.

US household debt as a percentage of GDP has doubled since 1960 from 40% to 80%. As Martin Barnes of BCA Research points out, this is not quite as bad as it might first look. A great deal of the rise is from lower and middle income families finally being able to buy a home as well as qualify for other types of credits. While this has caused an increase in delinquency rates, it has also allowed home ownership to become more universal which is a good thing.

Nonetheless, there are again limits, and it appears that consumers are at least beginning to slow down the growth of their credit. The practical limit is that at some point credit growth cannot outpace income growth. My reading of the numbers is that the vast majority of US consumers are not in trouble, but they do not appear anxious to increase their debt. Since debt growth has clearly been the engine for the growth of consumer spending, this suggests consumer spending is not going to be the engine for a powerful recovery.

Paul Kasriel of Northern Trust points out that growth in consumer spending and exports are a requirement for or pre-cursor to significant increase in business capital spending. If this is true, and I agree with him that it is, then that leaves housing as the last possible stimulus for the long awaited "V" shaped recovery.

Housing is already at an all-time high and it is hard to see how it can grow any more. The best we can hope for is continued low mortgage rates and for the housing industry to simply remain at the current levels. To expect any more is not realistic, given the slowly rising unemployment.

Economists are projecting a rise in S&P 500 corporate profits in the 15% range. It will be closer to 5% than 15%, probably in the high single digits. This could change for the positive if capacity utilization increases, among other things, so we will watch this closely. But right now I do not see a big jump in capacity utilization in the near future. This is not the stuff of which 4% economic growth is made of.

That being said, there are factors which would lead one to believe that we will again Muddle Through. The proposed Bush tax cut and government deficit spending is a decided boost to the economy. Low rates are a stimulus. A falling dollar will help the deflation fight and US exports.

While the economy is certainly not robust, the recovery has been profitless and jobless and there seems to be no real area which will lead to significant growth, there is nothing to suggest that we are on a verge of a double dip recession. We Muddle Through.

I think the Bush administration is adding the stimulus plan to provide some insurance that the economy will stay out of recession through 2004. I think for 2003 it is likely to work, but my estimate is that growth will be probably between 2% and 2.5%.

As an aside, I monitor the yield curve almost daily. There has not been a recession in post-war America when short term rates have not risen above 20 year Treasury rates for 90 days approximately 4 quarters prior to the onset of recession. This is called an "inverted yield curve." A Federal Reserve study has shown that it is the single best and most reliable indicator of future recessions. We are a long way from that point. Can we see a recession without an inverted yield curve? It is more than an academic question.

We can get an inverted yield curve by short terms rates rising or long term rates falling or a combination. That is why I do not think the Fed will raise rates this year. They cannot afford to raise rates until the recovery is robust, unemployment is low and consumers and business can handle the increased interest rate costs without pain.

If there is any interest rate change this year, it will be another cut. I hope not, because that will mean we are having problems, probably an unpleasant surprise, and that Greenspan feels we need the emotional stimulus of knowing the Fed is on the job and still cares. Another 25 basis point cut will achieve little of actual consequence within the economy, but it would be done in an effort to shore up consumer and investor confidence.

As I wrote in 2001, Greenspan has raised interest rates for the last time in his career. He retires in 2004. He will not raise rates in 2004, but will leave that task for his successor, who will not raise rates prior to the second Tuesday in November.

It is primarily because of the yield curve that I think the underlying economy will Muddle Through. Because rates are so low and artificially distorted, we may not get a fully inverted curve prior to the next recession. But we should see some kind of move where the yield curve at least flattens. For those of you who want to see the "curve," and for those who like to monitor interest rates, you can click on http://www.bloomberg.com/markets/C13.html?sidenav=front.

What are the risks to the Muddle Through Economy? A surprise in Iraq. Right now everyone thinks it will be short and successful. Another major terrorist incident would be a significant issue. If the President's stimulus package or some version thereof (see below) does not pass that could turn the mood of the country negative and crunch consumer spending.

And I must admit if the stimulus package gets passed quickly, if we see a significant bear market rally, a drop in unemployment and a short and successful war in Iraq, it is not hard to think GDP could grow another 1% over the Muddle Through 2.5% range. But those are a lot of ifs.

Deflation Hiding Behind the Trees and Bond Prices

My less-than-sainted Dad would often tell me after a moment of youthful bragging something like, "Let not him that puts on his sword boast like him who takes it off." His actual version was a tad more colorful, but there are ladies who read this letter.

Greenspan, Bernanke and crew have bragged that they have the "ammunition" (their word) to defeat the deflation bully. Much of the world breathed a sigh of relief to know the Fed was on the job and started worrying about the coming inflation. Call me a cynic, but I am not prepared to abandon my deflationary views just yet.

As Stephen Roach of Morgan Stanley points out, "For the economy as a whole, GDP-based inflation slowed to just +0.8% in 3Q02, the lowest rate in nearly half a century. Another year of sub-par economic growth in the 2% vicinity -- pretty much my personal prognosis -- could well find inflation moving even lower, possibly flirting with the "zero" threshold of outright deflation. The authorities must do everything in their power to avoid such an outcome."

Larger federal deficits, a falling dollar and increased growth in the money supply should hold outright deflation at bay for this year and maybe the next. The real test -- the moment when we see what the Fed's ammunition is worth -- is during the next recession. At that point, we will see whether they are pushing on a string and we develop a Japanese liquidity trap, or they can actually move mountains.

Are we headed for a Japanese style deflation? Right now, I think not. That is because the Japanese consumer prefers cash to consumption, and coupled with their insane banking system that is what has created their liquidity trap and deflation. That is not the picture of the US consumer or of our banking system, nor has it been in our national character for some time. There is a difference, for good or bad, between the two national personalities. (For explanations of a liquidity trap, go to http://www.google.com and type in liquidity trap.) But I could just as easily argue that an aging boomer generation will want to increase savings dramatically and thus become more like the Japanese. But that requires a change in the character of my generation, and one I do not currently see.

That does not mean the Fed will have it easy. I think that at some point the Fed is going to have to put its printing press where its mouth is. I do not think that happens in any serious way until the next recession.

In 1998, I became a big proponent of long term zero coupon government bonds. It has been a very good 40% or so run in my favorite bond fund, The American Century 2025 fund (BTTRX). Last year we saw almost 20%. It is the most aggressive of the bond funds. This is a volatile fund, and has lost almost 6% so far in the first 10 days of this year.

A recent survey of Schwab account holders revealed that 40% of them did not understand that they could lose money in a bond fund. I am sure none of my readers were in that group, as all of you are well above average in investment savvy, but that is an appalling fact. If interest rates rise, you WILL lose money in bond funds.

For reasons I will outline below, I think we could see a significant rally in the stock market. This will not be good for bond funds. Much of the market has put their deflation fears to rest. They are now worried about inflation, which is not good for bonds.

While I do not think long term interest rates will be allowed to rise too much without active intervention from the Fed, interest rates will probably drift higher for some time.

Sidebar: if interest rates, and specifically 10 year treasuries move a lot higher, then that will increase mortgage rates. Rising mortgage rates will threaten to push the economy back into recession if allowed to persist in a time of weak recovery. A strong and growing economy can handle rising mortgage rates. I do not think this one can.

Don Peters, who has one of the best track records I know of for predicting interest rates and Gary Shilling both think interest rates have much further to drop. They may be right, but I believe interest rates are going to continue to be volatile. The problem is that if they are right and you exit your long bonds now, you will miss much of the move when rates begin to drop again (if and/or when they do). These things happen quickly, as the last few days suggest. If you believe deflation is still in the cards, hold at least some of your bond positions. If you think inflation is on the way, sell all the bonds you do not plan to hold to maturity. If you are not sure, lighten up your bond position.

My current thinking is that long term bonds (other than those you plan to hold to maturity) are now more of a trade than an investment. If you hold a gun to my head, I think we see lower rates in the future during the next recession. They could be substantially lower if the Fed has not been able to induce inflation, and there are no signs they have been able to do so as yet.

But the period in between now and the next recession will be volatile. If you are going to hold long bonds, you have to look over the valley of volatility to the next recession. Both Peters and Shilling think you will be well rewarded for your patience, and their independent track record on bonds for the last two plus decades speaks for itself.

What should income investors do? First, do not chase yield. If you can't deal with volatility, do not buy long bond funds. If you need income, I would suggest the traditional ladder of variable length bonds and hold to maturity. You should look at medium term high quality corporate bonds.

Also, consider TIPS - Treasury Inflation-protected Securities. They rose 16% last year, and have excellent potential for capital gains when inflation does come back, which it eventually will (again, in my opinion).

As a type of "call option" on the economy, you might consider a portion of your portfolio in a conservative high yield bond fund. If the economy improves, then high yield bonds will rise. The capital gains plus the yields could be quite nice. Go to Morningstar and look for 4 and 5 star rated funds. Put a close stop on the fund.

This is a year of Transition and Surprise. Can the Fed and the world deal with deflation? Right now, the market says yes. This is the battle. We will either transition to inflation or slide further toward deflation. It is in the balance.

Rallies In a Secular Bear Market

The primary trend of this market is down. We are in a secular bear market. (For a detailed discussion of what a secular bear market is go to www.absolutereturns.net and read the relevant chapters in my book-in-progress called Absolute Returns .)

Secular bear markets usually do not end until P/E ratios are in the single digits, which is far from where we are today. This primary trend is likely to last for the remainder of this decade, at a minimum. I do not have the space today, but will write in an upcoming e-letter about the very well-reasoned analysis done by Gary Anderson and separately by Ed Easterling. Anderson gets as much as $60,000 a year for his newsletter on stocks and timing, depending on the assets under management. He is quite sharp. Hedge fund managers among my readership will want to pay attention and review his work. He shows why we could see 4-5,000 on the Dow before this cycle is over, even though he is somewhat bullish this moment.

Easterling, another hedge fund manager, takes a very different approach. His work suggests that we could be in a sideways trading range for at least another ten years, with some serious risk to the downside as well.

But that is the future. What about this year? I read everywhere or at least from the cheerleaders, that the odds are that we will see a rise in the market, because there has only been one time in history when the markets went down four years in a row. The odds are only one in a hundred.

With all due respect (actually with no respect at all), that is the worst statistical garbage I have read in quite some time. First of all, there have only been three times when the market have even had a chance to go negative four times in a row, and one of those times the market was down less than .5% in year, so that hardly counts as down three in a row. So if that type of statistic was valid, then the odds would be either 1 in 4 or 1 in 3.

But it is meaningless. The conditions in any one given year are the reason for the market to go up or down. I am going to discuss why this market could significantly rise and/or significantly fall. It has nothing to do with odds. If any broker tries to get you to buy stock based upon this "statistic," hang up or fire him.

First, how can I think the market might rise if I think we are in a long term bear market? Let's look at a few reasons.

While the performance of the stock market in any one year is random from a statistical standpoint, over a complete cycle, there is more solid footing. There have been two 50% rallies in the Japanese Nikkei while it has dropped over 75% in the last 12 years. There have been at least a dozen 20% rallies. They were all hailed as the end of the bear and the beginning of a new bull.

Ed Easterling has allowed me to reproduce a chart with some very interesting statistics on bull and bear markets. What we find is that in most long term secular bear cycles the market goes up 50% of the time in any given year. In bull markets they go up 80% of the time.

As noted above, bear markets have historically ended in single digit P/E (Price to Earnings) ratios. If this market were to go directly to that single digit P/E without a few years where the stock market actually rises, it would be the first time in history in the US, and I cannot think of or find an example in any major market anywhere else. There seems to be something about the psychology of a bear market that demands a respite. Bear markets do not end when there are still bulls in the corral. These bear market cycles take years, and typically longer than a decade, to shake out.

I should point out that for the market to go directly to about single digit P/E ratios would require a drop of at least another 50-60%. I do not need to discuss the kind of devastation that would produce in the world.

You can go to this very interesting table at http://www.2000wave.com/marketprofile.asp.

What could spur a rise this year even as the markets are historically way over-valued? I met with the manager of a major long short hedge fund this week. Their approach is based on value. They buy value long and sell bad companies short. They did quite well last year, performing in the top 10% of long short equity funds. Today they are close to 50% in cash. His problem is that he can't find enough companies he feels comfortable about to invest.

There are not just enough stocks with low enough values to interest him. This is not surprising. But the intriguing piece of information was that he can't find anything to short. All the obvious stocks to short have large short positions already from other hedge funds and individual investors. To get in today is very dangerous.

That is because these hedge funds are very sensitive to their relative standing to each other and to profits and losses. A long short hedge fund is supposed to preserve capital. If a "short rally" starts and a hedge fund holds its position it can quickly drop more than their previous historical losses, making investors nervous. Most long-short equity hedge funds did not have a particularly good year last year, and do not want to have a second losing year, even if it is small. Thus many managers are "scared money." If a short position begins to deteriorate, they could bail very quickly, creating a short rally. (You have to buy the stock long to cover your short position, thus in theory driving the stock up even further.)

In his opinion a significant short rally was possible. But what if such a rally begins to create a market in which all stocks start to move? Then momentum traders move in and create more buying. Many hedge fund managers with significant cash will not have the discipline to let the market run from them and will begin to chase the market in an effort to at least stay near their S&P 500 benchmark. Hedge funds that are traders (and there are hundreds of them) will smell blood and profits and help drive the feeding frenzy. By the time the market has moved 20%, the cheerleaders are proclaiming the end of the bear market, and the small investors pile in, chasing the now hot mutual funds.

What could be the fuel to keep such a rally going? Trimtabs tells us that companies are going to have to fund their pension plans by over $100 billion over the next year. As an example, General Motors will increase its pension contributions by $3 billion (cutting its profits by 26% in the process) this year. That is just one company.

These companies have fixed positions for their pension funds. For instance, their consultants may have them in 50% in stocks, 40% bonds and 10% cash. Since they lost 20% on their stocks last year and their bonds went up, they are now "underweight" on stocks, so that means they will plow much of the new cash into the stock market in an effort to get back to their target allocations.

Mix in large increases in the money supply and you have the conditions for a bear market rally. In the table I mentioned above, the average gain in positive years in bear market cycles was 24%!

Underlying all this is going to be the repeal of the dividend tax. If this happens, it will put a new and higher floor on the eventual bottom of the bear market. This makes dividend paying stocks worth more. You can argue that dividends were much higher in previous bear market cycles, and that did not keep the stocks from going much lower, but I would point out the dividends were taxed in past bear markets. This will not start a new bull cycle, but I do think it changes the equation on the eventual bottom. While that may be cold comfort when the Dow is at 6000, that level is a lot better than 4 or 5,000.

Let's be clear about one thing. Bush is not putting out this dividend tax repeal as a ploy. He is dead serious. This is not a negotiating position. I know from personal experience here in Texas that when he stakes out a position, he argues and pushes for it aggressively. He is not looking for a compromise.

He tried to change the tax structure in Texas in 1998.e is very hard to say "no" toHeHe He did not have close to a majority of his own party supporting him. He eventually lost that fight, but he did not back down.

This time he will get most of his party (hopefully McCain will come along) and a few dems and he should get his dividend tax repeal. While I am generally in favor of all tax cuts, this one is important in that it will change the corporate culture in America. Dividends will rule, and dividends require actual profits and not stock pumping to get your options cashed.

I believe the hope from the Bush team is that this will put new life into the stock market, or at least a base for a few years at the least. Whether it will remains to be seen, but it is a brilliant political move and also a proper philosophical move as well. It may well be the most important long term contribution from the Bush presidency.

Let us make no mistake about this. Bush is putting his re-election on the line. If this tax repeal fails, it could very well tank the market and sour the mood of the country. That could tank his re-election. He could argue it was those bad democrats, but it would probably ring hollow to those whose retirement accounts are down. This is an all-or-nothing, bare knuckles political brawl.

Son of Bubble

Now let's look at why the market is going to go down this year. First and foremost is that valuations are WAY too high for a significant bear market rally. Other than the last bubble, we are near all-time highs for previous bull markets. How can you rally from what is already high? How can a new bull start from the top floor? Can we say Son of Bubble?

Earnings are going to disappoint investors. Not by as much as in 2002, but they will still be below current analysts' forecasts. It's hard to see a sustainable rally coming from constantly lower earnings estimates.

The list of problems is long: Iraq, terrorism, deflationary world pressures, a Muddle Through Economy, a possible retreat by foreign investors because of the dollar, etc.

So where will the stock market end up for the year? I don't know, and that's the honest truth. Anything I said would be a guess, and I do not want anyone investing hard money on my guess. I could guess and be lucky as I do have a 50-50 chance to be right, but to then tell you that my guess was anything but luck next year would be dishonest.

I do think we could see a very serious rally this year. Whether it will last the year is not clear, although it easily could. Could we see a rally after Iraq is done, tax cuts are in place and a nation breathes a sigh of relief? You bet, as the fuel for a rally is there in the form of pension fund cash and a lot of cash in the hands of investors. Will they be once bitten, twice shy? When this rally fails, as it eventually will, they will be even more embittered and the resulting drop will be worse than what would occur if we simply maintain a trading range.

I think the next significant leg down in the stock market comes as a result of the next recession, whenever that is. As I will discuss in the next few weeks and make a longer case in my book, AT BEST the trend is a sideways trading range for the rest of this decade. History suggests we will not be so lucky. But this year, we may dodge a 4th straight bullet. We will see.

In the meantime, it is best to follow the advice that Dennis Gartman reminded me of: treat the stock market not as a stock market but as a market of stocks. This is a stock picker's market. There are always companies which will do well in any year. This is also a period where market timers should do well. In a few weeks, I will point you to some successful timing programs and managers. There are not many, but there are some who have done well.

The Oil Patch

One wild card is the price of oil. If the war with Iraq is short, and does not destroy their wells, we could see the price of oil come down significantly. This would probably be as much or more real stimulus than the tax cuts. On the other hand, a significant price rise in oil from here could offset any tax cuts, especially when you factor in the tax increases which are coming from states and cities.

Our new best friend, Vladimir Putin, will do his best to put as much oil into the world markets as possible, but a serious rise in oil prices could throw a world economy that is already wobbly into recession. Let us hope that does not happen.

Summary: On the Gripping Hand

In summary, I think this year is another Muddle Through Year for the US. The dollar should drop further against the euro. The economy should grow much like last year, in fits and spurts. Profits will disappoint, but will rise. Bonds and the stock market are in transition, and we could see a significant rally, or sparked by a negative surprise, another bear year. This is a year to be cautious. Unless you are an astute trader, if you want to buy stocks to play a rally, buy value and dividend stocks from companies who can grow their dividends. Dividend stocks should do well this year, even if the market is down slightly.

In my opinion, it should be a year where most hedge fund styles should do well. Commodity traders and global macro funds should have trends to follow and a second good year in a row, after a decade of disappointment. If you are an accredited investor ($1,000,000 or more net worth) and would like information on hedge funds and private offerings, you can go to www.accreditedinvestor.ws and subscribe to my free letter about these funds. Oh, one last prediction: mutual funds and stock analysts will tell you now is the time to buy. The market is a lock to go up. Cheerleaders of the World, Unite.

My Biggest Forecasting Mistake

As a final note, let me take you through one optimistic point: if the economy only grows at 2.5% year for the next ten years and inflation is 2%, neither of which are unreasonable to assume, then the GDP is 50% bigger in ten years than it is today. It will be 30% larger in real terms. The economy grew 177% in real terms from 1966 to 1982, which most consider to be a secular bear period. The stock market was flat for the 16 years.

There are going to be plenty of opportunities over the next decade for astute investors and entrepreneurs. The main forecasting mistake I have been guilty of over the past years is to underestimate the ability of individuals and businesses in the free market to adjust to uncertainty and problems.

I recognize we have significant problems in our economy. We are going to have to deal with our huge national debt, over-extended consumers, aging population, deflationary pressures or the inflation which will come about from the Fed's pumping of the money supply to fight deflation, an over-valued dollar foreign competition pressures, trade accounts deficits, an over-valued stock markets, not enough retirement savings. Federal government deficits, high taxes, and the list goes on and on. All of these will have a significant effect upon our economy and investments.

But the one thing that we need to remind ourselves of it that most Americans are like you and me. When we are presented with a problem, we deal with it. We take our lumps and get up and move on. We figure out how to make next year better. We are an amazingly optimistic and resilient people.

The new technologies and the new companies that will drive the next bull market have probably not yet been invented or started.

What's in store for 2003 from Millennium Wave?

This next year, it is my intention to add a few features to the web site. I will start posting 3-4 articles a week that I think are of interest. I WILL get my book finished in the next few months.

If you are reading this letter for the first time, you can join approximately 1,500,000 investors who get my free weekly e-letter, where I deal with the topics above in a far more in-depth manner, by going to www.2000wave.com and signing up for the letter. To find out more about me you can go to www.johnmauldin.com. At that site you can find links to chapters I have posted on my book called Absolute Returns and my others free e-letter on hedge funds and private offerings.

I look forward to serving you in 2003, and welcome your letters and comments. Please know that I wish you the best year of your life in 2003.

Your betting 2003 will be a great year analyst,

(Whether or not my predictions come true.)

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