Bull Market or Gloom and Doom?

John Mauldin | Thoughts from the Frontline
February 8, 2002

My theme for the last few weeks has been that we are in the Muddle Through Economy -not much downside but not much upside. The data this week reinforces my point. Today we will look at the evidence that continues to mount.

Then I am going to do something dangerous: disagree with the world's smartest bond manager, Bill Gross of Pimco. His recent call for the Fed to raise interest rates is simply wrong.

Finally, we are going to look at what the possible fallout from Enron and Global Crossing will do to corporate balance sheets this year. If you are in the stock market, you absolutely must read this section.

I want to welcome a lot of new readers this week. We are now over 200,000 readers. I think you will find Millennium Wave Online to be a valuable source of financial analysis that will make you a better investor. Each week, I look at hundreds of source documents and private reports and bring you what I think is the important central themes. I take complex topics and make them understandable. I help you think through the data to see what it really means, and try have some fun as we do it.

So, let's put on our thinking caps and see how we can take all this information and apply it to our investment portfolios.

Up, Down and Sideways

If you are a bull, there is plenty of good news. The leading indicators are up for the third straight month. Unemployment actually went down from 5.8% to 5.6%! GDP for the fourth quarter was significantly better that analysts predicted, although I continue to believe it will be revised downward into negative territory at the end of the month.

Consumer confidence is up significantly. New home sales, while showing some signs of exhaustion, are still running at a strong pace. Productivity rose by an astounding 3.5% in the fourth quarter. (Since actual hours worked dropped, that must mean we worked extra fast to produce the same amount of goods and services in less hours. I guess that is why everyone seemed so tired after Christmas. I certainly was. See below.)

Overseas, German manufacturing orders and output all surprised on the upside by a considerable margin. Morgan Stanley is predicting "Euroland inflation rate to drop to 1% or lower by late spring or early summer.....The inflation outlook is the key reason for us to believe that the ECB is likely to lower interest rates by up to 75 bp in the first half of the year." That means that - maybe - some help is on the way from overseas to get the world economy back on track.

All in all, it appears to bulls that the economy will eke out a small gain this quarter and come roaring back in the fall. They believe earnings surprises this fall will all be to the upside, and the markets will respond.

The Bull Market in Doom and Gloom

But the bears respond with a different set of facts: Veteran market analyst Richard Russell "...is worried. Why? Because the entire economy is straining under an enormous debt burden while stocks are still very expensive and incomes fall. The Labor Department reports that the hours people work just suffered their biggest drop since '91. Fewer hours = less income = less spending = fewer sales, less profit and even higher stock P/Es...unless stock prices fall." (Daily Reckoning.)

Stanley Roach tells us "America now faces the hangover from the bust [of the stock market bubble] -- low saving, high debt, excess capacity, and a massive current account deficit. As a consequence, for the United States, vigorous growth will be much harder to come by in the years ahead than it was in the Roaring 1990s." He stands by his call for a double-dip recession.

And there is evidence he can point to: France is dramatically lowering its economic forecast. European economic growth is now likely to be less than 1% for the year. Argentina has imploded. Japan is clearly in an economic deflationary spiral.

Announced US lay-offs went up, increasing the likelihood that unemployment is still going up. The Institute for Supply Management reported that its January results showed the U.S. service economy unexpectedly contracted last month, a clear sign the climb out of recession isn't assured. Capacity utilization continues to creep toward depression era lows.

Company after company announces lower earnings or are re-stating their profits from past reports. This is creating a malaise and sense of uncertainty among investors. And to cap it off, Daschle has killed any chance of a stimulus bill coming out of congress, leaving the economy to muddle through on its own.

For the first time since 1929, the stock market has failed to respond to interest rate cuts. I assume your mailbox is like mine, with warnings from newsletters predicting a coming depression worse than 1929. The dollar will lose half or more of its value virtually overnight and gold will rise to $1,000 or even $2,000. The only remedy, of course, is to buy their newsletter which will show you how to build a life raft. It's amazing what "un-revealed, little known secrets for financial survival" you can get for $49 or $99. And for $5,000 they can make you the richest man in the lifeboat.

So, Who's Right?

Like the constantly run (and annoying) commercial on CNBC about the manager with conflicting reports from his staff who turns to his friend and wants to know who is right and is told, "the answer is they're both right."

When you ask me, "Who is right - the bulls or the bears?" my answer is they're both wrong.

Both arguments focus on only one part of the equation. There is no argument from this quarter that there is a great amount of "systemic risk" in the economy. I have spent whole issues chronicling them in detail. But there are also a lot of available resources to deal with the problems. The country is awash with debts, but we also have greater assets and cash flow to deal wit them. There are no 1930's style runs on the banks. Yes, credit card debts and home loans are defaulting at record levels, but so far the financial industry has adequate capital to deal with them. There is a reason credit card interest is so high, because these companies expect large defaults.

Corporations are in the process of scaling back to sustainable levels of production, but there is not wholesale retreat except in a few over-built industries like telecom and certain tech sectors. The reduction in unemployment shows that there is still some strength in the economy. Many industries have dropped inventories to much more realistic levels.

Healthcare, a large part of the economy, is growing, although there are some very weak links in the health care world. Basic services, food, housing and retail are holding up, although profits are down. Things are not just that bad, unless you are newly unemployed.

In short, business and the Fed responded much more quickly to the impending recession than normal, and so the recession has been milder than normal.

But that is far from expecting a return to the Booming 90's. Corporate executives complain of "no visibility." Executives who can't see reliably into the future don't start new projects or invest new capital.

World growth is slow to non-existent. "Global trade currently amounts to about 24% of world GDP, well in excess of shares prevailing in earlier global recessions -- 17% in the mid-1970s and 19% in the early 1980s. With America's IT implosion taking the world trade cycle from boom to bust over the 2000-01 interval, recession spared few in the global economy. A globalized world that reaped the benefits of US prosperity in the latter half of the 1990s is now feeling the pain of America's post-bubble shakeout." (Stanley Roach of Morgan Stanley again.)

The world economy was driven by US consumer demand. Demand in the rest of the world grew at an anemic pace of about 30% of US growth. We were the engine. Now that we have stalled, growth will be MUCH slower. If inflation is "too much money chasing too few goods" then deflation is the opposite. There is simply too much capacity in the world, capable of producing too many goods and every country and business is competing to sell their products at lower and lower prices.

Yes, the Fed is printing money at a heart-stopping rate, but debt defaults and bankruptcies, tighter lending standards and a slowing velocity of money has created the smell of what Greg Weldon calls "paper burning." As I have repeatedly written, the #1 Japanese export is deflation. It is a product we could do without.

All this means that while business will survive, for the next year or so profits will be poor. Abby Joseph Cohen's prediction of $50 earning for the S&P 500 is so much smoke. Why anyone listens to such cheerleading is beyond me.

Martin Barnes of the influential Bank Credit Analyst agrees we are in for a weak recovery, but he also thinks the risk of projecting a slow recovery is to the upside. I think the risk is to the downside. But the probability is that the recovery is just slow. We will have to wait for the next time for the doom and gloom writers to be right. Will it be next year? 0r 2004? It is entirely too early to say. For now, despite the worst predictions, we have missed the end of the world as we know it. And so, we muddle through.

Bill, Say It Ain't So!

Bill Gross of Pimco is the manager of the world's largest bond funds, and maybe one of the savviest bond managers anywhere. He is one of my "must-reads" and I find him very thought-provoking. But his latest arrow is way off target. He is calling for Greenspan - double-dog daring him! - to raise interest rates. If it were anyone but Gross, I would shrug and go on. But since what he writes will be taken very seriously in many quarters, let me (with some trepidation) suggest he is 180 degrees wrong.

His argument is as follows: Everyone (including yours truly) expected long term interest rates to come down along with short term rates. Because they didn't the recovery is going to be much slower than it should be. Long term rates are what really matter.

He makes a case that raising short-term rates would actually lower long term rates. Why? Let me let him make his case:

"...the answer...rests in a tricky phenomenon known as "rolling down the yield curve." The simplest example comes from using the example of a two-year Treasury Note yielding 3%. To the unsophisticated eye, the "return" on this piece of paper seems undoubtedly and indubitably to be 3%. It will be if held for the two-year maturity. But what if the hedgie [hedge funds] or intelligent bond investor sells that two-year note after one year with one year to go until maturity? At that time (as long as Alan Greenspan keeps short-term rates low) the investor will hold a one-year Treasury Note which yields 2%, not 3% because that is today's existing yield. The investor's original two-year Treasury Note with a 3% fixed coupon will then be priced in the market at 101 not 100. In other words, in addition to the 3% current yield our "roll down investor" has earned a 1% capital gain for a total of 4% for the first year. Now granted, 4% is still not a great return when compared to a 5 1/2% long-term Treasury bond or a 6 1/2% mortgage, but you can take this "roll down" principle and apply it to five-year Treasuries or better yet five-year swaps and theoretically approximate those 6%+ yields and more with less risk because of their shorter durations.

"How about this for a rather simplified conclusion: The lower Greenspan takes short rates and the longer he promises to keep them there, the harder it will be for mortgage rates and long-term yields to come down. PIMCO-like investors and the hedgies will avoid or even sell the long end, for the comfort of rolling down the intermediate portion of the curve. This year's disinflationary trend will shrink to the background as a primary influence.

"And so? And so? Well, the interesting conundrum of all this - if true - is that the current predicament may resemble the nightmarish philosophy of our Vietnam experience in which we thought it was necessary to destroy the country in order to save it. While that turned out to ultimately be untrue, the parallel today is that Greenspan may have to threaten to raise short-term rates in order to lower mortgage and long-term yields. Only then will "yield curve rollers" desert the security of the roll down for the greater risk and reward of the longer end of the curve. ...By keeping rates low and suggesting they will not rise until the U.S. economy is back on its feet, Greenspan may be guaranteeing just the opposite. For if long-term mortgage rates do not come down then refinancing or "refis" will soon cease to be a factor in bolstering U.S. consumer income. And if long-term corporate borrowing rates do not come down then investment will continue to languish."

Prescription for Disaster

Let me say here that I think if Greenspan raises short term rates, long term rates will come down. But not for the reason Gross suggests. They will come down in response to sheer, unadulterated panic in the stock market and a flight to cash and long term bonds. Nothing could put a damper on the economy any faster than a precipitous rise in rates.

That being said, let's look at some of the elements of his arguments. I called a few fixed income hedge fund managers, very savvy individuals with a LOT of time on the bond trading desks. They had read Gross's column, and they also felt he was wrong. They thought it was more likely long rates would go up, in sympathy with short term rates, at least for the short-term.

This would be a killer for the Muddle Through Economy. If Greenspan starts to seriously raise rates before the end of this year, I will probably get bearish quickly. We would be back into recession so fast it would even make Stephen Roach blink.

Second, the hedge fund market may be big, but it is small compared to the overall bond market. Beating up on the traditional whipping boy of hedge funds is easy, and in this case is wrong. We must look to other reasons.

I asked one manager why he thought long term mortgage rates were as high as they were? He answered, "Because investors simply want more than 5% for lending money for 30 years on a mortgage." Long term 3% money is simply not an interesting investment (pardon the pun).

The Greenspan Two-Step

Third, what makes us think raising Fed funds rates would work? Yes, Greenspan lowered rates, but he was always behind the market. He moved in concert, like an intricate square dance, "leading" by innuendo, switching between his long-term and his short-term interest rate partners.

His long term interest rate partner simply refused to be led, and has left the dance floor. He used his last dance floor trick in October, by announcing the cancellation of the sale of 30 year bonds. It didn't work.

You can only lead a partner where they want to be led. Forcing them is nearly always a prescription for disaster. Trying to force the markets to artificially adjust would have unintended consequences. It isn't right to fool with Mother Nature, and it is a mistake to aggressively interfere in free markets. It creates more problems than it solves.

Price to Book Value Crisis

A long time reader sent me some rather startling statistics on current price to book values of the Wilshire Index, which is basically the entire US public markets. I have to admit I was skeptical, so I asked Troy where did he get these numbers? He sent me back the address of the official Wilshire Index site. You can see it at www.Wilshire.com.

The entire market cap for the Wilshire Index is $12.7 trillion. Wilshire calculates that the price to book value ratio is 6.25. That means the book value for the public American business is just north of $2 trillion. It follows that the market values these companies 6 times more than there account statements suggest is the real value. That is a lot of optimism.

Historically, book value runs below 2 in recessions, and I believe has been below 1 in recessions in the past century.

20% of the market value is in technology and another 20% is in financial services. 86% is in just a few large cap stocks. How many of these large companies use fast and loose accounting to over-state earnings and increase their book values?

Question: How much book value is going to be written off this year in response to company after company coming "clean" in response to Enron and Global Crossing? $100 Billion? $250 billion? Double that? More?

Worldcom alone has $50 billion in goodwill on its books, which is substantially over-stated. How many more companies will write off billions as Juniper did last year to the tune of $50 billion?

Price to book value ratios could go to nosebleed levels of 7 or 8 or 9 simply because of a new climate of stricter accounting standards. How can a market rise in a climate where the book values of companies are falling dramatically and we are in the Muddle Through Economy of very slow growth? But how much can markets fall when investors keep hoping for a return of the Booming 90's?

In line with my writings of the past few weeks, Robert Marcin on theStreet.com did a brilliant essay on how all these valuations are going to affect investors. I wish I had written it:

"...Do not kid yourself. This Enron crisis is huge. Not because of the wealth that Enron destroyed, but rather because of the repercussions it will have on the financial reporting system. Greenspan and Kudlow contend that stock valuations should improve because companies will be forced to report honest income statements. But here's the way I see it: All the "wink-wink" accounting tricks that most companies use to inflate reported profits will be gone: "big-bath" and acquisition charges fed back into income; pension profits; unrecognized option expense; inventory write-offs fed back into profits; special-purpose-entity profits; off balance sheet liabilities; recurring and nonrecurring charge-offs; bogus revenue recognition; and "pro-rata, pro forma, operating profits."

The Future of Valuations

"The financial system will purge itself of these accounting tricks, and it won't be pretty. There are probably a few more Enrons, Tycos (TYC:NYSE - news - commentary) and Elans (ELN:NYSE - news - commentary) out there. More significant for investors, however, will be the stark admission that many companies have played games with the numbers to inflate growth rates and stock prices for many years.

"Contrary to Greenspan's and Kudlow's assertions, valuations will suffer as companies ratchet down growth rates. Risk premiums for equities will rise in this period of higher uncertainty. Reported profits will be reduced. Stocks will retreat as honest, but lower, profits get capitalized at lower valuations."

We entered a long term bear market cycle in 2000 which will typically last for a decade. There is a great deal of denial at the beginning of these cycles.

If that were not the case, we would all simply buy S&P 500 puts and make money hand over fist as the market crashed. But it is not that simple.

Look at Friday's market action. Boom - out of nowhere the market rallied big in the last few minutes. There are still lots of true believers out there who dream that a world of 20% compound growth is possible.

A lot of dreams were built in the last bubble. A lot of investors want "just one more ride" and this time, they promise themselves, they will get out at the top. There is an entire industry of investment cheerleaders built around separating investors from their reason, their instincts and their money.

This is the decade of slow and steady. It is the decade of seeking absolute returns. It is the decade for market timers and nimble traders and value managers. But like generals who fight the last war, many investors seem to want a return of the old regime of momentum and growth investing.

We won't see it return for this market cycle. As study after study shows, markets always - 100% of the time - return to trend. It can happen slowly or it can happen fast, but it WILL happen.

What this means is that gross over-valuations put an upper limit on the rise of the market. There is currently an artificial floor of investor expectations which prevents a drop of 40% or so back to trend.

The market will go back to trend. Either prices will drop or earnings will rise. I have made the case repeatedly that earnings will rise very slowly. The new Enron era of accounting just makes that case even stronger, as accounting tricks will become a thing of the past.

Will stocks drop to meet earnings, or will investors keep the market floating at current levels, patiently waiting for the Godot of earnings to appear?

I can make a good argument for either case. My firm has a unique database of money flow indicators going back almost 30 years. I can tell you that in our data for the last two years the markets are behaving in entirely new patterns. Two years ago I would have thought that could not happen.

We are in entirely new investor psychology territory, and to predict what will happen around the next curve in the road when no one has been there is difficult at best.

Aggressive investors with a few nickels to gamble and are bearish can buy a few S&P 500 or NASDAQ 100 puts. But don't bet the farm. This is the decade of slow and steady.

Coming Attractions

This has been one of those weeks where the tyranny of the urgent got in the way of the important. I know I am supposed to be against cloning for a host of ethical reasons, but there are times when an extra me or two would be quite useful. It is probably just as well that it will not be possible in my life, because there are times when I might yield to temptation.

I had intended to get a chapter or two in my next book called "Absolute Returns" finished. Maybe next week. The first chapters I post will be on the case for a long term bear market cycle. I will let you know when they are ready.

Dad was very proud of his beautiful twins week. They made perfect homecoming queens. It is moments like walking them to the stage and seeing their excitement that make me remember that life is more than a balance sheet, and the most important things are not those we can touch with our hands but what we can touch with our hearts.

The sun is out, it is supposed to be a warm weekend in Texas, so my son and I hear the golf course calling. Until next week,

Your still walking down the middle of the economic fairway analyst,

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