Forecast 2004: The Silver Lining Economy

John Mauldin | Thoughts from the Frontline
January 9, 2004

For the last 10 days, I have been reviewing over 500 pages of forecasts, predictions, and data from a wide variety of sources. Some have been extremely bullish and others make you want to just slit your wrists and get it over with. But even ignoring the extremes, which are almost always universally wrong, never in all my years have I seen such a wide range of opinion and disagreement accompanied by an increased hardening of those opinions. With a few notable exceptions, there are a lot of analysts who seem more sure of their view of the future than they have been in the last few years.

I am one of the exceptions, but nevertheless I will plunge into the treacherous waters of writing my annual forecast issue. If I go into as much detail as I usually do on each topic, there is the potential for this e-letter to be much too long. Therefore I will try and take the larger picture, make specific and shorter predictions and save the details and the arguments for later issues. Let's begin by quickly reviewing how we did last year.

All in all, not bad. For masochists and those with lots of time, you can go to the archives at www.2000wave.com and read the 2003 forecast issue. But in general, given the vagaries of prediction, I would be glad to do as well this year. I clearly laid out the case for a bear market rally, and pointed out the average bear market rally was 24%. I called for lots of bond volatility and went from a long time bond buy and hold bull to a bond trader. Although I think there may be some more upside, the big gains from holding bonds have been made.

I wrote: "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."

I called for a continuation of the Muddle Through Economy and a 2.5% GDP, but wrote: "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."

Those ifs and more came about, as the dramatic drop in interest rates allowed homeowners to re-finance their mortgages in the second quarter, adding to the stimulus fuel of tax cuts and rebates, increased government spending and low Fed rates. The final GDP for the year may well be close to 3.5%. I fully admit to being surprised by the third quarter's powerhouse growth. That growth elicited the quote of the year from Warren Buffett, something like "I could throw a helluva party, too, for $1 trillion dollars."

I predicted in January of 2003 that Greenspan would not raise rates in 2004, and I stand by that prediction this year. At that time, I was all alone in the corner. Now that view has been adopted by 6 of 15 analysts in the recent issue of Barron's. Actually, I wrote that Greenspan had raised rates for the last time in his career in early 2001, but I assumed that he would retire in the summer of 2004. He may yet get the opportunity to raise rates, but not this year, as I will discuss.

I called for a drop in the dollar and a rise in gold. I totally blew it on my oil price forecast. I suggested TIPS which have done well. I thought commodity funds and macro traders would do well, and many of my favorites have prospered handily. I was bullish on high yield bonds.

Even given my usual muddle through caveats and "on the other hands," not to mention how difficult it is to even see around next week's corner, I would be happy if I could get as lucky this year. Given the conflicting forces at work in the economic world, it would be lucky indeed if it turns out as well, as there are more than the usual caveats and issues.

The Silver Lining Economy

Each year as I sit down for my forecasts, I try to focus on what the main macro-economic forces are and how they will affect the markets and our investments. In 2001 it was the coming recession; in 2002 it was a weak recovery and the beginning of the Muddle Through Economy; last year it was Surprise and Transition.

While this may surprise a few readers, in many respects, this will be my most upbeat prediction for the economy as a whole for the last five years. While there difficult issues we will have to deal with, I think the proper way to view the economy this year is as The Silver Lining Economy.

Every manager, entrepreneur and CEO is constantly looking for ways to serve their clients and improve their business. As a starry eyed optimist, I am constantly coming up with ideas. Because of the vast complexities of the securities business, many of these ideas I run past my attorneys to see how we can proceed. Then if I get a positive answer, I typically send it to Bob Amedeo. Bob is the Chief Operations Officer at Altegris Investments, a firm with which I work very closely. A former SEC attorney, he has been in the alternative investment business for many years. All who know him respect him for his thoroughness and knowledge.

I frequently characterize Bob as the person in my life who is most adept at finding the dark clouds within my silver linings. It usually takes him only a few minutes to come up with a list of problems that face any proposal, many of them of potentially small chance of happening but nonetheless issues which must be addressed. When his more sober analysis does prove to be right, which it often does, he gently reminds me how smart it was to have taken the steps in advance to deal with potential future problems - the dark clouds - even if they were low probability events. Acknowledging the potential dark clouds has saved me from more than a few hassles.

And that is much the same way I see the economy shaping up for 2004. There are some nice silver linings that contain some very dark clouds. There will be a lot of good news that will tempt investors to see only the silver linings as they will indeed be pretty, but ignoring the future potential for dark clouds to overwhelm them will result in problems. Now let's run down my predictions. I know that I am not giving you the supporting data, but I promise to do so in coming weeks.

The Economy Grows Above Trend

First, the economy will grow above my longer term Muddle Through forecast of 2-2.5% per year as an average for the decade. In Las Vegas, you can bet what is called the "over/under line." As an example, you can bet that the total score for both teams in a football game will be either over or under a particular number. The forecasting team at Dresdner Kleinwort suggests consensus among analysts is for a GDP growth of 4.2%.

I would take the "under" bet of 4.2%, but if the consensus number was 3%, would most likely take the "over." That being said, I think that we end the year with less momentum than when we began. The first half will be stronger than the latter part of the year. I fear I will be talking about Muddle Through again before the year is out. By the way, that is NOT consensus. Most observers, and in particular the highly respected Bank Credit Analyst, see 2005 being strong as well.

Why will it be this good? In a word, stimulus on top of more stimulus. Eventually, it will not be enough, but for the first part of this year, it will suffice. Let me give you a number of reasons we should expect the economy to do well this year.

*The Bush Tax cuts are not one time events. They will continue to provide stimulus to the economy throughout the year. Indeed, without the tax cuts and a low Fed funds rate, we would likely be in, or close to, a recession.

*The Fed will not raise rates, keeping them low throughout the year. There will be no reason to raise rates. Inflation is unlikely to rise this year, and as today's employment report confirms, even an economy growing as well as this one is not producing jobs at anywhere close to a pace that will significantly lower the unemployment race. The Jobless Recovery is still unhappily intact. Treasury Secretary Snow staked his reputation on an economy that would soon be producing 200,000 jobs a month. His reputation is sadly on the way to being tattered and bruised.

Today's report showed we did created only 144,000 for the entire fourth quarter. This is a quarter in which the GDP numbers will be quite good. That does not bode well for the future. Greg Weldon noted that:

"And, just like the Challenger-Gray-Christmas layoff report, the US Payroll report revealed 'breadth' in terms of sectors posting a decrease in jobs, including:

* Retail ... down a HUGE (-) 38,000 ... on top of November's massive monthly decline of (-) 28,000.

"US Retailers not only FAILED to hire a SINGLE net-new employee during the PEAK Holiday sales season ... they posted a 4Q job contraction of 57,000. We view this dynamic, as a microcosm ... a micro-to-macro phenomenon of SIGNIFICANCE ... as a SURE SYMPTOM of PRODUCTIVITY, in terms of Holiday retail sales, that did NOT require HUMAN labor input, for facilitation. Deflation REIGNS within the US labor market, case closed."

To repeat my long held position, this is not an environment in which the Fed will see a need to raise rates. Indeed, they are clearly telling us, at every available venue, they do not intend to raise rates.

*Business profits are on the mend, which is good for the economy. It will spur some business investment spending. At some point, it needs to create job growth if the recovery is to become self-sustaining.

*Two of my Three Amigos are doing quite well. Long time readers know I watch three key indicators to give me a sense of the strength of the economy. The ISM numbers (projected manufacturing orders, etc.) are excellent. High yield bonds are telling us that the underlying strength of smaller businesses is improving. But capacity utilization is still anemic, and well below the level which would require businesses to invest in building more capacity. Faster growth in business spending is necessary for a sustained recovery and jobs growth.

*Housing, while it will soften, will not fall out of bed. This will keep an important part of the economy chugging along.

*Government deficit spending is huge and is a strong stimulus. Of course, it will be a problem in the future, but not this year.

*The stock market should do well for at least for the first half of the year, buoying hopes and sentiment.

* Finally, consumer spending is continuing to grow, albeit modestly. Consumers seem willing to increase their debt and decrease their savings. We are increasing debt service faster than disposable income. Over the recent decade or so, the savings rate has dropped from 12% down to 2%. Much of the growth in consumer spending this last decade has come from reduced savings, as the "wealth effect" of an increasing stock market and home values have left consumers feeling good enough to increase immediate consumption at the cost of current savings.

I have written about the all-time highs in personal debt, although much of it is mortgage debt, which is not a bad thing, as more and more renters buy homes. Still, the non-mortgage growth rate is extraordinarily high. Today's labor report shows that average hours worked is down over the last quarter and average hourly pay is flat. Mortgage delinquencies are rising and bankruptcies continue to set new highs.

Consumer debt is rising faster than incomes are growing. This is an unsustainable trend. It will eventually have to slow down and moderate. At some point this decade, boomers start to save more and consumer spending growth will slow dramatically.

Given these facts, how can the consumer continue to increase spending? Is he (or she) not clearly at the end of the line? I think not yet. Predicting the demise of the American consumer has been with us for a long time. Bank Credit Analyst found this interesting piece of history.

Debt Fears Are Nothing New

"Consumer short-term debt ... is approaching a historical turning point. Having risen at an abnormally fast rate for ten years, it must soon adjust itself to the nation's capacity for going into hock ...which is not limitless. Whether the rate of growth in consumer debt will slow down is no longer the question ... it must slow down."

That was from the March, 1956 issue of Fortune magazine. They also quote from other sources throughout the years since then. They were all obviously wrong.

The way to bet on the American consumer has been to always, always, always take the "over" side. Eventually, of course, that will be the wrong bet. I stand among those who look at the numbers and charts and wonder "how long?" But my guess is that it will not be this year. There is still some room left on the credit card.

The Dollar Continues to Slide

That brings us to another part of the dark cloud - the trade deficit. We must borrow as a nation about $500 billion each year to finance our foreign purchases over what we export. I became bearish on the dollar in early 2002, and thus bullish on gold. The dollar, depending upon which index you use, is down 15-20% from its high. Against the euro, it is down 50% from the highs, although only 6% from when the euro was first introduced.

I have often written about the woes of the dollar, and will do so in the future. Suffice it to say that I think it drops to $1.40 on the euro this year, and ultimately $1.50-$1.60, but hopefully not this year - that would be too much pain too soon for everyone. The yen will strengthen to below 100, and may touch 95 this year. The Canadian dollar may be the best bet, as it is the "commodity currency" that has moved the least vis-a-vis the dollar. The Bank Credit Analyst thinks the Canadian currency could rise to $1.20 on their terms, or more than $.80 in ours. That is a very healthy rise, indeed. It will make my Nova Scotia trip this summer much more expensive.

How can I be so optimistic about the year with such a trade deficit and such a lower dollar? Will not foreign countries start to dump the dollar? Will not this force the Fed to raise rates? I obviously think that answer is no.

Japan spent $190 billion (with a B) last year to fight the fall of the dollar in terms of yen. According to estimates by Dennis Gartman (and he is usually bang on) they have already spent $30 billion in the first week of January, and have barely kept the yen above 106. That is simply staggering.

Other Asian countries are fighting the depreciation of the dollar as well. If they had any intention of stopping or throwing in the towel, they would not be going to such extreme lengths. The world seems committed to an orderly fall in the dollar. This means they must buy our debt.

This, of course, allows us to keep buying their "stuff" and thus keeps their economies going and out of recession. They will seemingly continue to do so until they create their own consumer demand. It is of course an unsustainable trend, but the end is not yet.

The key is China. They must allow their currency to begin to float against the dollar and open up their markets. By WTO agreement, this will happen by 2007. I think they move sooner on a slow graduated basis, but it does not look like they will move much, if at all, this year, and they are still buying US debt.

Interestingly, import prices have not risen all that much, nor have our exports. With this drop in the dollar, I would have liked to see a concomitant shrinking of the trade deficit. It has not happened. I am assured this is a lagging issue, and we will see the deficit narrow.

Stock Market Predictions

This is a momentum market. The best way I can summarize my views is to tell you of a bet I made today. It is a small amount, to be sure, but ego is on the line. Let me emphasize this is a guess. I have no "model" or crystal ball.

If you add the closing year end numbers of the S&P 500 and NASDAQ together, I took the under for the year. That means I think the combined price of the indexes will decline. If the S&P 500 does indeed rise, I expect the NASDAQ to fall more. I would also take the over for May, as a further rally may be in the future. I think a continuation of this rally is quite possible, as earnings should do well, and investors seem to be happy with the short-term. But the upside does not seem to me to be all that great. I would buy value and yield and have a trailing stop loss. How close would depend upon your own particular circumstance.

It might be more helpful to give you the opinion of Richard Bernstein, the Chief Strategist for Merril Lynch, who sees the S&P 500 at 1010 at the end of the year. The technical analysts at UBS see a first half rally and a second half decline.

I feel more comfortable thinking about the longer term trend. We are in a decade long secular bear market, and will trade sideways to down for many years. The next recession will see the market making new cycle lows. But enjoy the run as long as it lasts.

Bonds Repeat, Gold Goes Up Some More and Oil Prices Rise

Bonds will again be volatile. I would see longer term rates somewhat higher at the end of the year, unless we are starting to see signs of a recession. The key will be to watch the employment numbers. This recovery cannot sustain itself without far more growth in jobs. There are 670,000 more people who have stopped looking for work in just the last three months. They are no longer counted against the unemployment number, which is increasingly becoming a bogus figure. Almost five times as many people dropped out of the labor pool in the fourth quarter as found jobs. That is terrible.

If we continue in this jobless recovery, it will start to affect consumer spending and housing and a host of job sensitive sectors. It could lead to a recession and a resumption of deflation. The Fed will not allow this without a fight. They will move to bring long rates down. This is not a prediction, just an observation, as I have no way to know if job creation will manifest itself. It has not to date. I have written on this in the past and will follow this closely in upcoming letters.

Let me throw out a thought that lurks in the back of my mind: the next move by the Fed on interest rates may be to cut them. Outrageous? Not if we do not see a real growth in employment.

I continue to be quite bullish on gold. Buy on dips and corrections. I do not think of gold as a commodity. Gold is a neutral currency. As long as the dollar is dropping, gold will continue to rise.

Sadly, I think that oil is not going back down for some time. Neither is natural gas going to drop substantially. Unless Iraqi oil get back on line or Saudi Arabia decides to cheat on their quotes even more than they already are, it looks like gas prices this summer could be quite high, which will not be good for the economy. I wonder if Bush will consider using the Strategic Oil Reserves if prices get too high and threaten consumers (and voters)?

Speaking of Bush, he will win in November, but it will be closer than the current polls show.

In summary, it appears to me that this year will be one that the bulls will enjoy. We will watch for the dark clouds together, but let's not fail to enjoy the silver lining while it is here.

Bullseye Investing

This will be a busy year for me. My book, Bullseye Investing , will be in the bookstores sometime in April. Amazingly, I will be getting the edits from the publisher (John Wiley and Sons) next week and they will be on PAPER. In this age of electronics, I will be doing the final check on old-fashioned paper. The book will go into far more specifics about investing than I can touch upon in this letter. I hope it will do well, as I have put a lot of time and effort into it.

I expect to do a lot of travel in conjunction with the book, so I will be able to make more new friends from among my readers as I travel more than I have in years. Hopefully I will be coming soon to a town near you.

I expect to move offices in the first part of the year, staying in the Fort Wroth area, but we have not yet decided upon where we will

As a side note, and now that the book is finished, I will once again resume writing the Accredited Investor E-Letter this month. Many readers write and ask about specific investment recommendations. Frankly, most of what I do involves private offerings, hedge funds and other types of alternative investments, about which I can say nothing in a public forum. If you are an accredited investor (at least $1,000,000 net worth), you can go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds and private offerings. Please read all the material on the site so you can understand the process, especially the part about risks. I do not like to limit the letter based upon net worth, but there are very specific laws about who can get legally get information about and invest in private offerings. I always follow the rules. (In this regard, I am a registered representative of the Williams Financial Group, an NASD member firm.)

I will be in Miami February 6-10 and will have time to meet with clients and potential clients.

Let me wish you the best for 2004.

Your starry eyed optimist analyst,

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