Hope Deferred

John Mauldin | Thoughts from the Frontline
September 6, 2001

Finally, I give you an alternative mutual fund for your cash instead of money market returns.

A Glimmer of Hope on the horizon, but not much more. This week's e-letter has been difficult to write. There is a MOUNTAIN of data that I have sifted through, trying to read the future from the combination of facts and trends. Like reading tea leaves in the bottom of the cup and predicting the future, a lot depends upon the bias of the reader.

The most dangerous forecasters are those who tell an audience what they want to hear, rather than what they need to hear. Almost as dangerous are those whose bias only allows them to see one side of the coin. If all you can see is "heads", then that will be your call every time the coin is flipped. You will be wrong 50% of the time.

There is enough data out this week that one can make a beginning case for a soon-to-be here recovery. Yes, even with the extremely negative action in the stock markets, I can find something positive. Let's start with that.

For new readers, I look at what I call the Three Amigos: the NAPM Index, capacity utilization and junk bonds. In past recessions, these indicators have turned up just about the same time that the stock market did, and typically well in advance of the end of the recession, for reasons I have discussed in past letters.

Last month, I noted that junk bonds have started to show signs of bottoming. That is still the case. You can find some funds which have turned up, but the funds I watch are simply moving sideways to slightly up. This is in stark contrast to the free fall of earlier this year. That is one positive.

Secondly, the NAPM manufacturing numbers came in better than expected. New Orders, Export Orders and Production were all above 50, which means growth, even though the overall index was below 50 at 47.9. However, as Greg Weldon notes, when you look at the deeper numbers, there are still some troublesome trends.

First, this month's focus was on inventory levels. A higher percentage reported too much inventory than last month, and few reported too little inventory. Indeed, this reports suggests that inventories are still a problem at a lot of firms.

Only 8% reported that employment is rising. This is obviously not a good sign.

But the eye-opening number was the NAPM Price Index. It is at 33.9, showing companies have no ability to raise prices. This is down from 65.7 in January, and is just another strong indication that my deflationary theme of the past year is coming into bloom.

On balance, this has to be seen as good because of my often made point: something has to start to get better before we can talk about The Bottom. We need to see a few months of the Three Amigos showing signs of life before we can blow the all-clear whistle. But two out of three are trying to get up off the mat. Now we will just have to wait to see if they fall back down or rise to their feet.

A Few Other Bright Spots

Kevin Klombies, our Canadian chart man, is still bearish on the stock indexes, but like me, he is looking for signs of The Bottom. He has found a few and I list them for you:

"First, real money supply growth is an excellent leading indicator for the overall economy- and it has been strong. Second, our work argues that commodity prices are going to bottom around the end of the year and then turn higher. Third, the yen's March bottom has held- so far- so a year end recovery in commodity prices still looks good. Fourth, lumber does a nice job of leading the base metals and it turned up months ago. Fifth, the Fed seems determined to create another bubble and keeps talking about the wealth effect from real estate. Sixth, while Japan may still be an investment waste land, longer-term rates in that country have stopped declining and may even be on the up swing. Last, net of technology a significant number of sectors continue to do quite well."

And on the Other Paw

I would remind you that the closer to The Bottom we get, the worse things are going to look. Therefore, since we are not at The Bottom but near it (in my opinion), things are going to look a whole lot worse in short order. You can't have a Bottom when things are looking potentially better. Bottoms occur when things stop getting worse. We are not there yet. So let's look at the bad news.

That things can get worse is made clear in today's release of the NAPM Service Sector numbers. While the manufacturing Index shows signs of turning around, the Service sector, which accounts for 80% of the economy, is finally in free fall. This Index had held up in spite of the woes in manufacturing this year, with some drop-off, but last month the numbers showed a severe problem.

Analysts had expected 49.5, but the number came in at 45.5! NAPM's index of prices paid, a measure of costs for purchased materials and services, fell to 48 in August from 49 in July. This is a continuation of our deflationary theme. When previously Teflon-coated service sector prices begin to drop, thing are serious. Again, inventories are a problem. The inventory index declined to 43.5 in August from 46. The index of supplier deliveries fell to 48 from 53.

This precipitated a sharp sell-off in the stock markets today. Adding fuel to the fire was another in a series of negative employment reports. Ugh. For the week of August 18, continuing unemployment insurance claims rose 6,000 to 3.17 million, the highest level since the week of September 26, 1992.

Yardeni, in an otherwise optimistic article notes that he may have to cut his earnings estimate for the S&P 500 to $40 for this year. Even if earnings rebounded an amazing 25% that would mean the market would be at a P/E ratio of 25 AFTER the rebound. This suggests to me that we could see the market drop a lot further if earnings do not show a sign of life soon. By a lot further, I mean the S&P 500 could go lower than 1,000. Yardeni tells us, "Of course a sell off in technology stocks would push the broad averages down too, especially the Nasdaq. This tech-heavy index is likely to test the year's low of 1638 soon. if it breaks below that level, then 1,400 is probably the next key support level." One other well known analyst, Bernie Schaeffer, thinks 1,250 on the NASDAQ is possible.

Sidebar predictions: Speaking of the stock market, I cautiously offer the following: For the record, my birthday is October 4. In celebration thereof, we initiated an office pool last week for the purpose of predicting the price of the S&P 500 on my birthday. With $20 on the line, I chose 1062. Coincidentally, my office is evenly split between bulls and bears.

If Yardeni is right, my more bearish associates may win my money.

Hope Deferred Makes the Investor Grow Weary.

The bad news is dashing hope and stock prices.

Japan Sinks Lower

The world markets are entangled to a degree that many could not anticipate, even 20 years ago. It is very important to US investors what happens in Japan and Europe.

The new Japanese Prime Minister came into office declaring that he would usher in an era of reform, especially in the banking arena. He was going to make Japanese banks write off their debt and clean up their balance sheets. Until this gets done, it will be extremely difficult for any Japanese recovery to go forward. This was greeted with positive, if somewhat skeptical, enthusiasm around the world.

It seems the skepticism is warranted. Stratfor.com tells us that now the PM is back-tracking rapidly. It appears he is going to let the bank reform stretch over 7 years, which may mean a decade or more in Japanese-speak.

This is serious. Last week I reported that some knowledgeable experts are concerned that Japan might implode. This lends credence to their view. While Japan may be on the other side of the world, they are the second largest economy. If they have serious problems, it may be a bigger blow to the world economy than a recovering US can balance.

Japan is in outright recession and monetary deflation is the order of the day. Their markets hit new lows weekly. Their market is now where it was in 1984, or a 17 year low! And there appears to be no bottom. Official unemployment is at 5%, and unofficially may be 50% higher. For the Japanese, this is serious.

The country is mired in a system which is antiquated and keeps prices artificially high. Newer firms are coming in and offering US style discount stores in scores of market sectors and are creaming their competition, mostly small independent operators. The resulting unemployment and confusion is hard on their economy and its people.

Ten years ago people were writing about Japan, Inc. and telling us that the future was Japan. The US was a fading star. Now we find that the Japanese miracle was a mirage, built on false premises and manufactured money.

A few weeks ago, I wondered in this column if my long Euro/short Asia strategy would hold, as the dollar fell across the board. Now it seems I was right, at least so far, to affirm my position. Greg Weldon demonstrates convincingly that Japan and other Asian nations are once again doing their best to devalue their currencies against the dollar. He notes that it seems the Asian countries are in a "competitive devaluation race" against each other in an effort to make their products more affordable to the US and European consumers.

This "race" is a symptom of severe structural problems in these economies. None of them will go away until the structural problems are solved. They are all hoping in a US recovery to pull them out of their quagmire. But even if we do come out of recession, it may be years before the American consumer starts to once again pull the Asian economies into any sort of growth.

There is simply too much production capacity for too many products in the world. One of two things will happen. Either some of that capacity will be shut down through bankruptcies, leaving those left standing the ability to sell their products at a profit; OR prices will continue to drop, companies will struggle through, cutting overhead, cutting wages and employees in an effort to be the last man standing.

This restructuring is going to be felt harder in the rest of the world than in the US. Why? Well, for starters we shipped much of our production overseas in the last 20 years. Secondly, the rest of the world over-built manufacturing capacity in anticipation of a continued boom.

I believe we will see an economic recovery in the US, but it is going to be a weak one for at least 2002. Any talk of 3% growth in 2002 is foolish. I read where the Blue Chip Economists predict we will grow somewhere in the range of 2% for the last half of this year, and higher for next year. (I forget the exact number, and can't find the article.)

Don't buy it. These are NOT independent analysts. While their shingle may say they are, they are in just as much hock to their client's needs as is any in-house economist at an investment bank.

This is cheer-leading of the worst sort. Most economists either have clients who want to be able to tell their customers "good news" from their in-house economists and thus encourage buying today, or they have rose-colored glasses.

Now there are some very good independent economists. It is just that very seldom do you read published reports from them that are negative. Why would a company release a negative report and discourage their customers? They keep the bad reports internal and only release the good news.

Finally, there are analysts I highly respect, such as Richard Russell, who has been writing the Dow Theory Letter since 1958. He has an excellent record of predicting the ups and downs of the stock market. Of the market-timing strategies monitored by The Hulbert Financial Digest since 1980, his is one of just two that have beaten a buy-and-hold policy adjusted for risk. Russell points out that the Dow Theory does not forecast how long a trend will persist. He has noted, however, that the typical bear market lasts one-quarter to half as long as the preceding bull market. That could mean that this bear market will last at least until 2003.

To finish this week's letter, I am going to reprint Russell's letter of mid-August. It is mandatory reading, and comes from someone who has earned the right to our respect.

*************

Richard Russell
Dow Theory Newsletter
August 17, 2001

Predictions abound regarding the "coming turnaround in the economy." It reminds me of the story of the "wonder kid" who kept coming up with these amazing statistics. Finally, someone asked the kid, "How do you do it? How do you remember all these incredible statistics?" The kid answers, "I don't remember them, I just make them up as I go along."

Which is about what's happening as the various analysts, strategists and fund managers continue to predict "a turnaround in the first quarter of next year" or "in the next six months" or by "the fourth quarter of this year." You want to know the dreaded secret? These guys are just guessing. The truth is that they haven't a clue, not the hint of a clue.

You want some examples of boneheads who were guessing and worse, guessing wrong? OK, it's 1973 just before the worst market collapse in stock prices since the 1929-32 horror. And here is just a sample of a few guesses:

January 17, 1973 "The danger is that business may get too good too soon. Up to now there has been a strong element of business and consumer caution that has helped to keep the recovery under control. There are signs, though, that the caution is diminishing." --Alan Greenspan.

June 5, 1973, Treasury Secretary George Shultz states that there are "bargains galore in the stock market now. I almost wish I wasn't in my present position, so I could get my hands on some money and invest it" The Dow was 901. By late 1974 the Dow had crashed to 577. Most stocks did worse than the Dow.

October 1, 1973 writing in Forbes, Myron Simons, director of research at Wooden & Co., "The market & has hardly reflected at all the growth in earnings and in investment that has taken place in the past decade. Since we have probably seen the worst of our inflation with last month's staggering increase, it's time to turn bullish."

And on and on. Talk is cheap, analysts' egos are large, dumb predictions are forgotten, and where the stock market is concerned, BS always reigns supreme.

A subscriber asked me, "Russell, I'm not going to hold you to this, but honestly -- what are your secret, inner-most thoughts about what lies ahead?"

I hesitated saying the following, but I thought, "What the hell, if this is what I really think, I might as well tell my subscribers. They're paying their hard-earned money to hear what I have to say." So here goes.

I think this market is going to go further on the downside than anyone thinks possible. I think we're early into the 'big daddy' of bear markets.

Next, I believe that Greenspan has his reputation and his legacy on the line and he knows it (this little guy has a big ego). I think he'll give money away in his frantic effort to turn the stock market and the economy around.

I think we're going to see a long list of extremes. I think we're going to see interest rates go way, way down, with the long bond maybe hitting a yield of 3% (the yield on the 10 year T-note is already 4.84%).

I think we're going to see deflation (we're already seeing it in the stock market, and the stock market leads) and I think we're going to see deflation across the board, INCLUDING, the price of homes and real estate in general. I believe it was 1954 when the yield on stocks dropped below the yield on bonds. The age of the stock market had arrived.

My belief is that before this bear market is over, stock yields will once again climb above bond yields. The age of income will have returned (it was last seen during the '30s and '40s).

CONCLUSION: It's a bear market. So far we've had months of erosion. We're in the second phase now, and in the second phase stocks go down on bad news.

************************

The above is not entirely inconsistent with my personal view, by the way. I think we will see a rally later this year, as the economy hits bottom. Then, after what will seem like a return to the good old days, investors will notice that profits haven't rebounded. Stocks will be close to all-time highs on a P/E value basis. THEN we will see the next leg of the bear market. Will it be sideways or a drop? As bad as Russell predicts, or a kinder gentler bear? There is no way to know this far in advance. As Russell points out, I am just guessing. But lately my guesses have been as good as some, and better than most. History says, though, that those of us in the prognostication business will eventually be wrong, and at a time when it will cause the most embarrassment. However, I hope to avoid a red-face for a few more months.

Soon, I hope to be able to write that it is time to venture back into the markets. But to protect ourselves, when we do, we will stick with VALUE, VALUE, VALUE and more VALUE.

Money Market Woes

I get a lot of letters from readers and many questions from clients along this line, "OK, I have my bond position. I am out of the stock market. Where do I put my cash? Money market rates are really low."

Let me recommend a fund for those of you who have a lot of cash but don't want to take a lot of risk: The Vanguard Fixed Income Short Term Maturity Fund (VFSTX). This fund has a Morningstar rating of 5 stars. They say: "In general, short-term bond funds aren't designed to provide big thrills, but this one loads up on investment-grade corporate bonds instead of government and other high-quality debt. Its low fees, low volatility, and solid long-term returns also make it stand out."

There is more risk to this fund than a government money market fund, but the fund sticks to investment grade corporate debt. Year to date, it has returned 6.9%, and is clearly being helped by the interest rate environment.

Since it can go down in value, this is not a place to put short-term money. This is for cash you expect to have one year from now.

Vacation Value of the Year

Correction: I told everyone I was going to Flippin, Arkansas. My wife and I actually spent last weekend in Fairview, Arkansas which is a suburb of Flippin at the Riverbelle Bed and Breakfast. I have been in 40 countries and 48 states, and for my money, this is one of the best value mini-vacations I have ever had. (I should point out that my wife found this place, for which she takes no small credit.)

Sybil and Bob Redmond have a slice of heaven on earth on the White River, which is supposedly the best fly-fishing river in the country. He says he has caught over 100 fish per session on more than one occasion. Their large and immaculate home is spacious and exquisitely decorated, with every amenity the heart can desire (including the best spa I have ever been in). The grounds and gardens are beautiful, and perfect if you are looking to relax away from the pressures of the world. The deck is perfect for reading, and Bob and Sybil are great chefs. You can see it at http://www.bbonline.com/ar/riverbelle/. Tell them I sent you. I will be back. It seems like a perfect place to do the final edits on my book.

There is so much more we could write about but it is time to push the send button. We will just have to save the rest for next week.

Your still waiting to be a bull market cheer-leader analyst,

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