House of Credit Cards

John Mauldin | Thoughts from the Frontline
April 19, 2002

Today, we will look at a company that will pay you 8.7% a year because you are getting older. Yes, my Maine Source for value investing has come up with a gem for this month's value stock.

But first, we are going to examine a HUGE deluge, a veritable tidal wave of data, that has been dumped into your intrepid analyst's lap (top) this week, all of which points to the truth of my primary macro-economic theme: we are in a Muddle Through Economy. In fact, we can start to see real reasons that suggest we will be in a Muddle Through Stock Market for a long, long time. And that, investment fans, means you better have your portfolios adjusted for Absolute Returns. 8.7% will seem real good in a sideways to down market, let me assure you.

Stick with me for what should be one of the more interesting letters of recent months. Rather than delve into what could easily be 50 pages of data, I am going to give you the broad brush, and point you to sources, if you care to follow up on the details.

What we will be doing is to examine the problems facing our economy, and specifically what Greenspan is likely to do given the options he has.

House of Credit Cards

The American consumer is doing his bit to bring the world out of recession. Imports (not including oil) surged 4.7% in February. The slightest sign of a recovery and the consumer breathes a sigh of relief. Sales of products from abroad were up across the board. After a recession, imports are supposed to be dropping as a percent of GDP. Not so this time. Paul Kasriel of Northern Trust used the term "house of credit cards" to describe the ability of the consumer to keep this up. As we will see below, I think the signs are that we will see this slow somewhat

I have written extensively about the assertion by Morgan Stanley that the trade deficit will widen to 6% of GDP in 2003, which is clearly unsustainable. In the past, a huge portion of our trade deficit was covered by foreign companies, mainly European, buying American assets and companies. A second large portion was foreign buying of our bonds and stocks. These two sources, especially mergers and acquisitions, are slowing up.

My contention of the past few months is that the dollar is very vulnerable. It now looks like that vulnerability is appearing before our eyes, much sooner than many, including me, expected. Currencies all over the world, from the Czech Koruna to the Australian Dollar are beginning to make new highs against the dollar.

It is interesting to watch the responses of various governments. Asian countries are not happy about this, especially as the Japanese government continues to work to create a lower yen. This means the other Asian countries must figure out a way to keep their currency competitive. Taiwan in particular comes to mind.

Europe, on the other hand, is willing to let the euro rise. Most of them are content, with the exception of Switzerland, whose central bank wants the value of the Swiss franc to drop.

I think it is reasonable to assume the dollar will drop 10% against the euro over the next year, and get back close to parity. But this currency drop will not be across the board, as Japan in particular has expressed a determination to lower the value of their currencies against the dollar. The other Asian tigers have clearly demonstrated in the past that they will not let their currency values get too far from a depreciating yen.

(Master Trader Greg Weldon thinks the euro-yen trade is a great opportunity for commodity traders. I agree. I have a hard time believing the dollar is going to get much stronger against the Euro and its related currencies. Another idea you might consider is shifting some assets to the Euro or its relatives. You can open CDs in the Euro or other currencies at Everbank right here in the USA. Just click here to view their information page.)

The importance? Normally, a depreciating dollar would make imports more expensive and thus heat up inflation. But global production capacity is so high that companies world-wide, and not just those in the US, have little pricing power. That will help keep a lid on inflation. Greenspan will keep a close eye on the value of the dollar, but will not panic.

The Bush administration is likely, in my view, to come to the conclusion that a slightly weaker dollar policy sooner rather than later is in our best interest. It makes our exports more competitive, it will help lower imports somewhat and thus maybe head off a trade deficit crisis that could loom in 2003-2004. This would significantly hurt the dollar, slow the economy and giving us stagflation in 2004, which is not a very god environment in which to hold a national election.

King Dollar, while not being knocked off the throne, will have to share power with the euro.

The Fed IS Worried About Inflation

The number of economists who have written this month calling for the Fed to raise rates soon so as to head off inflation is increasing. Yet Greenspan, in several commentaries made it clear that he is in no hurry to raise rates. I think it is likely the first time he raises rates will be in August, and that Fed rates will rise very slowly to 3%.

Yet, Greenspan is worried about inflation, even though he tells us not to worry in that regard. Why do I say so? Today I will argue the reverse of my thesis in 1999. Back then, even as he raised interest rates, he was increasing the money supply at what would normally be alarming rates. I said he was trying to do two things. He wanted to slow an over-heated economy and bubble down, and thus he was raising rates.

But he was worried about outright deflation, and so he increased the money supply. With some short rest periods, he has been tapping on the money supply gas pedal in an effort to head off deflation ever since.

Now Greenspan is putting on the breaks. Statistical Guru Greg Weldon gives us these numbers.

The data from the Fed last night shows every money supply category down significantly. March M-2 growth was Zero. In fact, there was actual contraction.

One of the stats I like to keep my eye on is the rate of change in the growth of the money supply over time. The three month rate of change (ROC) for M-1 was only 2.2%, down sharply from 6.5% the week before. Ditto for the corresponding numbers for M-2 and M-3. Even the 12 month ROC is beginning to drop across the board.

But Greg gives us an even more telling series of stats. He looks at the rate of change for the M-3 aggregate numbers for the last 13 weeks. It has been dropping like a rock for the last 7 weeks, steadily coming down from 8.5% to 4.4%.

Greenspan is putting on the brakes, and that is why he tells us not to worry about inflation. He is taking care of it.

So why not raise rates as well? Remember last week we talked about the huge growth of interest swaps? Well, this week we find that this segment of the derivatives world grew dramatically in the last half of 2001. Clearly the evidence points to the fact that more and more companies are swapping out long term debt for short term debt. This is significantly lowering their interest rate expenses.

But the problem is that even as interest rate expense drops, it is growing as a percentage of corporate profits. Andrew Kashdan of Apogee Research writes, "Specifically, pretax profits equaled 224% of net interest expense at the end of 2001, down from 292% in 2000 and almost half the glorious 400%-plus level reached back in 1996. Similarly, internal funds as a percentage of net interest expense fell to 380% in 2001 from 411% in 2000 and 563% in 1996."

I read that and got one of those "aha" moments. Greenspan, while saying we are on the road to recovery, keeps hinting that we are not out of the woods as an excuse not to raise rates.

Most analysts think that a rise in rates by 1% or 2% would not make much difference to corporate profits, as companies have longer term debt. But we can clearly see that while many of the companies, like GE, are raising long term money, they are swapping it out for short term rates. This helps their bottom lines today. They also do not put the existence of these swaps into their balance sheets. We don't know who is doing what, but the macro data is compelling the swaps are extensive.

If Greenspan were to raise rates, he could (and he probably thinks would) cripple US corporate profits. If short term rates were to rise by 2%, it might mean interest expenses could rise by 70% or more. (You can get short term money for about 3% or less if you are credit worthy.) That would cut into critical money needed for capital expenditures and growth just as we are coming out of a recession.

Greenspan is boxed in. Raising rates risks a double dip recession. But a return of inflation risks stagflation. What's a central banker to do? Tighten money, as he is doing. Case closed.

Except. Except I keep looking at the implications of all this. Especially when I factor in a few more clues.

The Data Says: Muddle Through

Kashdan (Apogee Research above) also tells us that "Last week's increase in the unemployment rate made headlines, but the claims data also bear watching if one wants to discern labor market trends. We're watching, and what we're seeing is not encouraging. The four-week moving average of initial jobless claims for the week ended last Saturday was 433,750, an increase of 9,750 from the prior week. There was also a big jump in the actual claims number for the week ended March 30, a period distorted by the extension of benefits under recently passed federal legislation and by the Easter holiday.

"But continued claims data, as ISI points out, are not distorted by the recent legislation, since only initial claims filed on or after March 15 are eligible for the benefit extension. And here, too, we're seeing big increases. In the week ended March 30 (the latest data available), continued claims rose by 145,000, to 3.78 million, for the largest increase so far this year. The number had risen slightly between February 23 and March 16, before picking up steam in the two latest weeks. In strong recoveries, says ISI, such as 1975 and 1983, continued claims never backslid like this. Such a reversal did occur, however, in the sluggish recoveries of 1971 and 1991. The bread lines aren't forming just yet, but the claims data are something to keep an eye on."

Government receipts are down significantly. The U.S. budget deficit widened 27% in March from a year earlier as the recession and tax breaks cut into revenue. The shortfall grew to $64.2 billion. The increase pushes the nation toward its first annual deficit in five years. The shortfall for the first half of this fiscal year is $133.6 billion, more than four times as large as the gap of $24.8 billion in the first six months of fiscal 2001.

From tax receipts growing at 10% in 2000 we are now watching tax receipts drop 7% from a year ago.

While the US government can write checks, state and local governments are raising taxes, fees and anything else they can do to get revenue.

IMF cut the prediction for 2002 growth for the Asian economies, simply because of the rise in oil prices. Oil is also having a negative effect on the US consumer, and thus likely to slow our economy as well.

The Meyers Group tells us "The economy shows more evidence that a recovery is underway, but homebuilders eased the pace of construction activity in March, possibly waiting for assurance that the worst is behind us. Builders' apprehension about future home buying activity shows more prudence than pessimism."

Inflation was much lower for March than most economists predicted. While for the past 12 months inflation is still at 1.2%, if you go back just ten months it is 0.4%! I maintain my prediction from two years ago that we will see an annual inflation number this summer with a "0" as the first number!

Time to Find Absolute Returns

I could go on and on, but you get the picture.

The sizeable growth in the economy in the first quarter is widely held to have been due to inventory rebuilding. Much of the growth in imports was probably due to inventory building as well, and does not necessarily mean that the consumer will not get more cautious as the recovery weakens this quarter and unemployment does not turn down significantly.

A decreasing money supply, a weakening dollar, growing oil expenses, rising local taxes, slower home building, slower retail sales growth, an extended consumer, etc. all point to an economy that is not going to have a "V" recovery. While nothing points to another dip into recession (barring some unforeseen event) this is not a climate for strong growth.

It is precisely a prescription for the Muddle Through Economy. And because this will be a weak recovery, we are not going to see a significant rebound in overall corporate profits anytime soon.

As corporate profit growth continues to disappoint investors, they will grow increasingly disenchanted with the stock market. Not all at once, but over time. And this means we will see a Muddle Through Market. Broad market indexes like the NASDAQ, DOW and S&P will be in a sideways to down direction, trading in a channel that will not look pretty for several years.

An 8.7% Yield While We Get Older

What's an investor to do? Find value! Find companies or funds that will pay you to invest in them. My Maine Source for value is Tom Donaldson, former chief investment officer for a Maine bank who now manages private money. He recently sent me a whole group of great ideas (for my management clients), but the one I like the best this week, and which I report to you, is one which takes advantage of the fact that we boomers are getting older. In fact, they will pay you 8.7% if you buy their shares! This is what Tom writes:

"Senior Housing Properties Trust, listed on the NYSE symbol SNH, is a real estate investment trust (REIT) focusing on the ownership of senior housing and elderly care properties. The companies properties include assisted living residences, congregate care communities and skilled nursing care facilities. With a market capitalization of over 850 million, SNH is geographically diverse with facilities in 28 states valued at over $1.2 billion. The recent acquisition of Crestline Capital's 31 high-end retirement communities operated by Marriott gives the company further strength in predominantly private pay communities operated by Marriott. The current dividend of $1.24 represents a yield of 8.7% at the current price of $14.25. The dividend was just increased April 8th. SNH's conservative capital structure of 40% debt gives the company significant flexibility to pursue additional investment opportunities. The shares sell at a discount to the peer group. A possible 10% move in the stock with this yield could result in an 18% annualized return. Not too shabby in a muddle through market. Only buy with limit orders."

More Value Coming Your Way

Next week, I take a way too short a trip on Wednesday to Puerto Vallarta to meet up with my bride. She gets to stay, while I have to leave Saturday to get back up to Palm Springs to speak at an investment conference for money managers. I will be in Southern Cal until Thursday afternoon. I still have a few slots open to meet with potential clients, if you would like to discuss your investment portfolio with me. As a manager of managers, I can introduce you to some very capable managers who have been successful during the recent market turmoil.

While I am in Mexico, I have asked one of my favorite writers, Lynn Carpenter of the Fleet Street Letter, to write my weekly letter. She is going to talk about how she finds great value stocks and show you how you can, too! This is a letter you will not want to miss.

Basketball play-offs begin this week. The Dallas Mavericks are due. I can feel it. I will be courtside Sunday afternoon for the beginning of the Run to the Finals. Of course, we have to get past a few California teams. But hey, maybe even my Mavs can Muddle Through to a title.

Enjoy your week, hit 'em straight, and find some time to be with your family and friends. Life is much better when we muddle through together.

Your thinking about guacamole, golf, beaches and romantic nights analyst,

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