Investing on Faith

John Mauldin | Thoughts from the Frontline
June 1, 2001

Faith is an interesting thing. "The substance of things hoped for, the evidence of things not seen," said Paul. Invisible though it may be, faith makes men do things that all the facts in the world, lined end upon end, could not provoke them to do.

I look at the markets of the past few months, and marvel. I think I understand the theoretical nature of faith, having graduated from seminary in what seems like a past life, but was really only a few decades ago (well three, anyway). Fortunately for some poor unsuspecting church, I never went into the pastorate, but immediately upon graduation went into business. I never regret the time spent, though, as those lessons serve me well from time to time.

Lately, I have been pondering the nature of faith and hope as I watch the markets, and read magazines and articles: "Three Funds You MUST Buy Today", "Five Sure-fire Tech Stocks", "Our Ten Best Bets to Double This Year" and so on. I am sure you see them as well.

My theme for the past few weeks has been: The Federal Reserve is Fighting History. Which force wins will have a HUGE impact on our investments and economic lifestyles. When elephants fight, we are told, the mice do well to stay out of the way.

Of course, the brave among us can bet on one of the two combatants, and if you pick the winner, you will stand to prosper handsomely. If the Fed is going to win, you should be buying stocks now. Stocks are up an average of 15% or more a mere 12 months after the Fed begins to cut rates.

If history is to be the victor, you should be shorting the markets (if you are VERY brave), buying bonds or stay on the sidelines waiting for a lower entry point. Stocks usually go down an average of 40% or more during recessions.

Side-Tracking for a Paragraph:

As I read and listen to what passes for investment analysis over the last few months, I increasingly get the feeling that faith in History or faith in the Fed is driving more of the discussion and analysis than anything other factor. While we all try to line up our "facts", as I do almost every week, it is almost as much to confirm our "faith" as it is to come to a conclusion. The tone of the debate on TV and in print seems a lot more like a religious discussion than a secular debate on investments. Indeed, don't some of the analysts you read or listen to sound like TV preachers? Now, back to the commentary.

Anirvan Banerji wrote a very interesting article on the Street.com called "Faith vs. Fact" this week. I will be quoting him, as well as the usual suspects in this week's e-letter as we line up some facts and try to handicap this epic battle between the Fed and History.

Now, with that thought as an introduction, let's look at this week's economic action.

Sorting through the almost 100 articles I read from a wide variety of sources this week, the first thing that struck me is the serious rate of decline in the world's leading economies and in world trade. I will give you just the highlights, most of which are gleaned from Greg Weldon's superb economic commentary.

First, Mexico has entered its second quarter of outright recession. Australia, Korea, Taiwan and even Switzerland have posted their first quarter of GDP losses, and are clearly slipping into recession.

Japan is clearly in recession. Worse, they are starting to show signs of a "liquidity crunch". That means they are having to raise cash in order to cover bad debts. What gives us our clues? First, the obvious sign is the strengthening of the Japanese Yen. You can reason it this way. If your country is in recession, and you think things are going to get worse, you get out of your currency and into another currency you think is safer. A prime example is the huge flight of cash leaving Argentina.

We saw this happening over the past few months. But in the past weeks, the Japanese Yen is getting much stronger. But not just against the dollar. It is getting stronger against every currency. That means they are selling assets all over the world in order to raise cash.

It is well known that some HUGE Japanese banks and insurance companies are in trouble. The Japanese government has a fund that basically loans money to insolvent institutions in order to keep from having a crisis. It is a last resort sort of fund. That fund has begun to grow every month, as more and more "problems" lose face and come begging at the door. You can bet they are selling everything including the kitchen sink before they show up, hat in hand, to the government door.

The rest of Asia is showing signs of problems: Korea, Malaysia and Thailand experienced serious export declines between 5-7% in April. That is bad for them. Bad for us is that Malaysia and Korean imports are down 10% and 13% over the last year, and showing real declines in the past few months. That means they are not buying our goods. Similar numbers are beginning to show up throughout the world.

Countries all over Asia are in a "race" to see who can lower their currencies more than the next country so the US will buy THEIR products. This hurts their consumers as they must pay more for foreign products. That is why they are buying less from us. It hurts our companies as we face price competition. It keeps our companies from being able to make profits.

Fortress Europe is starting to show signs of real deterioration.

The European Purchasing Managers Index is down for Europe as a whole, with Germany leading the way down. The German Purchasing Managers Index has now had 11 straight monthly declines. The problem is widespread. France, Italy, the UK and Ireland all had lower numbers.

From France: "Of the ten component indicators of consumer confidence in France over the five months of 2001, NOT A SINGLE ONE has shown a SINGLE MONTH of "increase" AT ANY TIME during the ENTIRE YEAR! (Weldon)" Some of these components are actually negative.

Both the German and British stock markets have backed off recent highs. Like our recent market action, they keep trying to go back up and fail.

I could go on and on, but you get the picture. I could details India's woes, not to mention the numerous problems in South America. Countries representing over half the world's GDP are already in recession or rapidly moving toward it. In the recessions of the last 20 years, there were economies which could act as the engine and pull the world back into a growth phase. But now, the three main economies of the US, Japan and Europe all have problems, and they are all getting worse.

Banerji sums up: "growth in ECRI's Global Long Leading Index recently dropped to a 20-year low, recalling the international recessions of 1981-82 and 1973-75, during both of which the U.S. experienced severe, 16-month recessions. Were history to repeat itself, there would be no recovery until the summer of 2002. The Fed's aggressive rate cuts should limit the damage this time, but there's no room for complacency."

In the US:

A number of researchers wrote this week about the Economic Cycle Research Institute's (ECRI) recent report, including Banerji mentioned above. I think these are important, so let's review some of these numbers. They are telling us that we are on the way to recession.

Popular opinion (at least as far as the talking heads, economists and the stock market is concerned) believes we are going to avoid a recession. They are betting the Fed knocks out History in the fourth round (or quarter).

But ECRI leading Employment Index has plunged to a new 19 year low in March, and keeps dropping to even lower lows. Further: "despite the Fed's actions, all our leading indices of economic activity are still falling, including ECRI's U.S. Long Leading Index, which has a longer average lead at recoveries than stock prices do... The bottom line is that the leading indicators based on the economic fundamentals don't see a recovery yet, but the markets do."

Weldon says this better than I can: "For a refreshing change ... the headlines actually capture the true essence of the data release, as US spending rose at it's fastest pace since January --- while simultaneously, and conversely --- US income rose at it's slowest pace since November. Let's rewind for emphasis ... SLOWEST income growth ... FASTEST spending growth. This then begs the question ...... Is gravity real ???"

Underscoring the problem is the 5th straight month of a negative savings rate. This all means that consumers are using savings to keep up spending. Hence, Weldon's question about gravity. How long can the American consumer keep up this pace of spending more than they make?

Weakening world demand can be seen in the continuing price woes of the base metals like copper, aluminum and nickel. These metals, especially copper, are used in a wide variety of production and manufacturing processes, and can be seen as leading indicators of a global slowdown.

The Chicago Federal Reserve released this week its "National Activity Index". To explain it would take too much space, so let's cut to the chase. It is BARELY hovering over the level at which this index would tell us we are in recession. The trend in this Index is not good.

Released this morning, the National Association of Purchasing Managers Activity Index is again lower, at 42.1, and is officially below their declared recession level. All nine components of this Index fell. Of course, the stock market has gone up on this news.

Remember me talking about the slowdown in world trade? The NAPM export index has dropped 10% in just the last two months to 45, and both import and export numbers have set new current cycle lows.

The optimists who are betting on Greenspan to KO history, point to his powerhouse track record and what happens after he starts cutting rates. To keep their faith up, like a class of yoga students, they daily chant their mantra: "Don't Fight the Fed! Don't Fight the Fed!" That, it seems to me, is the sole basis of their faith. But those who think History will win counter with a few facts gathered from numerous sources upon which they (should I just come out and say we?) base our "faith".

*Never have we had a negative yield curve and not had a recession four quarters later. The yield curve tells us a recession should begin in the third quarter.

*Industrial production has never dropped for seven straight months without having a recession.

*We have never seen such large losses in non-farm payrolls without a recession in the last four decades. Banerji notes that despite popular opinion, increases in unemployment usually PRECEDE recession buy 7 months. This means a recession should begin in the third quarter. Further, many recessions started from employment rates better than we currently have, so the fact that we only currently see 4.5% unemployment gives us no encouragement, at least from a historical perspective.

*Manufacturing and trade sales have dropped 1.6% since last August. Such a decline has never occurred outside a recession.

*I continue to repeat, because you need to hear this: the stock markets declines over 40% in an average recession.

*I won't even discuss in this letter the problems in the debt markets, trade deficits, decreasing profits, more lay-offs, etc.

In Summary

If we are going to avoid a recession, SOMETHING needs to start showing some signs of a recovery. But as I survey the statistics, I ask myself where? What reason do I have to think that unemployment won't increase? How long can consumer spending hold up? When is production going to start back up? Everywhere I look there are far more negatives and questions than positive aspects and answers.

So, where do we place our faith? Do we trust in Greenspan or do we believe in History? (And to my spiritual brethren I understand where we should place our Faith. I am trying to make an economic point, not a religious one.)

Right now, the majority of investors have put their faith in Greenspan. They believe his aggressive rate cuts will win the day, avoid a recession in the US and help pull out the world. That, plus the aggressive expansion of the money supply is once again showing up in the stock market. These two things are the ONLY explanations I can have for the recent rise and seeming buoyancy of the stock market.

In truth, it does not seem like the bears are fighting the Fed, but fighting the Faith of investors IN the Fed. Not to mention their faith in Cisco, GE, IBM and Microsoft.

How long can it last? Longer than most of us have money to bet that things will go down, it seems.

I may be showing my age, but remember the "Thrilla in Manilla"? Ali and Frazier, those two war horses in their prime, went toe to toe. Everyone had an opinion on who would win. You could line up your facts and make a strong case for both fighters.

While I shake my head and wonder, I still can't bring myself to fight History. History has an unblemished record of winning.

What to Do:

First, if you feel you must be in the stock market, then think value, value, value! Look for solid income and balanced funds and managers. Find a disciplined approach you have confidence in and stick to it. If we have a recession, then the NASDAQ and all stocks with high P/E ratios are in trouble, if History is any indication.

If you cannot afford to risk a portion of your principal, then I think this market is a dangerous one. If you are in growth funds, you have seen a nice pop up. The market has moved up, and back down some since I said to get out a few weeks ago. But be aware that you are fighting History if you are in this market as a long term buy and hold investor.

I should also point out the above advice is for long term investors. Traders with cast iron stomachs can do well in this type of market. My recent conversations with numerous hedge fund managers brought this point home. There are many investment styles which love this type of action. Personally, I don't like it. But that is why I don't day-trade stocks. My stomach is not made for day-trading.

For Those Who Would Like to Bet on History

Long time readers know I have been a proponent of long term government bonds for the last 18 months, and we have done well for that period. However, this year has seen my favorite long-term fund, the American Century Target 2025 fund lose about 7.5% so far this year, although today it looks like we will get back another 2% as rates are beginning to drop.

Last year, long term rates evidently went down too fast, and it has taken time for the market to adjust. If we are headed into a recession, then you would expect from reading Mr. History that long term rates could drop from the 5.7% rate we are at today to as low as 4%, depending upon how serious a recession we get. That offers a very nice potential gain. Depending upon the bond fund you choose, you could see 30% gains or more if rates come down.

The question is, "When will rates start to once again go down?" Don Peters of Central Plains Advisors is in the top 1% of all bond timers in the US. He uses completely fundamental analysis in his market predictions, and looks over the peaks and valleys of market action to try to predict where we will end up. His long term view is that we will be below 4% for long term rates when this cycle ends. He also acknowledges that the market will move up and down as we head to this point. His comes down squarely on the side of History when he makes his prediction, and doesn't worry when Greenspan seems to be winning the last few rounds. For him, History has more staying power.

Our firm represents Don Peters and his money management services. When we get a new client's money today, we are currently gradually investing in the bond funds that Don Peter's uses. We are going into these bond funds over a period of a few months, trying to minimize the effect of the current volatility. Lately, however, we have seen the bond market start to show some signs of life. Both technical analysts Kevin Klombies and Greg Weldon write that they think the bond market is potentially poised for a rally. That means now may be a good time to begin taking some of your bond positions. If it becomes clear we are headed into a full-blown recession within a month or so, I think we may look back and see the recent bond market problems as a wonderful buying opportunity into which we wished we had put more cash.

Gold Falls Again

I can't resist pointing out that once again gold jumped up last week, if only briefly, to almost $300 before getting soundly smacked down to $266 as I write. Several people wrote me to suggest that this indicated we are headed for inflation, and not the deflation I am concerned about. If gold had crossed the $300 level and stayed there for some time, I might too get worried.

I used to be a Big-time Gold Bug. But I cannot work up any enthusiasm for the metal when every time it moves up some central bank or major producer starts selling and pushes the price right back down. All that happens is that professional traders make a huge profit and gold bugs once again get splattered on the windshield. I know many of you believe the gold market is rigged. In my opinion and experience, some parts of it probably are. But that is all the more reason for amateurs to avoid it. Playing for long term gains in a rigged market is not a recommended investment program.

My deadline approaches. I hope the weather stays beautiful, as there is a Scottish festival near us this weekend. I will take the kids and once again try to teach them the beauty of the Irish fiddle and the haunting sounds of the bagpipes.

Thanks for the MANY kind letters and positive comments I have recently gotten. Thanks even more for recommending the letter to friends and associates. The growth of the letter makes me feel that you appreciate the effort this takes. And Lloyd, thanks even for your comments. There is always the need for improvement.

Your History watching Analyst,

Scroll down for comments.