Investment Wind Changes

John Mauldin | Thoughts from the Frontline
March 8, 2002

When you are sailing, it is important to know where the wind is blowing. You have to change the position of your sails as the wind changes.

This will be an important e-letter, as the data tells us it is time to change our investment sails. I will also be telling you about a stock which is paying a 7% dividend and an inexpensive source for investment advice that I particularly favor. As usual, there is a lot to cover, so let's get started. But first, a quick review:

In late 1999, I wrote that it was time to sell stocks, especially tech stocks. In August of 2000, I predicted a recession in the third quarter of 2001 and suggested it was time to get out of the stock market entirely.

The reason was quite simple. The stock market drops before and during recessions. I simply did not want to fight the head wind. Later, I wrote that we would be looking at my Three Amigos indicators to tell us when the wind would change.

My goal was not to find the bottom of the market, but to get back in when the wind of the economy could be at our backs instead of in our faces. I will argue today that the wind is changing, but it will not be at our backs. It is coming from our port. We will have to use a different sailing strategy to make this wind work for us during the 80's and 90's.

I remember seeing a picture of a boat that was heavily anchored as the tide was coming in. The anchor held it to the ocean floor so well that the rising tide eventually washed over the decks and sank the boat.

This rising economic tide will not raise all boats. There are some boats that simply have anchors which weigh too much. They will sink.

The Recovery is Here

As I noted last week, the Purchasing Managers Index was strong. As I looked at the individual numbers, I was amazed at how strong they were. That suggests that a recovery is indeed in the works. Could it be stronger than I previously thought? Possibly, but below, I will outline why I don't think so.

The second of my Three Amigos are high yield bonds. I compared notes with high yield bond expert Steve Blumenthal. He points out that high yield bonds have put in a double bottom and are beginning to rally strongly. His system is more sensitive than mine, but I can see where mine will put in a "Buy" in a short period as well. So we have two confirmations.

We will not see Three Amigo capacity utilization numbers until next week, but since we have seen the drop in the numbers begin to slow, it is likely that this number will either be flat or rise.

In short, I think the Three Amigos are telling us the economic winds are no longer in our face. The question we must ask ourselves is, "Where is the wind coming from? Can we use it to get to where we want to go?"

How High Is Up?

It now looks like we are going to see growth numbers for this quarter in a robust 4-5% annualized range. Just a month ago, I was thinking 2% or less. Where did the extra growth come from?

I think it is in large part weather related, which has caused an odd statistical environment. Just as I wrote last week that a 17% drop in housing sales becomes a 16% gain when you seasonally adjust it, there is also a lot of other data that gets seasonally adjusted which will tend to show stronger GDP numbers than normal.

For instance, Richard Berner of Morgan Stanley writes: ".... there's no question that unseasonably warm and dry weather fueled both residential construction and state and local public works. The temperature in January and February averaged 2.4 degrees or 7.3% warmer than the average of the past five years. Thus, these two components of construction will likely add about a percentage point to first-quarter growth, and could subtract a like amount from the spring tally."

Ned Davis Research writes that the warm weather is responsible for the strong burst in retail sales so far this quarter. This number is again seasonally adjusted, so in the obtuse world of statistics, it means that spring numbers, even if they were the same, would be weaker.

The Federal Reserve Beige Book reveals some very interesting numbers. (The Beige Book is a monthly study of economic and business data from around the country.) While it confirms the improvement we have seen in recent economic news, it also is noteworthy in that its bullish tone was subdued. As in "Auto sales remained solid, but due to the expiration of incentives, have cooled from the rapid pace set in the 4th quarter" or "Residential real estate remained strong while demand for high end homes weakened" and "Loan demand was reported as mixed and credit standards were said to be unchanged to stricter".

It read like a description of the Muddle Through Economy. Things are not bad, but we are not back to the Booming 90's.

Bond Vigilantes Unite!

The bond markets are definitely not in the Muddle Through Economy Camp. Longer term interest rates are rising sharply as bond investors believe the economy is getting ready to take off, and to them that means the Fed will soon be raising rates in order to slow the economy down.

One of the ways that traders and bond investors bet on the direction of interest rates is the "Eurodollar Depo Strip." Greg Weldon writes today that market is pricing in a 225 basis point rise in interest rates by the Fed in the next nine months.

That is 25 basis points a month! I am not sure what these guys are drinking, but it must be high octane joy juice. I just can't see it, and neither does the Fed.

The respected and influential Bank Credit Analyst notes that, "The Fed has hinted that the markets are too aggressive in pricing rate hikes. A renewed stock slump or another burst of dollar strength could slow, or even short-circuit, the coming rate cycle. However, the dollar has recently weakened and equities are gaining momentum, underscoring that investors are starting to believe that the Fed will lag the upward pressure on rates. If interest rates are kept below the level needed to prevent economic overheating, then some asset market will witness a rapid appreciation (real estate or Equity Mania Part II?), or else inflation will rise if the overheating occurs. Stay tuned."

Two points from this quote: first, the Fed is not giving anyone the idea they are thinking about raising rates. Indeed, you can almost discern the opposite. Secondly, BCA is advancing the reason why the markets think the Fed will raise rates-to prevent another bubble somewhere.

I don't think our worry is economic over-heating, at least not yet. If the Fed was worried about economic overheating, they would simply stop or slow down the massive and scary growth in the money supply they are fostering. The only thing I see overheating are the Fed printing presses and the minds of the bond vigilantes.

I am not the only observer worried about the level of the growth in the money supply. The strict monetary crowd assumes that it will lead to inflation, and Gene Epstein writes in Barron's a well-thought out case that inflation is coming.

But that begs the question, Gene, of: "Why haven't we already seen inflation? Where is it? We have had massive growth in the money supply for years and yet the Economic cycle Research Institute's highly accurate predictor of inflation is at its lowest level?"

Part of the reason is what Greg Weldon calls "paper burning." We are seeing money depart this world in the form of debt defaults. Part of it is Japanese deflation coming to our shores.

Will this deflation phenomena we are currently in ever end? Yes, as all things end, but when is the question. Without going into a long discourse, just as I saw the seeds of deflation developing in 1998 I am noticing some curious developments which could foreshadow a resumption of inflation. These signs are small and far away, like Elijah's cloud, but they bear watching. I will do an e-letter on them at some point in the future, should they persist.

But all this speculation is the cause for the hard hits that bond funds are taking this week. If we do see a softening of the economy (on a seasonally adjusted basis, of course) next quarter, and once again ever lower inflation numbers, under normal circumstances you would expect interest rates to drop.

On a final note, before we get into some actual investment ideas, let me quickly turn to Stephen Roach's latest letter. He writes,

"But there's a second key question that must be addressed in assessing the likelihood that America is about to jump-start a world [which is] in synchronous recession: Does the US have the wherewithal to pull it off? This gets to the heart of the recovery debate, with the double dip at one end of the spectrum and the classic V-shaped recovery at the other end. While the latest statistics are certainly flashing vigor for the moment, I continue to believe that the US economy is going to have a hard time delivering any demand follow-through in the aftermath of any inventory pop. Even if I'm wrong on the double dip, I see the recovery outcome as decidedly subpar -- well below the growth trajectory evident in the current quarter. The headwinds from the structural excesses of the 1990s -- low saving, record debt, a massive capacity overhang, and a record current-account deficit -- should all act to inhibit cyclical recovery in US final demand over the next few years....

"The potential for a subpar US recovery underscores another aspect of the coming decoupling of the global economy -- the likelihood that America will having an exceedingly difficult time in financing its massive current account deficit at present exchange rates. In large part, that's because there has been a distinct narrowing of the sources of foreign capital inflows that accomplish this task....

"Needless to say, should foreign investors start to lose their appetite for dollar-denominated assets -- a much greater risk in a persistently weak US recovery than in a strong one -- they can be expected to exact a premium in the form of a weaker dollar and/or higher interest rates. This, in turn, could well lead to a significant shift in global allocation strategies, away from the US-centric formula that worked so well for a decade and back to a more realistic appraisal that takes America's likely reduced rate of return into more explicit consideration. Ultimately, that spells curtains for an over-valued dollar. Just because that hasn't happened yet doesn't mean it won't occur in the future. I continue to believe that either a double-dip recession or an anemic recovery could seal the fate of a significant depreciation of the US dollar."

While this sounds grim, all he is really saying is that the US economy is unlikely to grow as fast as most investors currently think. He is not predicting a depression or its like, just a far less robust economy than the 90's.

How Should We Then Invest?

Quick Review: I have made the case for a year that we are in a "Long term secular bear market". The Latin word for cycle is secula, and here the word secular means that the current cycle we are in is an overall bearish cycle. The last such cycle we saw was from 1966 to 1982. I will be finishing up the first draft of the chapters in my book which will deal with this and post them on the website within a few weeks.

That does not mean you avoid stocks. I only think you avoid stocks before and during recessions. I know some of you have made money in stocks during this last year, but most of you didn't. And those who did have gone through a lot of volatility.

In my thinking, when I suggest it is time to start getting back into the stock market it means that we have to use different styles of stock investing than those of the recent boom years. Let's look at the past bear cycle.

The economy is going to grow. That is not the issue. Strangely, the economy grew at twice the rate from 1966 to 1982 as it did during the boom years. But stocks did not. That is because at the beginning of 1966 and especially by 1972 the value of most stocks were off the charts.

In 1972, the Nifty-Fifty (that decades version of the New Economy stocks) had a P/E ratio of over 30. However, many of their counterparts in the less glamorous world in parts of the S&P 500 had P/E ratios with an average of 11. The biggest money managers all were concentrated in the glamorous stocks. A few years later, many of the Nifty-Fifty had cratered by 50% or more, while old boring companies like US Steel doubled. Dividends and value rule the day in secular bear markets. High-flying stocks come back to trend.

Today, we are seeing values go off the charts for many companies, while boring "Old Economy" companies languish. It looks like 1972 all over again. I predict that in a few years, we will see boring as good.

(Let me quickly point out that I am now talking about longer term investing, and not trading. The rules for traders would be quite different.)

One style of investing that works well in this type of market is value investing. It has done well over the past few years, even while my admittedly more timid (I like to think of it as conservative) style has been on the sidelines.

I think you should look for dividends and income. In other words -- Absolute Returns (which not coincidentally is the title of my next book on hedge funds).

Let me give you an example. I called Tom Donaldson, of Portfolio Management Consulting. Tom is a former senior investment officer of the trust department of a bank in Maine, and as such was responsible for their conservative portfolios. He has made money for his clients in each of the past 3 years, finding deep value and income investments to keep in their portfolios. I like his solid New England approach to finding investments. I got him to give me his best idea today. This is what he sent me:

"One year ago Lehman Brothers issued four million shares of Williams Energy Partners at $21.50. Williams Energy Partners is listed on the NYSE and trades under the symbol WEG. The Partnership is engaged in the storage, transportation and distribution of refined petroleum products and Ammonia. Not a glamorous business, but also not subject to the fluctuations of energy prices. Had you bought the units last year at issue, you would have received $1.43 in distributions last year and would have a nice 70% gain. Not bad for a bad market year. At the current price of $36.50 and a projected distribution of $2.36 the current yield is 6.5%. This week a major brokerage house issued a buy on the unit with a target of $44 dollars. The five year growth rate of the company has been north of 40%. When the Enron mess hit the airwaves WEG dropped from $45.00 to $33 recently and is recovering now. The news this week that Berkshire Hathaway has made a major investment in the parent company Williams Cos. speaks well for the Partnership's parent, the majority owner of WEG. A great buy for increasing distributions and some tax benefit to the distributions."

This is the type of investment I like. Good dividends today and good growth potential for those dividends to increase. They are also in a business that is not going away. Tom has promised to give me one idea a month from his bag of investments, so every few weeks, we will get one more idea.

By the way, I had a long conversation last week with a hedge fund manager who specializes in energy stocks. The view of their firm is that natural gas will eventually go north of $4, and that natural gas producers are good long-term values at this time.

Fleet Street Offer

The Fleet Street Letter is one of the oldest investment letters in the country. Lynn Carpenter, the editor, is one of my all-time favorite value investors. Her portfolios have been up every year and her readers have done well by her. She does solid research, knows her stuff and has a economic view that is similar to mine.

Here is a link to their latest subscription offer. The letter is normally $159, but I have gotten them to offer my readers the letter for $89 or two years for $159, plus throw in the usual special reports, etc. You can read the promotion letter, which has some very interesting and useful information, and then scroll to the bottom and order online.

If you are looking for good value investments, this is one resource I would definitely use. I should point out that I write for Fleet Street from time to time, although they do not pay me. Just another way Lynn gets good value at a cheap price.

High Yield Magic

Those of you who requested information on CGM's high yield bond timing program should have it in your email boxes by now. Steve tells me they are up 1.7% for the month in their unleveraged program. As I said last week, I think this is a good way to get into high yield bonds now so you can position yourself for their recovery as the economy turns better. If you haven't done so already, email me and we will send you back a PDF file with a special report on high yield bonds and CGM. The minimum investment is $50,000.

Memphis Travel Blues

I should disclose that your intrepid analyst is evidently a suspicious looking character. In a quick day trip to Memphis yesterday, I was most thoroughly searched both coming and going in Dallas and Memphis and again at the gate. I don't know whether it was my cologne or the black cashmere sweater that set off the alarm bells. While time consuming, I think planes are definitely safer, at least from middle-aged white male Texas Republicans, a suspicious group if there ever was one.

Have a great weekend, and let's slowly start getting back into the market by finding great value. Next week I intend to take up the question of the Euro, and will show you how to profit from the drop in the dollar that Stephen Roach was talking about.

Your ready for a relaxing weekend analyst,

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