Market Insanity

John Mauldin | Thoughts from the Frontline
November 30, 2001

Wow! What a data downpour the last few days! We are going to cover Warren Buffett, junk bonds, Enron, deflation, corporate accounting hank-panky, and the wildest markets I can remember. Let's jump in and see where we end up.

Insanity in the Markets

I have long followed the performance of commodity traders. October was one of the best months on record for a number of investment styles. November has been one of the worst. Such back to back wild swings are unusual.

But look at my favorite bond fund. Up 10% and then right back down. Stocks? Currencies? Metals? Everywhere we look, there is volatility. And some downright strange (might I say suspicious?) trading patterns.

That is exactly what a number of commodity traders did early in November, only to find that now the market says the Fed will raise rates by 170 basis points by December of 2002

This "investment" is made by a "spread" trade on the Eurodollar March-December Depo. This is one of those investment tricks you probably do not want to try at home, boys and girls. Please note the Big Boy traders are getting their heads handed to them.

There are a number of odd market conditions like this. Certain Eurodollar spreads now say that the Fed is likely to raise rates NEXT quarter. The difference between those who think the economy will rebound dramatically and those who think it will be slower are becoming very pronounced, and are causing economic earthquakes of about 9.0 on the Richter scale.

Enron Strikes?

Can we find some reason for the odd interest rate action? In talks with some traders, they off the record point to Enron. There appears to be large European business and financial exposure to Enron debt and these institutions are being squeezed on rates as they try to stop their bleeding from Enron debt derivatives. Is it this "short squeeze" that are taking rate spreads to levels that simply look ridiculous? Rumor? Fact? It makes more sense than someone actually believing the Fed is going to raise rates 150 basis points next year, as we will see below.

I think those traders who have the deep pockets (not too mention the nerve) to hold onto the above trade are going to make their November losses back and more. Now, let's look at the data and see what the odds are for the Fed to raise rates next year.

...the U.S. economy showed few signs of improvement in late October and the first half of November

"Economic activity generally remained soft through the first half of this month and evidence of additional slowing in most regions outweighed signs of recovery in a few districts," the report, commonly known as the beige book, said. Consumer spending was "mixed," the report said. While no- interest financing helped increase auto sales to "exceptional levels," other areas such as tourism were weak and non-auto sales "were spotty." There was evidence that spending remained "below Sept. 11" levels in most districts, the report said.

This is in stark contrast to the cheerleaders on CNBC and other places. They are beginning to grate on my nerves, as many simply say ignore the present and focus on a rosy future. They are leading investors, who have already lost trillions, down a primrose path of false hopes. The quotes they are giving will come back to haunt them, as did the quotes of cheerleaders (see below) in 1930. But better to be haunted by quotes than actual losses. Remember, they make money when you invest. It is always time to buy stocks if you sell stocks. But then again, that is just my opinion. Now back to our regular program.

Fed governors, in several public speeches, have left little doubt they intend to cut rates again at the December meeting.

The US bond markets are pricing in further cuts after that. I think it is at least an even bet we see at least another 50 basis point cut before this rate cutting cycle stops. The Fed will not stop cutting until there are clear signs of recovery. They do not want to be accused of not being responsive.

Then let's look at the influential and usually cautious Bank Credit Analyst for December: "A couple more quarters of negative GDP growth is not the real threat per se. The greater danger is that a self-feeding cycle of declining consumer spending and corporate sector retrenchment takes hold, pushing the economy into a downward spiral. The Fed is in a race against time. It will be under pressure to keep cutting rates as long as the negative headwinds continue to blow hard in the hope that an economic recovery will take hold before rates get to zero."

While they think the rate cuts and other stimuli will give us a second half recovery, it is not likely to be a strong one, in their opinion. One of the reasons they cite for a recovery is that unemployment was improving as they wrote their letter.

Yesterday, however, the unemployment numbers got worse. The 300,000 rise in benefit claims was the largest weekly increase since 1974. "Businesses are still slashing staffing levels at an aggressive pace," said William Sullivan, senior economist at Morgan Stanley Dean Witter & Co. in New York. "This suggests the unemployment rate for November could be anywhere from 5.6% to 5.7%."

No wonder, then, that consumer confidence is tanking. Mall traffic was down about 6%, even though sales were slightly up. But discounting was a huge factor. While sales may not drop this season, profits are going to be hard to come by for many retail stores. I have even done my patriotic bit and spent a few dollars as stores want to give me deals I find it hard to pass up. When you discount an item I want 50%, I and other shoppers take notice. But are you making money? When I am buying, I don't care what your profits are. When I am investing, I care deeply.

It is not just retail stores and computer firms. Auto sales surged as 0% financing enticed many a new car buyer into the dealers lots. But now what? If 0% worked so well, let's sweeten the deal. I swear this is true: Mitsubishi is advertising NO money down, 0% financing and NO payments until 2003 on 2002 model cars. Should I wait for them to pay me to buy a car?

I now see what is wrong with my own business model. I could grow a lot faster and make more money if I simply paid my clients to manage their money. I don't know what I have been thinking.

What do these retailers see that we don't? They see costly inventory and a likely further fall-off in consumer confidence

Given this weak view of the US consumer, it is my view the Fed is unlikely in the extreme to raise rates at all in the next 6 months, let alone the next quarter

Deflation And Italy? Say It Ain't So, Joe

I have been writing for several years that deflation is increasing. One of my main themes is that the Fed can increase the money supply at the huge rates we have been witness to for the past few years because deflation is masking what would normally be a huge inflationary increase in the money supply.

Everyone agrees that if the United States were to go into recession, the rest of the world will suffer even more. But we are not the only fish in the pond, just the biggest. If other countries have problems, it will affect us as well. And deflation is now roaring around the world.

Let's take just a brief glance at the numbers and then think about how that will affect us.

Japan is now deflating at about 2-4% per year and getting worse (depending on whose numbers you choose). Last month deflation was down .6% -- in just one month! Unemployment in Japan will soon be 6%. The banks are continuing to shrink loan portfolios.

Greg Weldon gives us these details on Europe:

"Europe is flooded, as the high-tide of the deflation tsunami rolls over the continent. Note the water-logged details for October ----

--- Italian PPI ... outright monthly deflation of 0.4%, rate underwater, pegged at (-) 0.6% ... drowning from the (+) 0.6% yr-yr rate of increase seen in September, and FAR below the surface relative to the (+) 6.8% PPI rate seen in Oct-00.

"Moreover, the decline was BROAD ... with the following components ALL posting monthly deflation ...Food and Drink... Paper and Printing... Oil Products ... Chemicals... Fibers... Rubber... Plastics... Metal Products... Electrical EquipmentSee Virginia ... it's NOT 'just' oil !!!"The numbers are just as bad for France, the Dutch, Spain and other Euroland countries. "The ECB should be throwing a life-preserver ... but as a result of theirless than aggressive monetary easing tack ... has instead, thrown an anchor to the drowning data."

The use of the word deflation and Italy in the same sentence is almost too hard to write, let alone fathom.

Going back to the Bank Credit Analyst, BCA argues that because housing and medical costs are running at rather high inflationary rates, the overall US economy is not likely to slip into outright deflation. Laying aside numerous concerns I have seen from realtor and building association economists about housing sales and prices, let's look at their assessment of corporate prospects:

"The odds that the overall economy will slide into deflation seem slim. However, the same cannot be said for the corporate sector, i.e. the portion of the economy most affected by market forces. A broad-based deflation in the corporate sector would have negative

implications for profits and for financial strains. As far as the stock market is concerned, it is important to know whether there will be a deflation problem in the corporate sector, regardless of what happens to the overall inflation rate. The trend in the producer priceindex, NAPM indexes of prices paid and in import prices all warn that pricing power in the corporate sector is eroding fast. The impact of this on profits is definitely one of the headwinds countering the Fed's attempts to rekindle growth. Measures of corporate pricing will merit close watching in the months ahead. The corporate sector is likely to skirtdeflation in the coming year and this argues against a strong profit rebound."

Repeat "...pricing power in the corporate sector is eroding fast."

NAPM (National Association of Purchasing Managers) numbers will come in Monday morning. Let me bravely predict they will be down again for the 16th straight month. Capacity utilization is a dangerously low 73%. Neither of these numbers suggest that corporations will be able to raise prices any time soon.

Deflation and low capacity utilization, along with increased efforts by other countries to lower their currency prices and maintain a strong dollar imports deflation to us. This implies that corporate profits are not likely to rebound the 25-40% or more analysts are expecting in 2002. Thus my expectation for the market to move lower.

GDP Games, Part 2

The National Bureau of Economic Research, the group that officially decides when we are in a recession, has declared the recession began in March. Most of us noticed this summer. I am a little miffed by this call. I wrote last August that a recession would start in the third quarter of this year. Now it appears that I was once again an optimist.

Last month the Commerce Department told us that the economy only shrunk .4% in the third quarter. After explaining why the numbers would change, I said exactly four weeks ago: "I have a bet with Greg Weldon that the final number is -1.2%. He thinks -1.1%. He has been hot lately, so he will probably win." He is still hot. It came in at exactly -1.1%.

GDP is probably shrinking at a 1.9% pace, according to the consensus of 51 estimates in the Blue Chip Economic Indicators survey for November. The economy will probably grow at a 0.5% rate in the first three months of 2002, the survey showed.

I was not included in the survey. But then I do not have a cheerleaders union card, so I will probably not be asked to the dance. I would suggest that there is no way the economy grows. The consensus will change in February. It will be down. You read it here first.

OK, if corporate profits are going down, then why are stock prices going up and bonds going down? I looked back in the files and found an answer.

Barron's Weighs In

1930

And now we come to the heart of the matter: our investment portfolios.

Last week I reviewed a book called Stock Cycles, which suggests we are going into a long term secular bear market. Some of you missed the point that you can have a long term bear stock market cycle while the economy is still growing. It is not that I think that the US economy will not grow for the next decade. It will, and probably at a good pace. But investor's willingness to discount profits will not grow at the same rate it has in the past.

Let me bring up one more witness to the stand. "Warren Buffett, will you swear to tell the whole truth and nothing but the truth?"

The entire article is a forceful presentation that stock market returns over the next two decades are likely to be small.

A few quotes: "Now, there was a smart man, who did just about the hardest thing in the world to do. Charles Darwin used to say that whenever he ran into something that contradicted a conclusion he cherished, he was obliged to write the new finding down within 30 minutes. Otherwise his mind would work to reject the discordant information, much as the body rejects transplants. Man's natural inclination is to cling to his beliefs, particularly if they are reinforced by recent experience--a flaw in our makeup that bears on what happens during secular bull markets and extended periods of stagnation."

"...In 1979, when I felt stocks were a screaming buy, I wrote in an article, "Pension fund managers continue to make investment decisions with their eyes firmly fixed on the rear-view mirror. This generals-fighting-the-last-war approach has proved costly in the past and will likely prove equally costly this time around." That's true, I said, because "stocks now sell at levels that should produce long-term returns far superior to bonds."

"...Now, if you had read that article in 1979, you would have suffered--oh, how you would have suffered!--for about three years. I was no good then at forecasting the near-term movements of stock prices, and I'm no good now. I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two.

But I think it is very easy to see what is likely to happen over the long term. Ben Graham told us why: "Though the stock market functions as a voting machine in the short run, it acts as a weighing machine in the long run." Fear and greed play important roles when votes are being cast, but they don't register on the scale."

Besides helping us understand where the stock market values are likely to be headed, Buffett shows how corporations use their pension fund income projections to increase the bottom line earnings they report as income.

If you project your fund to grow in the future, you can book profits today. The more growth you project, the more profits you can book. 9% of General Electric's profits last year were from projected pension fund profits. Buffett contends that the projections are unrealistic and will not come to pass. This means more profit write downs in the future.

It is not just GE. There are scores of companies who do this. 35 companies in the S&P 500 had more than 10% of their 2000 profits come from what is likely to be phantom pension fund profits, even as their pension funds were shrinking!

Buffett basically underscores everything we discussed last week. I strongly urge you to get and read this article. You can get it online at Fortune.com.

Junk Bonds Starting to Bounce

I get more questions about junk bonds than any other topic. "When," I am asked, "are you going to move into junk bonds?"

Maybe soon.

For the last 6 months, I update my junk bond timing program for clients about once a week and then go to sleep Now, however, the numbers are starting to turn up. I now run this program every other day. Basically, I want to see my "fast" short term average go over my "slow" long term average, and I want the differential to be more than a similar spread over money market averages. It is a little more complex than that, but that is the basic thrust.

The short term average for junk bonds have moved over their long term averages in several different systems I track. Now, I am waiting for the next step to trigger a signal.

Of course, I look for problems and I do see one. Junk bond values fell off the table after 9/11. They have now come back up to where they were before then. This dramatic price swing will mess around with the moving averages. I also cannot find such a drastic and quick price swing in looking back at historic files.

Aah, the woes of a money manager. As always, I let you see the inside of my thinking, even when it is not pretty and certain. In that spirit, I ask myself, "Do you follow the system religiously or do you compensate for one time price swings that have never happened in your models before? Do you miss a possible move or do you err on the side of caution in this environment? Please note that junk bond defaults are at an all-time high."

It will be several weeks, I think, before a possible signal in my system. I will have some time to look at the numbers, but I will err on the side of caution. I should note that there is a 2% trailing stop loss in my model, as junk bonds typically trend slowly. That is why the numbers posted for a few weeks after 9/11 are so out of normal patterns.

I will keep e-letter readers posted on a weekly basis, and clients should feel free to call if they have any questions.

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I received notice yesterday that the Hedge Fund conference at which I was to speak in New York next week has been cancelled due to a large drop-off in attendance. I was surprised, as the conference organizers are among the leaders in the conference industry, and the conference itself looked to be the best and most interesting of the ones I have seen this year. I was truly looking forward to going to a number of sessions.

The reason appears to be simply that people do not want to travel, as well as budget constraints. It seems to be hitting everywhere.

Important Afghanistan Update

Afghanistan: In the Line of Fire

Many of you gave generously to this cause, and you will see Ed and Walt as they give out the food and blankets you paid for.

Ed is going back in a few weeks. I will write more about this next week.

This has been an explosive and exhausting 12-hour day in the office, starting at 6 am. I had to rush through this letter faster than I like, so I hope what I was trying to say came through without seeming too dis-jointed..

Your looking forward to a glass of Anapuma Chardonnay Analyst,

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