Nuclear Waste or Gold?

John Mauldin | Thoughts from the Frontline
February 22, 2002

Long time readers have been asking me to re-visit some of my old themes and recommendations. Today we are going to visit our old friends, The Three Amigos , to see what these historically accurate indicators have to tell us about the direction of the economy. Is it safe to get back in the water? I suggest a special way to invest in high yield bonds that you don't want to miss.

Then we look at the coming surprise in the Consumer Price Index numbers that NOBODY is talking about, and that you will read about here first. It will have a major effect on your bond portfolios. I specifically answer your questions about long term bonds and interest rates.

Now, you want to be sure and read next week's letter. I get more questions on gold than on any other single topic. My usual response for the last decade is that I don't care to participate in a manipulated market. But my view is changing. I am going to lay out a case for gold that will be different from the usual heavy breathing you get from hard-core gold bugs (many of whom are good friends), and show you a special way to potentially profit on the yellow stuff, no matter which way the market goes. Now, we have a lot of data to cover this week, so let's jump in.

Three Amigos Update

Long time readers are familiar with the Three Amigos. These are three indicators that have historically been very good at signaling a recovery in the economy. They are Capacity Utilization, the ISM Purchasing Manager's Index and high yield bonds. I want to see all three of these indicators begin to move up as a signal that the economy is getting ready to take off. They also typically suggest that it is a good time to get safely back in the stock market. Let's see what they are saying.

First, remember that most economists are predicting a "V" shaped recovery that will boost GDP substantially in the last half of the year. Indeed, as most recessions end, this is exactly what you get: a 5-6-7% GDP growth rebound and an exploding stock market. I have argued that this time things will be different, and I think the Three Amigos agree with me.

The Purchasing Manager's Index is clearly telling us that things are getting better. The PMI is collected from purchasing managers across the country, and tells us what is actually being bought and sold in the manufacturing world. A PMI reading above 50% indicates that the manufacturing economy is generally expanding; below 50%, that it is generally declining. It is a little more complex than that, but this gives you a basic understanding.

From a ten year low of 39.5 in October, it has climbed back up to 49.9. That is good. The non-manufacturing index dropped to 49.5 which was a surprise, as most observers thought it would rise. You can go to the web site at www.ism.ws and see the details that make up the statistics.

Looking at the details, what you come away with is that overall things are improving, but not with the usual vigor associated with past recoveries. For instance, the number of companies reporting increased business activity is down from November and those reporting lower activity went from 25% to 31% in the last three months.

Prices showed a healthy rebound from truly depressed numbers to merely somewhat down. Unemployment seemed to stay flat, while inventories are decreasing at a faster pace.

All in all, the PMI tells us that recovery is starting to happen, but it is not going to be a typical "V" recovery. The PMI confirms my view that we are in the Muddle Through Economy.

Interestingly, that seems to be the view of the Bush administration. The U.S. economy will expand more slowly this year than analysts expect, growing at the weakest pace since 1991, according to assumptions in President George W. Bush's fiscal 2003 budget. They see the economy as growing at a slow 0.7% pace this year.

That is in stark contrast to the National Association of Business Economics. These are the blue chip economists who are supposedly the cream of the crop in predicting the economy. This group thinks that the economy will grow at 3.5% in the last half of the year Of course, these are the same guys that told us that we would see a second half recovery in 2001. Somewhere I remember reading (and if any of my 200,000 readers can find this I would greatly appreciate it) that the NABE has never predicted a recession until we were already in one.

Curiously, the very next article on Bloomberg had the headline: "CEOs Paint a Gloomier Picture of U.S. Economy Than the Statistics Suggest." The irony gave me my best laugh for the day.

Capacity Utilization Just Isn't

Capacity utilization has dropped for the last 19 months. No brief upticks. No false starts. Just straight down. I think this is likely to change soon, as we see inventories continue to drop. But we are now down to levels we have only seen for a few months since they first began recording this number in 1868. At 74.2, this is the lowest it has been since 1983.

That means two things. Businesses usually do not start to spend money to expand capacity when they have excess capacity. Economists usually associate a number above 80 as a signal of a healthy growing economy. Even in the 1991 recession, capacity utilization did not go below 78. (You can see these numbers at www.economagic.com, an excellent source of information for you statistics junkies.)

One of the things that contributes to a "V" shaped dynamic recovery is robust business "capital investment." That is not happening. Further, when there is too much excess capacity, it is hard for businesses to raise prices and thus increase profits.

A review of the ISM numbers and pricing power confirms that this is exactly what is happening. That means that even as the economy recovers, and it is doing so, that profits at many corporations are not going to recover as much as analysts expect.

For capacity utilization to remain in a downward spiral while the PMI recovers is unusual. Unless I am missing something, I cannot find a case where this has happened in the past. The two combined seem to be telling us we are in a weak recovery.

Once again, the Three Amigos suggest is that we are in the Muddle Through Economy.

Nuclear Waste or Gold?

The Bush administration approved the Yucca Mountain site as a national dumping ground for our nuclear wastes. The 49 states who wish to get rid of their nuclear waste material were happy, especially those states that were alternative sites. Predictably, Nevada is not as pleased.

Junk bonds have been the nuclear waste of investments for almost three years. Moody's Investors Service on Wednesday reported the junk bond default rate rose to 10.4% in January, the highest since 1991, but said the rate should fall by more than one-third by the year's end.

Moody's projected that the 12-month default rate, which reached a post-Great Depression high of 13% in July 1991, will peak this quarter, before dropping to 6.8% by the end of 2002.

Junk bonds are also one of my Three Amigos. Typically junk bonds and junk bond funds begin to recover at the bottom of a recession. Again, historically we would expect this to have started to coincide with the rise in PMI. It did not.

I have written before that I think junk bonds will be a great place to invest as the economy begins to recover. After the 1991 recession, junk bonds returned over 70% during the next three years. Similar returns happened after the 1982 recession.

This happens because at the bottom of a recession, junk bonds are nuclear waste. Nobody wants them. Some junk bond funds are now paying 13%, although total return is down as NAV has dropped dramatically.

Typical is the Federated High Income fund (FHIIX). The fund has dropped from $12.09 exactly four years ago in 1998 to only $7.54 today, almost 30%. Fund NAV values are where they were in 1991. It has been a long round-trip. Some funds have done worse and some have done better. But all junk bond funds have been creamed.

Long-time readers know that I have a high-yield bond timing program for clients. Junk bonds are one of the few investments which actually trend pretty well. If you use a fast moving average vs. a slow moving average, with a few whistles and bells, you can move in and out of the market with reasonable success.

My program is fairly conservative, waiting for the market to move. It has been in money markets for the last three years, except for a few days. This has been good, as junk bonds have dropped over 30% in that period. Safe, but boring.

I think Moody's is right. Sometime this year, and probably within a few months, investor's will want to move a portion of their portfolio into high yield bond funds. Let me give you a few reasons why.

First, many of the bonds that are problems have already been sent to the penalty box. Unlike a Russian hockey player, they do not get to come out after two minutes. They will stay there for a long time. That is why the NAV of junk bond funds are so low. As the economy recovers, the ability of companies to pay their debts and the confidence of investors increases.

Secondly, we have seen some of the real volatility in the junk bond markets begin to calm down. That is a good thing.

Finally, many investors are waiting for the high yield markets to recover. Getting 2-3-4% on bonds is not very much, and the thought of 12% yields is going to become very enticing. AMG tracks mutual fund cash flows. We are seeing large amounts of money move into high yield bond funds. But my sources indicate that the funds are not spending the money yet. They are sitting on the cash. When that cash gets invested, it will stabilize the market, and drive values up.

As more and more people come back to the high yield market, prices for the bonds go up and yields go down. Much of the potential gains over the next few years will be in the form of capital gains as yields go back to normal levels.

I do not think we will see the 70%+ as we did in the years following 1991. Why? The spreads have not gotten quite as wide as in 1991, and in the Muddle Through Economy junk bonds will probably not snap back as fast. But I like the opportunity in junk bonds much better than I do in stocks.

I Fire Myself

I am a basically a manager of managers. I look at the economy and try to figure out where the potential for good returns will be in the future, and then try to find managers who have demonstrated an ability in that area.

The only portfolios I directly manage are the high yield bond portfolios mentioned above. Long time readers know that I rarely mention my money management business, assuming that if you are interested, you will contact me. I will make a brief exception, and give you a four paragraph ad and then back to the CPI.

Over the last few months, I have been looking at a high yield bond timer whose record is significantly better than mine. I went to visit Steve Blumenthal of Capital Growth Management (CGM) in Pennsylvania last month. He was gracious enough to show me how he times high yield bonds. Bluntly, his system is better than mine.

I have hired and fired managers many times. Knowing what I now know, I have to fire myself and hire Steve. I think CGM will capture more of the upside in high yield bonds over the next few years.

(Note to clients: you will get a detailed report on Blumenthal and CGM very soon. I will be suggesting you switch to his service.)

When will the high yield bond move start? I don't know. My system says not yet. I will still tell readers when it does. But CGM has made money each of the last three years as these funds went into the toilet, while mine sat on the sideline. I am hopeful they can continue to make money while we wait for the real turn to come. In my opinion, letting Steve manage your high yield portfolio while you wait is a good option. I also think the wait will not be long.

CGM has negotiated capacity with a number of high yield bond funds that allow them to use their fund for timing purposes. There is a limited capacity, and I think it will fill up soon. CGM has two different programs for most clients. One program uses leverage as well. More aggressive investors will be interested in this feature.

If you are interested in seeing his numbers and a more complete analysis, simply email me your name, address and phone number and we will send you the material. I need the information for my records. No one will call you. If you like what you see, you can call us and ask all the questions you like. Minimum investment is $50,000.

Now back to our regularly scheduled e-letter.

The Shocker in the CPI

Inflation, we are told, is tame. In January, the yearly rate of inflation was down to 1.1%.

I wrote in the fall of 1998 that we would see outright deflation in the CPI in our future. I got more than a few laughs. But as I looked at the deflationary pressures that were being set adrift in the world, it seemed to me that the course we were on was deflationary.

We have lived with inflation for 60 years. It is the devil we know, and most of us have figured out how to make it work for us. That being said, we have seen inflation erode our buying power by 77% since 1984. (You can see the actual numbers by going to the St. Louis Federal Reserve web site.)

Gradually, inflation has come down. 1.1% seems low, right?

That number does not tell the whole tale. The entire amount of inflation over the last 12 months was in the first four months of that period. Over 1% of the inflation was in the first three months. For the last 8 months we have been in outright deflation!

By this summer, we will see a CPI number that has a "0" handle, as the traders say. Inflation will be 0.(something)%. It is quite possible that we will see a minus sign in front of that zero this year.

This has several huge implications.

The bond vigilantes, those traders who see inflation over every hill, have been wrong. At some point, more and more of them should throw in the towel. This will help long term rates come down. I think those of us who are long bonds will be rewarded for our perseverance this summer.

There is a historical view that long term government bonds pay an average of about 3% plus inflation. Right now, long term bonds are pricing in a 2.3% rate of inflation. Bond traders and investors clearly do not believe that inflation is gone. What will they believe when the CPI is negative?

Anything is possible. It is possible they continue to think inflation is around the corner. I think it is likely, however, that long term rates come down. Could we see long term government rates as low as 4.5%? I think so. Better bond forecasters than I am (like Gary shilling and Don Peters) think even lower numbers are possible. For those clients and readers who in the American Century Target 2025 Fund, if rates do drop into this area, it will give us a nice return. If no inflation does not bring down long rates, then I am going to have to re-think my world.

Secondly, this gives the Fed more room to continue to expand the money supply without having to worry about raising rates. My 2002 forecast stated as much. Making annual forecasts make me nervous, as no one likes to be wrong. Since the bond and futures markets were pricing in a Federal Reserve rate hikes of as much as 1.75% when I made that forecast, I should have been a little nervous.

But this week we read that an influential member of the Federal Reserve board agrees. Gary Stern, president of the Fed Bank of Minneapolis told his listeners that the U.S. economy is close to recovering from recession and "subdued" growth without inflation may allow Federal Reserve policy makers to hold interest rates steady for some time.

"I don't expect to be confronting a serious inflation problem in the next several quarters," Stern said in an interview. "So my foot is not heading for the brake," he said, referring to the possibility of the Fed raising rates to slow the economy. (Bloomberg)

His entire speech sounded like a description of the Muddle Through Economy.

Finally, this is just another reason why corporate profits are going to have a hard time rising at a 15-20% pace. Deflation gives no pricing power to businesses. They have to figure out how to be more productive with their assets in order to increase profits. The always astute Ned Davis Research notes that "Producer Price Inflation, which best describes manufacturing pricing power, fell 2.6% last year, the biggest drop in 50 years!"

PPI is a leading indicator of CPI direction - and it is saying outright deflation.

Please note that mild deflation is not something to be too alarmed about. It certainly is not the worst thing that can happen. The country can grow very nicely in a deflationary environment, as long as it does not get out of hand. I do no think the Fed will let this happen.

But it IS something my Boomer generation has never seen. The investment rules which worked for the last 50 years are going to get changed in this environment. If you don't change as well, you will not be happy with your returns.

Japanese Conspiracies

I have outlined why I think deflation is in our future in past letters. But I think we will re-visit one reason today, and that is our friend Japan, which I wrote about extensively last week. If you missed it, you can go to the archives and read that letter.

Greg Weldon found this gem. Eisuke Sakikabara, former Japanese government financial guru, was known as Mr. Yen in Japan's heyday. Like Alan Greenspan, his musings would move the yen up or down.

Listen to his quote from a few days ago: "What we are in this moment is an economic crisis. Economic crisis eventually reach the financial sector. It is not unlikely for the yen to reach 150 or 160 before the end of this year."

After pointing out that this was my forecast, let me give us some further pause for reflection. I had a long discussion with Weldon yesterday about a number of disturbing reports he has found. The Japanese government is floating trial balloons with enormous implications. Basically, they are suggesting they would buy bank non-performing loans at BOOK value (not market value), as well as buy stock that is used as bank collateral at BOOK value and not market value. This would inject capital back into the banks. We are talking over one trillion dollars worth of bad debts.

This would be a huge government liability for a nation already way in over its head. The only way out would be for the government to do what every banana republic has done since the invention of money: they will have to monetize the debt. They will print money.

First, this is not reform. They are also talking about forgiving the debts of these companies. This does nothing to get rid of companies which are incompetent and cannot compete. It does nothing to free up good companies. This is a prescription for blatant corruption, as you can bet there will be huge pay-offs to government bureaucrats and legislators for keeping the rich and powerful from having to face bankruptcy.

It is precisely because it allows the good ole boys to remain in power that I think it might happen. It will cream the average Japanese tax-payer at the expense of the rich and powerful. This is a very bad thing for Japan. But it is also a very bad thing fore the rest of the world.

If they do this, and right now it seems to be getting serious thought, the yen will not hold at 150. Book it. I can remember when the yen was at 300. Weldon posed this question to me:

"As we watch the values of Japanese stocks and assets go back to the levels of the 1970's, why should we think the yen will remain the same?"

The yen going back to 160 or higher will cause a great deal of problems throughout Asia. That is exporting their deflation to the world. It will cause competitive devaluation from competing currencies throughout Asia, and increase tensions in the region. It could lead to more bubbles, further deflation pressures in the US, and a prolonged stagnant world economy. Japan continues to my biggest economic worry.

Tech Stock Capitulation

When Jim Cramer throws in the towel on tech stocks, it is note-worthy. Read his latest missive:

"People keep looking for tech to lead us out of the wilderness. They don't understand that it is tech that put us in the wilderness and tech that takes us deeper into the wilderness every time we bank on it. This lesson is hard to understand because it became gospel in the last decade that tech is the only place to make any real money.

"That was true then -- now it isn't. But we are still hooked, and we keep believing, with the mutual funds being the worst sinners. Let me make this as clear as possible: Tech stocks don't get higher multiples than nontech stocks anymore. If you see some with higher multiples, if you own some with higher multiples, you should sell them. Then you won't lose as much money as those who don't."

I continue to think the stock market is in a trading range -- moving sideways, up a little, down a little, now you see a bull, now you see a bear. But avoiding high multiple stocks, tech or otherwise, is critical.

Our opportunities are elsewhere, and will be for awhile.

It is time to wrap things up, but I wish I had a few more pages. I have some very interesting notes on US debt and thoughts on the future of the Euro. I will save them for another week. For new readers, I write this column each week as a discipline. I try to distill the hundreds of pages of material I read each week. It makes me think through the economy and its implications on investments, and to think about where opportunities will show themselves in the future. I try to show you what I think is important, and maybe it will make you a more thoughtful investor.

I am grateful to all the people who forward this letter to their friends, for the investment publishers who send it to their subscribers and for those who post it on web sites around the country. It has been an amazing thing to watch this letter grow in size and reach.

I do read all your letters and comments, good and bad.

Once again, we will have great weekend weather in Texas. I think a little golf and some quiet family time might be in order after the unusually hectic week I have had. Enjoy your weekend.

Your doing better than muddling through analyst,

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