Out of Africa

John Mauldin | Thoughts from the Frontline
February 2, 2001

The Millennium Wave Sector Model has switched into the Rydex Energy (RYVIX) from the Internet fund (RYIIX). As I predicted, that trade lost money. We are now down 6 out of 7 trades for January alone, when "normal" would only see 2 or 3 trades in a month. This market is too volatile for sector rotation models, but this investment style will have its day before the end of the year. Patience, Dr. Siddique. We will get there.

The Millennium Wave Investor Sentiment Index is a red-hot 84.55, fractionally up from last week, and I wonder how much higher can it go?
The Millennium Wave Sentiment Momentum Index is 47.38, fractionally up with plenty of room to rise
The Millennium Wave Sentiment Percentage Uptrends is 25.40, leaping -soaring- rocketing- up for the fourth straight week!

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Many of you misunderstood me last week. I am starting to write for the Fleet Street Letter, which charges for its newsletter. My e-letter will continue to be free. The only "charge" I ask is that you occasionally send me your comments and questions, good and bad, and forward this letter to those you think might enjoy it and suggest they subscribe for free by writing me at john@2000wave.com

Roller Coaster Bonds

I am going to briefly touch on bonds first, as many of you are noticing the serious volatility in interest rates and the losses and then gains in my favorite bond fund, the American Century Target 2025.

First, the yield curve went positive on January 22. By my tracking, the worst day was January 2 at a negative -.95. Since today is a positive .08, that is a HUGE swing in just 30 days. Furthermore, when you get to the short end of the curve, from five years to three months, the numbers are still substantially out of whack, with 90 day rates significantly above (.40 basis points) two year rates.

I have pointed out that prior to any recession, the yield curve normalizes. By that I mean, the longer the term of the note or bond, the higher the yield or interest rate. We are in the middle of that process now, and it is messy. The recent spike in 30 year rates to 5.68% from below 5.50% caused the Target 2025 to drop over 5% in a few weeks. But now rates are down around 5.48% again, roughly where we started the month.

What happens during the "normalization" times is that bond market traders are trying to trade spreads and take advantage of the discrepancies. This last month has seen a few traders be on the wrong side of the trade, and they have had to "cover their shorts". When you do that, you have to buy the instrument you are "short", thus sending the price up, especially if enough traders are all trying to "cover" at the same time. But traders may not care if they are wrong on the 30 year bond, as the may be right on another contract and are just betting that the difference will make them a profit.

When a lot of traders all make this same bet, it can cause some volatility, which is what we have seen. When the market comes right back down to where it started, it makes me think we just had a classic short squeeze. When these things happen, you have to remind yourself of the fundamentals.

The fundamentals are this: we are moving to a slowdown/recession. Long term rates go down during such periods. Long term bond values go up.

Confession: While I write a lot about bonds, and am very familiar with them, I do have a few experts I check in with from time to time. One of those is Don Peters of Central Plains Advisors. Don has an audited track record showing him to have made 13.96% in government bonds for the last 20 years (ending September, 2000) using no leverage. For the last 10 years he has done 14.92%. In that same ten years the Lehman bond index did 8%, so he has substantially beaten the average bond trader. In fact, he is in the top 1% of all traders for those periods. Last year his clients made 31%. He treats bonds as capital gains instruments and not income instruments and works to get total gains. When he talks, I listen.

Don has forgotten more about bonds than I will ever know. Much of my thinking about bonds is colored by his views, as well as those of the Bank Credit Analyst (BCA), Yardeni and Greg Weldon. Peters is of the opinion that long term 30 year bond interest rates will eventually go to 4%. Yardeni thinks 4.5%. BCA thinks bonds are oversold, but because of the slowing economy still thinks portfolios should still be weighted to bonds. So do I.

BCA and Peters also agree that the time will come when we will move from Treasuries to high yield bonds. The difference between high yield bonds and treasuries is about 8%, and it could get worse if the slowdown becomes a recession and short term rates drop even more. Typically, the difference is about 5%. Just as we have made a snappy 30% in long term bonds last year because rates dropped, we could see that again this year if he is right about the direction of interest rates. Then there is the potential, just like 1991, to see the same thing happen in high yield bonds.

In 1991, high yield bonds rose 58% in 18 months. What happens is that during a recession, high yield bond funds become repositories of "nuclear waste" as more and more companies default on their bonds. At the bottom of the recession, when rates start to flatten out, those "bad" junk bonds get marked down and junk bond funds lose a lot of value, as they have done for the past two years.

But the tighter the rubber band stretches, the bigger and faster the snapback. As an investor, I hope junk bond funds melt down. I am thinking China Syndrome. Because sometime after that period we will want to own some of these funds for the once in a business cycle ride back to "normal".

We are at least 6 months, I think, from that period and maybe even a year.

In my forecast, I mentioned that if first quarter GDP growth was less than 1%, that would not be good. The yield curve tells us that any recession should not begin until this summer. If that is true it means there are a lot of disappointing earnings announcements and bond defaults in front of us. Using Biblical analogy, these times are just the beginning of woes.

If the consumer confidence and manufacturing numbers continue to come out as negative as they have been in the last few months, I expect Greenspan will cut rates again sometime in mid to late February, between now and the March 20 Fed meeting, and then again at that March meeting. This will boost the stock market, as "everyone" knows that the markets increase an average of 17% in the year following the third rate cut.

It should also help our bonds. Now, Greg Weldon reminded me of one thing we should watch. In regards to oil prices, we have largely been helped by a powerful dollar. Oil is priced in dollars. If you lived in Europe, oil went up an extra 10-15% because the dollar rose against the Euro. Now the dollar is coming down. If oil rises and the dollar keeps falling, that would be seen as "inflationary" by the Fed and might make them slow down the pace of rate cuts. However, if the price of oil stays stable in terms of dollars, or the dollar stabilizes, that means this summer the inflation index will have a full year of high oil prices and could actually start to show deflation, which means the Fed could be even more aggressive. OPEC cutting its production as much as it recently did must mean demand is weakening, not just here but around the world where oil went up in terms of local currencies even more than here. Can they hold the line? Will some nations start cheating? Is the Pope Catholic?

If the demand for oil around the world starts to slow due to slowing economies , I think oil prices will drop as some OPEC countries cannot resist cheating. New supplies are coming online in Angola, which will soon be a bigger producer than Nigeria.

I have been to Luanda, Angola (Lo-o-o-ng story). It was a hell-hole five years ago, but once it was a beautiful Portuguese style coastal city. I liked the people and the positive attitudes I saw even in a war torn sewer of a town. This country could be a boom in the making, if the rebel Savimbi will give it up and actually accede to elections. (The US backed him in the 70's and 80's because we didn't like the "communist" regime. They held elections, Savimbi lost, to his and everyone's surprise, and he went back to war. The hero of democracy went from hero to thug. We backed the wrong horse.) If Savimbi does capitulate or accede to a truce, adventurous types might want to travel to Angola and find some opportunities.

In any event, I think too many of these third world regimes, including Russia, need the cash. I bet on greed. I think oil comes down, opening the way for deeper rate cuts by Greenspan.

As an aside, I have been to about 15 countries in sub-Saharan Africa. I love the continent and the people. Our foreign policy has made a HUGE mess of Africa. I sincerely hope Bush puts in some realistic Africa hands who understand that these countries need real economic growth and not hand-outs. If we wanted to really help Africa, we should drop all trade barriers and tariffs on a quid pro quo basis, country by country, on anything manufactured in Africa. A true free trade zone, like NAFTA, but without the 1000 pages of rules. Just make it free trade with a one page document.

Cut off all aid, except humanitarian. The African people are entrepreneurial by nature. They have to be just to survive. You watch the economic explosion if we did that. But of course, trade unions here would denounce that. Why do I doubt Maxine Waters and Jesse Jackson will call the heads of the trade unions racists for that stance?

Speaking of Racists

I had a conversation with a good friend of mine last week, Michael Williams. He is an elected Texas state wide official (the powerful Chairman of the Railroad Commission, which really is the oil and energy commission), and we were discussing the Ashcroft hearings. I had the displeasure to listen to them for a few hours while driving from Baltimore to DC last week during rush hour. It turned my stomach. My friend also listened to much of the hearings. We sadly concluded that we must be racists, as many of the things they said made Ashcroft a racist we were in agreement with and would have made the same decisions and votes he had made.

There's just one problem, though, that we had. My friend is black. He is conservative and one of the most popular statewide elected Republicans in Texas. I have adopted two black sons. Normally, you would not think as either one of us as racist, Michael for the obvious reason and me for the not so obvious reason (unless I show my family portraits). In fact, we both have pretty strong opinions about what we consider racist viewpoints. I have ruined more than one gathering when the talk turned distasteful and I revealed I had black sons. (I also have two beautiful Korean daughters.)

I have often found it interesting that I get pegged with certain viewpoints because I am a conservative activist which are far from my actual beliefs. Michael has the same situation. He finds black Republicans are supposed to have certain deficiencies. He is always amazed, for instance, that his liberal friends just assume that he has not read black literature or has any understanding of other "black" topics.

It is one thing to say, "I don't like Ashcroft's votes or his views." But to call him a racist because of those views is the politics of personal destruction and is as divisive a thing as can be done. Are all the 50+ Republican Senators who voted against Ronnie White racists? How can we ever have a national dialogue to help reconcile our differences when it is assumed I am a racist just because I am a conservative?

We need to begin to look past philosophical differences and see the person who holds those views. I find I can be friends with many people with whom I may hold deep philosophical differences. By setting up a dialogue, we find that on many issues our goals and values are the same. If we stop vilifying the person and seeing the common humanness, if you will, our nation will be better served.

Right now, we have leaders on both sides, who seem more interested in vilifying the opposition rather than in having civil discourse. They feel they will lose their support and cash flow if they don't keep whipping up hatred and mistrust. It is much easier to create an "us" against "them" world if the "them" are seen as bad people who are really, secretly trying to destroy you. The leaders of these groups can get more press and following by doing so.

I freely admit that some of the best practitioners of divisive tactics are on my side of the aisle. I, for one, am getting tired of "us" against "them." I think I am not alone, and that the majority of this country is just about ready to say a plague on both your houses. If this is true, then George W. with his call for civility may be coming onto the stage at an historic moment. It is my fervent hope that President Bush can really help change the climate in the country to one of more rational discussion and we can put the politics of personal destruction behind us. If he does nothing more than that in four years, he will be a success in my books.

By the way, I mention my adopting children of other races to make a point about stereotypes and not to suggest it is anything to make me special. They are simply kids - my kids - and thus give me the joys and heartaches (and college bills) all kids give to parents.

Back to the Markets

Last week, I wrote that I expected to see a correction after the rate cuts. If Greenspan had cut rates 75 basis points, I think we would have had a nice bounce and then the correction, which I told you I would play for a 5% point drop. The markets had already factored in 50 basis points, so we will get a correction from here.

I think we will continue to see a pullback like we are seeing today, though how much of one my data does not say. But I see nothing in the sentiment data which suggests to me this leg of the market rise is through. This drop is just one of consolidation. If you are thinking of putting some more money in the market, now would not be a bad time, though I continue to feel that we will see a real drop in the market some time in the future. But I repeat my mantra: Until investors believe Greenspan is not going to keep us out of recession, this market is not going down. When and if they lose faith, look out below. But they are clearly inclined to be true believers today.

Now is also a good time to buy your long term government bonds. Wait on the high yield funds. I will tell you when, but it won't be for months.

Your stepping off his soap box analyst,

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