Pipeline Economics

John Mauldin | Thoughts from the Frontline
August 17, 2001

This is a slightly longer than normal e-letter. I have put a lot of thought into this week's letter, and lay out a case as to why we are at a very critical juncture. Serious investing requires serious study. Simply making predictions with no rationale is useless and potentially harmful. In this issue, I make more than a few predictions. This should be a very useful letter for investors. I hope you find it helpful.

There was lots of important economic news this week, and we are going to jump right in. Also, since I pointed out last week some of my best calls for the last year (it has been a good year so far), it is only fair I discuss an area where I might be wrong, and why. Well, maybe not completely wrong, but read on and see. We move quickly to survey a fire in the oil patch. And finally, one of our Three Amigos is actually showing signs of life. The other two are still AWOL. But you have to start somewhere.

Pipeline Economics

In the real world, if you put gas or oil into one end of a pipe, you expect to get gas or oil when it comes out the other end. If you turn the water on, you expect to get water at the end of the hose.

Economics and business is much the same way, but with one big difference, and the key word is "expect". The relationships between economic inputs and expected results is not as certain as our water hoses. When Greenspan puts rate cuts into the pipeline, we expect to see an economic recovery. Because of those expectations, investors start to re-deploy capital. The problem is that is just one of many, many things going into our economic pipeline.

To take the analogy further, it takes pressure to move something through a pipe. Plus, depending upon the length of the pipe, it can take a lot of time. Each input adds or subtracts from that pressure. And then there are those nasty leaks.

I remember reading the analysis when Greenspan first cut rates in January. The consensus seemed to be that it takes 12-18 months for rate cuts to take effect. But since the rate cuts were faster and deeper than any in previous history, we were going to see a faster recovery: the still missing second-half recovery. Forget next year, the cheerleaders told us, things were going to happen quicker, so buy stocks now.

Now it is the second half. Now the cheerleaders tell us to buy because the recovery is going to start real soon. The rate cuts have been in the pipeline for seven months, and any day now they will have an effect, so buy stocks.

I see the ubiquitous Schwab commercial almost every day where the chairman tells nervous investors to just take a deep breath and relax. He tells us in his soothing voice the market has experienced problems like this before, and everything will be alright. Soon. (Implication: keep buying stocks and mutual funds from Schwab.)

The problem is the US economic pipe is huge and it takes a lot of pressure to move the economy forward. Normally, this is no problem, as the pipe is tight and there is a lot of additional economic stimulus to keep things moving forward.

But lately, there have been some leaks in the pipe, draining pressure and slowing things down. That means Greenspan is going to have to fix the leaks or apply more rate cut pressure.

Let's examine some of the leaks which are sapping our national economic growth.

Leak # 1: First and foremost is the growing global trade recession. I have outlined in detail for the last few months the seriously deteriorating global trade picture. Nearly every country's imports and exports are down from last year, many developing countries seeing drops in the 20-30% range. We have recently seen serious deterioration in Germany and the rest of Europe. Their cheerleaders told us earlier this year they would not have a problem.

A global trade recession will obviously have an effect on the economic pipeline, and the leak is getting bigger. Cutting rates in the US will have little short-term effect on this leak. There is no Greenspan equivalent for the world economy. The US consumer has been the engine for world growth. That engine is losing its steam. Until Greenspan can get more coal into the consumer engine, it doesn't seem realistic to expect that leak to get fixed any time soon.

Leak #2: Industrial Production is down, down, down. By now you have read the headline that Industrial Production was down 0.1% in July and was the 10th straight negative month. But the devil is in the details, and Greg Weldon loves to give us the details.

"Of the 22 "Industry Groups" for which details are provided, 21 revealed a yr-yr contraction in output ... while ONLY ONE showed a gain...EACH of the groups listed above, revealed NEW LOWS in terms of the yr-yr contraction. "

The only group which showed a gain was the auto industry, which also showed a huge monthly gain in July of 6.2%. Without auto sales, July would have shown a serious drop. Anybody who has looked at buying an auto recently has noticed the deep discounts available. The auto industry is one of the few areas keeping the pressure up.

Many areas such as home electronics, textiles, and metals are down more than 10% from last year. You have seen how Cisco, Cienna and other tech firms are down 20-30% or more just in the last quarter, and telling us this quarter looks worse.

How did it happen? They suffer from Mauldin syndrome.

I have been in business for 25+ years. There have only been a few times in my life when I was not more optimistic about future business potential than reality actually delivered. You would think I would get it by now, but I always assume I can get some project done quicker than what actually happens. I always think the demand will come faster and be greater.

Now, sometimes I really do get it right. Sometimes I have even under-estimated demand. But, normally, I am simply too optimistic. (My friends and business associates, besides laughing, know I am being kind to myself. But what the heck, a selective memory is better than no memory. )

I can hear the chorus from readers now. Most entrepreneurs and businessmen have the same syndrome. If we really knew the future potential - if we really knew how much pain and how little profit we were going to make on some of our ventures, we would not have started them.

But we keep doing so, because every now and then we really hit one out of the park. The thrill of that moment keeps us coming back. Like a mother, we eventually forget the pain of child-birth.

For almost the last two decades, US industrial and technology management has been hitting them out of the park. They were able to overcome mistakes with even bigger winners because a boom economy covered a lot of sins.

The last half of the decade seemed to show no end to demand. Like the Japanese telling themselves Tokyo real estate was actually worth more than all of California, we convinced ourselves that demand for products, especially technology, was on a permanent 20% growth curve. And so, we built capacity to handle that growth, because if we didn't, our competition would and we would lose market share, not to mention our outrageously high paid corporate management jobs. The risk of not being ready for growth was bigger than the risk of overproducing. We could always cut back if things slowed down.

The problem is that nearly everyone overbuilt at the same time. And now, 21 out of 22 industries are having to cut back. Capacity utilization (a Three Amigo) is continuing to deteriorate. Industry operated at 77 percent of capacity in July. That compares with 77.2 percent in June and would be the lowest since July 1983. (Bloomberg)

In the past year, the operating rate for electrical machinery has dropped 23.2 points to 68.6, a 25-year low. The capacity utilization rate for high-technology industries tumbled 1.6 points to an all-time low of 65.1. The operating rate for communications equipment has fallen almost 10 points in the last three months, which is hardly a harbinger of an imminent recovery. (Bloomberg)

Just as I was hitting the send button, Weldon sends me this from the Philly Fed which re-enforces my point big-time. It seems the Mauldin Syndrome is still alive and well despite a full recession becoming apparent.

"Only 17.5% of firms reported receiving new orders in August ... while 59.3% report they EXPECT to receive new orders.
--- Only 8.6% of firms reported a rising backlog of orders ... against which 30.2% expect to report such in six-months.
--- Only a lowly 6.9% of firms reported that they are raising the prices "received", while nearly THREE TIMES as many (18.1%) expect to raise prices within six months."

This is one reason why unemployment has remained low. Companies are not letting employees go who they think they will need in just six months. They are biting the bullet now to be prepared in the future. The implications are obvious. This is a perfect explanation for why unemployment always continues to climb even after the recession bottom has been reached. It takes time to wring out the Mauldin Syndrome within a business. It also means that future earnings are going to continue to take hits until management decides to balance current expenses with realistic growth expectations.

The good news is that rate cuts can have an effect on this leak. However, the cheerleaders that expect it to do so this quarter are just not checking the pipeline. 12-18 months from last January starts next year. Since we are seeing some of the worst numbers in almost two decades pile up in our economic pipeline, it might be a second quarter or even second half recovery. (Remember, the stock market and our Three Amigos will go up before the economy is "officially" in recovery.)

Rate Cut Prediction

I have been on the record expecting more rate cuts after the regular August meeting next week. I think next week Greenspan cuts 25 basis points. To do more would spook the market into thinking he thinks it is REALLY bad. I believe he will then follow up with at least two more rate cuts before the end of the year, as the economy will not be seen to be responding and the pressure to do something will be enormous.

He has the room to cut a lot more. He will do so. He will keep putting more pressure into the pipeline until growth comes out the other end.

Leak # 3: Deflation

Was it last year I wrote that I expected to see a negative Consumer Price Index monthly number this summer? I think it was, actually. Right on time, the CPI fell 0.3% last month. For the last 3 months it has only been 1.4%, down from 1.9% for the last 6 months. Just a few months ago, the annual number was 3.6%. The trend is clearly down. (Weldon)

How could I make such a prediction last year? Because the inputs into the price pipeline were deflationary, with the major exceptions of energy and tobacco. They have remained so. There is more disinflation or outright deflation in our future. Keep your eye on what is going into the pipeline, because there is a good chance that is what is going to come out.

This is despite Greenspan increasing the money supply at rates that are eye-popping. I see some writers begin to talk about Greenspan pushing on a string, but we are not there yet. They compare our current situation with Japan, and while there are some similarities, the differences are pronounced. Their banking situation was/is a disaster, as were/are their government deficits and economic policies. (The Japanese Prime Minister last week called for the Bank of Japan to create inflation as a means to stimulate growth.)

As if choreographed, we also see potentially serious deflation showing up in China and Japan. Europe had its version of the CPI drop slightly this month.

I have written about the coming deflationary trends in the world economy for almost two years. Deflation has been coming down the pipeline for a long time. It is just now beginning to become evident.

This does not have to be a bad thing. In fact, it allows Greenspan to supply liquidity and cut rates more than he normally could without stimulating inflation. Europe's Central Bank should be able to start cutting rates to help stimulate their poor economy as well. Greenspan could use some help with the heavy lifting.

Deflation may even partially mask the effects from a dropping dollar (see below). Yes, one day the Fed will have to slow the money supply growth down or they will risk inflation. But not now.

Am I Wrong on the Dollar?

About a month ago, I wrote that I expected to see the dollar drop against the Euro but to gain or stay flat against the Yen and other Asian currencies.

Since then, the dollar has been in free fall against the Euro, losing 7%. But there has also been a serious 4% decline in the Yen, and except for some South American currencies, the dollar is down across the board.

I did not feel at that time the dollar was in for a major drop against the Euro ( as much as 20-30%). I thought we would see it go to parity: 1 dollar equals 1 Euro.

The recent action in the Asian currencies calls this "optimistic" view into question. While a few weeks does not a trend make, this type of serious drop in so short a time makes me nervous.

On the other hand, the Japanese Finance Minister, Haruhiko "Hari Kari" Kuroda, tells me not to worry. This is just temporary. From Bloomberg:

"Japan's currency has gained 4.4 percent against the dollar so far this month. Government officials and analysts have expressed concern its strength would hurt Japan's fragile economy by making exports less competitive abroad. The yen's rise is "particularly inappropriate,"' Kuroda said, according to a report on Dow Jones Newswires. He said the government is "closely watching" the currency and would "take appropriate steps as needed," fueling speculation the Bank of Japan may sell yen in the currency market to weaken it.

"The last thing Japan needs to see is the yen appreciating on a sustained basis, and Kuroda's warning the markets," said Alex Beuzelin, a currency analyst at Ruesch International in Washington. "Tokyo will not sit idly by and watch the yen continue to strengthen."

So maybe the Asian countries, including Japan, are just in for a quick pit stop before they again start racing to see who can de-value their currency more.

So I will stick by my original forecast. If Japan devalues its currency, then the rest of Asia should follow. We will have to wait and see if I am wrong. Sidebar: the above mentioned Philly Fed report noted that 45% of businesses surveyed said the strong dollar had a negative of substantial negative impact on their business. Only 10% said it helped. There are silver linings to a dollar decline.

There are other leaks, like consumer debt, inventories, slowing industrial sales, slowing business loans, increased debt delinquencies and more. But let's get more positive and talk about:

Pipeline Pressure Inputs

Not everything is leaking. Consumers, while slowing down somewhat, have not yet given up. Interestingly, I read reports that restaurant sales are holding up. As mentioned above, auto sales are at an all time high. Housing is red-hot, with new starts at close to all-time highs as mortgage rates are finally beginning to drift down. Health-care is still steady.

Even though unemployment is increasing, 95.5% of us still have jobs. Which brings up an interesting point. One reader and my favorite weekly critic, Mike Strong, is in the job placement business. He writes me that his business is good, as demand is still strong in the tech areas. The lay-offs from big tech firms finally gives him supply.

But another "head-hunter" reader told me last week his business died about two months ago. He is changing industries, going into niche areas in health care where demand is still strong.

So, far from expecting the economic pipeline output to slow to a drip, I think there is enough pressure to keep us from drying up. Eventually, inventories will drop, sales will stop dropping and things will stabilize. We will see continued slowness until the rate cuts and money supply begin to take affect.

Growth is in the pipeline. It is just going to take more time than the cheerleaders expect.

One Amigo Shows Life

I watch our Three Amigos weekly. In the last few weeks, junk bonds appear to be trying to make a bottom. They are up only a little, and are staggering, but they appear to no longer be in free fall. Now, we got just this type of action in the spring prior to a big drop, and it could happen again. I keep repeating, however, that before we can talk about a recovery, something has to start to turn up. I want to see all our Amigos smiling before we sound "All Clear".

Junk bonds rose 79% after the last recession. You can bet I will keep you informed.

Warning: Rough Seas Ahead

The S&P 500 index typically has its worst month in September, according to market research firm MarketHistory.com. October -- the month of both the 1929 and 1987 stock market crashes -- ranks as a close second. The main reason is mutual fund companies typically sell losing stocks in the September-October period to offset capital gains from winning stock picks. Individual investors start bailing out as stocks decline, further depressing the market.

We are approaching earnings warning season. I think this period will be worse than last quarter. Coupled with the above note, I expect the next few months to be rough. But if the rate cuts in the pipeline are going to take affect next year, late fall could be The Bottom. Christmas could come early.

Fire in the Hole

This week I read a sobering article on the situation in the Middle East. My good friend, Gary Halbert, analyzed a private report by Stratfor.com, a highly respected international research group. He quotes much of it in his monthly newsletter.

I confronted a ranking GOP Congressman with the gist of this article this week. He basically confirmed the seriousness of the situation. Stratfor.com suggests that Israel is preparing to attack the Palestinian territories in the near future. Other reports suggest Iraq is massing troops on the Jordan border.

The situation is intractable. Last week, The Jerusalem Post reported that the Palestinian Authority daily Al-Hayat al-Jadedah printed on its front page that "the occupation is using naked women to hunt down intifada youth."

As serious news, they reported that a female Israeli soldier got on top of a tank, began taking her clothes off "until she was nearly naked", and when Palestinians came close enough to throw rocks, she pulled out a gun and killed two and wounded nine in the crowd. (The old gun in the lingerie trick. The Israeli's must have seen it on Austin Powers.)

If Palestinians would report or even believe such drivel, then they are too far gone to consider reasonable negotiations. Arafat has clearly lost control. He may be evil, but he is not stupid. He would not push Sharon this far if he could control his people. Hamas and the other groups simply want a war. They think world opinion will make Sharon give in. They are wrong.

IF Prime Minister Sharon should initiate a war during September/October, I wonder what the results will be? Israel will win, of course. I doubt the leaders of Egypt or Syria will want to get involved, as they would not survive politically and maybe not physically if they lost a war with Israel, as they almost surely would. Iraq might have to fight across Jordan, and Israel would crush them when they arrived.

But even if the conflict remained "isolated", what would US response be? What would Arab response be to any action we took? What would happen to the price of oil? How would the markets react? I know, in light of the blood-bath it would be, that thinking of our economy might sound insensitive, but it could have repercussions far beyond Jerusalem.

Big Boys AWOL

The percentage of the market the Big Boys normally have is about 21%. They are now down to less than 14% and dropping. There "sentiment" is only slightly positive. In any type of crisis, their absence would not provide the usual floor for the stock market, making a potential drop even worse.

Putting all the above together: we are entering the traditionally rough September/October season, more negative earnings warnings to come, more recession in the near-term pipeline, possible big disruption in the Middle East, the AWOL action of the Big Boys, etc. and it does not make a good recipe for a near-term market bottom in stock market prices.

If you are in the market and are determined to stay there no matter what, I would take a long vacation to somewhere where there is no news unless you have a strong stomach. Consider some puts to hedge your portfolio. Talk to your broker about the potential ways you could hedge your individual portfolio.

For those of you who are waiting on the sidelines, be patient. In my opinion, we are going to get a great buying opportunity. Traders? Have fun and good hunting. This could be one heck of a ride. Many hedge fund managers are probably drooling.

Labor Day

My bride and I will be in Flippin, Arkansas, near Bull Shoals Lake on Labor Day weekend ( about two hours north of Little Rock), for a quick get-away and her birthday weekend celebration. Sweet lady that she is, I get to play golf one morning. On the off chance a reader will be near there, I would love to play golf with you.

Then I come back and tackle the Mauldin Syndrome. From now on, I will double the time and triple the cost estimates on any projects I start. (Except my new book. I know it will be a best-seller. Marji, I promise it will be ready for editing in December. I'll get started next month for sure!) My new fund is almost ready, a few weeks late, but this time I have a really good excuse. I promise.

Oh, by the way, my oft-mentioned and favorite aggressive bond fund the Target 2025 Fund (BTTRX) is at an all-time high today. If the sun is shining, I play golf with my son tomorrow.

Life is Good.

Enjoy your weekend,

Your ever-optimistic-to-a-fault analyst,

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