Recession Watch

John Mauldin | Thoughts from the Frontline
July 23, 2004

There are always a few dark clouds that determined bears can find, even in the best of times, albeit they may be no bigger than a man's hand. Most of the time, they dissipate into the wind, leaving nothing but ulcers for the worry warts in their place. It's just no fun listening to Jeremiahs in the summer (or at any other time, for that matter).

But sometimes, these clouds grow, and like Elijah running to Jezreel for cover, investors might be wise to do the same. This week we survey the economic horizon to see if there are signs of a recessionary cloud coming this way, and if so, what should we do? We look at what the color pink says about the markets and muse upon the nature of recessions.

It should all make for interesting reading. But first (you knew it was coming) I want to thank The CEO Refresher, a website that is geared to helping business leaders and professionals find the information they need to improve their lives and businesses. They recently named Bull's Eye Investing as the best book of 2004 and added it to their list of "Best Business Books of All Time." I also note that the book was #5 last week on the Toronto Globe and Mail list of business books.

If you have not yet got your copy of what the New York Times called "serious summer reading" in their list of just five books for summertime fare, what are you waiting for? You can get a 32% discount at www.amazon.com/bullseye. And now back to our regularly scheduled program.

Let's start today with a page from chapter 2 in Bull's Eye Investing. It will set us up nicely for a discussion on recessions.

Faith versus History

"In the 17 years from the end of 1964 to the end of 1981, the Dow Jones Industrial Average gained exactly one-tenth of 1 percent. In the bull market that followed from 1982 to the peak in March 2000, the Dow rose from 875 to 11,723, a spectacular rise of 1,239 percent or over 13 times from the starting point.

"We all remember what a difficult time that first period was. There were three recessions, oil shocks, Vietnam, stagflation, the collapse of the Nifty Fifty, Watergate, short-term interest rates rising to 18 percent, gold at $800, and very high inflation. "Bad news on the doorstep" seemed to be the theme of the period.

"Compare that to the subsequent period. Tax cuts and lowering interest rates fueled a boom in the stock market and the economy. Computers invaded our lives, making us more productive. By the end of the period, even Alan Greenspan was extolling the virtues of technology-led productivity growth. Inflation became a nonfactor, and mortgage rates dropped almost as fast as our property values rose. The Internet promised new ways to prosper. Peace seemed to be breaking out, and government budgets ran to surpluses.

"It stands to reason, doesn't it, that the economy did poorly during the long bear market period and far better during the bull market? You would think that, but the reality is far different. Gross domestic product (GDP) actually grew 373 percent from 1964 through 1981. During the period from 1982 until the beginning of 2000, the economy grew only 196 percent, or about half of the earlier period.

"Even if you take out the effects of inflation, you find the economy grew almost identically in both periods. In the first period (a total of 17 years) real GDP growth was 74 percent, and the second (a total of 18 years) GDP was slightly higher at 87 percent.

"Yet if you take into account inflation, you didn't see a profit in your 1966 buy-and-hold portfolio of Dow stocks in 1982; you had to wait another 10 years, until 1992, for an inflation-adjusted return.

"Yet, if you listen to many advisors and analysts today, you should be buying stocks because the U.S. economy is growing, or at least getting ready to grow. "It is always a bad idea," we are told, "to bet against the U.S. economy."

This strategy would be valid if the economy was the main driver of stock market prices. The economy more than doubled in real terms from the end of 1930 through 1950. Yet stocks prices were roughly the same after 20 years!

A reasonable analysis of the links between stock markets and the economy shows that stock markets do tend to go down before and during recessions, but they do not always go back to new highs after recessions.

Investors are told to invest for the long run. "It is impossible to time the market" is the mantra of mutual fund managers everywhere, even as they buy and sell stocks in a feverish frenzy, trying to improve their performance. They can trot out studies that show that long-term investors always do better, even as the churn rate of professional managers is far beyond that of ordinary average investors.

I believe most of these studies are grossly misleading, and are now doing great damage to the retirement prospects of entire generations. In fact, the advice that traditional money managers proffer is precisely the wrong strategy for a secular bear market."

A Few Thoughts on Economic Growth

What causes an economy that is robust and growing to become sullen and laden with problems? Who pulls the lever that slows things down, and why would they want to? If stimulus has helped create new jobs and economic growth, then why not even more stimulus?

Part of the answer is simply that the business cycle seems to be part of the warp and woof of the nature of man. Since the Medes were trading with the Persians, we have gone from boom to bust to boom. There are cycles and waves for economies and investments, and to ignore them - to deny their existence -- is usually hazardous to your portfolio health.

In many times and places, recessions and depressions are a result of a catastrophic event, either natural or man-made. Wars and draughts, plagues and governmental stupidity have all been a cause for economic hardship.

But sometimes it is simply the rise and fall of the economic tide, each wave either bringing us closer to the shore of prosperity or further away. Looking at long periods of economic history, we can see those waves. Especially since the industrialized period, those waves have become quite pronounced.

This weekend, I was with my ten-year old son, sitting rather awkwardly on a surfboard at La Jolla Beach, listening to a young surfing god (Ralph West) teach my son about catching the wave. They come in sets and it is important to wait for the right wave - to look out over the horizon and see what swells are coming.

The swell determines the nature of the waves. Is it a New Zealand or an Hawaiian swell? Will it break to the right or to the left? Do you need a long board or a short board? Do you need fins? Will the swells be 5 minutes apart or 15 minutes apart? Will you be able to find the Green Room, that special place where the wave curls and you ride through the tube? Will you be stuck in the whitewash, a garbage day fighting the wind and weather?

Or, will the surf be so small and timid that only the very good or the very light can catch a wave, and for only a few seconds of ride? Such was the case last week, and thus I felt comfortable going with my son into the surf. Six-foot waves would have kept this old body on the shore. One must know your limitations.

And thus it is with economic patterns. Is it an inflationary or deflationary swell? Is it a secular bear or a secular bull wave? Knowing where you are in the cycles is important.

On a long term scale, we are in a secular bear cycle. The stock market will eventually, over the coming years, find its way to below trend valuations (P/E ratios), probably somewhere in the low teens, if not lower.

On the intermediate term, we seem to be in a range bound trading cycle. As Bill King noted today: "Most everyone realizes that stocks have traded sideways for 2004. The DJIA's 8% range for the past seven months is a historically tight range. The venerable Richard Russell recently noted that the 8% range equates to the 1972 market. Mr. Russell adds that the historic bear market of 1973-74 ensued. The AMEX, which then housed the speculative issues and small caps, lost 89% of its value.

"... Comstock Partners sees a similarity in some of the major indices' 2004 action with their respective 2000 action. Comstock acknowledges that 2004's range is tighter because it is a mini-bubble as compared to the 2000 grand bubble."

There has never been a true long term bull market start from the valuations levels at which we find ourselves today. You can get substantial bear market rallies, as we did in 2003. As I have noted before, the market goes up 50% of the years within a secular bear market.

As Richard noted, the nasty 1973-74 bear market followed that tight trading range bound market of 1972. The trigger for that bear was an oil shock and a nasty recession.

We could, and probably will, see a "range-bound" market for some time. But the next major turn of the market will be down, pushed over the cliff by a slowing economy and/or a recession.

For reasons which I will start to delve into this week, and fill out over the next few months, I think we will see the economy soften in 2005 and perhaps -- perhaps - roll into a recession in later 2005 or in 2006.

On average, the stock market drops 43% in a recession. That means a Dow in the 6,000 range. The Nasdaq will be ugly, as it is the most over-valued of the indexes.

(I should remind investors that 1973-74 created a great buying opportunity. It was also the most famous of all Richard Russell's calls, at the bottom of the bear. Richard began writing the Dow Theory Letter in 1958. Richard turns 80 this weekend, and still writes every day, to the largest audience of his career. I wish him the very best on this special day, and hope to be reading his wisdom and comments for many more years. He is a special man. www.dowtheoryletters.com)

What Causes a Recession?

Recessions are not things to be feared, if you are ready for them. It is just a different type of swell with different types of waves and breaks. You can ride that wave with the right type of board. Of course, experience helps, or at the very least good instructor is needed.

Even in a serious recession, life will carry on. Employment will be over 90%. Most of us will go about our business, adjusting to the ebb and flows. They are not typically long affairs and a rebound will always follow.

Recessions, the Austrian economists tell us, are necessary. They allow us to hit the reset button, curbing the excesses of the previous boom. Weak companies are replaced by the strong, debt is reduced, and entrepreneurs and business people everywhere are forced to become creative.

What do we know about recessions? As noted above, stock markets drop. In most parts of the Long Wave cycle, interest rates drop. Employment drops as well. Normally consumer spending and the housing market slump, although in the recent recession, we saw both consumer spending and housing surprisingly strong. Typically, the currency of a country in recession will weaken.

Recessions are a natural part of the business cycle. They come about because of excess capacity or spending or debt or confidence or a combination of factors. Depressions, I should note, are not natural in a free market economy. Depressions need massive mistakes by government to come about (that includes the Fed as government).

And most important for us to remember, recessions are by definition deflationary in nature. That means if inflation does not in fact rise above 3%, we will once again be talking about the threat of deflation during the next recession. While that will allow me to recycle some old e-letters from 2001, cutting down on a few Friday's writing time, there are few other benefits of deflation.

What causes a recession, other than a "shock" of some kind, like the oil shock in 1973? In an economy the size of the US, it is typically not one thing or even 3 or 4 things. It will be a combination of many things reversing previous trends. At some point, consumers become nervous and start to spend less and then businesses begin to cut back supply and a downward spiral is started.

Will it be a slowing housing market coupled with rising rates, a disappointing stock market and/or a job market that starts to grow below trend? Could it be any of a half-dozen other combinations of slowing trends?

In 2000, it was not consumers, but businesses that began to cut back their investment spending, and there was simply too much capacity and we had a business spending recession. Quick intervention by the Fed made home mortgages lower, which helped prop up a housing market. Remember, unemployment barely went above 6%, and along with normal population growth and increased use of sub-prime mortgages kept the demand for housing hot.

Because Bush tax cuts (not one, but three and all quite significant) put more money in the hands of consumers, and because low mortgage rates allowed home owners to refinance their homes, not only lowering their mortgage payments but allowing them to take cash out and spend it, consumer spending grew more or less steadily. I cannot find another example of a recession in which those occurred.

Coupled with government deficits, which are also (temporarily) a stimulus, the last recession was the mildest in post WW2 history. As I have noted, the "doctors" put the country on steroids, and the patient recovered. But there were a few noticeable side effects. Personal debt, which is normally reduced during a recession, has soared to levels never seen, both on a relative and absolute basis. Government deficits are again soaring. As consumer spending did not retreat the trade deficit did not come into balance. Since housing did not slow down, housing prices have risen by 20-30% over trend in the last five years.

Now, when we enter the next recession, the medicine cabinet, while not entirely empty, has been severely depleted. There will be no more tax cuts. Indeed, if Kerry wins, there is a guaranteed tax increase as the Bush tax cuts will be phased out. Rates are already low. Maybe, though I currently doubt it, the Fed will be able to get short term rates back to 3.5%. That means only about 2% or so of realistically effective rate cuts. That is not much in the Fed's tool box to fight a recession. Yes, they could "move out the yield curve" and force long term rates lower, but at some point, too many steroids will cause even more problems down the road.

Can consumers load up on even more debt? Probably not enough to make as much of a difference as in the last few years. Indeed, real wages are starting to drop.

Now, let's segue to another item, which will then take us to the real point of this week's letter.

The Delusional Nature of Pink

In the "for what its worth" department, my friend Gary Scott sends me his daily letter, full of interesting ideas on investing and the occasional odd tidbit. He likes looking for trends, so in yesterday's letter he reminded me of a very serious group called the Williams Inference Center, which sifts through mountains of reports and data looking for disparate anomalies which taken together may tell us of some new trend. They have a good track record of drawing attention to trends before they become mainstream. He shared some of their current thoughts, like a slowdown in US business around the world, due to unfavorable world opinion / reaction to Iraq; that individuals will overtake corporations as the drivers of change; that there will be a surge in demand for genetically modified grain crops, especially in India and China, etc., where the middle class is rising & restrictions are few; and growth in low-cost sensor technology (such as 'radio-tags'). They also mention that Saudi Arabia (the major source of U.S. imported oil) -- not Iraq -- will present the most problems in the Mid-East: big debt ... handful of aged, ruling families ... shrinking middle class and declining per-capita income. Any problem there could easily & drastically impact U.S. oil interests.

I find myself nodding with interest, as these all seem reasonable enough, and indeed I also think they are true. Then we come to the last one: "the rise in the popularity of the color pink may foretell a harsh stock market reaction -- pink (psychologically) symbolizes delusion denial (e.g., of soaring household debt, etc.). Pink is the equivalent of rose-colored glasses."

Not remembering any pink shirts in my closet, I asked my daughter, who works across the hall, if indeed pink was showing up any more than usual. "It's really big now, especially overseas," Tiffani reported, just coming back from six months in Cypress and Eastern Europe.

Intrigued about this unusual inference from what is a rather scholarly, staid outfit, and perhaps a tad skeptical, I called James Williams and asked about the danger in the color pink.

"Pink," he says, "is regarded in the psychiatric literature as the color of denial. And we have been seeing a rise in the use of pink in clothing for the past few years. People are buying pink clothes for their dogs. I even have a clipping where men are buying women's shoes so they can wear pink shoes." So far, that latter trend has skipped Texas, but when I am in London and Paris next month, I will keep an eye out and report back to you.

(I just turned around and saw Jim Cramer on Kudlow and Cramer (CNBC), wearing a pink shirt -- at least it was pink on my set. Yet another confirmation anomaly for Mr. Williams. Is Cramer in denial? Or maybe his wardrobe manager? He looked good in it, though.)

Williams then drew my attention to three areas of denial: debt, age and law. People deny they are in debt, and add more. They deny they are getting older. And they deny the law, breaking it with no compunction. He has cabinets full of stories confirming the tsunami of denial breaking over our collective minds.

In the 90's, people ignored risk. After the market crash and the recession, they now verbally acknowledge risk, but essentially deny it is there. They press forward as if the denial of a secular bear market will cause it to go away. The biggest trend in TV, Williams notes, is now Reality TV. We seek our reality in our entertainment, and deny the reality in our lives.

"It is all quite entertaining," says friend Bill Bonner of the Daily Reckoning, "watching the masses create another bubble, denying the risk, telling themselves they are getting rich as their paper wealth grows along with their debt."

But it will not be so amusing for those in denial come the next recession, whenever that takes place. It takes two, and sometimes three, bear markets to bring reality back to a bubble intoxicated market. At least that's what the psychologists who study such things tell us.

The next recession may bring the end of denial, at least for this cycle. It will also destroy a lot of paper wealth in the process.

"Isn't it just some doom and gloom vision, you are having, John?" I can hear you asking. "Take your vacation already and soak up some optimism."

No, it is trying to focus on reality. There will be a recession. It is not if, but when. And whenever it happens, the market will recede, perhaps dramatically. Deflation will threaten. Problems will arise. None of them will bring down western civilization, or threaten the progress of man. They will be the normal problems of excess which will be dealt with and then the world and the economy will move on. But ignoring the repetitive nature of the business cycle, telling ourselves that tomorrow will be like today, is denial, which can be deadly to your investment portfolio.

There have been either growth recessions or outright recessions every 4-6 years for the last forty years. (By growth recession, I mean a slowing of growth that does not actually result in a cessation of growth.) We are now well over three years into this recovery. The next slowdown is due within a few years, at the least. The last recession simply did not do the normal work of a recession. We are seeing things slow down from the torrid, steroid induced pace of last year.

Now we can look out over the ocean. We can look for the swells which will bring that recessionary wave. And then you can either ride it or get "wiped out." (For non-surfers, and those of later generations who missed Frankie and Annette, a wipe out is a spectacular fall off your surfboard.)

As an example, if the economy does not grow over 3% per year, unemployment will begin to rise. At some point, growing unemployment will start the forces that bring about recessions.

When most problems rise, there are causes that we can look back and say, "That is when we should have known." In my industry, we look at investment managers and funds. From time to time, there are problems. If it is a manager problem, almost invariably, there are signs well beforehand. But so often investors ignore the signs because they like the profits. They find reasons to gloss over a minor issue. And quite often, a problem never develops.

But if one does show up, you can look back and say to yourself, "This is when we should have known. This was the small clue." Managers, bonds, stocks, business or relationships, ignoring the small clues can be perilous.

Today, there are few signs of an impending recession. The economy is doing well. Business is profitable. Greenspan assures us that the economy is not likely to falter and that employment will pick up soon.

Can we begin to see what may be the warning signs of recessions? The housing construction market is slowing. Indeed, inside of yesterday's rather benign jobs report was the hidden numbers of significant losses of jobs in the construction industry in many states. Profit growth for America's largest corporations is projected to slow, even by normally optimistic analysts.

Are these clues, or simply noise in the background? We need to watch. We need to pay attention. Waiting until it is obvious to economists will be too late. Not one Blue Chip economist predicted the last recession, even though we had an inverted yield curve, which always precedes a recession, plus numerous other clues.

The astute James Montier is not one blind to the clues. He writes from his London office of Dresdner, Kleinwort Wasserstein that the surf may not be accommodating:

"All four of our previously identified potential triggers for problems with the global reflation trade seem to be occurring at the same time, creating the potential for a perfect storm. How well prepared are markets for this occurrence? Pretty poorly, if the continued elevated levels of leverage and investor complacency are any guide.

"Previously, we have highlighted four potential triggers for problems with the global reflation trades (i) rising US interest rates, (ii) a slowing US economy, (iii) a slowdown in China (iv) a stalling out of momentum. All four triggers seem to be occurring at the same time, potentially creating a perfect storm for the reflation traders.

For equity investors, the stalling out of momentum may be the biggest problem. The venerable Richard Russell has noted that there have been only four occasions in the last 25 years when the S&P500 has traded in such a narrow range for more than the current six months. Given the backdrop of an overvalued market, and a potential peaking of the cycle we suspect the break out of this range will be on the downside.

"Investors seem ill prepared for such an outturn. Leverage remains at extreme levels in a number of markets. Investors range from sanguine to complacent, whilst maintaining relatively high equity weightings. The most common argument we hear is that nothing will happen until the end of the summer holidays.

"This seems too laidback to us. Nowhere is this more prominent than in Japan. The profit cycle looks close to peaking, any downturn will catalyze a reality check on investors. We are cutting Japan from underweight to very underweight."

The night is late and the letter is already over-long. We will return to this topic in the future, examining the swells, looking for the set of waves that will signal a recession. Maybe we will get lucky and not find a recession in our future for many years. Maybe this time things are different. But I doubt it. So we sit uncomfortably on the board, bobbing in the waves, trying to maintain our posture while scanning the horizon. Surf's up, dude!

Vacation, London, Bermuda, San Francisco

Tomorrow morning I leave for 12 days in Quebec and northern Maine. My bride and I will be staying a few nights with Martin Barnes, the editor of Bank Credit Analyst and a man who is frighteningly brilliant. Perhaps he can turn me more bullish.

It now looks like I will be in London the first week of September, and maybe slip over to Paris and spend the weekend with Bill Bonner. If anyone is an antidote to Martin's optimism, it would be Bill. I may perhaps need to slip in a side trip to Switzerland (strictly business, you understand).

I will be speaking at the annual MAR Hedge Fund conference (maybe the largest such conference of the many in the industry). You can find out more by going to www.marhedge.com click on conferences.

I am speaking three times at the next Money Show event in San Francisco on September 22-24, 2004, at the San Francisco Marriott. They asked me to pass on the following note: Attend over 150 FREE educational workshops, 14 panel discussions, and general sessions focusing on economic and investment presentations and browse over 100 exhibits... all FREE. For complete details or to register online click the link below or call 800/970-4355 today. Don't forget mention me (John Mauldin) and Thoughts From The Frontline, along with priority code 003336. http://www.moneyshow.com/main/main.asp?site=sfms04i&cid=default&sCode=003336

My bride has forbidden me to take a computer with me on this trip, so I will be out of touch for the longest period of time that I have been in years. I have never visited Montreal and Quebec City. We will also drive on to Moosehead Lake in Maine for a few days, where I understand we will be without even a TV for news. We are talking serious withdrawal for this information junkie. Required reading is supposed to be non-business related, lots of sci-fi, although I may slip in one book. Communication will be the main menu item, it seems. It rather sounds idyllic, actually. I am so ready.

Have a good week. I will be.

Your looking forward to rest and relaxation analyst,

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