The “All Iraq, All the Time” Economy

John Mauldin | Thoughts from the Frontline
January 24, 2003

How, more than a few readers ask, can the economy continue to Muddle Through if I am right about the market eventually dropping another 40% before we get to the end of the secular bear market cycle? Won't such a massive destruction of wealth mean a depression? We look at that question, some thoughts on earnings, the world and a whole lot more this week.

What Are They Drinking?

First, let's look at the prospect for earnings growth this year. Global analysts are projecting earnings growth of more than 20% in the coming year, with unbelievable growth of 30% forecast for a Europe on the verge of recession, according to a survey by Thompson Financial.

Before we break out the champagne, Nick Nelson of Credit Suisse First Boston reminds us that every year since 1990 the January forecast from IBES, which was recently bought by Thompson Financial, has ultimately proved to be over-optimistic, on average by 9 percentage points.

Last year, I wrote about a National Bureau of Economic Research report that showed analysts were consistently wrong by about 50% over long periods of times.

Dick Hardy of D.A. Capital Management sent me a study done by their firm based upon US government statistics and research reports done by Bernstein Analysis. I will write more on the entire report later, but their work shows that real (inflation adjusted) S&P earnings have grown on average about 1.8% per year since 1889. Yet from 1995 through 2000 real earnings grew by 5.8%. That is a huge difference. However, when one backs out option expenses, non-recurring charges and over-funded pension plans, the earnings growth drops to 1.4%.

There are other studies which show that real earnings grow by 3% (using different sets of companies and assumptions) or roughly in line with GDP.

How can they make such projections? Because they believe we are going to have a second half recovery of significant proportions. Nearly all of their projected profits come in the last half of the year. This is the same cheerleading song and dance we got last year.

One of the central characteristics of a secular bear market is that the market goes from a period where companies have high P/E ratios at the top of the bull market to where there P/E ratios are typically in the single digits at the end of the bear. Studies I read today suggest we are still close to a P/E ratio of 30 based upon trailing 12 months earnings.

Today's level is higher than the top level of any previous bull market. There has never been a secular bear market cycle in history that has ended with P/E ratios at the level they are today. That is why I believe the market has a long way to go on the downside, and that this cycle will probably last for years. (New readers: for more information on a secular bear markets, see the chapter on them at www.absolutereturns.net)

It is entirely possible for an economy to grow significantly and the stock market to drop significantly. It is entirely possible for a company to double its earnings over time and see its stock market value drop. The difference between a good company and a good investment depends entirely on the valuation of the stock. I remind readers that from 1966 until 1982 the US economy grew in real terms approximately the same amount it did from 1982 through 1999 (around 177% or so). Stocks were flat for the first period and up 13 times in the latter.

Stock market valuations are based entirely upon the belief of the investor that earnings will grow at some expected rate. People tend to "forecast" by projecting the recent past and present into the future.

The more confident that investors are that the growth will occur far into the future, the more willing they are to pay for that growth today. Shake that confidence, and you shake the markets. During bear markets, that willingness to look into the future is diminished until at some point investors get focused on the very immediate future. "Show me the money" increasingly becomes the mantra at the end of the cycle.

Earnings are going to disappoint again this year. It is my belief you can take that to the bank. It is not to say they won't grow, it is just that they will not grow nearly as much as projected. This disappointment is what produces bear markets.

Where is the engine for strong earnings growth in the US? Construction spending is slated to fall slightly in the US for the first time since 1991. As we will note below, there is little reason to think consumer spending will rebound. While housing starts are solid, there is no reason to think they will increase from what is a very high plateau. There is little or no growth in mortgage financings. Business investment is waiting for a resolution and some certainty on Iraq. While one can point to statistics which suggest there might be some growth in the future (leading indicators or the ECRI numbers, for example, as well as high yield bond averages), they do not suggest, to me at least, the possibility of robust growth.

The "All Iraq, All the Time" Economy

The market has given back all of the gains (and a little bit more) it enjoyed during the first few weeks of 2003. What has changed? Have we had a slew of new negative statistics or surprises? Not really. A good part of the problem is that few traders want to be exposed to the market over the weekend prior to Hans Blix giving his report to the UN on Monday or Bush's State of the Union. There is too much uncertainty, and the market hates uncertainty.

The focus on the news channels seems to be "All Iraq, All the Time" and not on the economic stimulus package. Rumors such as the possibility Iraq will destroy their oil fields has oil going through the roof, and worries that it could hit $50 per barrel or more and shove the entire world into recession are becoming more common. The report from credible Iraqi sources that Saddam is outfitting his troops with gas warfare protective equipment and antidotes does not square with the assessment that any war will be quick.

I am not suggesting that the bear market is about Iraq, or that it will be over following a swift and easy conclusion. Secular bear markets are not about specific events and last for an average of 10 years or more. I merely finger Iraq for some of the recent market action. In a few months, it will be something else.

Another real difference is that at the beginning of the year it looked like dividends would not be taxed. That hope plus the belief that stimulus was around the corner produced optimism. Now, there is doubt as to whether Bush can get his dividend tax relief through the Senate. Further, as people look at what a dividend tax cut would mean to them, they find that the alternative minimum tax and the way the dividend tax relief is actually computed does not make as much a difference to their personal tax situation as they originally thought.

Volume in the markets is weak. When there is weak volume, it is easier for either selling or buying pressure to move the markets significantly. More than one stock market technician has noted that the markets have given up 50% of the gain from the October lows. To many technicians, this is important. This suggests to them that a re-test of the October lows could be the next stopping point.

With central banks throughout the world starting to increase their holdings of euros, the pressure is on the dollar. Even our new best friend Russia indicated they would move to more euros and less dollars. Et tu, Vladimir?

Thus, there is reason to believe that some of the selling pressure is coming from foreign, and especially European, investors. If you are in Europe, you have watched your US stocks drop 9% in recent months just from the fall of the dollar and the rise of the euro. That is not fun. Given that European investors now believe that the euro could rise another 10%, more and more of them will decide there may be better opportunities elsewhere.

All in all, the markets need to be given a reason to rise. Looking around the investment landscape, there are very few reasons you can find. It is no surprise the market is giving back gains and threatens to fall further. Until there is some certainty about the future, any gains will be short-lived.

Will a quick end to the war on Iraq and a stimulus package including a dividend tax cut be enough to change the mood of the investor? Maybe, but the longer the current malaise in sentiment is allowed to linger, the more doubtful it becomes.

Iraq: Behind Curtain #3

I have written, and firmly believe that Bush, Cheney, Rumsfeld, Powell and crew know a great deal that we do not. I hope that on Tuesday Bush decides to share a little of that information with us. We need to see what is behind curtain #3. This is a very important speech for Bush, and his future election hinges on it.

But let's move on to the question we announced at the beginning of the letter: "How, if the long term direction of the market is down, could I think the economy could Muddle Through again this year?"

A new Federal Reserve Bulletin on the changes in US family income and net worth caught my attention this week. I read through the statistic laden 32 pages, and bring you the gleanings. I give you less than a half page of statistics before I get to the importance of them. (You can see the full report at http://www.federalreserve.gov/pubs/bulletin/2003/03bulletin.htm#jan)

* First, the net worth of the median (the family in the absolute middle) household in the US is down only 6% from 2001 in 2002 (through October 4) and up about 2% since 1998. The median net worth of the family in the middle of the pack is $80,000. Yet the average net worth as of October is $341,000, down about 18% over the previous year. Figures were not available for 2000, but presumably the deterioration of the average net worth was also substantial that year, so the average net worth is down considerably since the beginning of 2000.

* The average net worth of the richest 10% was $2,754,000 in 2001.

* Over the decade, though, we have not done that bad. The average net worth, even after the ravages of the recent stock market decline, is almost 50% higher than they were in 1992. But the median net worth is only up 30% over the same period. The gap between rich and poor, and even between almost rich and rich, is getting wider.

* The study shows the stock market crash did not materially affect the net worth of a large majority of Americans. It is the wealthy who have been the most affected. Even though over 50% of Americans own stocks or mutual funds, the difference between the size of the holdings of the bottom 50% and the top 10% is huge.

* Contrary to popular opinion, there are not that many people (percentage wise) on the edge of bankruptcy. The study shows the average family is spending slightly less of its income on debt related expenses over the decade (and down from 1998) and is saving a little more. US families are now saving 59% some amount, up from 55% a decade ago.

* Overall, incomes have risen in real terms. The median income for white families rose 10% in just the three years from 1998-2001, and by 20% for African-American families in the same period.

Thus, it is no mystery why "consumer spending" has not suffered as much as one might have thought after the bursting of the stock market bubble. Except for those people who have lost jobs, or retirees who have seen significant asset losses, not much has changed in spending habits. We still spend most of what we earn. In terms of consumer spending, it appears to me the growth of real household income has largely offset the loss of income due to increasing unemployment.

A second observation that leaps out at me as I look at the statistics is how significant home ownership is to a person's net worth. 67% of America's family own homes, and those homes increased 12% for the median family. Since the average median net value of a home is $122,000 it is not difficult to see the importance of home ownership to a family's net worth.

This Federal Reserve study reinforces what I have written about many times: the key to consumer spending is the employment number. We will not see a revival in consumer spending -- and thus the economy -- without an increase in employment. An increase in unemployment will reduce consumer spending which will bring on a recession.

Let's review for a moment.

Consumer spending while not rising by much this year will probably Muddle Through, unless there is a further significant drop in employment or a prolonged Iraqi war. The Fed study cited above suggests that even though delinquencies and consumer debt are at all time highs, there is no reason to believe that it is going to be a serious problem in the near future. (By near I mean in the next few quarters.) Construction spending is slated to be flat to slightly down. Housing is holding up.

The dropping of the dollar will help many US businesses, especially exporters and multinational firms, be more profitable and thus ease the pressure on jobs. I still believe we will get an economic stimulus package. Interest rates are not going to rise, and the Fed will continue to accommodate with easy money. In fact, the recent stock market drop may get them to start pumping the money supply again, as opposed to the flat numbers I wrote about last week.

Same Song, Second Verse

All in all, this is just about where we were at this time last year. I should note that I do not think we will Muddle Through forever. There is a recession in our future, and that is when we will see the next big leg down in the bear market.

What will cause it? It could be any number of things, but a rise in interest rates is my number one suspect. That will seriously hurt housing valuations and new home sales, which will impact a lot more consumers than the stock market has. That is why I believe the Fed will do whatever they can to keep interest rates low until they think the economy is strong enough to handle higher rates. Whether they can artificially keep rates down without bringing back inflation (and thus higher rates) remains to be seen. But that is a story for another day.

Why Things Will Get Better (Eventually)

Just because this letter has been so gloomy, let me leave you with a few positive thoughts. During the last secular bear market cycle, there were more than a few companies created which became big winners. Think of Microsoft and Intel.

When recessions present us with the necessity of creating our own jobs, this becomes the seed for the future growth of the economy. It takes time, but it follows as day follows night.

There are a number of people who have recently been "downsized" and unable to find another job. Recent studies suggest that many of them are starting their own companies. 80% of those will fail, as do 80% of all new companies. But the 20% that succeed will help build the basis for a stronger economy and more employment after we work our way through the current economic problems. In the Fed study, the group with the highest net worth was the self-employed.

50 Great Innovators

Finally, I must confess that I recently joined AARP. You can now do so at 50. It has nothing to do with age, as I cannot even imagine retirement at 53. I did it simply because membership helps save me a lot on my travel expenses.

Along with this membership comes their magazine, which I have resisted reading. Somehow it seems like acquiescing to age to read the magazine. But I was drawn to their March/April issue which profiles "50 Great Innovators" over 50. It was quite inspiring to me. It is good to remind ourselves of the gifts and talents that are alive and flourishing in our country.

Economies grow and recede. They always will. But the human experience suggests that given the right conditions of freedom and opportunity, the prospects for the long term future are exciting.

One of my personal heroes in the AARP crowd is Richard Russell, who writes the Dow Theory Letter. At 78, he writes every day and is writing better than he did in 1958, or when I first ran across him in the mid-80's. I cannot recommend his investment advice and wisdom strongly enough. I hope I can write as clearly and forcefully as he does when I am 78. I will have to improve quite a bit but then I have 25 years to practice. (You can subscribe to his letter at www.dowtheoryletters.com.)

Tomorrow I leave for Palm Beach to speak at the Global Alternative Investment Management conference on hedge funds and private offerings. It is being held at the PGA National Resort. I will leave my golf clubs at home, as it looks like it will be warmer in Texas. It will be a full five days of meeting with clients and friends, interviewing hedge funds and maybe working in a little fun. If you are an accredited investor (basically $1,000,000 net worth) I write a free letter on hedge funds and private offerings. You can get more details and subscribe at www.accreditedinvestor.ws. (I do not like to limit the letter, but there are very specific laws about who can get legally get information about private offerings.)

Have a great week.

Your Muddling Through analyst,

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