The Muddle Through Middle: Why Stocks Drop While the Economy Grows

John Mauldin | Thoughts from the Frontline
February 28, 2003

In most issues of this weekly letter, I spend our time together looking at specific trees and various flora, commenting upon how they affect the overall economic forest. Today, it is time to drop back and look at the forest as a whole, given that we may be on the precipice of events that could change the very character of the forest in which we live.

I am going to do so as a way to frame what I think of as the rationale for my economic world-view. I believe we are in a Muddle Through Economy for a long period of time, and probably the rest of the decade. I have had more than a little criticism of this belief, on scores of websites and in letters from readers, either from those who would suggest that it is Doom and Gloom, or from those who think it naively Pollyanna. I prefer to think of it as neither of the poles, but as a more straightforward and realistic assessment of our future. It is lonely in the Muddle Through middle, and I enjoy the few who share the space with me.

Essentially, what I mean by Muddle Through is a period of time when the economy grows at a slower pace than long-term trends. This is NOT to suggest there won't be growth. I think there is every reason to believe that the US GDP in real terms will be 20%+ larger in 10 years than it is today. That is admittedly, far less than the 3.5% annual growth assumptions by many mainstream analysts. Since the US population will not grow anywhere near as fast, on average we will be better off in ten years in terms of per capita income. I simply cannot see how projecting real growth is Doom and Gloom.

Others will list a long line of negative factors, asking how can I not see a lengthy recession or even a depression in our future? How can I think that a collapse of the dollar or the demise of the consumer or the collapse of the economy due to debt or the bursting of the housing bubble or the War in Iraq or the US trade deficit or the US Federal budget deficit or the coming ravages of deflation as the Fed pushes on a string or the re-occurrence of massive inflation due to a rapidly growing money supply or stagflation or [whatever - you fill in the blank] will bring us to The End Of The World As We Know It?

Some seem to think that what I mean by Muddle Through is that we will grow by 2% a year forever and ever, uninterrupted by the above problems. This is emphatically not the case.

I clearly see a recession in our future. In fact, I would be willing to bet that we have ten recessions in our future in the coming century, if I thought you would be around to pay me. Despite the best efforts of the Fed and Congress, no one has been able to repeal the business cycle. The business cycle has been a fact of life since the Medes were trading with the Persians. The economies of the world will be subject to this immutable law long after we are ancient history.

The questions are not if we will have a recession, but when and how significant and what will be the primary cause(s) of the recession in our future? What will be the fallout from a recession? How quickly will we recover?

Following that recession, whenever it is, we will have an economic recovery. If it is a steep and longer recession, it will probably be a significant recovery, as we will wash away much of the above listed problems - a kind of "hitting the reset button." If it is a mild recession, such as we recently experienced, it is likely to produce a mild recovery, much like we are in now.

It is quite doubtful, barring some unforeseen catastrophic event (unlikely) or government stupidity (always a possibility), that we go into a permanent, decade long recession. But I also cannot see how we go back to the Roaring 90's. The headwinds are against us. The world is going to have to adjust to a new dynamic that is not US-centric, and that change will mean economic progress will be slower throughout the world.

One more thought about recessions: they happen on the margin. If the economy were to recede by 2%, and employment drop another 3%, that would be considered a serious recession. But we would still be doing business at 98% of what we did last year, and 92% of us would still have jobs.

Most of us would not consider a 2% loss of our income to be the end of the world. That is not to diminish the severe and heart-breaking individual problems which happen during recessions. Those are quite real. But the end of the world is not a 2% or 4% drop in GDP (unless, once again, it is your job or business).

Where Are We Today? Clear Sailing or Recession?

Today, if one looks at the problems, it is easy to forecast recession this quarter. But if one looks at the data, we appear to be muddling along. Growth last quarter was an anemic 1.4%, and it appears that we will grow again this quarter. When you look at the economic indicators, while not suggesting strong growth, it doesn't reveal a recession coming soon. By soon, I mean in the next 6-9 months. If things break right, we could see above 2% growth in the near future.

But that does not mean we have clear sailing. There are clearly forces lurking about which could push what Stephen Roach (chief global economist at Morgan Stanley) calls an "economy growing at stall speed" into recession. He is most worried about an oil shock, ann indeed, if prices do not come down within the next few months, that is a worry on a global basis.

Remember, I said recessions happen on the margin. What could happen to cause the economy of the US to recede by 2%? My first thought it that if consumers spent 3% less, that would certainly slow the economy, if not precipitate a recession, as businesses adjust their hiring down to try and stay profitable. Consumer spending and the housing industry are the pillars of the economy now, especially as capital investment by business is still in the doldrums.

What would cause the ever faithful US consumer to spend 3% less? The easy answer is that he has 3% less to spend. If increased local taxes, increased energy prices (gas at the pump, utilities, etc.) and increasing medical bills are not balanced by an increase in income somewhere else, then it is very conceivable that the consumer has 3% less to spend. If the consumer decides to save, or gets less confident and begins to cut debt rather than spend, you could easily see US consumers spending 3% less. Raj Gupta tells us in a must-read Barron's interview that same store sales have slowed dramatically from the pace of the first half of 2002, with many stores now showing no growth at all.

This is why it is critical, from strictly a recession avoiding point-of-view, that Congress passes a tax-cut. A tax-cut is designed to put more money back into the hands of the consumer. Just a few points of tax cuts could make the difference between slow growth and/or no growth. Remember, we are talking about the margin here. An economy in a 2% recession would be a disaster if you are a politician. Believe me, if we go into a recession, it will be called the Bush Recession by Democrats, even though president's have little to do with the actual economy. They unjustifiably get to take credit if things go well and get the blame if they don't.

I have written before that my Muddle Through Economy scenario for this year is dependent upon a significant tax cut to offset cost increases elsewhere. I leave the argument for whose taxes to be cut to another space, simply noting that it must be done or else we will be in recession. Bush and his team clearly understand this, and that is why he is so insistent on an economic stimulus plan.

Does that solve the core problems? No, of course not. It merely pushes the problems into next year and/or onto another generation. Will a tax cut prevent recession for all times? Clearly the answer is no.

Given the deficits, I can understand the call by some that now is not the time to cut taxes - that we should not push our debts onto our children, etc. But such a call is a prescription for recession, which would also produce even more deficits. It is a classic Catch 22.

So, to avoid a recession or a near miss later this year we need two things to happen: a tax cut and a drop in oil prices. I think they are both likely to happen, but they are by no means sure.

Let's look at some results that could flow from a possible recession. First, the stock market:

We are in a secular bear market. We will continue to be in one until Price to Earnings (P/E) ratios are brought back to trend. That can happen by either share prices dropping or earnings rising or a combination of both. These market periods last a long time. We are probably in the third inning (of a nine inning game for foreign readers) of the current secular bear market cycle.

My studies show that the stock market drops an average of 43% before and during a recession. I think the next big leg down in the stock market will be precipated by a recession. Could we see the market drop another 40%? The short answer is yes.

Richard Russell turned me onto a fantastic web site called www.decisionpoints.com. They have more charts and graphs updated daily for technical traders than any site I know of for the price. They maintain a huge range of data and charts on stocks, funds and statistics, all for a mere $20 per month.

One of their charts is a weekly study which analyzes P/E ratios for the S&P 500 based upon historical norms since 1925. The average for the last century was for a P/E ratio in the 15 range. The P/E ratio would occasionally and briefly dip below 10% and up until the last bubble, would occasionally (and briefly) rise above 20-22. We have been above 22 for quite some time now, which is a very unusual situation.

Carl Swenlin, the mind behind this fantastic website, gave me permission to quote the following:

THE REAL P/E RATIO

The "as reported" P/E for the S&P 500 (a.k.a. earnings based on GAAP -- Generally Accepted Accounting Principals) is the historical standard for reporting earnings. The normal range for GAAP P/E ratio is between 10 (undervalued) to 20 (overvalued). The investment sales industry would like us to think that "pro forma" or "operating earnings" is the same as GAAP, but operating earnings are a fabrication prone to gross distortion. There is no standard by which operating earnings can be judged because operating earnings are not based on real accounting -- all revenue is included, but selective expenses are ignored. This version is becoming known as EBBS (Earnings Before Bad Stuff). Standard & Poors has introduced a third version called "core" earnings, which is more critical and analytical than the other two, and is designed to reveal the true condition of the company. We can only use GAAP earnings for historical comparisons, because there is no historical record for the other two. Core earnings should be used for individual company value analysis. Pro forma earnings should be viewed as a deliberate deception and should be ignored.

The following are based on S&P 500 12-month trailing earnings for the last quarter reported by Standard & Poors. The estimated P/E is calculated by dividing the most recent S&P 500 close by the EPS:

"As Reported" (GAAP) EPS is $30.04; P/E is 28.00. "Core" EPS is $20.78; P/E is 40.48. "Pro Forma" EPS is $44.04; P/E is 19.10.

Based upon the latest GAAP earnings the following would be the approximate S&P 500 values at the cardinal points of the normal historical value range. They are calculated simply by multiplying the GAAP EPS by 10, 15, and 20:

Undervalued (P/E = 10): 300 Fair Value (P/E = 15): 451 Overvalued (P/E = 20): 601

2002 Fourth Quarter S&P 500 Earnings: Reporting is 96% complete with the results so far showing a 30% decline from the same quarter a year ago. Twelve-month trailing earnings are projected to be 28.40, which gives us a P/E of about 29.

Those are indeed sobering numbers. Let's put them into perspective. As studies I have written about previously show, all bubbles come back to trend when they burst, and they tend to go well below trend. Secular bear market have always ended in single digit P/E ratios. These has been no exception.

Am I forecasting the S&P 500 is going to 300 this year? No, that is not the way secular bear markets have tended to work. Could we see a drop of another 20%-30%-40%? Quite easily. There is no real way to know how much it will drop, other than 20% would be a small drop for a recession, and 40% would seem big after the current 40% drop.

But to get back to a single digit P/E ratio this year would require a drop of 65%, which would simply be too far, too fast. Such a drop would be a pre-cursor to much worse economic problems, and would mean that there are problems we do not yet know about today.

The more likely scenario is a significant drop caused by the next recession, some sideways years with a few bull market mixed in, and then the final drop in the following recession later this decade. During this interim period, the economy and profits and earnings are growing, so we can go back to single digits without necessarily going back to 300 on the S&P 500.

We can get to single digits by going sideways for a long time as earnings finally catch up, or we can ratchet down. The sideways for a decade or more is only possible if we have no recessions and I think that is not likely.

Thus, I think 500 on the S&P and 5,000 on the Dow are both a stark and realistic possibility, in my book. Remember, secular bear markets all have their own individual psychology. A growing economy does not lead to secular bull cycles. For new readers, I again note the economy grew almost exactly as fast in real terms from 1966 to 1982 as it did between 1982 and 1999. The first period had no stock market gains and the latter had 1300%.

That is why I can predict a growing economy, if slower than trend, and still talk about lower stock market prices. The two are NOT inconsistent.

Until the time we appear to be entering the next recession, the stock market could go sideways or rise significantly. There are numerous examples of 20%+ rises in the midst of a longer term bear market cycle. By sideways, I mean in a range of 15%. That does not preclude a fourth year in a row of losses, but it also does not preclude a rise. A lot - more than a whole lot - depends upon how the Iraqi conflict is concluded, whether Bush gets his tax cuts and how quickly oil prices fall. My perhaps unreasonably optimistic hope is that everything works out well, we get tax cuts and oil comes down quickly.

The Fed (and thinking politicians, neither who cannot admit it publicly) hope and belief is that the longer we forestall a recession, working through the problems mentioned early in this letter, the milder the recession will be and the quicker the recovery process.

There are reasons to support this view, and thus I hope to see a recession put off as long as possible. I am not some masochist. I like even Muddle Through growth. But my hope really makes no difference. We could see a recession start this year, or it could be put off for a few years before rearing its head. The world will unfold as it always has, and we players get to adjust for reality.

Thus, in my opinion, I would not be invested long-term in the stock market given the uncertainties and my view there is another ugly bear market in our future. This is a stock pickers market -- a traders market -- a timers market. There may indeed be some stocks that are screaming buys right now in terms of value and can be bought for the long run. Not a lot, but some. They are mostly small and/or micro-cap which bring their own problems. You need to pick and choose carefully based upon a lot of due diligence and homework. But mutual funds, index funds, and other such broad stock substitutes are not where your money, pensions, or annuities should be.

Let's Look at Interest Rates

Another thing could bring us into recession. If mortgage rates were allowed to rise, it would cause a drop in the housing market and probably a drop in housing prices, or at least a clear slowing of the growth. This would hurt consume confidence, thus slowing spending and hurting both of the functioning pillars of this economy simultaneously.

Long-term interest rates will only be allowed to rise, to the extent the Fed can control them, when it is judged the economy is strong enough to handle higher rates.

That makes the single best predictor of recessions - an inverted yield curve (where short-term rates are higher than long-term rates) - useless. If the Fed artificially constrains short and long term rates, then an inverted yield curve is almost impossible.

(The New York Federal Reserve did a study in 1996 of 19 potential predictors of recessions. [I think it was 19 - it might have been 29 - I have read too many research papers.] The inverted yield curve was the most reliable, and the only one that was consistent.)

Recessions are by their very nature deflationary. The Fed has told us they will not allow deflation. They must steer a course between letting deflation take hold and precipitating inflation and causing long term rates to rise prior to the economy being on a sound footing.

The two forces will be at odds, with one winner. I believe the Fed when they tell us they will move "out the yield curve" to inject liquidity into the system, and as a ay to lower longer rates. They will probably do so too late, but they will eventually act. They will move faster if mortgage rates start to rise.

I believe that if the Fed allowed rates to go back up today, as weak as the economy is, that it would throw us into recession. Greenspan did it to Bush 1, but I do not think he will be able to raise rates this year without a lynch mob forming, nor do I think he desires to. As I wrote almost two years ago, Greenspan has raised rates for the last time in his career. Raising rates in a presidential election year is a no-no. It is unlikely he will want to be re-appointed.

Therefore, while rates will eventually rise, as one way or another inflation creeps back in (either "naturally" or forced). Interest rates may stay down a lot longer than most observers think today. In 1980, as Volker fought inflation, it took a few years for the market to actually reverse course.

The Dollar Defies Gravity

The trade deficit is growing again. Interestingly, the dollar is dropping almost solely against the euro, but our deficit with Europe is rather small. The dollar is holding its own against the Asian currencies, most of whom with which we have monster deficits. They are willing to take dollars in order to keep their factories going, and these countries invest in our bonds to keep their currencies competitive with each other. Theoretically, these international dollars should be intrinsically worth less each year, but the Asian firms still reckon it is better than nothing. Thus they finance our deficits.

This cannot go on forever. The dollar has to drop against other currencies besides the euro. Euroland is either in recession, or close to it. A further rise in the euro will actually not be good for them, as it will hurt their exports. It is deflationary, and they are on the brink of deflation. The European Central Bank will soon be forced to cut rates again.

The next international crisis, after Iraq is finished, may be one in which Europe (justifiably this time) complains about a too strong dollar compared to Asia. They will pressure the world central banks to buy euros to soften the rise of the euro and make the Asian currencies rise against the dollar. When the European recession gets serious, as it will, we will watch for major finger-pointing and shouting matches. Iraq may just be a warm-up.

By the way, a drop of even 20-30% of the trade weighted dollar is not a catastrophe. I remember living through that in the 80's. I don't seem to remember the world coming to an end. For savvy investors, it offers opportunities. A lot of the people I respect are starting to look seriously at foreign bonds, and I have long been a fan of euro denominated bank accounts at Everbank here in the US. They have done quite well since I first recommended them early last year, thank you very much. (Call Chuck Butler at 314-984-0892, ext 102. for details.)

Same Song, Second Verse

Now, let's summarize what I just said. The economy will continue to Muddle Through, until the point we tip once again into recession. When that happens, the stock market is likely to drop precipitously. That recession will pass just as all others have passed. We will recover. Interest rates, at least Fed controlled rates, will likely be flat for awhile, at least until we are well into the next recovery. The dollar is over-valued, and will fall. (That also means that gold will rise - but that is another story for another time.)

That is not the end of the world. I could have written almost the same thing (except for the reverse on interest rates) in 1978. That was then, and is now simply the business cycle in action. I do remember being told to buy survival foods, bomb shelters, gold, real estate, avoid stocks, etc. during that period, and for years after. We have (mostly) all survived and done quite well in the ensuing 24 years.

If you buy the Wall Street cheerleading that the only way to grow your portfolios is by investing 70-80-90% of your portfolio in stocks, then the above analysis may indeed be Gloom and Doom. If you sensibly adjust your portfolio to get Absolute Returns, it is a simply a matter of changing your expectations to reflect reality. A 5% bond yield is better than a 10% drop in the stock market. Bonds, indeed money market funds, have in the past outperformed stocks over ten year periods when they are at the nosebleed valuations like they are today. (See Robert Shiller's great book Irrational Exuberance .)

If you are focused only on the stock market, then the next decade will not be pretty, in my opinion. If you look around for the myriad of other opportunities, and have reasonable expectations, then you can do just fine. You may not be able to grow your portfolio at 10% a year (unless you take more risk than I would personally tolerate), but you can grow it quite nicely.

In short, I think the world looks similar to the period of 1966-1982. That was not the best time for stocks, but there were a lot of other opportunities. That is not Doom and Gloom. That is not Pollyanna. I believe it is simply being realistic. It is much better to take what it gives you and be thankful.

We will have a secular bull market again in our future, and when that happens, we will once again become irrationally exuberant at the end. It is a cycle. No trend lasts forever, especially secular bear markets. Projecting current events or trends far into the future is almost always wrong. Things change. You must change your investment strategy with them.

I will get a lot of letters asking me to tell you exactly what the best ways to get Absolute Returns are. I am writing the book as fast as I can, and will post chapters as they get finished. Soon. I promise.

Florida

Next week, I will fly to Delray Beach on Thursday for the Investment U conference. They just nailed down my speaking times on Saturday, so I will call all those who have told me they want to meet on Monday and schedule a time to meet on Friday or Sunday. I will be in Austin for Pension Fund conference March 26, and will be in Tucson in late April at a private investment conference.

This last week, I must sadly confess I did not get much done on my book. Between two inches of ice in Dallas/Fort Worth and a miserable stomach virus, I lost a few days of productivity. I hope to catch up some this weekend, as my bride has taken a few days off to go to Mexico for some needed R and R. I must admit, it can be a strain living with me. I make myself tired sometimes trying to keep up. I get complaints from my shadow. But she does it admirably, and loves me all the same. A good wife is a blessing, and I am a blessed man.

I trust you have a good weekend.

Your missing his bride already analyst,

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