By John Mauldin | 6 February 2009
The Right Direction, At Least
The Jobs Will Come
Can We Have a Little Inflation, Please?
Those Wild and Crazy Analysts
When confronted about an apparent change of his opinions, John Maynard Keynes is reported to have said, "When the facts change, I change my mind. What do you do, sir?" The earnings season for the 4th quarter is almost 80% complete, and the facts are dismal. It is worse than the current data shows, and could get uglier. Unemployment is increasing, and consumers are both saving more and spending less as incomes are not keeping pace with what little inflation there is.
All in all, a very different set of facts than a few quarters ago. This week we examine some of the new facts, and start out by analyzing how Thoughts from the Frontline has done over the past two years with some of the more important predictions. It should make for an interesting letter.
The Right Direction, At Least
Over the last year, I have become increasingly more bearish on the economy than I was in January of 2007. In my 2007 annual forecast issue, I said that we would be in a recession by the end of the year (we were), and that it would be a long but not too deep recession, with a multi-year below-trend Muddle Through period to follow. I was thinking GDP would maybe be down 2-3%. As I have repeatedly written in this letter and said in speeches, the US stock market drops by an average of 43% in recessions.
I saw no reason to be in the stock market, as there was just too much risk of a serious bear market. Further, since international markets now have close to a full correlation with the US markets, foreign stock indexes would be in trouble as well. I also said interest rates would be coming down and deflation would be a problem before we got through this recession.
(As an aside, there are a lot of very well-known perma-bearish analysts who called the recession, but were very bearish on the US dollar and/or positioned their clients in emerging-market stocks or other markets. Their clients have been mauled. Just because you get the economy call right doesn't necessarily mean you can call the right investment shots. Before you invest with a manager because he seems to have been right about something, look to see what his actual investment strategy has done. And that includes me or my partners.)
I also predicted the bursting of the housing bubble and the subprime credit crisis in late 2006 and 2007. While I was completely wrong about the severity of the current recession, at least I got the direction right. My advice would have been the same, which was avoid long-only stock portfolios and mutual funds, be long bonds, and access active, absolute-return managers and funds [[but most bonds, except for USTs, have also gotten killed! : normxxx]].
But the facts have changed. The reality is that we are in a much worse recession than I thought it would be two years ago. And as I wrote last month, we will probably be in recession for the full calendar year 2009, with the same lengthy multi-year Muddle Through Economy I originally envisioned, albeit from a lower base. So, what does that look like? Let's look at a likely set of facts, in no particular order.
1. Consumers are going to save more and spend less. It is likely that US consumers are going to push the savings rate back up to 6% (or more). Total US net worth decreased by $7.1 trillion through the third quarter of 2008, from housing and stock market losses. The trend suggests that could easily decrease another $6-7 trillion by the end of this quarter. Greg Weldon speculates that it could easily be down $15 trillion by the end of the cycle.
That is a massive amount of wealth destruction. And while the absolute numbers are not as large in the rest of the world, the relative magnitudes are. This is a truly global recession. Economists say that anything below 2.5% in world growth is a global recession. We are down to 0.5% and falling.
2. The stimulus package is simply a pork-laden, misguided piece of legislation. The nonpartisan Congressional Budget Office released a report (I think yesterday) that says "CBO estimates that this Senate legislation would raise output and lower unemployment for several years... In the longer run, the legislation would result in a slight decrease in gross domestic product (GDP)." There is way too much spending on items that have very little current effect on the economy.
I am in principle in favor of a deep and large stimulus package. We need one, but what is on tap is not what will stimulate real job growth. All it does is create more debt that will have to be paid later by our kids. What else could we do? For instance, US companies have so much money squirreled away that Allen Sinai of Decision Economics concluded that, if the US lowered tax rates temporarily on repatriated earnings, companies would repatriate US$545 billion. There is a precedent for this: we saw US companies bring home $360 billion in 2004 as a result of the temporary 5% tax rate contained in the American Jobs Creation Act. (Sent to me by Louis Gave of GaveKal, whose work will be highlighted in next Monday's Outside the Box)
Why not set a 10% tax rate to simply bring the money home, and a 5% rate if they use it for capital spending or to create jobs? Now that is stimulus that would actually result in more taxable income! And that money did help to create a boom in 2004. On an aside, this just goes to show how out of balance the US corporate tax system is.
What little real stimulus is in the bill will not hit all that much in the first half of this year. The fourth quarter of 2009 is likely to look better than the first quarter, but it is also likely to have a negative sign in front of it. I hope I am forced by the facts to change that prediction.
3. I am somewhat more hopeful about the Federal Reserve and Treasury programs, although all they really do is buy time for financial corporations to heal themselves. That is not all a bad thing, though. Volker did it in the early 1980s by allowing banks to carry debt from Latin American countries that was in default at full loan value. Otherwise every major bank in America would have been bankrupt.
And I agree that a lot of the process will be wasteful and unproductive. But such is the nature of crisis planning. Hopefully, they will not put into service the notion of a large "bad bank," but rather go ahead and put the zombie banks to sleep and help the healthy ones survive. But if US taxpayer money is involved, then shareholders should be wiped out first. If the rest of us have to lose on our stock investments, then bank investors should not be in a special protected class.
The downgrades by Moody's today of 2,446 different classes of Residential Mortgage Backed Securities will be a real blow. The losses on ABS' are just going to keep coming. Commercial mortgage paper will soon be written down as well. Banks will likely need at least $1.5 trillion in private investment and government funding.
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4. As I have noted for almost two years, it will take until at least 2011 for the housing market in the US (and bubbles elsewhere, as in England and Spain, etc.) to stabilize. It will take several years for the creation of a new credit system to rationally replace the old "shadow banking system." This is why the recovery will take so long.
For an economy to grow over time, you need some combination of increasing population, productivity increases, and credit creation. We have destroyed a large part of our credit creation model (which was deeply flawed, even though for awhile it seemingly worked well) here in the developed world, and we simply have to build a new one. That is why I believe we are going to see the creation of a massive new Private Credit Market that will compete with banks.
You can see this developing here and there, but it is going to take time. The Fed is stepping in now and buying mortgages, credit card debt, student loans, etc., which is useful in the interim, but they need to make sure they do it at rates that will attract private capital and capital formation. We do not want to turn the Fed or Treasury into a national mortgage bank subject to political whim.
That would be worse than what we have now. As an example, the government is now nearly the only source for student loans, as they set prices which just did not allow private companies to compete. We must not do that with mortgages.
5. The US government will run multi-trillion-dollar deficits for at least two years. As noted above, I think the current stimulus package will not be deemed sufficient by the third quarter, and the compelling need politicians will feel to do more will be almost uncontrollable. Interestingly, the increase in federal spending is going to be accompanied by a substantial decrease in state and local spending, as almost all nonfederal entities must balance their budgets, and tax receipts are way down.
If consumers are spending 5% less, it stands to reason sales taxes are down by 5%. Property taxes will be down, as will the state portion of income taxes. Increasing taxes will bring about local voter rebellion, so spending cuts will be the order of the day. As an example, state employees in California have every other Friday off, which cuts their pay by 10%. Expect more such cuts everywhere and on everything.
And while I am on the subject, state, county, and municipal pension plans are woefully underfunded. As in by trillions of dollars— much as I wrote in Bull's Eye Investing in 2003. The signs were so there, and in a few years governments are going to have to figure out how to deal with major shortfalls in funding, as many municipal pension plans will be technically bankrupt.
Accompanying the increase in federal spending will be a real decrease in federal tax receipts, which will make the federal deficits worse.
6. The main driver in the economic world currently is deflation, as I have been writing for a long time. Yes, we had a brief whiff of inflation last year, but that was primarily commodity-driven, and that force is now spent. Commodities are likely to rise in price again, but not in the near future.
This is going to give the Fed the room to print money to monetize the federal deficit, and indications are that Bernanke will do it with a vengeance. He will do everything in his power to keep the US economy from catching the "Japanese Disease," that is, descending into a deflationary spiral. I fully expect them to "move out on the yield curve" and set longer rates at some lower number as well.
All of the above leads me to the following conclusions.
We are going to some new lower level of GDP and consumer spending, maybe as much as 5% lower, which is a serious recession. And the "recovery" is going to be slow. We don't get back to 3% GDP growth in 2010. Let me once again print a graph I have used several times, but it is just so important. You need to think about this one. This shows what the US economy would have been without mortgage equity withdrawals (MEW) from 2001 to 2006.
Notice that the US economy would have grown less than 1% a year for five years, and barely that by 2006. And that is with consumers saving less than 1-2%! Now, let's imagine a world with savings going to 6% (or more), because shell-shocked US consumers now realize they may actually have to save to be able to retire. And what is it going to feel like when housing drops another 10-15%? Or more?!?!? And what if we have a repeat of a major summer bear market— which I make the case for in a few pages?The Jobs Will Come
We could see well-below-trend growth for several years. I spoke this week to a small group of entrepreneurs that my daughter is involved with. (It is a business development/mentoring program called Vistage. I know several people who have seen their businesses really take off because of what they learned. If you are running your own business, I highly recommend it. I can see the differences it is making in my own business because of Tiffani and other people I know who are involved. Check out their web site.
What I told them is that for those businesses which are dependent on the US consumer, their world is going to be smaller for a long time. We are in a period where the economy is going through what economists call 'rationalization'. We are going to have to reduce the number of retail stores, coffee shops, automobile plants, fast food restaurants, car dealerships, etc., until we get to a [lower] level that makes rational sense for the [reduced] size of the economy. We just built too much stuff, launched too many stores, and created too much capacity for almost everything.
The idea for the business person today is still to be standing when we get through this, as we will. That is what free market economies do. The day will come when we get back to 3-4% GDP growth. But it will be a rational growth based on 'real' fundamentals, one that will last a long time. So hope is not a business strategy. You need to be planning for a lengthy recession and a slow recovery.
And if your business is one that helps producers cut costs? Or improve production? Then this is your time to shine. It is not clear what the stimulus plan will be, but look at it to see if there is something you can do to get in the way of that flow of money. There are opportunities out there.
We were in a similar period of malaise in the late 1970s. Everyone wondered where the new jobs would come from. The correct answer was, "I don't know, but they will." As it turned out, we saw the creation of whole new industries, which the government had little to do with.
It is still the right answer. The new industries that we will see next decade? Biotech? Energy? A new wireless telecom build-out? Something out of left field? The correct stance is to be cautiously optimistic. I am seeing some amazing private equity deals and new ventures. It is really a great time if you have capital, as you can pick among some very nice opportunities.
Can We Have a Little Inflation, Please?
Getting back to the Fed and deflation, there will come a point (I hope) when the Fed will actually bring about some inflation. That means they will have to tap on the brakes to keep from letting it get out of hand. That of course will slow any recovery, which is another reason I think the recovery from the current recession will be a lengthy one.
It is asking too much for them to get it "just right." There is no formula here. They really do have to make it up as they go.
And while I don't think it is the likely case, it is quite possible that we could see a repeat of '70s-style 'stagflation'. We could also slip into Japanese-style deflation, as the Fed may just be 'pushing on a string'. There is just no way of truly knowing. You have to stay nimble and go with the facts as they come down the road.
As investors, your goal is also to be standing when we get through this. There is another bull market in our future, as hard as that may be to imagine now. But it is several years off. Now is still a time for absolute returns and active management.
You want to arrive at the dawn of the next bull with as much of your assets as possible. How will we know when we are there? Because valuations will be low [[but, more important, no one will think them worth anything!: normxxx]]. Which is a perfect time to segue into an analysis of current market valuations, as we close the letter.
Those Wild and Crazy Analysts
I have been writing about analyst earnings forecasts for some time. Earnings forecasts just keep dropping. I talked with the very interesting and gentlemanly Howard Silverblat from Standard & Poors, who is in charge of assembling the data for the S&P earnings. When I went to their web site, I noticed that "core" earnings were missing from their spreadsheet.
Core earnings take into account pension fund commitments and other items that sometimes do not make it into reported or operating earnings. During the last bear market, core earnings were a lot lower than reported earnings, as companies adjusted their pension commitments to make things look better than they were. I was wondering if we would see the same thing happening now.
I asked Howard about that, and he said they were having some issues in calculating them but expected the core earnings numbers to be back up in a month or so. And he quoted sources that suggested S&P companies were underfunded by $250 billion in their defined-benefit pension plans. Late last year, the Bush administration waived the requirement that companies fund their pensions to at least 92% of needed capital. It is now down to 80%. That leaves companies some room to play with on their balance sheets.
I commented on how bad earnings were last quarter. The web site shows earnings were a negative $3.14 a share, the first time they have ever been negative for a whole quarter. Ever! That was with 65% of companies reporting. He commented that it was worse than that. They don't have it up yet, but with 78% of companies reporting, losses are now a staggering -$8.56 a share. And it could get worse. The write-offs this quarter are just huge.
As he wrote, companies are not only throwing in the kitchen sink, but the refrigerator, washer, and anything else they can find as they seek to write off everything they can, to get it over with and start the new year fresh. They need to do a kitchen remodel, but there is no financing available. So, how does that affect total earnings for 2008?The table above/left shows analyst projections from March of 2007 through today. Notice how they kept falling over time. They are now down 70% from what was expected two years ago. Earnings for 2008 are a paltry $29.57 and dropping. The S&P 500 closed at 868.60. That makes the P/E (price to earnings) ratio 29.4. (I use a decimal to show I have a sense of humor.)
So, what are they projecting for 2009? Let's take a look. Notice that they too have been falling over time.
If the S&P 500 were to close where it is today, and using the estimates for the first two quarters of 2009, the P/E ratio would be 36.4 on July 1. But what if earnings merely fall to where they were in the last recession, or about 55-60% of where the projections are today? That would drop the 12-month trailing earnings for the four quarters ending June 30 to $15.90 and result in a nose-bleed P/E of 54.7 by the middle of the year.If earnings don't come in dramatically better for the first quarter as opposed to last quarter, we could be setting up for a nasty summer bear market. Even in the bear market of 2001-2, the P/E did not get above 47. Which, by the way, at a 47 multiple would correspond to a range for the S&P of either 1111 if the earnings come in as projected or 731 if they come in at the lower range.
I see nothing on the horizon which suggests the economy is going to get manifestly stronger in the next two quarters. The real risk is that earnings come in weak for both quarters and investors simply despair this summer, throwing in the towel and bringing about a vicious bear market. I would seriously consider hedging any long positions you have before earnings season this next April. If they come in stronger, then we will see.
Your really optimistic for the long run analyst,
John Mauldin
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