2003 forecast: transition and surprise - john maul

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    2003 Forecast: Transition and Surprise
    A World of Hurt
    King Dollar and the Guillotine
    Gold Has a Lot More Glitter to Come
    The Muddle Through Economy, Part 2003
    Deflation Hiding Behind the Trees and Bond Prices
    Rallies in a Secular Bear Market
    Summary: On the Gripping Hand
    My Biggest Forecasting Mistake

    By John Mauldin

    We cover the globe, currencies, the US economy, bonds, stocks,
    deflation, inflation, gold, oil and more!

    For the last three years, making annual predictions has been
    relatively easy, at least as compared to this year. You try to
    discern the dominant theme for the year and then everything else
    usually flows from there. In 2000, it was an over-valued stock
    market. In August of 2000, the interest rate yield curve went
    negative, and as I wrote at length at the time, Federal Reserve
    studies (among others) showed that a recession always followed a
    negative curve by about 12 months. I saw no reason for that not to
    be the case this time. I suggested strongly to readers that the safe
    move was to get out of the stock market entirely at that time.

    Thus, coming to January of 2001, a second half recession was the
    dominant theme of 2001, and the general slowdown throughout the
    world provided a back-drop for a very bearish picture. I began to
    write that year that we were beginning a probable decade long (at
    least) secular bear market. Last year, the theme was the arrival of
    deflation, a less than robust recovery and the development of my
    view that we are in a Muddle Through Economy. (I should point out
    that I first wrote about deflation in the fall of 1998 and strongly
    suggested readers consider long term zero coupon Treasury bonds at
    that time. That has been a very good trade. Later we will consider
    whether it will be so in the future.) In March of 2002 I turned
    bullish on gold and bearish on the dollar.

    All in all, it has been a reasonably good track record, with of
    course the usual bumps here and there. Long term bonds were not a
    winner in 2001, although they did very well in 2000 and last year.
    Stocks have had some tradable rallies, but the trend has been down.

    I have been meditating for over a month what the main themes for
    this year's forecast should be. The problem is that there are no
    obvious over-riding themes, in my opinion, that control the rest of
    the picture. As I have thought about it, this is the year of
    Transition and Surprise. As we examine our portfolios and look to
    what might unfold in 2003, we will want to keep these two words in
    the front of our minds.

    Please keep in mind these are predictions and not prophecies. I did
    not receive them on stone tablets shoved under my office door. They
    are my best take after reading hundreds of pages of economic
    analysis form scores of services. They are my opinions, and are not
    guaranteed. The one prediction I can confidently make is that I will
    change my opinion on at least a few of these thoughts sometime in
    the year. That being said, let's look at 2003: Transition and

    On the Gripping Hand

    To the usual economic essay that starts "On the one hand..." and
    continues "On the other hand..," in my past annual forecasts I have
    added a third possibility, "on the gripping hand." This comes from
    Larry Niven & Jerry Pournelle's masterful 1993 science fiction novel
    "The Gripping Hand" which involved a species of aliens with three
    arms. Since economists are about as alien a species as we have on
    earth, and because we are indeed trying to "get a grip" on our
    finances, it seems appropriate. As we examine each economic arena
    and market, we shall look at both sides of the issue and try to come
    away with some idea (the gripping hand) of what might really happen.

    (Because of the rather large range of topics we will be discussing,
    I am not going to provide my usual lengthy analysis of each
    individual market. I will cover in future letters those areas which
    beg for more in-depth analysis.)

    A World of Hurt

    Before we look at the US economy, let's quickly review how the rest
    of the world is doing. Europe is on the verge of a recession, if not
    already there. Incredibly, even Chancellor Gerhard Schroeder's own
    optimistic economists (called for some reason the "Five Wise Men")
    openly bring into question his proposed tax increases, saying they
    may prevent Germany's economy from growing at the anemic 1% rate
    they forecast for this year. Italy is not well, France is doing
    somewhat better, but it is only in relationship to Germany that you
    would use the word better. (Bloomberg)

    Incredibly, while deflationary forces sweep the world, the European
    Central Bank is still fighting the last war. They are so afraid of
    inflation they provided only one measly interest rate cut last year.
    They seem to be waiting until the patient becomes comatose before
    providing blood. My take is they will cut rates again this year, but
    only grudgingly and not soon enough or deep enough to have any real
    influence prior to a recession starting. Even though the dollar is
    falling, Europe is not going to be a source of significant export
    growth until it works through its current malaise.

    I have lost count of how many final stimulus packages have been
    proposed or enacted in Japan. Japan redefines the meaning of
    futility. The country is mired in long term deflation and recession.
    A large chorus of national leaders calls for the yen to drop to a
    value of at least 130 against the dollar and some say the Bank of
    Japan should target 150-160 from the current 118. This of course
    would make Japanese exports cheaper and therefore more affordable to
    US consumers, help Japanese exports rise and allow them to continue
    to export their deflation to the US and the rest of the world.

    There will be a new counterpart to Alan Greenspan at the Bank of
    Japan this year. He will probably be from the school of thought
    which says Japan should develop a specific inflation target. I agree
    they should, but doubt very seriously whether they will be able to
    do so without serious structural reform to their banking system. The
    Bank of Japan in combination with the government is the only
    management team which makes Wall Street analysts look competent.

    Look for the yen to drop with the appointment of a new BOJ chairman,
    as there will be lots of speeches calling for a drop in the yen
    among government circles. Then as no action actually follows the
    rhetoric, the yen will probably drift back up. You are pretty much a
    failure as a central banker when you cannot destroy your own
    currency. Maybe this year the leopard will change its spots, but I
    am skeptical.

    The rest of Asia, and especially China, continues to grow. The trade
    surpluses of these countries continue to rise, especially with the
    US. Latin America struggles as Argentina is a basket case and Brazil
    has seen its currency drop 30% in the last year.

    King Dollar and the Guillotine

    The US trade deficit continues to rise. It is well over 5% of GDP
    and going to 6%, and such levels normally mean a serious correction
    in the value of a currency. While the dollar has dropped, especially
    against the euro, it has not dropped as much as you might think on a
    trade weighted basis. (I have done extensive analysis of this
    problem in previous letters, under the theme "What if they gave a
    dollar devaluation party and no on came?")

    The dollar is doing better than it should because China has fixed
    the currency to the dollar, and the rest of Asia is in a competitive
    currency devaluation race (Greg Weldon's terminology) to see who can
    make their currency lower in order to attract US consumers. The
    world and especially Asia will continue to be addicted to the US
    consumer. They sell us their products for electronic dollars, and
    then buy our government paper and stock. The world either owns 35%
    (BCA Research) or 42% (Morgan Stanley) of our Treasury debt. Morgan
    Stanley also reports foreign investors own 18% of US long term
    securities and stocks.

    Why would foreign central banks continue to buy and hold large
    positions of dollar denominated US assets when it is clear the
    dollar is over-priced? Because they have a Hobson's choice. They can
    take pain now or take it later. Politicians are the same all over
    the world. They prefer to take their pain later, even if it will be
    more severe.

    If a country stops taking dollars and buying US assets, then their
    currency will rise and make their products less attractive to our
    consumers. In export driven economies, this is a disaster,
    especially for the politicians, as it assures a recession at the
    very least. Thus they continue to support our spending habit.

    Canada, Mexico, China and Japan account for 47% of the trade
    weighted currencies. The Canuck is flat for the year, the peso is
    actually down 10% and the yen is down more than 10% for the year,
    much to the consternation of the Bank of Japan, as noted above. The
    Chinese currency is pegged to the dollar, so there has been no
    movement. (These and other currency figures cited are from A. Gary
    Shilling's INSIGHT newsletter)

    Thus the drop in the euro is the single major reason the dollar has
    dropped slightly on a trade weighted basis, when seen on multi-
    decade chart.

    Is there a limit to this? Of course. We can't sell more than 100% of
    our assets, and we are now selling $500 billion a year. At this
    rate, the rest of the world will own 100% of our government debt in
    ten years, even as we grow the deficits. Clearly this is not
    sustainable. When does the pain of taking over-valued dollars become
    more than the pain of selling less to the US? I think it is when
    China allows their currency to float. Asian countries do not
    necessarily want an over-priced dollar; they simply want the price
    of their currency to be favorable in relation to their neighbors.
    The gorilla in this process is China, and when they allow the
    renminbi to rise, that will be the real end of the dollar as the
    rest of Asia will feel comfortable inletting their currencies rise
    as well.

    There is an increasing call from many corners of the world for the
    Chinese to allow the renminbi to float. They have not responded to
    the pressure, but as do all countries will act when they feel it is
    in their own best interests. That will probably be when they think
    their own consumer demand is growing and solid, and thus can sustain
    a possible slowing of sales to the US. When that will be is anyone's
    guess, so the dollar could be surprisingly strong even when by all
    rights it should drop. But China could be the surprise move which
    sets this set of dominoes in motion. This is one area we will watch
    closely this year, as it will be a surprise and will be the
    transition to a much lower dollar fairly quickly.

    (Sidebar surprise question: which country has the third largest
    trade surplus behind Japan and Germany? Answer a few paragraphs

    By the way, this is not the end of the world, as some would have you
    think. The dollar dropped by over 1/3 against all currencies in the
    80's and early 90's, and the US seemed to move along just fine.
    Inflation dropped during that time and the economy grew. A falling
    dollar will help our exports, of course. I expect the Bush
    administration to tacitly approve a weak dollar policy while
    continuing to say the market should determine prices.

    The one real exception is the euro, as the European Central Bank
    seems quite content to let the dollar drop. Even with the weakness
    in Europe, I think it is likely the dollar will continue to drop
    against the euro. In 2002, I predicted the euro would rise to parity
    by year end, and it has gone decisively past that point, to $1.05.
    Those readers who opened euro denominated bank accounts at Everbank
    are happy today. The "natural" target of the next 12-18 months, if
    not sooner, is around $1.17, which is where the euro started about
    four years ago. You can buy a euro denominated CD from Everbank by
    calling Chuck Butler: 314-984-0892, ext 102. (Full disclosure:
    Everbank has a business relationship with my publisher. I know of no
    other US based bank from which you can buy CD's denominated in
    foreign currencies. If you know of one, I will be glad to add them
    to the list.)

    I believe Europe will resist a drop much further than $1.17 until
    China starts the dollar tumbling down the hill so they can stay
    competitive as well. It is truly every country for themselves in the
    currency markets.

    (The answer to the question above is that bastion of capitalism:
    Russia. Their trade surplus in 2002 was $44 billion. They also have
    the lowest taxes of any major country. Khrushchev loses. Reagan
    wins. And the biggest winners are the Russian people.)

    This naturally brings us to that international currency: gold.

    Gold Has a Lot More Glitter to Come

    Gold has finally gotten off the floor, and has become the hot
    investment of the year, up around 35% or more, depending upon which
    day you look. I think it has more room on the upside.

    First, gold finally broke through the $325 barrier. Dennis Gartman
    tells us that the reason is that the Bank of Canada finally finished
    selling all the gold it wanted to at that level. There now seems to
    be someone major selling in the $355 area. When that supply is
    worked through, the next level of resistance is $385 per one of my
    favorite gold technicians Ian McAvity.

    Central banks are not in some vast conspiracy to hold down the price
    of gold. They simply want to sell what they have. They do not
    understand the yellow stuff, and don't want to own it. As gold
    rises, they will sell more. The prefer electrons to hard metal,
    which in theory can earn interest. (The lease rates on the gold they
    lend to banks and dealers are quite small, which is the way they
    make something on their gold holdings.)

    My long held belief is that gold acts like a currency, and if the
    dollar drops another 10% against the euro, you could easily see
    another 10% rise in gold. Because gold is so thin a market, it could
    rise much further fairly quickly, if central banks decide to limit
    their sales.

    And as Paul McCulley of Pimco points out, gold needs to rise as a
    sign that the world is dealing with its deflationary problems. For a
    very fascinating and well written historical study of the
    relationship of gold to inflation/deflation see his January essay at

    When the need of central bankers coincides with the direction of the
    market, we should pay attention. Thus, I continue to be a long term
    fan of gold and gold stocks (at least since March of 2001).

    The Muddle Through Economy, Part 2003

    Economists throughout the country are predicting that this year we
    will see a resurge in capital spending, and this will be the trigger
    for a return to the boom years with 4% growth. I think not.

    First, let's look at my Three Amigo Economic Indicators: the ISM
    numbers, capacity utilization and junk bonds. The ISM number is the
    old NAPM (National Association of Purchasing Managers) and is a very
    accurate independent measure of the level of purchasing and business
    activity. It has recently turned modestly positive, which means
    business is finally doing better, but not great. Capacity
    utilization stinks. This is a measure of how much of your potential
    production you are actually using. It now hovers around 76%, which
    means that business has no pricing power, and if you can produce all
    you can sell and then some, what reason is there to increase
    capacity by spending money on more factories and production
    capacity? Better to use the money to pare down debt.

    As the level of business loans as a percentage of GDP is still
    dropping, that suggests business is not borrowing to increase
    capacity. That suggests the resurgence of capital spending mentioned
    above is still beyond the horizon.

    Finally, junk bonds have improved somewhat over the past few months,
    but not a lot. When the economy starts to roll after a recession,
    junk bonds ceased to be treated as nuclear waste and earn the
    respectable title of high yield bonds. They show a real jump in
    value. After the recession in 1991, we saw junk bond funds rise 70%
    in the next three years. Interest rate returns and spreads over
    treasury bonds are still very high, but sl-o-o-o-wly coming down.
    This also suggests that the economy is improving, but still quite

    There are three main components which normally lead a recovery in
    the economy: consumer spending, housing and capital spending by
    business. We saw weak consumer spending in the holiday season. While
    overall it did not fall out of bed, the "growth" was anemic, and
    moved down the food chain from upscale stores to Wal-Mart and
    Target. Even so, they performed below earlier projections.

    US household debt as a percentage of GDP has doubled since 1960 from
    40% to 80%. As Martin Barnes of BCA Research points out, this is not
    quite as bad as it might first look. A great deal of the rise is
    from lower and middle income families finally being able to buy a
    home as well as qualify for other types of credits. While this has
    caused an increase in delinquency rates, it has also allowed home
    ownership to become more universal which is a good thing.

    Nonetheless, there are again limits, and it appears that consumers
    are at least beginning to slow down the growth of their credit. The
    practical limit is that at some point credit growth cannot outpace
    income growth. My reading of the numbers is that the vast majority
    of US consumers are not in trouble, but they do not appear anxious
    to increase their debt. Since debt growth has clearly been the
    engine for the growth of consumer spending, this suggests consumer
    spending is not going to be the engine for a powerful recovery.

    Paul Kasriel of Northern Trust points out that growth in consumer
    spending and exports are a requirement for or pre-cursor to
    significant increase in business capital spending. If this is true,
    and I agree with him that it is, then that leaves housing as the
    last possible stimulus for the long awaited "V" shaped recovery.

    Housing is already at an all-time high and it is hard to see how it
    can grow any more. The best we can hope for is continued low
    mortgage rates and for the housing industry to simply remain at the
    current levels. To expect any more is not realistic, given the
    slowly rising unemployment.

    Economists are projecting a rise in S&P 500 corporate profits in the
    15% range. It will be closer to 5% than 15%, probably in the high
    single digits. This could change for the positive if capacity
    utilization increases, among other things, so we will watch this
    closely. But right now I do not see a big jump in capacity
    utilization in the near future. This is not the stuff of which 4%
    economic growth is made of.

    That being said, there are factors which would lead one to believe
    that we will again Muddle Through. The proposed Bush tax cut and
    government deficit spending is a decided boost to the economy. Low
    rates are a stimulus. A falling dollar will help the deflation fight
    and US exports.

    While the economy is certainly not robust, the recovery has been
    profitless and jobless and there seems to be no real area which will
    lead to significant growth, there is nothing to suggest that we are
    on a verge of a double dip recession. We Muddle Through.

    I think the Bush administration is adding the stimulus plan to
    provide some insurance that the economy will stay out of recession
    through 2004. I think for 2003 it is likely to work, but my estimate
    is that growth will be probably between 2% and 2.5%.

    As an aside, I monitor the yield curve almost daily. There has not
    been a recession in post-war America when short term rates have not
    risen above 20 year Treasury rates for 90 days approximately 4
    quarters prior to the onset of recession. This is called an
    "inverted yield curve." A Federal Reserve study has shown that it is
    the single best and most reliable indicator of future recessions. We
    are a long way from that point. Can we see a recession without an
    inverted yield curve? It is more than an academic question.

    We can get an inverted yield curve by short terms rates rising or
    long term rates falling or a combination. That is why I do not think
    the Fed will raise rates this year. They cannot afford to raise
    rates until the recovery is robust, unemployment is low and
    consumers and business can handle the increased interest rate costs
    without pain.

    If there is any interest rate change this year, it will be another
    cut. I hope not, because that will mean we are having problems,
    probably an unpleasant surprise, and that Greenspan feels we need
    the emotional stimulus of knowing the Fed is on the job and still
    cares. Another 25 basis point cut will achieve little of actual
    consequence within the economy, but it would be done in an effort to
    shore up consumer and investor confidence.

    As I wrote in 2001, Greenspan has raised interest rates for the last
    time in his career. He retires in 2004. He will not raise rates in
    2004, but will leave that task for his successor, who will not raise
    rates prior to the second Tuesday in November.

    It is primarily because of the yield curve that I think the
    underlying economy will Muddle Through. Because rates are so low and
    artificially distorted, we may not get a fully inverted curve prior
    to the next recession. But we should see some kind of move where the
    yield curve at least flattens. For those of you who want to see the
    "curve," and for those who like to monitor interest rates, you can
    click on http://www.bloomberg.com/markets/C13.html?sidenav=front.

    What are the risks to the Muddle Through Economy? A surprise in
    Iraq. Right now everyone thinks it will be short and successful.
    Another major terrorist incident would be a significant issue. If
    the President's stimulus package or some version thereof (see below)
    does not pass that could turn the mood of the country negative and
    crunch consumer spending.

    And I must admit if the stimulus package gets passed quickly, if we
    see a significant bear market rally, a drop in unemployment and a
    short and successful war in Iraq, it is not hard to think GDP could
    grow another 1% over the Muddle Through 2.5% range. But those are a
    lot of ifs.

    Deflation Hiding Behind the Trees and Bond Prices

    My less-than-sainted Dad would often tell me after a moment of
    youthful bragging something like, "Let not him that puts on his
    sword boast like him who takes it off." His actual version was a tad
    more colorful, but there are ladies who read this letter.

    Greenspan, Bernanke and crew have bragged that they have the
    "ammunition" (their word) to defeat the deflation bully. Much of the
    world breathed a sigh of relief to know the Fed was on the job and
    started worrying about the coming inflation. Call me a cynic, but I
    am not prepared to abandon my deflationary views just yet.

    As Stephen Roach of Morgan Stanley points out, "For the economy as a
    whole, GDP-based inflation slowed to just +0.8% in 3Q02, the lowest
    rate in nearly half a century. Another year of sub-par economic
    growth in the 2% vicinity -- pretty much my personal prognosis --
    could well find inflation moving even lower, possibly flirting with
    the "zero" threshold of outright deflation. The authorities must do
    everything in their power to avoid such an outcome."

    Larger federal deficits, a falling dollar and increased growth in
    the money supply should hold outright deflation at bay for this year
    and maybe the next. The real test -- the moment when we see what the
    Fed's ammunition is worth -- is during the next recession. At that
    point, we will see whether they are pushing on a string and we
    develop a Japanese liquidity trap, or they can actually move

    Are we headed for a Japanese style deflation? Right now, I think
    not. That is because the Japanese consumer prefers cash to
    consumption, and coupled with their insane banking system that is
    what has created their liquidity trap and deflation. That is not the
    picture of the US consumer or of our banking system, nor has it been
    in our national character for some time. There is a difference, for
    good or bad, between the two national personalities. (For
    explanations of a liquidity trap, go to www.google.com and type in
    liquidity trap.) But I could just as easily argue that an aging
    boomer generation will want to increase savings dramatically and
    thus become more like the Japanese. But that requires a change in
    the character of my generation, and one I do not currently see.

    That does not mean the Fed will have it easy. I think that at some
    point the Fed is going to have to put its printing press where its
    mouth is. I do not think that happens in any serious way until the
    next recession.

    In 1998, I became a big proponent of long term zero coupon
    government bonds. It has been a very good 40% or so run in my
    favorite bond fund, The American Century 2025 fund (BTTRX). Last
    year we saw almost 20%. It is the most aggressive of the bond funds.
    This is a volatile fund, and has lost almost 6% so far in the first
    10 days of this year.

    A recent survey of Schwab account holders revealed that 40% of them
    did not understand that they could lose money in a bond fund. I am
    sure none of my readers were in that group, as all of you are well
    above average in investment savvy, but that is an appalling fact. If
    interest rates rise, you WILL lose money in bond funds.

    For reasons I will outline below, I think we could see a significant
    rally in the stock market. This will not be good for bond funds.
    Much of the market has put their deflation fears to rest. They are
    now worried about inflation, which is not good for bonds.

    While I do not think long term interest rates will be allowed to
    rise too much without active intervention from the Fed, interest
    rates will probably drift higher for some time.

    Sidebar: if interest rates, and specifically 10 year treasuries move
    a lot higher, then that will increase mortgage rates. Rising
    mortgage rates will threaten to push the economy back into recession
    if allowed to persist in a time of weak recovery. A strong and
    growing economy can handle rising mortgage rates. I do not think
    this one can.

    Don Peters, who has one of the best track records I know of for
    predicting interest rates and Gary Shilling both think interest
    rates have much further to drop. They may be right, but I believe
    interest rates are going to continue to be volatile. The problem is
    that if they are right and you exit your long bonds now, you will
    miss much of the move when rates begin to drop again (if and/or when
    they do). These things happen quickly, as the last few days suggest.
    If you believe deflation is still in the cards, hold at least some
    of your bond positions. If you think inflation is on the way, sell
    all the bonds you do not plan to hold to maturity. If you are not
    sure, lighten up your bond position.

    My current thinking is that long term bonds (other than those you
    plan to hold to maturity) are now more of a trade than an
    investment. If you hold a gun to my head, I think we see lower rates
    in the future during the next recession. They could be
    substantially lower if the Fed has not been able to induce
    inflation, and there are no signs they have been able to do so as

    But the period in between now and the next recession will be
    volatile. If you are going to hold long bonds, you have to look over
    the valley of volatility to the next recession. Both Peters and
    Shilling think you will be well rewarded for your patience, and
    their independent track record on bonds for the last two plus
    decades speaks for itself.

    What should income investors do? First, do not chase yield. If you
    can't deal with volatility, do not buy long bond funds. If you need
    income, I would suggest the traditional ladder of variable length
    bonds and hold to maturity. You should look at medium term high
    quality corporate bonds.

    Also, consider TIPS - Treasury Inflation-protected Securities. They
    rose 16% last year, and have excellent potential for capital gains
    when inflation does come back, which it eventually will (again, in
    my opinion).

    As a type of "call option" on the economy, you might consider a
    portion of your portfolio in a conservative high yield bond fund. If
    the economy improves, then high yield bonds will rise. The capital
    gains plus the yields could be quite nice. Go to Morningstar and
    look for 4 and 5 star rated funds. Put a close stop on the fund.

    This is a year of Transition and Surprise. Can the Fed and the world
    deal with deflation? Right now, the market says yes. This is the
    battle. We will either transition to inflation or slide further
    toward deflation. It is in the balance.

    Rallies In a Secular Bear Market

    The primary trend of this market is down. We are in a secular bear
    market. (For a detailed discussion of what a secular bear market is
    go to www.absolutereturns.net and read the relevant chapters in my
    book-in-progress called Absolute Returns.)

    Secular bear markets usually do not end until P/E ratios are in the
    single digits, which is far from where we are today. This primary
    trend is likely to last for the remainder of this decade, at a
    minimum. I do not have the space today, but will write in an
    upcoming e-letter about the very well-reasoned analysis done by Gary
    Anderson and separately by Ed Easterling. Anderson gets as much as
    $60,000 a year for his newsletter on stocks and timing, depending on
    the assets under management. He is quite sharp. Hedge fund managers
    among my readership will want to pay attention and review his work.
    He shows why we could see 4-5,000 on the Dow before this cycle is
    over, even though he is somewhat bullish this moment.

    Easterling, another hedge fund manager, takes a very different
    approach. His work suggests that we could be in a sideways trading
    range for at least another ten years, with some serious risk to the
    downside as well.

    But that is the future. What about this year? I read everywhere or
    at least from the cheerleaders, that the odds are that we will see a
    rise in the market, because there has only been one time in history
    when the markets went down four years in a row. The odds are only
    one in a hundred.

    With all due respect (actually with no respect at all), that is the
    worst statistical garbage I have read in quite some time. First of
    all, there have only been three times when the market have even had
    a chance to go negative four times in a row, and one of those times
    the market was down less than .5% in year, so that hardly counts as
    down three in a row. So if that type of statistic was valid, then
    the odds would be either 1 in 4 or 1 in 3.

    But it is meaningless. The conditions in any one given year are the
    reason for the market to go up or down. I am going to discuss why
    this market could significantly rise and/or significantly fall. It
    has nothing to do with odds. If any broker tries to get you to buy
    stock based upon this "statistic," hang up or fire him.

    First, how can I think the market might rise if I think we are in a
    long term bear market? Let's look at a few reasons.

    While the performance of the stock market in any one year is random
    from a statistical standpoint, over a complete cycle, there is more
    solid footing. There have been two 50% rallies in the Japanese
    Nikkei while it has dropped over 75% in the last 12 years. There
    have been at least a dozen 20% rallies. They were all hailed as the
    end of the bear and the beginning of a new bull.

    Ed Easterling has allowed me to reproduce a chart with some very
    interesting statistics on bull and bear markets. What we find is
    that in most long term secular bear cycles the market goes up 50% of
    the time in any given year. In bull markets they go up 80% of the

    As noted above, bear markets have historically ended in single digit
    P/E (Price to Earnings) ratios. If this market were to go directly
    to that single digit P/E without a few years where the stock market
    actually rises, it would be the first time in history in the US, and
    I cannot think of or find an example in any major market anywhere
    else. There seems to be something about the psychology of a bear
    market that demands a respite. Bear markets do not end when there
    are still bulls in the corral. These bear market cycles take years,
    and typically longer than a decade, to shake out.

    I should point out that for the market to go directly to about
    single digit P/E ratios would require a drop of at least another 50-
    60%. I do not need to discuss the kind of devastation that would
    produce in the world.

    You can go to this very interesting table at

    What could spur a rise this year even as the markets are
    historically way over-valued? I met with the manager of a major long
    short hedge fund this week. Their approach is based on value. They
    buy value long and sell bad companies short. They did quite well
    last year, performing in the top 10% of long short equity funds.
    Today they are close to 50% in cash. His problem is that he can't
    find enough companies he feels comfortable about to invest.

    There are not just enough stocks with low enough values to interest
    him. This is not surprising. But the intriguing piece of information
    was that he can't find anything to short. All the obvious stocks to
    short have large short positions already from other hedge funds and
    individual investors. To get in today is very dangerous.

    That is because these hedge funds are very sensitive to their
    relative standing to each other and to profits and losses. A long
    short hedge fund is supposed to preserve capital. If a "short rally"
    starts and a hedge fund holds its position it can quickly drop more
    than their previous historical losses, making investors nervous.
    Most long-short equity hedge funds did not have a particularly good
    year last year, and do not want to have a second losing year, even
    if it is small. Thus many managers are "scared money." If a short
    position begins to deteriorate, they could bail very quickly,
    creating a short rally. (You have to buy the stock long to cover
    your short position, thus in theory driving the stock up even

    In his opinion a significant short rally was possible. But what if
    such a rally begins to create a market in which all stocks start to
    move? Then momentum traders move in and create more buying. Many
    hedge fund managers with significant cash will not have the
    discipline to let the market run from them and will begin to chase
    the market in an effort to at least stay near their S&P 500
    benchmark. Hedge funds that are traders (and there are hundreds of
    them) will smell blood and profits and help drive the feeding
    frenzy. By the time the market has moved 20%, the cheerleaders are
    proclaiming the end of the bear market, and the small investors pile
    in, chasing the now hot mutual funds.

    What could be the fuel to keep such a rally going? Trimtabs tells us
    that companies are going to have to fund their pension plans by over
    $100 billion over the next year. As an example, General Motors will
    increase its pension contributions by $3 billion (cutting its
    profits by 26% in the process) this year. That is just one company.

    These companies have fixed positions for their pension funds. For
    instance, their consultants may have them in 50% in stocks, 40%
    bonds and 10% cash. Since they lost 20% on their stocks last year
    and their bonds went up, they are now "underweight" on stocks, so
    that means they will plow much of the new cash into the stock market
    in an effort to get back to their target allocations.

    Mix in large increases in the money supply and you have the
    conditions for a bear market rally. In the table I mentioned above,
    the average gain in positive years in bear market cycles was 24%!

    Underlying all this is going to be the repeal of the dividend tax.
    If this happens, it will put a new and higher floor on the eventual
    bottom of the bear market. This makes dividend paying stocks worth
    more. You can argue that dividends were much higher in previous bear
    market cycles, and that did not keep the stocks from going much
    lower, but I would point out the dividends were taxed in past bear
    markets. This will not start a new bull cycle, but I do think it
    changes the equation on the eventual bottom. While that may be cold
    comfort when the Dow is at 6000, that level is a lot better than 4
    or 5,000.

    Let's be clear about one thing. Bush is not putting out this
    dividend tax repeal as a ploy. He is dead serious. This is not a
    negotiating position. I know from personal experience here in Texas
    that when he stakes out a position, he argues and pushes for it
    aggressively. He is not looking for a compromise.

    He tried to change the tax structure in Texas in 1998.e is very hard
    to say "no" toHeHe He did not have close to a majority of his own
    party supporting him. He eventually lost that fight, but he did not
    back down.

    This time he will get most of his party (hopefully McCain will come
    along) and a few dems and he should get his dividend tax repeal.
    While I am generally in favor of all tax cuts, this one is important
    in that it will change the corporate culture in America. Dividends
    will rule, and dividends require actual profits and not stock
    pumping to get your options cashed.

    I believe the hope from the Bush team is that this will put new life
    into the stock market, or at least a base for a few years at the
    least. Whether it will remains to be seen, but it is a brilliant
    political move and also a proper philosophical move as well. It may
    well be the most important long term contribution from the Bush

    Let us make no mistake about this. Bush is putting his re-election
    on the line. If this tax repeal fails, it could very well tank the
    market and sour the mood of the country. That could tank his re-
    election. He could argue it was those bad democrats, but it would
    probably ring hollow to those whose retirement accounts are down.
    This is an all-or-nothing, bare knuckles political brawl.

    Son of Bubble

    Now let's look at why the market is going to go down this year.
    First and foremost is that valuations are WAY too high for a
    significant bear market rally. Other than the last bubble, we are
    near all-time highs for previous bull markets. How can you rally
    from what is already high? How can a new bull start from the top
    floor? Can we say Son of Bubble?

    Earnings are going to disappoint investors. Not by as much as in
    2002, but they will still be below current analysts' forecasts. It's
    hard to see a sustainable rally coming from constantly lower
    earnings estimates.

    The list of problems is long: Iraq, terrorism, deflationary world
    pressures, a Muddle Through Economy, a possible retreat by foreign
    investors because of the dollar, etc.

    So where will the stock market end up for the year? I don't know,
    and that's the honest truth. Anything I said would be a guess, and I
    do not want anyone investing hard money on my guess. I could guess
    and be lucky as I do have a 50-50 chance to be right, but to then
    tell you that my guess was anything but luck next year would be

    I do think we could see a very serious rally this year. Whether it
    will last the year is not clear, although it easily could. Could we
    see a rally after Iraq is done, tax cuts are in place and a nation
    breathes a sigh of relief? You bet, as the fuel for a rally is there
    in the form of pension fund cash and a lot of cash in the hands of
    investors. Will they be once bitten, twice shy? When this rally
    fails, as it eventually will, they will be even more embittered and
    the resulting drop will be worse than what would occur if we simply
    maintain a trading range.

    I think the next significant leg down in the stock market comes as a
    result of the next recession, whenever that is. As I will discuss in
    the next few weeks and make a longer case in my book, AT BEST the
    trend is a sideways trading range for the rest of this decade.
    History suggests we will not be so lucky. But this year, we may
    dodge a 4th straight bullet. We will see.

    In the meantime, it is best to follow the advice that Dennis Gartman
    reminded me of: treat the stock market not as a stock market but as
    a market of stocks. This is a stock picker's market. There are
    always companies which will do well in any year. This is also a
    period where market timers should do well. In a few weeks, I will
    point you to some successful timing programs and managers. There are
    not many, but there are some who have done well.

    The Oil Patch

    One wild card is the price of oil. If the war with Iraq is short,
    and does not destroy their wells, we could see the price of oil come
    down significantly. This would probably be as much or more real
    stimulus than the tax cuts. On the other hand, a significant price
    rise in oil from here could offset any tax cuts, especially when you
    factor in the tax increases which are coming from states and cities.

    Our new best friend, Vladimir Putin, will do his best to put as much
    oil into the world markets as possible, but a serious rise in oil
    prices could throw a world economy that is already wobbly into
    recession. Let us hope that does not happen.

    Summary: On the Gripping Hand

    In summary, I think this year is another Muddle Through Year for the
    US. The dollar should drop further against the euro. The economy
    should grow much like last year, in fits and spurts. Profits will
    disappoint, but will rise. Bonds and the stock market are in
    transition, and we could see a significant rally, or sparked by a
    negative surprise, another bear year. This is a year to be cautious.
    Unless you are an astute trader, if you want to buy stocks to play a
    rally, buy value and dividend stocks from companies who can grow
    their dividends. Dividend stocks should do well this year, even if
    the market is down slightly.

    In my opinion, it should be a year where most hedge fund styles
    should do well. Commodity traders and global macro funds should have
    trends to follow and a second good year in a row, after a decade of
    disappointment. If you are an accredited investor ($1,000,000 or
    more net worth) and would like information on hedge funds and
    private offerings, you can go to www.accreditedinvestor.ws and
    subscribe to my free letter about these funds. Oh, one last
    prediction: mutual funds and stock analysts will tell you now is the
    time to buy. The market is a lock to go up. Cheerleaders of the
    World, Unite.

    My Biggest Forecasting Mistake

    As a final note, let me take you through one optimistic point: if
    the economy only grows at 2.5% year for the next ten years and
    inflation is 2%, neither of which are unreasonable to assume, then
    the GDP is 50% bigger in ten years than it is today. It will be 30%
    larger in real terms. The economy grew 177% in real terms from 1966
    to 1982, which most consider to be a secular bear period. The stock
    market was flat for the 16 years.

    There are going to be plenty of opportunities over the next decade
    for astute investors and entrepreneurs. The main forecasting mistake
    I have been guilty of over the past years is to underestimate the
    ability of individuals and businesses in the free market to adjust
    to uncertainty and problems.

    I recognize we have significant problems in our economy. We are
    going to have to deal with our huge national debt, over-extended
    consumers, aging population, deflationary pressures or the inflation
    which will come about from the Fed's pumping of the money supply to
    fight deflation, an over-valued dollar foreign competition
    pressures, trade accounts deficits, an over-valued stock markets,
    not enough retirement savings. Federal government deficits, high
    taxes, and the list goes on and on. All of these will have a
    significant effect upon our economy and investments.

    But the one thing that we need to remind ourselves of it that most
    Americans are like you and me. When we are presented with a problem,
    we deal with it. We take our lumps and get up and move on. We figure
    out how to make next year better. We are an amazingly optimistic and
    resilient people.

    The new technologies and the new companies that will drive the next
    bull market have probably not yet been invented or started.

    What's in store for 2003 from Millennium Wave?

    This next year, it is my intention to add a few features to the web
    site. I will start posting 3-4 articles a week that I think are of
    interest. I WILL get my book finished in the next few months.

    If you are reading this letter for the first time, you can join
    approximately 1,500,000 investors who get my free weekly e-letter,
    where I deal with the topics above in a far more in-depth manner, by
    going to www.2000wave.com and signing up for the letter. To find out
    more about me you can go to www.johnmauldin.com. At that site you
    can find links to chapters I have posted on my book called Absolute
    Returns and my others free e-letter on hedge funds and private

    I look forward to serving you in 2003, and welcome your letters and
    comments. Please know that I wish you the best year of your life in

    Your betting 2003 will be a great year analyst,
    (Whether or not my predictions come true.)

    John Mauldin
    [email protected]

    Copyright 2003 John Mauldin. All Rights Reserved

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