mauldin's commentary

  1. 374 Posts.
    Who Turned Off the Printing Press?
    Same Song, Second Verse
    Your Taxes Will (probably) Increase
    Iraq and the Hidden Oil Tax
    John, You are a Wimp
    Palm Beach and a Debate on Hedge Funds

    By John Mauldin

    No sooner is my Muddle Through 2003 forecast out, than we get a
    barrage of data which gives cause for concern. Can we still Muddle
    Through with an increase in taxes (you read that right!), higher oil
    prices, more medical costs, and a slowing world economy? Is the Fed
    actually winning the War Against Deflation? We look at all that
    today, plus I answer a few critics of my forecast.

    Who Turned Off the Printing Press?

    Last November 21 we were promised by Federal Reserve Board governor
    Ben Bernanke that the Fed had the problem of possible deflation well
    in hand. They knew its causes, had the keys to the printing press
    and were prepared to use it should deflation actually become a
    problem. More than one analyst has assumed that inflation should now
    be our concern, as the Fed has committed us to that path. After all,
    if you can't trust a central bank to destroy a currency when they
    set their minds to it, who can you trust?

    As noted last week, I am not as convinced as some of my more
    illustrious fellow analysts that the Fed can so easily deal with
    deflation. Understand, it is not whether they can ultimately win
    (they can), but whether the intervening period is as smooth a
    transition to inflation that the large majority imagine.

    Let's look at where we are today, and what gives me cause for
    concern. The Producer Price Index for 2002 was a negative number for
    the first time since the data began to be collected since 1974. "On
    a year-to-year basis, core PPI was down 0.4% in December, the lowest
    calendar year reading in the nearly 30-year history of the data,
    reflecting mild deflation in underlying goods prices," said David
    Greenlaw, chief economist at Morgan Stanley in New York. (National

    The Consumer Price Index rose a mere 0.1% for a second month in a
    row. The core rose 1.9 % in 2002, the smallest increase in three
    years. The economy probably slowed in the fourth quarter to a 1.4%
    annual rate. This is holding down price inflation because companies
    have little room to raise prices.

    Greenspan spoke last quarter of the economy being in a "soft patch."
    This was born out yesterday when the Fed released its monthly Beige
    Book analysis of the economy. The actual report is certainly not
    upbeat. "Most districts characterized growth as 'sluggish' or
    economic activity as 'soft' or 'subdued,' " the Fed said in its
    latest regional economic survey known as the beige book. "Reports on
    consumer spending were consistently weak, with disappointing holiday
    sales." (Bloomberg) Nevertheless, the Fed projects the economy to
    grow at 3% this year.

    Art Cashin (of CNBC fame) writes me that he finds it very
    interesting to look at the contrast between the very positive
    speeches of the various Fed governors and the actual wording of the
    Federal Reserve beige book and the minutes of the Fed meetings.
    There is a significant disconnect.

    Let's look quickly at some of the latest pieces of the puzzle:
    Capacity utilization, one of my Three Amigos, dropped again today.
    "The Federal Reserve said manufacturers use 75.5% of capacity, well
    below the average of 80.9 % in 1967-2001. Even during the 1990-91
    recession, factories used 77% of capacity to produce goods."
    (Arizona Republic) This translates into no ability to raise prices.
    When you couple that with commodity price increases, it means
    reduced profits for lots of companies, unless they cut jobs and
    other expenses. Not a pretty picture for the economy. This is a
    prescription for a continuation of the jobless, profitless recovery.

    Industrial production fell 0.2% last month after rising 0.1% in
    November. This was surprising as the ISM number (an independent
    measure of economic business activity) was up rather nicely in
    December. This causes me to suspect one of these numbers. It will be
    interesting to see next month whether one or the other (or both)
    come back toward each other.

    The University of Michigan U.S. consumer confidence survey
    "unexpectedly" fell in January for the first time in three months.
    The university's sentiment index dropped to 83.7 from 86.7 in
    December. I am not so sure why we can call this a surprise. We find
    101,000 less jobs in December, a looming war, and poor Christmas
    sales. That is not the backdrop for a rise in confidence. But the
    real kick in the confidence pants is the lack of confidence that a
    stimulus package will get through congress, with local headlines
    trumpeting tax increases (see more below).

    Same Song, Second Verse

    All of this suggests a continuation of a sluggish, Muddle Through
    Economy. None of this makes me think there is any reason to change
    that forecast this early in the game. Much of the last quarter of
    2001 was just as ugly, and we worked our way through a year long
    soft patch. There are a lot of positive factors in the way of
    restructuring that has happened within businesses in the last year.

    What does worry me then?

    I was very clear (at least I hoped I was) that my belief in a Muddle
    Through Economy depends upon the short term stimulus from the Fed,
    the federal government and hopefully a drop in oil prices after the
    Iraqi crisis. I feel that these should combine to buy us one more
    year of Muddle Through.

    Without this stimulus, it is my belief that we could/will slip into
    recession in the second half of this year. We are not that far away.
    Muddle Through does not provide a lot of cushion.

    Given the rather somber character of the numbers and Federal Reserve
    reports mentioned above, I decided to go look at how the War Against
    Deflation was coming at the Fed. Since Bernanke said he knew where
    the keys to the printing press were located, I thought perhaps we
    would start seeing some real high-powered money coming into the

    Maybe they do know where the keys are, but a look at the numbers
    says they have run out of ink, or at least electrons. Greenspan
    keeps telling us productivity is up, and this is the reason to be
    optimistic, but money supply productivity is not up. Maybe the staff
    had a few extra holidays. Let's look at the numbers.

    Money supply is typically measured by a series of statistics called
    M-1, MZM, M-2 and M-3. Each statistic adds yet another element of
    money. M-1 is basically cash and demand deposits at banks. M-3 is
    the broadest measure, and includes time and savings deposits at
    institutions, money markets, overnight and term euros, repos, IRAs
    at commercial banks, etc.

    M-1 has not grown since the end of July. M-2 is up a miserly 0.3%
    since November 1, or roughly an annualized 1.2%. Even Nobel laureate
    Milton Friedman said the Fed should stop manipulating the money
    supply and simply grow it at 2.5%. M-3 is flat since about the time
    of Bernanke's speech.

    Friedman tells us that inflation is an increase in the money supply.
    Others talk about inflation/deflation in terms of consumer prices. I
    have written at length about this in the past, and will not labor
    the fine details here. The point is that the money supply is not
    growing of late and at a time when deflation is still knocking at
    the door.

    Although the actual dollar creation at the Fed has been flat
    recently, in December it was up significantly. What is happening
    then? Why no gradual increase in the money supply? (I invite you to
    go to, click on the Fred database and look at the
    monetary databases and their components, as well as commercial
    banking data.)

    We have watched commercial and industrial bank lending drop over 20%
    at large banks and over 10% at all banks since the beginning of
    2001, and this steady drop shows no sign of stopping. It is a
    combination of tighter lending requirements and businesses simply
    not wishing to borrow.

    Lending to individuals has been growing at a steady pace over the
    past few years, even during the recession which was unusual. The
    exception was for real estate lending, which is exploding. But total
    lending to individuals has gone flat in the last few months. Small
    time deposits are down, as well as retail money funds. This is not
    too surprising, as they now pay next to nothing. But it suggest the
    possibility that consumers might not be responding to Fed stimulus
    and might be paying down debt, or at least not incurring any more.

    There is a concept called the velocity of money. Basically, it has
    to do with how many times the "same" dollar is spent in a given time
    period. If I spend a dollar with you and you turn around and give it
    to Bill and he then spends it with Susan, the dollar has changed
    hands four times. It is important to economists to know how fast
    this takes place.

    Similarly, when a bank loans me $100 and I spend $90 and you spend
    $81, that puts more money in circulation. Each dollar deposited at a
    bank allows for more loans to be made and more money to go into the
    money supply. The faster these dollars move, the more active and
    growing the economy.

    The velocity of money can both affect inflation and be an indicator.
    I countries where inflation is large, people rush to buy something
    or invest the cash. In high inflation cash is trash. It is the
    opposite in deflation.

    The concern among some observers is what happens if the Fed leads
    the economic horse to drink, but the horse isn't thirsty? What if
    the consumer joins business and starts to borrow less, or spend
    money more slowly? What if the Fed creates money but other parts of
    the money supply chain slow down?

    The last few months worth of data makes me wonder.

    Let's be very clear about something. In Bernanke's now famous speech
    (which I bet he wish he had not made), he was talking to economists
    about the hypothetical means to deal with inflation. He certainly
    was not implying that any of these methods were getting ready to be
    rolled out.

    Let me make two observations: first, an economy in which the Fed
    felt compelled to move out the yield curve and buy longer term
    treasury notes in order to increase the money supply and lower rates
    to provide stimulus will not be a pretty economy.

    Secondly, it will probably be one in which the economy is already in
    or very close to recession. The moves described by Bernanke are
    fourth quarter, we are down by two touchdowns and our game plan is
    not working type of moves. The Fed taking such actions would be a
    signal to the markets that the economy was very weak. It is not
    clear whether the markets would react positively to a Fed getting
    with the program or negatively with a realization things must be
    very bad.

    Michael Lewis of HCM reminded me of the following important
    observation by the famous economist Hyman Minsky in 1984:

    "We now have an inflation-prone system in which conventional steps
    to contain inflation tend to trigger a debt deflation process, which
    unless it is aborted will lead to a deep depression."

    I think the Fed will be reluctant to take any of the moves described
    in Bernanke's speech because they will worry about unintended
    consequences. It is not clear the market will rejoice at such moves,
    because the consequences down the road could be serious. As I have
    written before, a logical outcome of most of the proposed actions is
    stagflation. But when push comes to shove, they will be forced to
    act, because they believe, as do most observers, that Minsky is
    right. They would rather see stagflation than a depression.

    (He is also the economist who told us that economic stability leads
    to excess and then recessions. Long periods of stability eventually
    lead to irrational exuberance and bubbles which lead to crashes. He
    was right.)

    And that is why I am not convinced that interest rates are at their
    bottom. They well could be. Things could be better than I think, and
    a turn-around could already be on its way. But I want to see some
    evidence that the War Against Deflation is progressing as planned.

    Deflation is not some weak sister dictator like Saddam Hussein
    against an overwhelming US Army, with more power than the world has
    ever seen. It is a powerful, vicious force that is enveloping much
    of the rest of the world. They are deporting their deflation to us.
    It is not clear that the Fed's printing press is as effective as a
    cruise missile.

    The drop in the dollar I predict could be a help to a Fed bent on
    beating deflation, as it makes for higher prices in the US. But it
    is a two-sided coin. It could mean foreign investors pulling dollars
    from the US, thus putting upward pressure on interest rates and a
    slowing of a fragile economy.

    A slowing economy which turns into recession at this point is
    clearly deflationary. As I said last week, we will see if the Fed
    can put their printing press where their mouth is during the next
    recession. That is when I will be convinced interest rates will rise

    So, the data of the last few weeks, plus the concerns about money
    supply growth, suggest that it might take a little more effort on
    the part of the Fed to stimulate the economy to keep us in our
    Muddle Through world. We will be watching and report back to you.

    Your Taxes Will (probably) Increase

    The Center on Budget and Policy Priorities did a study on the budget
    difficulties of 40 states. They found in December there is a
    deficit for these states for the next fiscal year approaching $85
    billion. When you look at the individual states you find the
    headlines say it is much more. The study shows Illinois with a
    deficit of $2.7 billion. The governor today said it would be $4.8.
    They show Texas at $8 billion. I have it from close sources that it
    will be over $12. California is listed at $25 billion. The Governor
    says it is $36 billion, although optimists suggest it is a mere $26
    billion. (

    In short, the total deficits for states could well be over $100
    billion. Looked at your city and county budgets lately? These are
    also seriously short. I can find no estimate but it will be in the
    tens of billions.

    The cities and states will make up the difference by cutting
    expenses and raising taxes. Even in Texas, where the Republicans
    control both houses and the governor's office for the first time,
    and ran on a no tax increase platform, my side bet is that we raise
    taxes. The deficit is now 140% larger than thought publicly just
    three months ago. By some accounts, you would have to cut 40% of all
    discretionary spending in Texas to avoid new taxes. By that I mean
    education and a lot of services most Texans consider vital.
    Republicans in Texas will be like the dog that caught the car. What
    they do with it is the question.

    This scenario is played out all over the country. Increasing taxes
    does the opposite of stimulating the economy. Reducing actual
    expenditures also slows the economy down in the short run.

    Whatever stimulus we get from the federal government, it falls far
    short of any the effects of tax increases and spending cuts by the
    states. The best we can hope for is an offset of the two. But if
    congress delays it will have a serious impact on the economy.

    Bush recognizes this, and will put his reputation and full power in
    order to get a significant stimulus package through the congress as
    soon as possible. If it is delayed, it will seriously jeopardize his
    re-election chances.

    Iraq and the Hidden Oil Tax

    Finally, we come to Iraq and oil. I am starting to read reports from
    serious analysts that oil could easily go to $40 or more if a
    problem develops in Iraq and does not get resolved in Venezuela.
    Some say it could rise to $50 in the short term. I think their
    analysis has some credence. In the long run, oil will come down
    significantly. But it is the short run that could affect the

    Venezuela is the fifth largest producer of oil. Some are beginning
    to compare the "revolution" there with the overthrow of the shah in
    Iran. After the shah left, oil production dropped by two-thirds, and
    is still only 50% of what is was. Revolutions can and will cause
    serious economic disruption. The proposals by Chavez to re-organize
    their oil companies to punish his foes and favor his left-wing
    cronies are a disaster for oil production. The longer this goes on,
    the more concerned we should get.

    A serious increase in the price of oil acts like a tax increase on
    the economy. It will slow down not only the US, but the economy of
    the world. It is a serious drag on world growth. While we will see
    OPEC and other oil producing countries step up production, filling
    in for a lost Iraq (if Saddam trashes his oil filed as he leaves)
    and a reduced Venezuela will not happen overnight.

    All these factors weigh an economy down.

    I believe the flat growth in the money supply is probably temporary.
    There have been such periods before, although not accompanied by a
    clear softening of consumer spending and debt. I am betting we will
    get a stimulus package from the federal government sooner rather
    than later. The probability is that the crisis in Venezuela gets
    resolved and Iraqi oil fields are not allowed to be destroyed.

    The best outcome for the economy is for Saddam to leave, avoid an
    expensive war and leave the oil fields intact and even see them
    allowed to increase production. We need to see a resolution to the
    crisis in Venezuela. The worst case is that the oil fields get
    destroyed as Saddam assumes a Samson complex and pulls the walls
    down with him, while Venezuela deteriorates.

    If the worst case Iraq scenario happens, the Fed will find the keys
    and open the door to the printing press. Just as the stimulus from
    the last rate cuts made the recession far less severe than it could
    have been, the Fed will attempt to forestall or lessen the next one.
    But the damage will have been done, and the stock market will not
    act kindly.

    John, You are a Wimp

    The primary reason I write these weekly essays is it forces me to
    think through the implications of the scores, if not hundreds of
    articles, reports, essays, chapters, books reports and so on I read
    each week. It helps me think about what types of investments and
    funds I want to suggest to clients.

    Last week, I outlined why we could get a significant rally in the
    market, and this week suggest the opposite could happen. That is why
    I continue to think your investment strategy should not be a short
    term one-way directional play on the stock market, either up or
    down. I did not make a prediction for the stock market this year,
    although I predicted everything else. There were a few who wrote
    (and a lot of you thought) I was a wimp and simply copped out.

    While I said the general trend is down to flat over the next decade,
    I admitted to not knowing where we would be at the end of the year.
    That is because there are simply so many variables which have
    nothing to do with actual stock values as we come to the beginning
    of the year.

    I read a lot of market analysts I respect. There seems to be some
    consensus that if the Dow moves down below an average of 8250 or
    thereabouts, we could test the lows of last year. If we move above
    8900 (some say 9000) we could have a nice run. We are close to both.
    What would happen if within the next few weeks Saddam leaves (as
    rumored) and it becomes obvious Bush's tax cut will pass? What if
    the war is a real problem, and the tax cut is stalled in endless
    Senate filibusters?

    Graham tells us the market is a voting machine in the short term and
    a weighing machine in the long run. Could we see a (psychological)
    relief rally combined with a short covering rally that could be
    quite strong? You bet. Will it be a return of the bull? No, it will
    be just another bear market rally. But that is why a prediction of
    where the market will be is more of an analysis of psychology and
    less of actual statistics.

    As Bill Bonner says, the market "ought" to go down, as it is over-
    valued. I agree whole-heartedly. But sometimes the length of time
    between "ought" and "does" can be quite long, and the emotional
    response of an illogical market not doing what it "ought" can be
    frustrating to those like you and I who are coldly logical in our
    investment strategy.

    Over the next few weeks, I will make some specific suggestions of
    investments, funds, managers and programs that are available to the
    average investor which have the potential for gains in the types of
    markets in which we find ourselves.

    Palm Beach and a Debate on Hedge Funds

    Next weekend, I leave for Palm Beach Gardens where I will speak at
    the Global Alternative Investment Management conference (Jan. 26-
    29). This is primarily a conference about hedge funds and private

    Last year I delivered the keynote luncheon address, where I
    suggested that Modern Portfolio Theory is not practical for the
    individual investor, and the investment industry should stop using
    this high sounding theory as an excuse for mediocrity and to keep
    investors locked into poorly performing assets (contrary to my
    current reputation as a wimp). While the response was generally
    good, there were some who did not appreciate my rather blunt
    observations about industry ethics. Generally, they were people
    employed by those I criticized.

    This year, the conference organizers have invited Dr. Harry
    Markowitz, the economist who won the Nobel Prize for developing
    Modern Portfolio Theory. I shall listen humbly.

    I speak the next day, but on a far different topic: we debate the
    regulation of hedge funds and whether they should be available to
    the public. Long time readers know clearly where I stand. Not
    allowing investors to choose among the hedge funds of which the rich
    avail themselves is the last bastion of political incorrectness in
    this country.

    If I were to suggest that women should not be allowed to invest in
    hedge funds, the picket line, if not mobs, would be at my door. I
    would be accused of blatant and crass discrimination. But the line
    is now drawn between rich and poor. The average investor can invest
    in stocks like Enron, mutual funds like Janus 20, options, futures,
    Amazon and Cisco and a thousand other businesses in which they have
    no real information and which are clearly risky. But they are
    prevented from investing in hedge funds and private offerings.

    However, the rich and large institutions are pouring large sums into
    these funds. Presumably, they think there is value somewhere in
    these investments. I believe if an investor, no matter his net
    worth, can decide on which stock or mutual fund to buy, then he
    should be allowed to make up his own mind whether or not to invest
    in private offerings and hedge funds.

    The rules were written in a day and age in which they made sense.
    They no longer do, and it is my belief they will change by the end
    of this decade, if not sooner.

    I will now get down off the soapbox.

    Have a great week.

    Your just wanting a level playing field for investors analyst,

    John Mauldin
    [email protected]

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