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Archive for December 2013

Archive for December, 2013

Thoughts from the Frontline: Gary Shilling Review and Forecast

 

Should auld acquaintance be forgot
And never brought to mind?
Should auld acquaintance be forgot,
And auld lang syne!

For auld lang syne, my dear,
For auld lang syne,
We’ll take a cup o’ kindness yet
For auld lang syne

It’s that time of year again, when we begin to think of what the next one will bring. I will be doing my annual forecast issue next week, but my friend Gary Shilling has already done his and has graciously allowed me to use a shortened version of his letter as this week’s Thoughts from the Frontline. So without any further ado, let’s jump right to Gary’s look at where we are and where we’re going.

Review and Forecast

By Gary Shilling

In the third quarter, real GDP grew 2.8% at annual rates from the second quarter. Without the increase in inventories, the rate would be 2.0%, in line with the 2.3% average growth since the economic recovery commenced in the second quarter of 2009.

Furthermore, the step-up in inventory-building from the second quarter may have been unintended, suggesting cutbacks in production and weaker growth in future quarters. Also, consumer spending growth, 1.5% in the third quarter, continues to slip from 1.8% in the second quarter and 2.3% in the first while business spending on equipment and software actually fell at a 3.7% annual rate for only the second time since the recovery started in mid-2009. Government spending was about flat with gains in state and local outlays offsetting further declines in federal expenditures. Non-residential outlays for structures showed strength as did residential building. The 16-day federal government shutdown didn’t commence until the start of the fourth quarter, October 1, but anticipation may have affected the third quarter numbers.

Recovery Drivers

The 2.3% average real GDP growth in the recovery, for a total rise of 10%, has not only been an extraordinarily slow one but also quite unusual in structure. Consumer spending has accounted for 65% of that growth, actually below its 68% of real GDP, as shown in the second column of Chart 1. Government spending—which in the GDP accounts is direct outlays for personal and goods and services and doesn’t include transfers like Social Security benefits—has actually declined. Federal outlays fell 0.4% despite massive stimuli since most of it went to welfare and other transfers to state governments. But state and local spending dropped 0.9% due to budget constraints.

Residential construction accounted for 9% of the gain in the economy. This exceeds its share of GDP, but still is small since volatile housing normally leaps in recoveries, spurred by low interest rates. But deterrents abound. The initial boost to the economy as retrenching consumers cut imports was later reversed. So net exports reduced real GDP growth by 0.4% in the 13 quarters of recovery to date.

Inventory-building accounted for a substantial 19% of the rise in real GDP, suggesting the accumulation of undesired stocks since anticipation of future demand has been consistently subdued. Nonresidential structures fell 0.1% as previous overbuilding left excess space. Equipment spending contributed 20% of the overall growth, but has failed to shoulder the normal late recovery burst.

Nevertheless, the small intellectual property products component, earlier called software, accounted for 5% of overall growth compared to its 3.9% share of GDP. This reflects the productivity-enhancing investments American business have been using to propel profit margins and the bottom line in an era when sales volume has been weak and pricing power absent.

As we predicted over three years ago in our book The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation, and in many Insights since then, economic growth of about 2% annually will probably persist until deleveraging, especially in the financial sector globally and among U.S. consumers, is completed in another four or five years. Deleveraging after a major leveraging binge and the financial crisis that inevitably follows normally takes around a decade, and since the workdown of excess debt commenced in 2008, the process is now about half over. The power of this private sector deleveraging is shown by the fact that even with the immense fiscal stimuli earlier and ongoing massive monetary expansion, real growth has only averaged 2.3% compared to 3.4% in the post-World War II era before the 2007-2009 Great Recession.

Optimists, of course, continue to look for reasons why rapid growth is just around the corner, and their latest ploy is the hope that the effects of individual income tax hikes and reduced federal spending this year via sequestration have about run their course. Early this year when these negative effects on spending were supposed to take place, scare-mongers in and out of Washington predicted drastic negative effects on the economy. But federal bureaucrats apparently mitigated much of the effects of sequestration, and the income tax increases on the rich, as usual, didn’t change their spending habits much. So the positive influences on the economy as sequestration fades and income tax rates stabilize are likely to be equally minimal.

Furthermore, small-business sentiment has fallen recently. The percentage of companies that look for economic improvement dropped from -2 in August to -10 in September and -17 in October to a seven-month low. Those expecting higher sales declined from +8 to +2 in October. Most of the other components of the index fell, including those related to the investment climate, hiring plans, capital spending intentions, inventories, inflation expectations and plans to raise wages and prices. Other recent measures of subdued economic activity include the New York Fed’s survey of manufacturing and business conditions and industrial production nationwide, which fell 0.1% in October from September.

The New York Fed’s Empire State manufacturing survey index for November fell to 2.21%, the first negative reading since May. Every component dropped—orders, shipments, inventories, backlogs, employment, the workweek, vendor performance and inflation.

Global Slow Growth

The ongoing sluggish growth in the U.S. is indeed a global problem. It’s true in the eurozone, the U.K., Japan and China. Recently, the International Monetary Fund, in its sixth consecutive downward revision, cut its global growth forecast for this year by 0.3 percentage points to 2.9% and for 2014, by 0.2 percentage points to 3.6%.

It lowered its 2013 forecast for India from 5.6% to 3.8%, for Brazil from 3.2% to 2.5% and more than halved Mexico’s to 1.2%. For developing countries on average, the IMF reduced its 2013 growth forecast by 0.4 percentage points to 5%, citing the drying up of years of cheap liquidity, competitive constraints, infrastructure shortfalls and slowing investment. It also worries about their balance of payment woes. For 2014, the IMF chopped its growth forecast for China from 7.8% to 7.3% and from 2.8% to 2.6% for the U.S.

Fiscal Drag

Fed Chairman Bernanke continually worries about fiscal drag. Without question, the federal budget was stimulative in earlier years when tax cuts and massive spending in reaction to the Great Recession as well as weak corporate and individual tax collections pushed the annual deficit above $1 trillion. But the unwinding of the extra spending, income tax increases and sequestration this year and economic recovery—weak as it’s been—have reduced the deficit to $680 billion in fiscal 2013 that ended September 30.

From here on, the outlook is highly uncertain with persistent gridlock in Washington between Democrats and Republicans. So far, they’ve kicked the federal budget and debt limit cans down the road and they may do so again when temporary extensions expire early next year. It looks like many in Congress have no intention of resolving these two problems and may be jockeying for position ahead of the 2014, if not the 2016, elections.

In our many years of observing and talking to Congressmen, Senators and key Administration officials of both parties, it’s clear that Washington only acts when it has no alternative and faces excruciating pressure. A collapsing stock market always gets their attention, but the ongoing market rally, in effect, tells them that all is well or at least that it doesn’t require immediate action.

The Fed

With muted economic growth and risks on the downside, distrust in the abilities or willingness of Congress and the Administration to right the ship, and falling consumer and business confidence, the burden of stimulating the economy remains with the Fed. Janet Yellen, the likely next Chairman, seems even more committed than Bernanke to continuing to keep monetary policy loose. The Fed plans to reduce its buying of $85 billion per month in securities but the negative reactions by stocks (Chart 2), Treasury bonds (Chart 3) and many other securities to Bernanke’s hints in May and June that purchases would be tapered and eliminated by mid-2014 made a strong impression on the Fed. Similarly, the release of the minutes of the Fed’s October policy meeting— which again said officials looked forward to ending the bond-buying program “in coming months” if conditions warranted—resulted in an instant drop in stock and bond prices.

The Fed is trying to figure out how to end security purchases without spiking interest rates, to the detriment of housing, other U.S. economic sectors and developing economies. It’s moving toward “forward guidance,” more commitment to keep the short-term interest rate it controls low than its present pledge to keep it essentially at zero until the current 7.3% unemployment rate drops to 6.5% and its inflation rate measure climbs to 2.5% from the current 1.2% year-over-year.

The hope is that a longer-term commitment to keep short-term rates low will retard long rates as well when the Fed tapers its asset purchases. This strategy appears to be having some success. Treasury investors are switching from 10-year and longer issues to 2-year or shorter notes. This is known as the yield-steepening trade as it pushes short-term yields down and longer yields up. As a result, the spread between 2-year and 10-year Treasury obligations has widened to 2.54 percentage points, the most since July 2011. Banks benefit from a steeper yield curve since they borrow short term and lend in long-term markets. But borrowers pay more for loans linked to long-term Treasury yields. There’s a close link between the yield on 10-year Treasury notes and the 30-year fixed rate on residential mortgages.

The Fed has already signaled that it may not wait to raise short rates until the unemployment rate, a very unreliable gauge of job conditions as we’ve explained in past Insights, drops below 6.5%. Bernanke recently said that “even after unemployment drops below 6.5%, the [Fed] can be patient in seeking assurance that the labor market is sufficiently strong before considering any increase in its target for the federal funds rate.” At that point, the Fed will consider broader measures of the job market including the labor participation rate. If the participation rate hadn’t fallen from its February 2000 peak due to postwar baby retirements, discouraged job-seekers and youths who stayed in school since job opportunities dried up with the recession, the unemployment rate now would be 13%.

The Fed is well aware that other than pushing up stock prices, its asset-buying program is having little impact on the economy. In a recent speech, Bernanke said that while the Fed’s commitment to hold down interest rates and its asset purchases both are helping the economy, “we are somewhat less certain about the magnitude of the effects on financial conditions and the economy of changes in the pace of purchases or in the accumulated stock of assets on the Fed’s balance sheet.” We wholeheartedly agree with this sentiment, as discussed in detail in our October Insight. Tapering Fed monthly purchases only reduces the ongoing additions to already-massive excess member bank reserves on deposit at the Fed.

Inflation-Deflation

Inflation has virtually disappeared. The Fed’s favorite measure of overall consumer prices, the Personal Consumption Expenditures Deflator excluding food and energy (Chart 4), is rising 1.2% year-over-year, well below the central bank’s 2.0% target and dangerously close to going negative.

There are many ongoing deflationary forces in the world, including falling commodity prices, aging and declining populations globally, economic output well below potential, globalization of production, growing worldwide protectionism including competitive devaluation in Japan, declining real incomes, income polarization, declining union memberships, high unemployment and downward pressure on federal and state and local government spending.

With the running out of 2009 federal stimulus money and gas tax revenues declining as fewer miles are driven in more efficient cars, highway construction is declining and construction firms are consolidating and reducing bids on new work even if their costs are rising. Highway construction spending dropped 3.3% in the first eight months of 2013 compared to a year earlier. Also, states are shifting scarce money away from transportation and to education and health care. We’ve noted in past Insights that aggressive monetary and fiscal stimuli probably have delayed but not prevented chronic deflation in producer and consumer prices.

Why does the Fed clearly fear deflation? Steadily declining prices can induce buyers to wait for still-lower prices. So, excess capacity and inventories result and force prices lower. That confirms suspicions and encourages buyers to wait even further. Those deflationary expectations are partly responsible for the slow economic growth in Japan for two decades.

Low Interest Rates

With the Fed likely to continue to hold its federal funds rate close to zero, other short-term interest rates will probably remain there too. So the recent rally in Treasury bonds may well continue, with yields on the 10-year Treasury note, now 2.8%, dropping below 2% while the yield on our 32-year favorite, the 30-year Treasury “long bond,” falls from 3.9% to under 3%. Even-lower yields are in store if chronic deflation sets in as well it might. Ditto for the rise in stocks, which we continue to believe is driven predominantly by investor faith in the Fed, irrespective of modest economic growth at best. “Don’t fight the Fed,” is the stock bulls’ bellow. Supporting this enthusiasm has been the rise in corporate profits, but that strength has been almost solely due to leaping profit margins. Low economic growth has severely limited sales volume growth, and the absence of inflation has virtually eliminated pricing power. So businesses have cut labor and other costs with a vengeance as the route to bottom line growth

Wall Street analysts expect this margin leap to persist. In the third quarter, S&P 500 profit margins at 9.6% were a record high but revenues rose only 2.7% from a year earlier. In the third quarter of 2014, they see S&P 500 net income jumping 14.9% from a year earlier on sales growth of only 4.7%. But profit margins have been flat at their peak level for seven quarters. And the risks appear on the downside.

Productivity growth engendered by labor cost-cutting and other means is no longer easy to come by, as it was in 2009 and 2010. Corporate spending on plant and equipment and other productivity-enhancing investments has fallen 16% from a year ago. Also, neither capital nor labor gets the upper hand indefinitely in a democracy, and compensation’s share of national income has been compressed as profit’s share leaped. In addition, corporate earnings are vulnerable to the further strengthening of the dollar, which reduces the value of exports and foreign earnings by U.S. multinationals as foreign currency receipts are translated to greenbacks.

Speculation Returns

Driven by the zeal for yield due to low interest rates and the rise in stock prices that has elevated the S&P 500 more than 160% from its March 2009 low, a degree of speculation has returned to equities. The VIX index, a measure of expected volatility, remains at very low levels (Chart 5). Individual investors are again putting money into U.S. equity mutual funds after years of withdrawals. “Frontier” equity markets are in vogue. They’re found in countries like Saudi Arabia, Nigeria and Romania that have much less-developed—and therefore risky—financial markets and economies than Brazil and Mexico.

The IPO market has been hot this year. The median IPO has been priced at five times sales over the last 12 months, almost back to the six times level of 2007. And many IPOs have used the newly-raised funds to repay debt to their private equity backers, not to invest in business expansion. Through early November, IPOs raised $51 billion, the most since the $62 billion in the comparable period in 2000. Some 62% of IPOs this year are for money-losing companies, the most since the 1999-2000 dot com bubble. Some hedge fund managers are introducing “long only” funds with no hedges against potential stock price declines.

The S&P 500 index recently reached an all-time high but corrected for inflation, it remains in a secular bear market that started in 2000. This reflects the slow economic growth since then and the falling price-earnings ratio, and fits in with the long-term pattern of secular bull and bear markets, as discussed in detail in our May 2013 Insight.

High P/E

Furthermore, from a long-term perspective, the P/E on the S&P 500 at 24.5 is 48% above its long run average of 16.5 (Chart 6), and we’re strong believers in reversions to well-established trends, this one going back to 1881. The P/E developed by our friend and Nobel Prize winner, Robert Shiller of Yale, averages earnings over the last 10 years to iron out cyclical fluctuations. Also, since the P/E in the last two decades has been consistently above trend, it probably will be below 16.5 for a number of years to come.

This index is trading at 19 times its companies’ earnings over the past 12 months, well above the 16 historic average. This year, about three-fourths of the rise in stock prices is due to the jump in P/Es, not corporate earnings growth. Even always-optimistic Wall Street analysts don’t expect this P/E expansion to persist in light of possible Fed tightening. Those folks, of course, are paid to be bullish and their track record proves it. Since 2000, stocks have returned 3.3% annually on average, but strategists forecast 10%. They predicted stock rises in every year and missed all four down years.

Housing

Residential construction is near and dear to the Fed’s heart. It’s a small sector but so volatile that it has huge cyclical impact on the economy. At its height in the third quarter of 2005, it accounted for 6.2% of GDP but fell to 2.5% in the third quarter of 2010 (Chart 7). That in itself constitutes a recession, even without the related decline in appliances, home furnishings and autos.

Furthermore, the Fed can have a direct influence on housing. Monetary policy is a very blunt instrument. The central bank only can lower interest rates and buy securities and then hope the economy in general will be helped. In contrast, fiscal policy can aid the unemployed directly by raising unemployment benefits. But by buying securities, especially mortgage-related issues, the Fed can influence interest rates and help interest-sensitive housing. The rise in 30-year fixed mortgage rates of over one percentage point last spring probably has brought the housing recovery to at least a temporary halt. Each percentage point rate rise pushes up monthly principal and interest payments by about 10%.

Of course, many other factors besides mortgage rates affect housing and have been restraining influences. They include high downpayment requirements, stringent credit score levels, employment status and job security and the reality that for the first time since the 1930s, house prices have fallen—by a third at their low.

Capital Spending

Many hope that record levels of corporate cash and low borrowing costs will propel capital spending. And spending aimed at productivity enhancement, much of it on high-tech gear, has been robust as business concentrates on cost-cutting, as noted earlier. But the bulk of plant and equipment spending is driven by capacity utilization, and while it remains low, there’s little zeal for new outlays.

That’s why capital spending lags the economic cycle. Only after the economy strengthens in recoveries do utilization rates rise enough to spur surges in capital spending. And as our earlier research revealed, it’s the level of utilization, not the speed with which it’s rising, that drives plant and equipment outlays. So this is a Catch-22 situation. Until the economy accelerates and pushes up utilization rates, capital spending will remain subdued. But what will cause that economic growth spurt?

Government Spending

It’s unlikely to be government spending. State and local outlays used to be a steady 12% or so of GDP and a source of stable, well-paying jobs. But no more. State tax revenues are recovering (Chart 8), but the federal stimulus money enacted in 2009 has dried up, leaving many states with strained budgets.

Pressure also comes from private sector workers who are increasingly aware that while their pay has been compressed by globalization and business cost-cutting, state and local employees have gotten their usual 3% to 4% annual increases and lush benefits. As a result, those government people have 45% higher pay than in the private sector, 33% more in wages and 73% in additional benefits. Oversized retiree obligations have sunk cities in California and Rhode Island and pushed Illinois to the brink of bankruptcy. Hopelessly-underfunded defined benefit pensions are a major threat to state and local government finances.

Municipal government employment is down 3.3% from its earlier peak compared to -0.2% for total payroll employment (Chart 9). And since these people are paid 1.45 times those in the private sector, two job losses is the equivalent of three private sector job cuts in terms of income. Real state and local outlays have fallen 9.5% since the third quarter of 2009.

Federal direct spending on goods and services, excluding Social Security, Medicare and other transfers, has also been dropping, by 7.2% since the third quarter of 2010. Both defense and nondefense real outlays are dropping, and this has occurred largely before the 2013 sequestration. At the same time, federal government civilian employment, civilian and military, has dropped 6% from its top (Chart 10).

U.S. Labor Markets

The U.S. labor market remains weak and of considerable concern to the Fed. Recent employment statistics have been muddled by the government’s 16-day shutdown in October and the impasse over the debt ceiling. Initially, 850,000 employees were furloughed although the Pentagon recalled most of its 350,000 civilian workers a week into the shutdown.

The unemployment rate has been falling, but because of the declining labor participation rate. We explored this phenomenon in detail in “How Tight Are Labor Markets?” (June 2013 Insight). As people age, their labor force participation rates tend to drop as they retire or otherwise leave the workforce. With the aging postwar babies, those born between 1946 and 1964, this has resulted in a downward trend in the overall participation rate—but it doesn’t account for all of the decline.

The irony is that participation rates of younger people tend to be higher than for seniors, but are declining. For 16-24-year-olds, the rate has declined sharply since 2000 as slow economic growth, limited jobs and rising unemployment rates have encouraged these youths to stay in school or otherwise avoid the labor force.

Meanwhile, the participation rates for those over 65 have climbed since the late 1990s as they are forced to work longer than they planned. Many have been notoriously poor savers and were devastated by the collapse in stocks in 2007-2009 after the 2000-2002 nosedive, two of only five drops of more than 40% in the S&P 500 since 1900.

Part-Timers

An additional sign of job weakness is the large number of people who want to work full-time but are only offered part-time positions—”working part-time for economic reasons” is the Bureau of Labor Statistics term (Chart 11)—and these people total 8 million and constitute 5.6% of the employed. This obviously reflects employer caution and the zeal to contain costs since part-timers often don’t have the pension and other benefits enjoyed by full-time employees.

This group will no doubt leap when Obamacare is fully implemented in 2015, according to its current schedule. Employers with 50 or more workers have to offer healthcare insurance, but not to those working less than 30 hours per week. When these people and those who have given up looking for jobs are added to the headline unemployment rate, the result, the BLS’s U-6 unemployment rate, leaped in the Great Recession and is still very high at 13.8% in October.

The weakness in the job market is amplified by the fact that most new jobs are in leisure and hospitality, retailing, fast food and other low-paying industries, which accounted for a third of the 204,000 new jobs in October. Manufacturing, which pays much more, has added some employees as activity rebounds but growth has been modest.

Real Pay Falling

With all the downward pressure on labor markets, real weekly wages are falling on balance. The folks on top of the income pile have recovered all their Great Recession setbacks and then some, on average. The rest, perhaps three-fourths of the population, believe they are—and probably still are—mired in recession due to declining real wages, still-depressed house prices, etc. Consequently, the share of total income by the top one-fifth, which has been rising since the data started in 1967, has jumped in recent years. The remaining four quintile shares continue to fall, although falling shares do not necessarily mean falling incomes.

The average household in the top 20% by income has seen that income rise 6% since 2008 in real terms and the top 5% of earners had an 8% jump. The middle quintile gained just 2% while the bottom 29% are still below their pre-recession peak. A study of household incomes over the 2002-2012 decade shows that the top 0.01% gained 76.2% in real terms but the bottom 90% lost 10.7%. In 2012, the top 1% by income got 19.3% of the total. The only year when their share was bigger was 1928 at 19.6%.

Real median household income, that of the household in the middle of the spectrum, continues to drop on balance, only leveling last year from 2011 (Chart 12). In 2012, it was down 8.3% from the prerecession 2007 level and off 9.1% from the 1999 all-time top. Americans may accept a declining share of income as long as their spending power is increasing, but that’s no longer true, a reality that President Obama plays to with his “fat cat bankers” and other remarks.

Households earning $50,000 or more have become increasingly more confident, according to a monthly survey by RBC Capital Markets, but confidence among lower-income households stagnated, created a near-record gap between the two. Of the 2.3 million jobs added in the past year, 35% were in jobs paying, on average, below $20 per hour in industries such as retailing and leisure and hospitality. Since the recession ended, hourly wages for non-managers in the lowest-paying quarter of industries are up 6% but more than 12% in the top-paying quarter. These income disparities are reflected in consumer spending. In the first nine months of this year, sales of luxury cars were up 12% from a year earlier but small-car sales rose just 6.1%.

Consumer Spending

With housing, capital spending, government outlays and net exports unlikely to promote rapid economic growth in coming quarters, the only possible sparkplug is the consumer. Consumer outlays account for 69% of GDP, and with falling real wages and incomes, the only way for real consumer spending to rise is for their already-low saving rate to fall further.

Even the real wealth effect, the spur to spending due to rises in net worth, is now muted. In the past, it’s estimated that each $1 rise in equity value boosted consumer spending by three cents over the following 18 months while a dollar more in house value led to eight cents more in outlays. But now the numbers are two cents and five cents, respectively.

True, the ratio of monthly financing payments to their after-tax income has been falling for homeowners, freeing money for spending. Those obligations include monthly mortgage, credit card and auto loan and lease payments as well as property taxes and homeowner insurance. Nevertheless, for the third of households that rent, their average financial obligations ratio has been rising in the last two years as rents rise while vacancies drop.

Declining gasoline prices have given consumers extra money for other purchases, and are probably behind the recent rise in gas-guzzling pickup truck and SUV sales. Furthermore, the automatic Social Security benefit cost-of-living escalator will increase benefits by 1.5% in 2014 for 63 million recipients of retirement and disability payments. Still, with low inflation in 2013, the basing year, that increase is smaller than the 1.7% rise last year and the lowest since 2003, excluding 2010 and 2011 when there were no increases due to a lack of inflation. Social Security retirement checks will rise $19 per month to $1,294, on average, starting in January.

In any event, retail sales growth is running about 4% at annual rates recently, about half the earlier recovery strength (Chart 13). And a lot of this growth has been spurred by robust auto sales, allegedly driven by the need to replace aged vehicles.

Shock?

Insight readers know we’ve been waiting for a shock to remind equity investors of the fundamental weakness of the economy, and perhaps push the sluggish economy into a recession. With underlying real growth of only 2%, it won’t take much of a setback to do the job.

Will the negative effects of the government shutdown and debt ceiling standoff, coupled with the confusion caused by the rollout of Obamacare, be a sufficient shock? The initial Christmas retail selling season may tell the tale, and the risks are on the down side. Besides the consumer, we’re focused on corporate profits, which may not hold up in the face of persistently slow sales growth, no pricing power and increasing difficulty in raising profit margins.

Nevertheless, we are not forecasting a recession for now, but rather more of the same, dull, slack 2% real GDP growth as in the four-plus years of recovery to date.

If you like what you read and would like to keep up with Gary for the next year, you can subscribe to Gary Shilling’s Insight for one year for $335 via email. Along with 12 months of Insight you’ll also receive a free copy of his full report detailing why he believes it will be “advantage America” in the coming years and a free copy of Gary’s latest book, Letting Off More Steam. To subscribe, call 1-888-346-7444 or 973-467-0070 between 10 am and 4 pm Eastern time or email insight@agaryshilling.com. Be sure to mention Thoughts from the Frontline to get the special report and free book in addition to your 12 months of Insight (available only to new subscribers).

Dubai, Saudi Arabia, Canada, and Auld Lang Syne

(For a little mood music, you can listen to James Taylor croon “Auld Lang Syne.” Or here’s the Beach Boys’ version.)

I am home for the holidays until January 8, when I leave for Dubai and then Riyadh for a week. There is the potential for a day trip to Abu Dhabi to meet with Maine fishing buddy Paul O’Brien. Then I am back home for a week before I fly to Vancouver, Edmonton, and Regina for a three-day speaking tour at those cities’ respective annual CFA forecast dinners. A note from a reader in Edmonton pointed out that it is already -30 there. I am actively hunting for my thermal underwear.

Oddly enough, my calendar then shows me home for four weeks before I head to Laguna Beach, CA, for a speech and then hop a plane to Miami. You would think that someone who flies as much as I do would have done a cross-country flight more than a few times, but this will be my first time ever to fly coast to coast in the US.

As noted last week, all my kids will be in town tonight, and we will celebrate our “official” family Christmas tomorrow. The poor grandchildren have had to wait three extra days to open their presents, but I keep telling them that waiting builds character. I get looks back from them that say they’re not sure what character is but they want nothing to do with it.

I have always enjoyed this time of year as an interlude for contemplating the future. For whatever reason, since I was in college I have paused as the new year approached to think about where I wanted to be in five years. Given that I’m 64, that means I’ve gone through this process some 42 times and seen the completion of 37 five-year planning cycles.

My batting average to date is 0 for 37. I never end up where I thought I was going to be, although there are times when I at least get the direction right, and fortunately there even a few times when the new midcourse correction means things turn out even better than planned.

Next week I write my 2014 forecast, for which the theme will be “Uncertainty.” Yet even in the face of overwhelming uncertainty, I will still come up with a personal five-year plan. Given the rather unique set of opportunities that have been presented to me in the past year, the plan is rather ambitious. And I expect it to change a lot. Among other projects, I expect to be announcing several new letters in the coming months that will be specifically directed to strategic portfolio planning. Right now our plan is to make these letters more or less freely available.

But the one thing that will hopefully not change is that I will be writing this letter to you, as together we try to make sense of the world. As the year draws to a close, I want to thank you for being part of my family of readers. And may the coming year surpass all your most wildly optimistic plans.

Your hearing “Auld Lang Syne” analyst,

John Mauldin, Editor
Thoughts from the Frontline
subscribers@mauldineconomics.com

 

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Outside the Box: Half & Half: Why Rowing Works

 

For today’s special Christmas Eve Outside the Box, my good friend Ed Easterling brings us pearls of wisdom on the subject of rowing vs. sailing. “Rowing?” you ask. “Sailing?” And, you’re thinking, “I would surely prefer to be a sailor.” Well, not so fast. Let Ed explain why putting your back into your investing process can pay off handsomely. A nice piece to think about as you are mashing the potatoes or icing the cake. You can see more of Ed’s marvelous work at www.crestmontresearch.com.

Sometimes with all the news of disasters, wars, and plagues, we forget that the human experiment is still fundamentally intact and advancing. My great friend Louis Gave shot me a note sharing this optimistic thought in his Christmas greeting:

The United Nations recently released a heartening update on its ‘millennium goals’ for the developing world, with many of its 2015 targets on the way to being met, or indeed already met. The target to halve the number of people living on less than US$1.25 per day was achieved in 2010; the proportion of undernourished people fell from 23% of the developing world in 1990-92 to under 15% in 2010-2012; more than 2 billion people gained access to improved sources of drinking water. The list goes on but suffice to say that never in history have so many people across the globe lived so comfortably. This reflects the fact that with global GDP set to exceed US$74 trillion this year, never has the world produced this much.

New energy production (and new forms of energy), robotics, nanotech, the second (or is it the third?) wave of the communications revolution, and the amazing discoveries in biotech are all unfolding before our eyes. Global trade is expanding, and slowly but surely governments are changing. An ebb and flow thing, to be sure, but the tide is clearly lifting more boats than ever.

Just this morning I read of a new type of muscle/motor that is amazingly small yet 50 times more powerful than human muscle, a potential new cancer drug/cure going into human trials next quarter, and another breakthrough in computer cycle speeds. Moore’s Law is safe for a few years!

But the old values are unchanging, of course. And they are still the ones that bring us true pleasure and joy. The love of family and friends, those deep conversations that bring insight and clarity, a well-told story, and a perfect tomato. A new TV may amaze, but the light in a child’s face brings a joy that is unmatchable.

Thanks for sharing this past year with me. I value your time and attention, in a world where our time is increasingly focused on more and more “stuff” and where we seem to be drinking information through a fire hose, constantly confronted with facts and “knowledge” rather than savoring the flavors of wisdom and insight.

This week I cook twice, with most of the family coming for Christmas Day and then the “official” family Christmas on Saturday when all the kids can come in and be together. And you enjoy your holidays as well!

Your feeling content analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

 

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Half & Half: Why Rowing Works

By Ed Easterling

December 23, 2013

Copyright 2013, Crestmont Research (www.CrestmontResearch.com)

So you’re in line at Starbucks. The guy in front of you orders a drink that takes longer to explain that it does to consume. You want a drip…with room in the cup for milk. Then YOU take longer to decide whether it’ll be cream, half and half, or some watered-down version of the natural product from cows. Decisions, decisions…

This article addresses two key questions for investors today: why do secular stock market cycles matter and how can you adjust your investment approach to enhance returns? The primary answer to the first question is that the expected secular environment should drive your investment approach. The investment approach that was successful in the 1980s and 1990s was not successful in the 1970s nor over the past fourteen years. Therefore, an insightful perspective about the current secular bear will determine whether you have the right portfolio for investment success over the next decade and longer.

Now, assume for a moment that you must pick one of two investment portfolios. The first is designed to return all of the upside—and all of the downside—of the stock market. The second is structured to provide one-half of the upside and one-half of the downside. Which would you pick? Which of the two would you have preferred to have over the past fourteen years, since January 2000? (Note: the S&P 500 Index is up 23% over that period.) In a secular bull market, the first portfolio—with all of the ups and downs—will be most successful. In a secular bear market, however, the second portfolio of half and half is essential. More about this shortly—and the insights may surprise you!

SECULAR STOCK MARKET CYCLES

Why should anyone take the time to assess the secular environment when investors are so focused on next quarter’s (or month’s!) account statement?

Steven Covey writes in Seven Habits of Highly Successful People:

Once a woodcutter strained to saw down a tree. A young man who was watching asked “What are you doing?”

“Are you blind?” the woodcutter replied. “I’m cutting down this tree.”

The young man was unabashed. “You look exhausted! Take a break. Sharpen your saw.”

The woodcutter explained to the young man that he had been sawing for hours and did not have time to take a break.

The young man pushed back… “If you sharpen the saw, you would cut down the tree much faster.”

The woodcutter said “I don’t have time to sharpen the saw. Don’t you see I’m too busy?”

Too often, we are so focused on the task at hand that we lose sight of taking the actions that are necessary to best achieve our goal. With investments, the goal is to achieve successful returns over time. We should not be distracted by a focus on this week or month; we need successful returns over our investment horizons—which often extend for a decade or two…or more.

And this is where Starbucks, Covey, and secular cycle strategies converge. Investors are too often tempted to focus on immediate returns. In periods of secular bull markets, that’s fine. But today, in a secular bear market, reach for the half and half. Take the time to assess the goal, as Covey emphasizes, and sharpen your investment strategy.

DON’T ACCEPT BREAKEVEN

Over the past 14 years since 2000, investors have repeatedly learned the lesson of falling back to, or recovering up to, breakeven in the market. While there’s no better feeling than coming from behind to breakeven, it’s a very bad feeling to watch a gain wither to a loss. But investors did not need to experience the same rollercoaster performance in their investment portfolios that the overall market traversed.

Some portfolios—generally it’s the ones that are indexed to the market using exchange-traded funds (ETFs) or mutual funds—have “participated” in the market’s ups and downs. That’s fine; such simple participation is what those funds are designed for. And that works great in secular bull markets like those of the 1980s and 1990s. But it does not work well in secular bear markets like today’s.

To illustrate, assume that the market drops by 40% and then recovers by surging 67%. An investor with $1,000 will decline to $600 and then recover to $1,000. So if you take the full cream option—all that the market gives—the illustrated cycle provides a breakeven outcome.

Chapter 10 of Unexpected Returns: Understanding Secular Stock Market Cycles (which has just been published in most eBook formats like Kindle, iPad, and Nook) contrasts the concept of a more actively managed and diversified approach to the more passive, buy-and-hold approach to investing. The chapter explores the concepts with the boatman’s analogy of “rowing” versus “sailing.”

Sailing is analogous to the passive investment approach of buy-and-hold—the use of ETFs and certain mutual funds to get what the market provides. Rowing, on the other hand, seeks to capitalize on skill and active management. Rowing uses diversification, investment selection, and investment skill to limit the downside while accepting limits on the upside. When the stock market plunges, portfolios built by rowing generally experience only a fraction of the losses suffered by those dependent on sailing. The expectation, however, should be that the “rowing” portfolios will also experience (only) a fraction of the gains.

The investment industry analyzes such fractional performance by assessing the so-called down-capture and up-capture of securities or portfolios. In other words, when the stock market declines, down-capture is the percentage of the decline that is reflected in your portfolio. If your portfolio declines ten percent when the market drops twenty percent, then your portfolio has a down-capture of fifty percent. Likewise, for market gains, up-capture is the relative percentage of your gains to the market’s gains.

During choppy, volatile, secular bear markets, most investors want little or none of the declines, but they want much or all of the gains. Beat the market! Other than for the luckiest of the market timers (which usually enjoy such success for fairly short periods of time), such a strategy is not realistic over most investment horizons. There is a more realistic expectation, however, that does fit with many risk-managed and actively managed portfolios.

USE THE HALF & HALF

Returning to the previous illustration, a portfolio structured to limit downside risk while participating in the upside would have fared better than breakeven. Although most investors seek somewhat less than half of the downside while achieving somewhat more than half of the upside, let’s assume that you have a half and half portfolio—50% down-capture and 50% up-capture. As the market falls 40%, your portfolio declines 20%—from $100 to $80. Then as the market recovers 67%, your portfolio rises by just over 33%. Your $80 increases to almost $107. So while the market portfolio gyrated from $100 to $60 and back to $100, your portfolio progression was $100, $80, and then $107.

Even better, consider the impact across multiple short-term cycles. The typical secular bear market has multiple cyclical phases—and there will be more of these cycles before the current secular bear is over. The effect of multiple cycles on the “rowing” portfolio is cumulatively compounding gains while the result for the “sailing” portfolio is recurring breakeven. The second cycle (using the same assumptions) drives the “rowing” portfolio from $107 to $85 and then to $114. The score after the third cycle: Mr. Market = $100 and your portfolio = $121. Three cycles of breakeven for the market still results in breakeven—you can’t make up for it with volume.

Of course, skeptics will respond that there’s often a difference between theoretical illustrations and empirical experience. Further, the S&P 500 Index has, at least at this point, increased 23% from the start of this secular bear in 2000. Yet the disproportionate impact of losses over gains is a formidable power.

As reflected in Figure 1, the S&P 500 Index started this secular bear market at 1469 and then took an early dive, ending 47% lower at 777 in October 2002. Five years later, the S&P 500 Index peaked at 1,565—up 101% from its low. By March 2009 the S&P 500 had sunk by 57% to 667. Now, four and a half years later, we are up 167% to 1,805. Cumulatively, the buy-and-hold portfolio (excluding dividends and transaction costs) is up 23% over the 14-year investment period.

For the alternative approach, let’s divide the percentage moves in half and apply them to your portfolio: -23.6%, +50.7%, -28.4%, and +83.5%. Your initial investment of $1,000 declined to $764 in less than two years. With half of the market’s gains, your portfolio climbed to $1,152 five years later. Then, applying just half of the subsequent market decline, your gain sank to a loss of $825. Ouch!… a gain yields to a loss. Note, however, that while the market found its bottom below its 2002 trough, your portfolio is nicely above its previous dip. For now, accept that consolation prize.

Figure 1. Half & Half vs. The Market

Then, with just half of the market’s gains over the past five years, your portfolio again advances to new highs. Over the secular bear cycle-to-date, the market is up 23%, compounding at a modest 1.5% annually. Yet your portfolio is up 51%, providing twice the compounded gain. With dividends and other income from your “rowing” portfolio, you have solid real (inflation-adjusted) returns.

Some people will focus on a shorter-term view, given the current economic, financial, and political uncertainties. They will reject a horizon of fourteen years and say that one cycle is not enough to benefit from a more hedged and diversified approach.

Interestingly, it doesn’t take numerous cycles to realize the benefit of the more hedged “rowing” approach. In the first cycle in Figure 1 (the early 2000s), market followers ended up 6.5%, while the rowing crew lapped them at 15.2%. In the most recent cycle, which includes 167% market gains since the bottom in 2009, buy-and-hold boosted portfolios by 15.4% while the harder working “rowing” investors currently lead with 31.4%.

The hedged “rowing” portfolio not only worked over the past fourteen years, it was successful over the course of the previous secular bear market from 1966 to 1981. After that sixteen years of secular bear, the S&P 500 Index portfolio showed gains of 33%, while the “rowing” portfolio had delivered 44%.

Keep in mind that there are many ways to structure a “rowing” portfolio. It is beyond the scope of Unexpected Returnsand Crestmont Research to develop or present specific alternatives. Nonetheless, rowing-based portfolios often consider—and include when attractively valued—a variety of components, including but not limited to: specialized stock market investments (e.g., actively-managed, high-dividend, covered calls, long/short equity, actively-rebalanced, preferred stocks, etc.), specialized bond investments (e.g., actively-managed, convertible bonds, inflation-protected securities, principal-protected notes, etc.), alternative investments (e.g., master limited partnerships, royalty trusts, REITS, commodity funds/advisors, private equity, hedge funds, timber, etc.), annuities, variable life, and others.

Clearly, some people will be skeptical about structuring portfolios to achieve (or improve upon) fifty percent up and down capture. Others will be looking for this article to present proof of a system that will lock in those results; it does not. But many others will relate today’s discussion to their own or their advisor’s experience. For the last group, this discussion intends to reinforce that good performance is not coincidence; rather it is the product of applying skill to portfolios that historically relied solely upon risk for return.

HOW IT WORKS

Market portfolios are outperformed by hedged portfolios in secular bear markets because of the disproportionate impact of losses in relation to the gains required to recover losses. Most significantly, as the magnitude of the loss increases, the required recovery gain exponentially increases.

In secular bull markets, on the other hand, gains significantly overpower losses. So although cyclical swings deliver the occasional “correction,” the recoveries far exceed the losses. The result is that above-average returns from sailing cumulatively exceed those from hedged rowing. In secular bear markets, however, gains across the secular period are cumulatively fairly modest or nonexistent. The result is that losses during secular bears well overpower the gains. Hedge portfolios mitigate some of the negative effects and enable investors to cumulatively succeed.

Figure 2 presents graphically the dynamic of offsetting gains and losses. As the losses increase, the required gain to reach breakeven exponentially increases. To illustrate the half and half effect within hedged portfolios, note that the required gain for a 20% loss is 25% and the required gain for a 40% loss is 67%. Those two points are chosen because 20% is half of 40%, consistent with the earlier “half and half” illustrations. Note that you will see the same effect with 10% and 20% or with 30% and 60%, etc.

Figure 2. The Impact of Losses

While the market investor needs 67% to recover from his 40% loss, the hedged investor only needs 25% to recover from one-half of the 40% loss (i.e., 20%). Yet when the hedged investor receives half of the market’s recovery, 33% from the near 67% surge, the hedged investor has exceeded the required 25% recovery return. As a result, the hedged investor achieves a net gain across the cycle.

So the gains from a hedged portfolio are not coincidental to the recent five years, fourteen years, or the secular bear market of the 1960s and ’70s. The gains occur whenever overall market gains are muted—in every secular bear market.

The current secular bear market has quite a way to go. The normalized price/earnings ratio (P/E) for the overall market is relatively high. The past fourteen years worked off the bubble levels from the late 1990s, but P/E has not declined to levels that are required to drive a secular bull market. A more detailed discussion and dramatic graphics can be found in an article titled “Nightmare on Wall Street” at www.CrestmontResearch.com.

YIELDING TO TEMPTATION

For some people, looking back fourteen years seems like an eternity. Needless to say, those same people are the most skeptical about analyzing a century of secular stock market cycles. They are also the most susceptible after the past five years to Siren’s call to overweight equities today. Yet a market that has run up substantially is more susceptible to correction or decline than it was before its surge. The trend is not always your friend. One of the documented weaknesses of human nature in investors is the tendency to ride winners despite their waning fundamentals (and sell some losers despite their newly attractive fundamentals).

Isn’t it ironic—in a Gary Larson Far Side kind of way—that the investor sticking his neck out may not be the tortoise-like rowing investor after all?!

So although the temptation to follow the momentum of 2013 might drive an overweighting of equities, this may be just the time to consider leaning away from passive buy-and-hold strategies in the market. We may soon be approaching the start of the next cycle—from the top.

Ed Easterling is the author of Probable Outcomes: Secular Stock Market Insights and the award-winning Unexpected Returns: Understanding Secular Stock Market Cycles. He is President of an investment management and research firm, and a Senior Fellow with the Alternative Investment Center at SMU’s Cox School of Business, where he previously served on the adjunct faculty and taught the course on alternative investments and hedge funds for MBA students. Mr. Easterling publishes provocative research and graphical analyses on the financial markets at http://www.CrestmontResearch.com.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

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PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Thoughts from the Frontline: What Has QE Wrought?

 

Now that we have begun tapering, we will soon see lots of analysis about whether QE has been effective. What will the stock market do? The US economy seems to be moving in the right direction, but the Fed has forecast Nirvana (seriously) – do we dare hope they can finally get a forecast right? Or have they jinxed us? This and a few other dark thoughts crossed my path on a beautiful day in San Diego; so in a very different Thoughts from the Frontline, I offer a number of small gifts rather than an overarching theme, and we will see if we can keep it short.

Let’s start with a wicked-brilliant essay by Dr. Woody Brock. It is way too long and penetrating to cover fully in this letter, but we can glean some bits of wisdom.

The world has been focused on central banks and the ending of QE. But Woody muses about a second dimension to this issue. If the true winner under a zero-interest-rate policy (ZIRP) has been the shadow banking system (as many, including your humble analyst, have observed) what distortions are baked into the market? What will happen as ZIRP finally goes away?

Woody asks questions not unlike those Jonathan Tepper and I ask in Code Red:

But what about the second dimension to the unwinding of ultra-easy monetary policy, namely, higher Fed funds rates and an upward shift in the entire yield curve – for reasons having nothing to do with QE? This is seldom discussed. From the research we have carried out, it is this second dimension of the end of easy monetary policy that is the more important of the two. The nation has never experienced six years of hyper-low interest rates. What impact has this had on the restructuring of the balance sheets of insurers and banks? In striving to match assets and liabilities across 24 consecutive quarters of near-zero rates, what tricks might financial institutions have played (reaching-for-yield via derivative positions) that could backfire and occasion a financial crisis once the yield curve rises from the dead? In particular, what about the increased utilization of new “collateral and maturity transformation” schemes that could occasion future panics?

And yet, the latest Fed papers are all about “forward guidance.” They suggest that, rather than QE, it is forward guidance promising a low-rate regime that is far more effective in producing the Fed’s desired ends. So if I read those papers and speeches correctly, we could be in a ZIRP-type policy for another three years. Where rates are starkly negative and investors are forced to seek yield in new and creative ways if they do not want to see their buying power eroded. But where we have little or no experience, and there might be a serious mismatch in duration.

Leverage Giveth and Leverage Taketh Away

Rewind to 2008-2009. What follows comes under the heading of full disclosure about painful lessons and a warning to those currently reaching for yield in new places. Without going into details, some (ok, a lot) of us had money invested in hedge funds that were part of the shadow banking system. There were all sort of creative funds invented to take private credit sources and circumvent normal banking functions. Life was good for a time, as “small” investors were able to get the returns normally reserved for banks. Except in cases of extreme leverage, we are not talking about lights-out numbers, just nice and steady high single-digit or low double-digit returns.

You could analyze the risks of the underlying investments and decide whether you were comfortable with the focus of the manager or fund. But as it turns out, the main risk you were taking had less to do with the actual investments but more to do with your fellow investors and their fetish for liquidity in times of stress.

Many of the funds in the shadow banking system had relatively short-duration money, which was invested in longer-term loans and financial structures. When everyone tried to redeem at once, the exits got crowded. Chaos ensued. It was not unlike – or maybe in some cases it was exactly like – an old-fashioned bank run.

Funds were forced to sell assets that were technically “good” but for which there were no buyers, except for investors who were picking up distressed debt. It was common to get assets at 50 cents on the dollar or less if you had ready cash. But those sales locked in significant losses for the sellers, and there was often modest leverage involved, which compounded the losses. Leverage giveth and leverage taketh away.

Other than the distressed-debt funds, which had a field day, there were only a few funds where the investors ended up OK. But those were funds where the investors’ money was locked up so they were forced to sit through the crisis. Yes, if you looked at the mark-to-market returns over the short term, it was ugly (VERY ugly in some cases) on paper; but during the next few years, as price normalcy returned, valuations climbed back to normal and interest rates pushed returns over time to what should have been expected.

Two lessons here:

One is that you need to make sure the credit funds (and actually, any funds) you are invested in have the ability to match the duration risk of the source of their funds AND of their (your fellow!) investors, with their underlying investments. As an easy example, if you are invested in a fund that makes three-year loans and offers daily or monthly liquidity, if that fund has sudden demands for withdrawal, it will be forced to sell assets in the open market and take immediate losses to return that money. That is clearly not good!

But if there is a three-year hold or lock-up for withdrawals, the fund can manage withdrawal requests in a normal fashion as the underlying investments mature. Investors who want to stay in the fund do not suffer from the need for liquidity of their fellow investors.

In today’s environment, the reach for yield is once again pushing investors into creative practices. Some funds are built to withstand a crisis, and others will get crushed. You must do your homework up front, and that includes thinking about what would happen to the underlying assets if another crisis comes along.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Things That Make You Go Hmmm – Quoth the Maven, “Evermore”

 

By Grant Williams

On January 29, 1845, the New York Evening Mirror published a poem that would go on to be one of the most celebrated narrative poems ever penned.

It depicted a tragic romantic’s desperate descent into madness over the loss of his love; and it made its author, Edgar Allan Poe, one of the most feted poets of his time.

The poem was entitled “The Raven,” and its star was an ominous black bird that visits an unnamed narrator who is lamenting the loss of his true love, Lenore. (We’ll get back to Bart Simpson dressed as the Raven later on.)

Today, the sad tale would be splashed on the cover of a million tabloid magazines with a title such as “Lenore Dumps Narrator,” “I’ll Never Find True Love Again — Narrator Spills on Tragic Split With Lenore,” or even “Kanye & Lenore — It’s Love! But Don’t Tell The Narrator.” But 1845 was the very epitome of “old school,” and so the poor, bereft narrator’s tale was shared with the world through a complex rhyme and metering scheme that was popularized by Elizabeth Barrett Browning in her poem “Lady Geraldine’s Courtship.”

“POETRY NERD!”

Quiet at the back or I’ll have you removed.

Now, as the narrator slips slowly, desperately into the pit of insanity, he discovers that the raven, with the license afforded the poet, can talk; and so he sets about asking the mysterious bird for guidance in navigating his torment:

Then this ebony bird beguiling my sad fancy into smiling,
By the grave and stern decorum of the countenance it wore,
”Though thy head be shorn and shaven, thou,” I said, “art sure no craven,
Ghastly grim and ancient Raven wandering from the Nightly shore —
Tell me what thy lordly name is on the Night’s Plutonian shore!”
Quoth the Raven “Nevermore.”

Unfortunately for the narrator, the raven’s vocabulary is limited to the single word nevermore, which, in a rare moment of clarity, the narrator reasons can only have been learned from an unhappy former owner:

Startled at the stillness broken by reply so aptly spoken,
”Doubtless,” said I, “what it utters is its only stock and store
Caught from some unhappy master whom unmerciful Disaster
Followed fast and followed faster till his songs one burden bore —
Till the dirges of his Hope that melancholy burden bore
Of ‘Never — nevermore’.”

It’s at this point that the narrator demonstrates beyond any last vestige of remaining doubt that he is, in fact, completely insane when, knowing full well that there is only one possible answer to any question he might pose his strange visitor, he pulls up a “cushioned seat” in front of the bird and proceeds to question him:

But the Raven still beguiling my sad fancy into smiling,
Straight I wheeled a cushioned seat in front of bird, and bust and door;
Then, upon the velvet sinking, I betook myself to linking
Fancy unto fancy, thinking what this ominous bird of yore —
What this grim, ungainly, ghastly, gaunt, and ominous bird of yore
Meant in croaking “Nevermore.”

So, with the vision firmly planted in your mind’s eye of a man completely out of touch with reality, seeking wisdom from a mysterious talking bird — knowing that there is only one response, no matter the question — Dear Reader, allow me to present to you a chart.

It is one I have used before, but its importance is enormous, and it will form the foundation of this week’s discussion (alongside a few others that break it down into its constituent parts).

Ladies and gentlemen, I give you (drumroll please) total outstanding credit versus GDP in the United States from 1929 to 2012:

Source: St. Louis Fed

This one chart shows exactly WHY we are where we are, folks.

From the moment Richard Nixon toppled the US dollar from its golden foundation and ushered in the era of pure fiat money (oxymoron though that may be) on August 15, 1971, there has been a ubiquitous and dangerous synonym for “growth”: credit.

The world embarked upon a multi-decade credit-fueled binge and claimed the results as growth.

Fanciful.

Floated ever higher on a cushion of credit that has expanded exponentially, as you can see. (The expansion of true growth would have been largely linear — though one can only speculate as to the trajectory of that GDP line had so much credit NOT been extended.) The world has congratulated itself on its “outperformance,” when the truth is that bills have been run up relentlessly, with only the occasional hiccup along the way (each of which has manifested itself as a violent reaction to the over-extension of cheap money.

Along the way, the cost of that cheap money has drifted consistently lower from its peak in 1980 — and the falloff was needed in order that we be able to keep squeezing juice from an increasingly manky-looking lemon….

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

Thoughts from the Frontline: The Monster That Is Europe

 

By: John Mauldin

This week, Geert Wilders and his Party for Freedom in the Netherlands and Marine Le Pen of the Front National (FN) of France held a press conference in The Hague to announce that they will be cooperating in the elections for the European Parliament next spring and hope to form a new eurosceptic bloc. Their aim, as Mr. Wilders put it, is to “fight this monster called Europe,” while Ms. Le Pen spoke of a system that “has enslaved our various peoples.” They want to end the common currency, remove the authority of Brussels over national budgets, and undo the project of integration driven with so much idealism by two generations of European politicians. (My thought about Marine Le Pen after looking at her policies is that if Marine Le Pen is the answer for France, they are asking the wrong question.)

For now, Le Pen and Wilders are in a decided, if growing, minority (think Beppe Grillo, who got 25% in Italy in the last election). But as the graphic below suggests, the stitching that is holding the Frankenstein of Europe together seems to be getting a little frayed. And my new worry is that the real monster, one likely to pop many more of the tenuous stitches that hold things together, could be lurking in German banks. This week’s letter explores a problem as “hidden” as subprime was back in 2006. Not as big, to be sure, but it might not need to be big to tug too hard the frayed threads that hold Europe together. (Note: this week’s letter will print out longer than usual due to the large number of graphs and pictures.)

But first and quickly, we have finalized the dates for next year’s Strategic Investment Conference. Mark your calendar for May 13-16. We are adding half a day so we can bring you a few more must-hear speakers. In addition to our always killer lineup of investment and economics thought leaders, I want to add some technology and politics. The significant difference about this conference is that there are no “B list” speakers. Everyone is a headliner. No one pays to get to speak or promote their deal. When we started the conference 11 years ago, my one rule was that we would invite speakers that I wanted to hear and create a conference that I would want to go to.

With my co-hosts Altegris Investments, we have done that and more. Attendees typically rate this conference as the best they attend. This year we have moved to San Diego, where we can have more space. We will still keep it small enough so that you can meet the speakers, as well as a room full of extremely interesting fellow attendees. You can sign up now and book your rooms by going to http://www.altegris.com/sic. Don’t procrastinate. Mark down the dates and plan your time accordingly.

The Complacency of Consensus

“But where are you out of consensus?” came the question. I had just spent a few minutes outlining my view of the world to a group of serious money managers here in Geneva, highlighting some of the risks and opportunities I see. The gentleman’s question made me realize that for the short-term, at least, I am all too sanguine for my personal taste. I have never thought of myself as one of those consensus guys. But when you consider that Japan is continuing down its path to starting a global currency war, with a currency that will drop at least in half from where it is now (plunging Japan into Abe-geddon); that China is launching its most serious economic overhaul in 20-30 years; that the US is still careening toward its day of reckoning with entitlement spending while dealing with the fall-out from taper tantrums in emerging markets; and that Europe is steering a course straight into deflation – the lot leaving us with Disaster A, Disaster B, or Disaster C as the consensus choice; then yes, I suppose I am a consensus guy, of sorts. But those are all worries that will come to a head later next year or the year after, not in the next few months or weeks, which is where most traders live. The trader who quizzed me wanted to know what was going to affect his book this week!

We seem to occupy a world where we are all somewhat uncomfortable. The problems are all so apparent; but somehow we are compelled to take risks anyway, hoping that the risks we take are properly managed or that we can exit at the propitious moment. The game seems to be moving along, absent another major shock to the system. It’s not quite party like it’s 2006, because the level of complacency is nowhere near the same; but we do seem headed down the same risk path, even though it scares us. Which means that it might take somewhat less than a subprime debacle and banking shock to trigger a crisis, since no one wants to be exposed when the next crisis happens. The majority of market players appear to believe that another crisis might materialize, but in the meantime you have to dance while the music is playing. Fifty Shades of Chuck Prince.

So, as investors and money managers, we must be on shock alert. Where will the next one come from? By definition, a shock is a surprise to the markets, something that few people recognize until it becomes too big to ignore. Ben Bernanke achieved a degree of infamy for saying that the subprime crisis would be contained, even as some of us were shouting that losses would be in the hundreds of billions (what optimists we were!). And then came the shock that created the biggest global economic crisis since the Great Depression. 

But an almost desperate reach for yield and shouldering of risk are clearly in evidence. Junk bond issuance is over 2.5 times what it was in 2006 and twice as high as a percentage of total corporate bond issuance. Leveraged loans are back to all-time highs, even as credit spreads continue to fall (see graph).

Collateralized loan obligations (CLOs) are close to all-time highs after almost disappearing in 2009. And subprime auto-asset-backed paper is projected to set a new record in 2014. Party on, Garth!

But if you ask the participants in those very markets, and I do, if there is any sign that the reach for yield is easing, the answer is generally “Not yet.” After 2008, everyone remains nervous; but when the analysis is done, enough buyers conclude that the future will be somewhat like the recent past. Although no one I talk to believes that in 2014 we will see another year in the stock market like the current one, still, the consensus outlook is rather sanguine. But I talk to more bulls than you might think. Last night in Geneva David Zervos was arguing (till rather late in the night, for me at least) his familiar spoos and blues with me (long S&P 500, long eurodollar). He is ready to double down on QE. Our hosts bought an excellent if outrageously expensive dinner (for the record, there is no other kind of meal in Geneva – can you believe $12 Diet Cokes?), and it was only polite to listen. And the trade has been right.

But for how long? Central banks are still going to be easy. But markets can be characterized as fully valued, at best, especially since there have been more earnings warnings this last quarter than at any time in the recent past. While the conditions are not quite the same as in 2006-07, we are getting a little frothy. So is it 2005, so that we can enjoy the ride into late 2006 and then look for an exit strategy? I would argue that the markets actually need a “shock” of some kind. And in addition to the “consensus-view” shocks mentioned above, I see one especially big, nasty lion lurking in the grass. In the form of German banks.

The Sick (German) Banks of Europe

Quick: I say “German banks,” and what’s the first thing that comes to your mind? The Bundesbank? Staid, no-nonsense central banking? The Bundesbank is all about maintaining the price of money – forget QE. Deutschebank? Big, German – must be stable and low-risk. The fact that southern Europeans are opening accounts left and right in DB must mean that DB is lower-risk than the local wild guys. Except that they have the largest derivatives portfolio, at $70 trillion (but don’t worry because it all nets out, sort of, and of course there is no counter-party risk!), and they are the most highly leveraged bank in Europe (at 60:1 in the last tests – not a misprint), which might give you pause. Although their CEO argues that their leverage doesn’t matter. And keeps a straight face. Just saying…

If something happens to DB, they are, in all likelihood, Too Big To Save, even for Germany. But Deutschebank is not my focus here today. It is their much smaller brethren, Too small to be called siblings, actually. More like first cousins twice removed. But there are a lot of them, and they all piled into some very interesting and, as it turns out, very questionable trades. And the story begins with the American consumer.

This Christmas, we will all engage, as will much of the world, in an orgy of gift giving. (I helpfully offer a few ideas of my own at the end of the letter.) The iPads and Xbox Ones and GI Joes with the Kung-Fu Grip (gratuitous esoteric movie reference) will be flying off the shelves. But the one thing that ties all those gifts together is The Box, the humble container unit, the TEU, which allows the world to transport all those items ever more cheaply. That story is resoundingly told in a book that Bill Gates featured in his Best Reads for 2013, simply entitled The Box. You can read a great review here. It turns out that the shipping container was created in the ’50s by a force-of-nature entrepreneur who fought governments and regulators (who typically tried to protect unions rather than help consumers) to bring the idea to market. It finally took off when the military decided it was the best way to ship material to the troops in Vietnam. It is one of those things that make sense and would have happened anyway, but as often happens, military spending drove the ramp-up.

The container was not without controversy. Longshoreman unions fought it aggressively, as containers meant fewer high-paying jobs. But The Box also meant far cheaper transportation of goods, and so it helped boost international trade. Now it is hard to imagine a world without containers. And even though the container business started in the US, there is not one US firm in the top 18 container shipping companies. The business is dominated by European and Asian firms.

And container ships were profitable. Oh my, fortunes were built. And they were so successful that a few German bankers looked at the easy money made by US bankers securitizing and packaging mortgages and decided they could do the same with ship financing. I know it is hard to believe, but the German government decided to create pass-through tax vehicles that gave serious tax preference to high-tax-rate investors for all sorts of things, including movies (such cinematic monuments as Terminator 3, I Robot, and the forgettable Stallone flick Get Carter were financed with German “tax shelters”); but my research has so far unearthed nothing to equal the German passion for financing ships. Seriously, would any US government entity give tax breaks to a favored industry? Would a Canadian or Australian or [insert your favorite country here] government? Such things are done by many governements, of course. Here we may apply Mauldin’s Rule (stolen from someone else, I am sure): Any seriously out-of-whack financial transaction requires government involvement (generally in the form of some market-distorting law).

Cargo ships, especially container ships, were serious cash machines for long-term money. Buy the ship with some leverage, put it to work, and watch the cash roll in. The Greeks were especially good at this, but the Germans and Scandinavians caught on quick. The Germans went everyone one better and allowed small high-net-worth investors to put their money into funds that financed these ships. At one point, I am told, German banks might have been financing 50% of the world’s cargo ships. (They control at least 40% of the world’s container ship market today.) Anyone familiar with limited partnerships in the US in the late ’70s and early ’80s knows how this story ends for the investors.

I came across this story from the inside, as a business partner of mine is in the shipping business; but he owns and operates a special type of ship: massive tugboats that move ocean drilling-rig platforms, and those are still in healthy demand. But his original financing many years ago was from Germany.

It turns out that if a little leverage makes a deal look good, then a lot makes it look even better. In 2007, ships were financed at 75% leverage (on average). It looks like 2008 vintages were financed in the 90% range! (Data is from a presentation I was sent, done by Dr. Klaus Stoltenberg of NordLB.)

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Image_1_20131211_OTB

Outside the Box: WTF?

 

It is a regular ritual for major US businesses: the end-of-the-quarter conference call in which the CEO dissects what just happened and gives us some insight on what to expect for the future of the company. My good friend Rich Yamarone, the chief economist at Bloomberg, is the creator of the Bloomberg Orange Book, a compilation of macroeconomic anecdotes gleaned from the comments CEOs and CFOs make on their quarterly earnings conference calls. He not only sits and listens to them present their views, he also picks up the phone and talks to them. He is very clued in on what’s happening in the real world of business.

In New York last week, at our dinner with a table full of economist types (including Art Cashin, Dan Greenhaus, and Ed Yardeni), Rich voiced his concerns about what he had been hearing. He let his inner Darth Vader out and ponderously informed us that we might soon be in a recession. The point was vigorously debated by Greenhaus and Yardeni, but Yamarone held his ground. So, for today’s Outside the Box, I asked Rich to summarize what he is hearing on the conference calls and tie it into his read on the economy. I am pleased that the resulting piece is delivered in his usual entertaining style, with lots of red meat. I think Lord Vader outdid himself.

I write this note from 35,000 feet, flying to Seattle, and there has been a LOT of white on the ground since I left home. Dallas is just today getting back to normal from a storm that left us with two inches of ice; and we were better off than 50 miles further north, where they had a four-inch mantle of slippery ice to contend with. Snow is so much easier.

I am off to Geneva tomorrow after a quick stop in Dallas to swap suitcases. That is a lot of uninterrupted reading and writing time, which I really need. Even worse than the ice, there has been a blizzard of email lately, and my inbox is overflowing worse than ever. I have always tried to enter the new year with an (almost) empty inbox, but this year keeping that resolution will be a challenge. If I owe you an email, hang in there; I’m working on it.

While I’m away, they are going to redo the office in the new apartment. Seems my contractor and my niece/architect/designer are not happy with the results, so someone has to start all over. And the glass doors keep getting cut wrong; but maybe by the time I get back I’ll see more of the finished product rather than continuing to live in a construction zone. Door handles would also be nice touch. Seems the hardware has been on back order for quite some time.

But in general I am spectacularly satisfied. Given the significant explosion from whatever was the initial budget, it is good that I am pleased. One thing I am actually quite amazed by is the quality of the new TVs. In spite of harassment from my kids, I had not gotten around to updating the TVs for about seven years, and the technology has made some great leaps since 2006. Watching movies on the latest Samsungs and the Sony 4K is a revelation. It is almost like being in the room with the actors, as if it were live theater seen on a stage. I caught a few moments of Apollo 13 with Tom Hanks and was simply blown away by the clarity. Apollo 13 featured some cutaways to 1970 tube TVs with their grainy pictures, and the contrast was almost jarring, though it brought back memories of what I thought was cool tech in 1970. I had not understood the hype until now. I guess TV was not one of my priorities, so the new stuff just came upon me all at once. But the kids are ecstatic about the new media room, so I guess that means I will get to see more of them.

There is just so much change happening everywhere, it is hard to keep up. But I try, as I know you do. Have a great week.

Your just trying to get through one email at a time analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

WTF?

By Rich Yamarone, Chief Economist, Bloomberg

What’s the Forecast? Economically speaking, existing conditions are cloudy with a chance of a storm. According to the latest entries in the Bloomberg Orange Book, we should expect to see more of the same – that is, sub-par economic activity with a propensity toward a downturn.

The economic data are poor given that the economy is 54 months into the expansion – the post-WWII average length of expansion is 60.5 months. The looming fiscal and monetary issues certainly aren’t likely to be stimulative. In fact, both are set to be more restrictive. Meanwhile, households remain plagued by inadequate real incomes and lacking employment prospects. Businesses are saddled with heavy government regulation and uncertain economic prospects – both domestically and globally.

I’m writing this note at the Lied Library on the UNLV campus in “Sin City,” also known as the Biggest Little City in the World,” “Glitter Gulch,” “The Marriage Capital of the World,” and “The Entertainment Capital of the World.” That’s a lot of nicknames for a city with about 600,000 people. The motto here is “What Happens in Vegas, Stays in Vegas.” From an economic standpoint, it should read, “What Happens in Vegas is What’s Happening in the U.S.” That is, the “haves” have and continue to spend particularly on luxury items. The “have-nots,” or the “have-not-a-lots,” are struggling. This is evidenced in the latest sentiment measures.

Those at the lower end of the income spectrum are considerably less confident than their upper-crust counterparts. And the higher income group isn’t exactly optimistic in recent months. This is crucial to the outlook since the middle-to-lower income group is the true driver of consumer spending, and subsequently overall economic growth. They determine the pace of expansion, recovery or downturn. The higher income group spends, and basically puts a floor of about 2 percent for total expenditures, while the lower income strata spends on necessities like food, fuel, shelter, and to an extent, clothing. The issue is that this middle income driver has been slipping into the lower income category, while the lower income group has fallen into the poverty level.

There’s a bit of irony here in Las Vegas. I’m an economist and part Welshman, making me one of the more frugal people on the planet. Economists aren’t exactly the first to run to “The Capital of Second Chances” – yet another nickname – and this place isn’t among the first consumers head off to when the going gets tough. For that reason, I have expenditures on casino gambling in my “Fab Five” indicators of discretionary spending.

During September, spending on casino gambling fell 1.6 percent from the previous month, and was up only 2.4 percent from year-ago levels. The outlook isn’t that encouraging according to the related comments in the Bloomberg Orange Book.

Caesar’s Entertainment CFO Don Colvin said: “Third quarter results, performance was driven by similar factors as the first half of the year, including continued softness in the domestic gaming market and competition.” Colvin added that “We see the Vegas gaming market kind of flattish I’d say and the hospitality in Vegas a strong positive…But we don’t believe there’s going to be a snapback in the challenged regional markets next year.” That’s not exactly encouraging commentary from an industry insider.

[Courtesy of my Bloomberg colleague, Julie Hyman, on assignment at Caesar's in Atlantic City, NJ]

Dan D’Arrigo, MGM Resorts’ CFO, highlighted from where the strength is coming, and again it appears to be from those atop the income spectrum. D’Arrigo noted, “On the casino side, we continue to see strong activity from our high-end international customers as our marketing team remains focused on driving that business to our Strip resorts. Our efforts are evident as baccarat volumes grew over 20% in the quarter driving a 16% increase in table games revenue at our wholly owned Las Vegas resorts.” I’m pretty confident that most middle- and lower-income people don’t even know what baccarat is – and some might confuse this with singer/songwriter legend Burt Bacharach who wrote ‘Walk on By.” This is apparently what Americans are doing when it comes to hitting the gaming tables. [For the record, Burt Bacharach and the card game baccarat are not the same thing.]

Most market pundits point to the housing market as a possible source of strength. I’m not exactly convinced that there has been a definitive improvement. The Mortgage Bankers Association’s Purchase Index has been locked in a sideways channel since mid-2010. And since June when the Fed first sent out the feelers that it might commence a tapering of policy in September, the level had slumped.

Interest rates – the price of money – matter. Yes, that’s right, the prevailing level of mortgage rates do matter to would-be home buyers. To argue that a higher interest rate will not have an adverse effect on the housing market is fundamentally wrong.

Most market participants were caught off guard when the Federal Reserve didn’t reduce its asset purchase plans in September after building in higher rates in June when the expectations of a taper were initially floated. I thought that a “no taper” announcement in September was a much easier call than many had expected. Admittedly, I thought it was more of a fiscal issue than the unknown impact of the higher interest rate environment.

Bernanke said during the presser following the Fed’s meeting that “We are somewhat concerned. I won’t overstate it, but we do want to see the effects of higher interest rates on the economy, particularly in mortgage rates, on housing.” Well, most of the associated data show a deceleration from a mid-year peak. Housing starts were 883,000 in August, lower than the 919,000 in May and 1,005,000 in March. Existing home sales were 5.12 million, lower than the 5.39 million units in July and August, while new home sales totaled 421,000 in August, down from a 454,000 pace in June. Pending home sales have fallen for five consecutive months, and are 2.2 percent lower than a year ago.

The Fed minutes from the Sept. 17-18 meeting ultimately revealed “While downside risks to the outlook for the economy and the labor market were generally viewed as having diminished, on balance, since last fall, a number of significant risks remained, including those related to the potential economic effects of the sizable increases in interest rates since the spring, ongoing fiscal drag, and the possible fallout from near-term fiscal debates.”

I still believe that the pause was a function of the government shenanigans rather than concern over the rising interest rate environment. In my world, I bet the conversation around that big marble and mahogany table at 20th & Constitution probably went something like this…

Chairman: “Okay, let’s wrap this meeting up. Does anyone here have a conceivable and legitimate reason why we should keep our foot on the pedal, and refrain from pulling back the monetary stimulus?”

Unnamed Fed Governor: “Well, there’s always Congress…”

Chairman: “Congress? They haven’t done anything, why should we worry about them? What could they possibly do that could cripple the economy more than they already have? We know that both parties want restrictive policies, Republicans want to cut spending and Democrats want to raise taxes, but they don’t ever propose legislation. It’s a catatonic state of affairs over there.”

Unnamed Fed Governor: “They could shut-down, and furlough about 800,000 workers, crush already dampened spirits,  and send a message that they have no ability or interest in solving the nation’s top ills.”

Chairman: “Whoa, that’s quite a stretch there Governor, don’t you think? I mean, who would risk re-election and public humiliation just to send a message of incompetence? Er, um, ugh, ahh…you know, why don’t we hold off from tapering here? Maybe the feeble economic recovery cannot withstand the simultaneous withdrawal of monetary stimulus, restrictive fiscal policy, and a government shut-down.”

While the investment world is convinced that the U.S. housing market has recovered since home prices as measured by the S&P Case/Shiller 20-City Home Price Index is 13.3 percent higher than a year ago, a detailed perspective would suggest the contrary. Activity in the individual regions finds only four areas (Washington, DC, Los Angeles, San Diego, and San Francisco) that have home price indexes that are convincingly above those levels registered during the throes of the housing crisis. Our beloved Las Vegas, NV region has increased as the thick black line in the associated chart suggests, but only to a level seen in January 2009, which was a crisis level.

Two Orange Book accounts helped shed some light on the continued concerns in the housing industry:

Armstrong World’s CEO Matthew Espe noted: “Residential demand slowed down, still strong year-over-year, but I think sequentially slowed down as we entered the end of August and September. That’s probably – we would assess that as being a function of a little rise in the mortgage rates, some overbuild in the builders and maybe some tightening of the credit restrictions.”

Stuart Miller the CEO of Lennar was slightly upbeat, but predicated his optimism on a short-lived increase in rates. Miller said, “Clearly, interest rates have moved higher, and mortgage rates have moved from their unprecedented low point towards more normalized levels. Accordingly, over the past couple of months, we’ve experienced a slowdown in our sales pace and traffic in our communities, as the consumer has adjusted to the change in the interest rate environment. But it is our belief that this change is mild and temporary, given the extremely low levels of housing inventory in the market.”

The local folks here refer to “The Gambling Capital of the World” – now this is just getting silly – as “Lost Wages,” and that too is an issue currently plaguing the rest of the U.S. Average hourly earnings have increased by 2.2 percent over the last 12 months – and a less than desirable 1.3 percent once you adjust for inflation. Clearly running in place isn’t going to get the economy going. The earl chatter regarding the upcoming holiday season is that it will be heavily promotional. 

And since consumers can’t spend what they don’t have, they’ve reduced the pace of spending to below that critical sub-2 percent pace of spending on real final sales of domestic product. There’s a little known rule of thumb in the economics world: when the annual growth rate of several economic indicators falls below 2 percent, the macro economy eventually slides into recession. Currently several of these statistics are flashing warning signals: real GDP (1.6 percent), real disposable personal incomes (2 percent), real consumer spending (1.7 percent), and real final sales of domestic product (1.6 percent). These are the broadest measures, possessing exceptional recession predicting abilities. The explanation for this is simple: like riding a bicycle, if you don’t pedal, you tip over. And when the tier one indicators don’t advance by a 2 percent pace, the economy grinds to a halt amid softer employment, incomes, and spending.

Linked ever-so-closely with changes in final sales of domestic product is the pace of employment, and both appear to be slumping in recent quarters. The frail economic recovery is simply not advancing at a swift enough pace to engender greater job creation. Staffing company, Kelly Services CEO Carl Camden said, “There are larger forces at play that continue to impact our business. 2013 has been beleaguered by the same slow and uneven growth trends we saw in 2012 and DC politics are shaking what little confidence US businesses had going into the fourth quarter…Given the uncertain climate and unimpressive job growth thus far in 2013, staffing revenues remain constrained in the staffing markets in which we’re engaged and there is still significant pressure on margins. Looking ahead, we don’t expect any meaningful improvement in the U.S. labor market and we believe that most companies will continue to hold off making key investments in people and capital until economic confidence and stability are restored.”

The most recent additions to the Bloomberg Orange Book show economic uncertainty is lingering. While it is doubtful that consumers withdrew spending altogether due to the temporary government closure in Washington, businesses that are dependent upon government reported feeling an impact. Housing activity advanced from low levels, but higher interest rates had a negative influence on activity. China’s economic recovery reportedly strengthened, while emerging markets activity deteriorated.

Interestingly, one quirky indicator – hair color sales – increased in the last reporting period, suggesting that some part of the population opted to self-style rather than head to the pricier salon.

The Bloomberg Orange Book Sentiment Index for the week ended Nov. 29 was 48.57, an increase from the 47.90 registered during the week ending Nov. 22. It was the 42nd consecutive weekly reading below 50.

Sub-50 readings suggest contractionary conditions, while above-50 is indicative of expansion. When looking at the Bloomberg Orange Book Sentiment Index, there are some things to keep in mind: Unlike the ISM or any of the Fed’s regional indices, the Bloomberg Orange Book includes comments from several industries, some of which are doing quite poorly — restaurants, select retailers, household products, etc. The ISM measures sentiment in the manufacturing sector, which is indeed on fire. In fact, very strong signals are coming from the manufacturers in the Orange Book. Unfortunately, there’s little-to-no associated hiring in this sector, but output is undeniably strong. The Orange Book comments that make up the Orange Book Sentiment Index are made with respect to the overall US economy, not just an individual sector.

To date, the lengthy string of sub-50 reading in the OB Sentiment Index has been spot on, predicting a sub-par economic performance. That’s exactly what we have experienced domestically here since the second quarter of 2012. Over the last six quarters, the average quarterly increase in real GDP has been 1.75% — that has traditionally signaled an economic recession — at least every time since 1948.

Some excerpts from the latest edition imply weakness in several, different industries.

Simon Property [SPG] Earnings Call 10/25/13: “…it is clear that the economy has slowed. You’ve seen it with wages, you’ve seen it with employment. Needless to say we don’t have to get into what’s going on in terms of leadership in our country, none of which we use as an excuse, because we put blinders on to the best of our abilities when it comes to that kind of stuff. But we’re operating at a high level in a very slow growth economy, and we’re outpacing the growth in the economy and that’s all that we can do, but we are affected by the economy.”

Caterpillar [CAT] Earnings Call 10/23/13: “….while it looks like there’s a good chance that the world economy could improve next year, there’s still much risk and uncertainty. The direction of U.S. fiscal and monetary policy remains uncertain, and the climate in Washington is divisive. Eurozone economies are far from healthy, and China continues to transition to a more consumer demand led economy. In addition, despite higher mine production around the world, new orders for mining equipment have remained low. As a result, we’re holding our preliminary outlook for 2014 sales and revenues flat with 2013, in the plus or minus 5% range.”

DuPont [DD] Earnings Call 10/22/13: “The macroeconomic environment and in particular global industrial production is improving sequentially, but at a slower pace than we expected three months ago. As a result, we recently lowered our global industrial production outlook for 2013 from 2.5% growth to slightly under 2%.”

Brinker International [EAT] Earnings Call 10/23/13: “The malaise we’ve seen in the category didn’t let up this quarter. Consumer sentiment is guarded at best and consumer confidence remains somewhat volatile. And there’s some evidence that guests have shifted some of their spending to larger ticket items like homes and automobiles. And while we believe this is a temporary phenomenon, but one that has certainly impacted casual dining here in the short term. And while employment rates are showing signs of improvement, casual dining in particular is being impacted by struggles many young adults are facing, particularly those in that 18 to 24 age range. Many are graduating college significantly un- or underemployed, weighted down with debt and often moving back home with their parents. And as a parent with two of those, it’s a scary thought.”

Air Products [APD] Earnings Call 10/29/13: “Economic activity in the second half of 2013 was slower than we had initially anticipated in most regions. Given the current economic conditions, we are planning for economic growth to be modest again in 2014. Globally, for the regions we operate in, we are forecasting manufacturing growth of 2% to 4%. In the U.S., uncertainty in the economy remains, despite the government restart. The combination of unresolved fiscal challenges, weak job growth, low consumer confidence and diminished global demand are likely to continue to act as a headwind on economic growth, despite the positive drivers of lower energy costs and strength in housing. We are forecasting a range of 2% to 4% growth.”

Revlon [REV] Earnings Call 10/24/13: “Total company net sales in the third quarter were $339.4 million, an increase of 1.1% excluding the impact of foreign currency fluctuations as compared to last year. This increase was primarily driven by higher net sales of Revlon color cosmetics despite low year-over-year new product net sales particularly in the U.S. as well as higher net sales of Revlon ColorSilk hair color and Revlon Beauty Tools.”

Timken [TKR] Earnings Call 10/24/13: “It’s now clear to us that the weakness in several of the key markets we serve, including the emerging market infrastructure, mining and energy exploration, is more a structural and will be longer lasting than we had expected. This leads us to believe that the slow steady improvement in demand that we’ve seen thus far in 2013 will extend well into next year. This situation has been exacerbated in the third and fourth quarter of this year by seasonal reductions in demand in some sectors.”

AutoZone [AZO] Earnings Call 9/25/13: “A key macro issue facing our customers today is the reinstitution of payroll taxes back to historic norms. This reduction in our customers’ take-home pay began at the beginning of the new calendar year and at this point it has been difficult to objectively quantify the ramifications of this change, however, we believe this is and will continue throughout the year to be a headwind to our consumer’s spending habits.”

Yamarone

The Orange Book is an exclusive publication of Bloomberg Brief Economics – a daily newsletter featuring proprietary Bloomberg data and analysis from Rich Yamarone and five other leading economists. To subscribe, please visit http://bit.ly/BriefJM.

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Outside the Box: WTF?

 

It is a regular ritual for major US businesses: the end-of-the-quarter conference call in which the CEO dissects what just happened and gives us some insight on what to expect for the future of the company. My good friend Rich Yamarone, the chief economist at Bloomberg, is the creator of the Bloomberg Orange Book, a compilation of macroeconomic anecdotes gleaned from the comments CEOs and CFOs make on their quarterly earnings conference calls. He not only sits and listens to them present their views, he also picks up the phone and talks to them. He is very clued in on what’s happening in the real world of business.

In New York last week, at our dinner with a table full of economist types (including Art Cashin, Dan Greenhaus, and Ed Yardeni), Rich voiced his concerns about what he had been hearing. He let his inner Darth Vader out and ponderously informed us that we might soon be in a recession. The point was vigorously debated by Greenhaus and Yardeni, but Yamarone held his ground. So, for today’s Outside the Box, I asked Rich to summarize what he is hearing on the conference calls and tie it into his read on the economy. I am pleased that the resulting piece is delivered in his usual entertaining style, with lots of red meat. I think Lord Vader outdid himself.

I write this note from 35,000 feet, flying to Seattle, and there has been a LOT of white on the ground since I left home. Dallas is just today getting back to normal from a storm that left us with two inches of ice; and we were better off than 50 miles further north, where they had a four-inch mantle of slippery ice to contend with. Snow is so much easier.

I am off to Geneva tomorrow after a quick stop in Dallas to swap suitcases. That is a lot of uninterrupted reading and writing time, which I really need. Even worse than the ice, there has been a blizzard of email lately, and my inbox is overflowing worse than ever. I have always tried to enter the new year with an (almost) empty inbox, but this year keeping that resolution will be a challenge. If I owe you an email, hang in there; I’m working on it.

While I’m away, they are going to redo the office in the new apartment. Seems my contractor and my niece/architect/designer are not happy with the results, so someone has to start all over. And the glass doors keep getting cut wrong; but maybe by the time I get back I’ll see more of the finished product rather than continuing to live in a construction zone. Door handles would also be nice touch. Seems the hardware has been on back order for quite some time.

But in general I am spectacularly satisfied. Given the significant explosion from whatever was the initial budget, it is good that I am pleased. One thing I am actually quite amazed by is the quality of the new TVs. In spite of harassment from my kids, I had not gotten around to updating the TVs for about seven years, and the technology has made some great leaps since 2006. Watching movies on the latest Samsungs and the Sony 4K is a revelation. It is almost like being in the room with the actors, as if it were live theater seen on a stage. I caught a few moments of Apollo 13 with Tom Hanks and was simply blown away by the clarity. Apollo 13 featured some cutaways to 1970 tube TVs with their grainy pictures, and the contrast was almost jarring, though it brought back memories of what I thought was cool tech in 1970. I had not understood the hype until now. I guess TV was not one of my priorities, so the new stuff just came upon me all at once. But the kids are ecstatic about the new media room, so I guess that means I will get to see more of them.

There is just so much change happening everywhere, it is hard to keep up. But I try, as I know you do. Have a great week.

Your just trying to get through one email at a time analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

WTF?

By Rich Yamarone, Chief Economist, Bloomberg

What’s the Forecast? Economically speaking, existing conditions are cloudy with a chance of a storm. According to the latest entries in the Bloomberg Orange Book, we should expect to see more of the same – that is, sub-par economic activity with a propensity toward a downturn.

The economic data are poor given that the economy is 54 months into the expansion – the post-WWII average length of expansion is 60.5 months. The looming fiscal and monetary issues certainly aren’t likely to be stimulative. In fact, both are set to be more restrictive. Meanwhile, households remain plagued by inadequate real incomes and lacking employment prospects. Businesses are saddled with heavy government regulation and uncertain economic prospects – both domestically and globally.

I’m writing this note at the Lied Library on the UNLV campus in “Sin City,” also known as the Biggest Little City in the World,” “Glitter Gulch,” “The Marriage Capital of the World,” and “The Entertainment Capital of the World.” That’s a lot of nicknames for a city with about 600,000 people. The motto here is “What Happens in Vegas, Stays in Vegas.” From an economic standpoint, it should read, “What Happens in Vegas is What’s Happening in the U.S.” That is, the “haves” have and continue to spend particularly on luxury items. The “have-nots,” or the “have-not-a-lots,” are struggling. This is evidenced in the latest sentiment measures.

Those at the lower end of the income spectrum are considerably less confident than their upper-crust counterparts. And the higher income group isn’t exactly optimistic in recent months. This is crucial to the outlook since the middle-to-lower income group is the true driver of consumer spending, and subsequently overall economic growth. They determine the pace of expansion, recovery or downturn. The higher income group spends, and basically puts a floor of about 2 percent for total expenditures, while the lower income strata spends on necessities like food, fuel, shelter, and to an extent, clothing. The issue is that this middle income driver has been slipping into the lower income category, while the lower income group has fallen into the poverty level.

There’s a bit of irony here in Las Vegas. I’m an economist and part Welshman, making me one of the more frugal people on the planet. Economists aren’t exactly the first to run to “The Capital of Second Chances” – yet another nickname – and this place isn’t among the first consumers head off to when the going gets tough. For that reason, I have expenditures on casino gambling in my “Fab Five” indicators of discretionary spending.

During September, spending on casino gambling fell 1.6 percent from the previous month, and was up only 2.4 percent from year-ago levels. The outlook isn’t that encouraging according to the related comments in the Bloomberg Orange Book.

Caesar’s Entertainment CFO Don Colvin said: “Third quarter results, performance was driven by similar factors as the first half of the year, including continued softness in the domestic gaming market and competition.” Colvin added that “We see the Vegas gaming market kind of flattish I’d say and the hospitality in Vegas a strong positive…But we don’t believe there’s going to be a snapback in the challenged regional markets next year.” That’s not exactly encouraging commentary from an industry insider.

[Courtesy of my Bloomberg colleague, Julie Hyman, on assignment at Caesar's in Atlantic City, NJ]

Dan D’Arrigo, MGM Resorts’ CFO, highlighted from where the strength is coming, and again it appears to be from those atop the income spectrum. D’Arrigo noted, “On the casino side, we continue to see strong activity from our high-end international customers as our marketing team remains focused on driving that business to our Strip resorts. Our efforts are evident as baccarat volumes grew over 20% in the quarter driving a 16% increase in table games revenue at our wholly owned Las Vegas resorts.” I’m pretty confident that most middle- and lower-income people don’t even know what baccarat is – and some might confuse this with singer/songwriter legend Burt Bacharach who wrote ‘Walk on By.” This is apparently what Americans are doing when it comes to hitting the gaming tables. [For the record, Burt Bacharach and the card game baccarat are not the same thing.]

Most market pundits point to the housing market as a possible source of strength. I’m not exactly convinced that there has been a definitive improvement. The Mortgage Bankers Association’s Purchase Index has been locked in a sideways channel since mid-2010. And since June when the Fed first sent out the feelers that it might commence a tapering of policy in September, the level had slumped.

Interest rates – the price of money – matter. Yes, that’s right, the prevailing level of mortgage rates do matter to would-be home buyers. To argue that a higher interest rate will not have an adverse effect on the housing market is fundamentally wrong.

Most market participants were caught off guard when the Federal Reserve didn’t reduce its asset purchase plans in September after building in higher rates in June when the expectations of a taper were initially floated. I thought that a “no taper” announcement in September was a much easier call than many had expected. Admittedly, I thought it was more of a fiscal issue than the unknown impact of the higher interest rate environment.

Bernanke said during the presser following the Fed’s meeting that “We are somewhat concerned. I won’t overstate it, but we do want to see the effects of higher interest rates on the economy, particularly in mortgage rates, on housing.” Well, most of the associated data show a deceleration from a mid-year peak. Housing starts were 883,000 in August, lower than the 919,000 in May and 1,005,000 in March. Existing home sales were 5.12 million, lower than the 5.39 million units in July and August, while new home sales totaled 421,000 in August, down from a 454,000 pace in June. Pending home sales have fallen for five consecutive months, and are 2.2 percent lower than a year ago.

The Fed minutes from the Sept. 17-18 meeting ultimately revealed “While downside risks to the outlook for the economy and the labor market were generally viewed as having diminished, on balance, since last fall, a number of significant risks remained, including those related to the potential economic effects of the sizable increases in interest rates since the spring, ongoing fiscal drag, and the possible fallout from near-term fiscal debates.”

I still believe that the pause was a function of the government shenanigans rather than concern over the rising interest rate environment. In my world, I bet the conversation around that big marble and mahogany table at 20th & Constitution probably went something like this…

Chairman: “Okay, let’s wrap this meeting up. Does anyone here have a conceivable and legitimate reason why we should keep our foot on the pedal, and refrain from pulling back the monetary stimulus?”

Unnamed Fed Governor: “Well, there’s always Congress…”

Chairman: “Congress? They haven’t done anything, why should we worry about them? What could they possibly do that could cripple the economy more than they already have? We know that both parties want restrictive policies, Republicans want to cut spending and Democrats want to raise taxes, but they don’t ever propose legislation. It’s a catatonic state of affairs over there.”

Unnamed Fed Governor: “They could shut-down, and furlough about 800,000 workers, crush already dampened spirits,  and send a message that they have no ability or interest in solving the nation’s top ills.”

Chairman: “Whoa, that’s quite a stretch there Governor, don’t you think? I mean, who would risk re-election and public humiliation just to send a message of incompetence? Er, um, ugh, ahh…you know, why don’t we hold off from tapering here? Maybe the feeble economic recovery cannot withstand the simultaneous withdrawal of monetary stimulus, restrictive fiscal policy, and a government shut-down.”

While the investment world is convinced that the U.S. housing market has recovered since home prices as measured by the S&P Case/Shiller 20-City Home Price Index is 13.3 percent higher than a year ago, a detailed perspective would suggest the contrary. Activity in the individual regions finds only four areas (Washington, DC, Los Angeles, San Diego, and San Francisco) that have home price indexes that are convincingly above those levels registered during the throes of the housing crisis. Our beloved Las Vegas, NV region has increased as the thick black line in the associated chart suggests, but only to a level seen in January 2009, which was a crisis level.

Two Orange Book accounts helped shed some light on the continued concerns in the housing industry:

Armstrong World’s CEO Matthew Espe noted: “Residential demand slowed down, still strong year-over-year, but I think sequentially slowed down as we entered the end of August and September. That’s probably – we would assess that as being a function of a little rise in the mortgage rates, some overbuild in the builders and maybe some tightening of the credit restrictions.”

Stuart Miller the CEO of Lennar was slightly upbeat, but predicated his optimism on a short-lived increase in rates. Miller said, “Clearly, interest rates have moved higher, and mortgage rates have moved from their unprecedented low point towards more normalized levels. Accordingly, over the past couple of months, we’ve experienced a slowdown in our sales pace and traffic in our communities, as the consumer has adjusted to the change in the interest rate environment. But it is our belief that this change is mild and temporary, given the extremely low levels of housing inventory in the market.”

The local folks here refer to “The Gambling Capital of the World” – now this is just getting silly – as “Lost Wages,” and that too is an issue currently plaguing the rest of the U.S. Average hourly earnings have increased by 2.2 percent over the last 12 months – and a less than desirable 1.3 percent once you adjust for inflation. Clearly running in place isn’t going to get the economy going. The earl chatter regarding the upcoming holiday season is that it will be heavily promotional. 

And since consumers can’t spend what they don’t have, they’ve reduced the pace of spending to below that critical sub-2 percent pace of spending on real final sales of domestic product. There’s a little known rule of thumb in the economics world: when the annual growth rate of several economic indicators falls below 2 percent, the macro economy eventually slides into recession. Currently several of these statistics are flashing warning signals: real GDP (1.6 percent), real disposable personal incomes (2 percent), real consumer spending (1.7 percent), and real final sales of domestic product (1.6 percent). These are the broadest measures, possessing exceptional recession predicting abilities. The explanation for this is simple: like riding a bicycle, if you don’t pedal, you tip over. And when the tier one indicators don’t advance by a 2 percent pace, the economy grinds to a halt amid softer employment, incomes, and spending.

Linked ever-so-closely with changes in final sales of domestic product is the pace of employment, and both appear to be slumping in recent quarters. The frail economic recovery is simply not advancing at a swift enough pace to engender greater job creation. Staffing company, Kelly Services CEO Carl Camden said, “There are larger forces at play that continue to impact our business. 2013 has been beleaguered by the same slow and uneven growth trends we saw in 2012 and DC politics are shaking what little confidence US businesses had going into the fourth quarter…Given the uncertain climate and unimpressive job growth thus far in 2013, staffing revenues remain constrained in the staffing markets in which we’re engaged and there is still significant pressure on margins. Looking ahead, we don’t expect any meaningful improvement in the U.S. labor market and we believe that most companies will continue to hold off making key investments in people and capital until economic confidence and stability are restored.”

The most recent additions to the Bloomberg Orange Book show economic uncertainty is lingering. While it is doubtful that consumers withdrew spending altogether due to the temporary government closure in Washington, businesses that are dependent upon government reported feeling an impact. Housing activity advanced from low levels, but higher interest rates had a negative influence on activity. China’s economic recovery reportedly strengthened, while emerging markets activity deteriorated.

Interestingly, one quirky indicator – hair color sales – increased in the last reporting period, suggesting that some part of the population opted to self-style rather than head to the pricier salon.

The Bloomberg Orange Book Sentiment Index for the week ended Nov. 29 was 48.57, an increase from the 47.90 registered during the week ending Nov. 22. It was the 42nd consecutive weekly reading below 50.

Sub-50 readings suggest contractionary conditions, while above-50 is indicative of expansion. When looking at the Bloomberg Orange Book Sentiment Index, there are some things to keep in mind: Unlike the ISM or any of the Fed’s regional indices, the Bloomberg Orange Book includes comments from several industries, some of which are doing quite poorly — restaurants, select retailers, household products, etc. The ISM measures sentiment in the manufacturing sector, which is indeed on fire. In fact, very strong signals are coming from the manufacturers in the Orange Book. Unfortunately, there’s little-to-no associated hiring in this sector, but output is undeniably strong. The Orange Book comments that make up the Orange Book Sentiment Index are made with respect to the overall US economy, not just an individual sector.

To date, the lengthy string of sub-50 reading in the OB Sentiment Index has been spot on, predicting a sub-par economic performance. That’s exactly what we have experienced domestically here since the second quarter of 2012. Over the last six quarters, the average quarterly increase in real GDP has been 1.75% — that has traditionally signaled an economic recession — at least every time since 1948.

Some excerpts from the latest edition imply weakness in several, different industries.

Simon Property [SPG] Earnings Call 10/25/13: “…it is clear that the economy has slowed. You’ve seen it with wages, you’ve seen it with employment. Needless to say we don’t have to get into what’s going on in terms of leadership in our country, none of which we use as an excuse, because we put blinders on to the best of our abilities when it comes to that kind of stuff. But we’re operating at a high level in a very slow growth economy, and we’re outpacing the growth in the economy and that’s all that we can do, but we are affected by the economy.”

Caterpillar [CAT] Earnings Call 10/23/13: “….while it looks like there’s a good chance that the world economy could improve next year, there’s still much risk and uncertainty. The direction of U.S. fiscal and monetary policy remains uncertain, and the climate in Washington is divisive. Eurozone economies are far from healthy, and China continues to transition to a more consumer demand led economy. In addition, despite higher mine production around the world, new orders for mining equipment have remained low. As a result, we’re holding our preliminary outlook for 2014 sales and revenues flat with 2013, in the plus or minus 5% range.”

DuPont [DD] Earnings Call 10/22/13: “The macroeconomic environment and in particular global industrial production is improving sequentially, but at a slower pace than we expected three months ago. As a result, we recently lowered our global industrial production outlook for 2013 from 2.5% growth to slightly under 2%.”

Brinker International [EAT] Earnings Call 10/23/13: “The malaise we’ve seen in the category didn’t let up this quarter. Consumer sentiment is guarded at best and consumer confidence remains somewhat volatile. And there’s some evidence that guests have shifted some of their spending to larger ticket items like homes and automobiles. And while we believe this is a temporary phenomenon, but one that has certainly impacted casual dining here in the short term. And while employment rates are showing signs of improvement, casual dining in particular is being impacted by struggles many young adults are facing, particularly those in that 18 to 24 age range. Many are graduating college significantly un- or underemployed, weighted down with debt and often moving back home with their parents. And as a parent with two of those, it’s a scary thought.”

Air Products [APD] Earnings Call 10/29/13: “Economic activity in the second half of 2013 was slower than we had initially anticipated in most regions. Given the current economic conditions, we are planning for economic growth to be modest again in 2014. Globally, for the regions we operate in, we are forecasting manufacturing growth of 2% to 4%. In the U.S., uncertainty in the economy remains, despite the government restart. The combination of unresolved fiscal challenges, weak job growth, low consumer confidence and diminished global demand are likely to continue to act as a headwind on economic growth, despite the positive drivers of lower energy costs and strength in housing. We are forecasting a range of 2% to 4% growth.”

Revlon [REV] Earnings Call 10/24/13: “Total company net sales in the third quarter were $339.4 million, an increase of 1.1% excluding the impact of foreign currency fluctuations as compared to last year. This increase was primarily driven by higher net sales of Revlon color cosmetics despite low year-over-year new product net sales particularly in the U.S. as well as higher net sales of Revlon ColorSilk hair color and Revlon Beauty Tools.”

Timken [TKR] Earnings Call 10/24/13: “It’s now clear to us that the weakness in several of the key markets we serve, including the emerging market infrastructure, mining and energy exploration, is more a structural and will be longer lasting than we had expected. This leads us to believe that the slow steady improvement in demand that we’ve seen thus far in 2013 will extend well into next year. This situation has been exacerbated in the third and fourth quarter of this year by seasonal reductions in demand in some sectors.”

AutoZone [AZO] Earnings Call 9/25/13: “A key macro issue facing our customers today is the reinstitution of payroll taxes back to historic norms. This reduction in our customers’ take-home pay began at the beginning of the new calendar year and at this point it has been difficult to objectively quantify the ramifications of this change, however, we believe this is and will continue throughout the year to be a headwind to our consumer’s spending habits.”

Yamarone

The Orange Book is an exclusive publication of Bloomberg Brief Economics – a daily newsletter featuring proprietary Bloomberg data and analysis from Rich Yamarone and five other leading economists. To subscribe, please visit http://bit.ly/BriefJM.

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Outside the Box and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA, SIPC, through which securities may be offered . MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

Things That Make You Go Hmmm – Mon(k)ey Puzzle

 

By Grant Williams  | December 9, 2013

Protruding from the sand a short distance to the south of the Pilot Pier, on the golden sands of Hartlepool in England’s North East, is a vertical wooden mast.

The mast dates back to the Napoleonic Wars, when the Emperor Bonaparte’s armies were marching through Europe, sweeping all before them as the aftermath of the French Revolution manifested itself in France’s aggressive attempt to take what it deemed as its rightful place at the head of the European table.

Of course, with Napoleon’s disastrous invasion of Russia in 1812, the French Army was to suffer one of the most comprehensive military defeats in history; but at the time of our story the battle was very much joined; and Britain, the mightiest naval power the world had ever seen, was locked in combat with her mortal enemy from across the English Channel.

Hartlepool, a small port in County Durham, was founded in the 7th century around Hartlepool Abbey, a Northumbrian monastery. The name originates from the Old English “heort-ieg” or “hart island,” as stags were seen roaming the countryside in great abundance.

Around the time of the Napoleonic Wars, Hartlepool boasted a population of about 900 people — all of whom seemed to be obsessed with the possibility of attack by France.

Gun emplacements were established and defences constructed in order to repel any French aggression, and the Hartlepudlians (as the people of that region were known) stood ready to fight the first Frenchman who dared set foot upon their beloved sand.

One night, amidst a terrible storm, a French chasse-marée (fishmonger ship) that had been pressed into the service of the Emperor capsized and sank off the coast of North East England, leaving a somewhat unusual but most definitely solitary survivor — a monkey, who found himself washed ashore, exhausted, battered and bruised from his nautical tribulations but still clinging to the mast, which remains there to this day.

One can only imagine how glad he must have been to end up on the golden sands of Hartlepool’s beach.

Unfortunately for him, he happened to be wearing a French naval uniform, which would, sadly, be the direct cause of his tragic demise a matter of hours after his miraculous escape from a watery grave.

The best guess that historians can posit is that the monkey was dressed in a sailor’s uniform for the amusement of the ship’s crew, but the Hartlepudlians were most definitely NOT amused; and upon finding him sprawled on the sand clad in a uniform with which they were unfamiliar, they immediately arrested him as a French spy and proceeded to force the confused monkey to stand trial right there on the beach.

The monkey was asked a series of questions designed to discover why he had come to Hartlepool; but with the monkey unable (or perhaps unwilling) to answer their questions, and with the locals uncertain as to what a Frenchman looked like, they reached the inevitable — but for the monkey somewhat unfortunate — conclusion that the monkey was a French sailor and therefore a spy.

The monkey was sentenced to death and hanged from the mast on the beach.

Music hall performer Ned Corvan immortalized the tale in “The Monkey Song,” a popular ditty of the time that contains the wonderful lines:

The Fishermen hung the Monkey O!
The Fishermen wi’ courage high,
Seized on the Monkey for a spy,
”Hang him” says yen, says another,”He’ll die!”
They did, and they hung the Monkey O!.
They tortor’d the Monkey till loud he did squeak
Says yen, “That’s French,” says another “it’s Greek”
For the Fishermen had got drunky, O!

To this day, the citizens of Hartlepool are known, much to their chagrin, in England (and around the world) as “monkey hangers.”

Now at this point in the proceedings, you are no doubt thinking to yourself, “He’s finally lost the plot. Where is he going this time?” Well, as you have indulged me and my tales of monkeys swinging from yardarms, I’ll tell you.

The people on that storm-tossed beach were confronted with something they didn’t recognize, and though logic dictated that they ought to investigate further before they took any action, the animal spirits of a group of excitable people ensured that they forgot about clear-headed analysis and did something that their descendants still regret over two centuries later.

Right now, today, investors all over the world are confronted by markets that have been dressed up for the amusement of the crew in charge of the ship, and nobody seems to recognize what they are looking at.

Sure, they look like markets, but at the same time there is an unfamiliarity that is extremely unnerving to at least a few in the gathering crowd.

The majority of the mob, however, have decided that they look enough like markets to charge in blindly in the expectation that all will be as it should.

Things are not as they should be. Far from it.

Everywhere one looks are signs that the markets are just monkeys dressed up in fancy costumes.

To continue reading this article from Things That Make You Go Hmmm… – a free weekly newsletter by Grant Williams, a highly respected financial expert and current portfolio and strategy advisor at Vulpes Investment Management in Singapore – please click here.

Thoughts from the Frontline: Interview with Steve Forbes

 

I’m not certain how many interviews I’ve done over the last decade. Hundreds? I know it is a lot. There are some interviewers who can somehow tease out what you really have in you. Tom Keene at Bloomberg, for instance, forces you to bring your A game, at whatever level you play. He brings it out of you. You know that he is smarter than you will ever be and that you should really be asking him the questions. Except that you’re not smart enough to ask the questions. I have to confess that every time I walk into the room with Tom I’m a little intimidated. I try never to show it, somewhat like the new kid on the block trying to put on a brave face, but inside I keep looking for the exit doors just in case I throw up all over myself. At the end of the day I’m still a small-town country boy from Bridgeport, Texas, trying to figure out how the big city works.

And then there’s Steve Forbes. If I’ve done hundreds of interviews, then Steve has done many thousands, on the presidential campaign trail with the best of the best, and gods did he learn the craft. I’ve done multiple interviews with Steve, and every time I sit down with him I feel that I’m with my best friend. Maybe it’s because we have a ton of shared values and I have read and admired him for years. I truly think he would’ve made a great president in the mold of Ronald Reagan, but for whatever reason New Hampshire did not agree. As I think even Steve will admit, while he may have a philosophical mind meld with Reagan, the Gipper had some small genetic extra, call it what you will.

But for whatever reason, Steve seems to bring out the passion in me. When I think about what central bank policies are doing to savers and investors, how we are screwing around with the pension system, circumventing rational market expectations because of an untested economic theory held by a relatively small number of academics, I get a little exercised. And Steve gives me the freedom to do it.

And so a few weeks ago, philosophically like-minded old friends sat down at his offices in New York to talk about the world in general. Monetary policy, Janet Yellen, gold, stocks, commodities, the time value of money, grandchildren, and a lot of other stuff, all folded together into what I think may be the best interview I’ve ever done in my career. Steve gives me the room to be me and allows that passion that has always been inside me to come to the fore. And with his smile and gentle demeanor, he eggs it on.

So this week, for the first time in 14 years of Thoughts from the Frontline, I offer you  a wide-ranging interview with John Mauldin, as conducted by the inimitable Steve Forbes. You can watch the video on our home page (lower right, under “Latest Video”) or read the transcript below.

John Mauldin: How Central Bankers Will Ruin The Global Economy

John Mauldin, investor and co-author of the new book Code Red, recently sat down with me to discuss monetary policy, a still-lagging economy, and how he might operate the Federal Reserve if he were in Ben Bernanke’s or Janet Yellen’s shoes.

Steve Forbes: John, good to have you back again.

John Mauldin: Steve, it is always fun to be with you.

Forbes: You’ve got a new book out, called Code Red.

Mauldin: Yes.

Forbes: Hot off the press.

Mauldin: Yeah, show it up twice now. There we go.

Forbes: Code Red, Jack Nicholson, A Few Good Men. Explain first the title.

Mauldin: Well, in that movie Jack Nicholson famously felt that he had to protect America. He was in charge. And so he issued his famous “code red,” and his line was, “You need me on that wall.” So at the beginning of the book I paraphrased his speech as if it were Ben Bernanke talking or now Janet Yellen:

“You need me on that committee. You want me on that central bank. Yes, you work for savers and creditors, but I’m responsible for whole economies. I have greater things to worry about.”

So in 2008 the central banks of the world had to issue a code red.

It’s like, a patient is brought by ambulance to the hospital, and instead of operating you put him on morphine. Or it’s like asking the arsonist to put out the fire. Part of the reason we had this very crisis was because of central bank policies and government regulations and the interweaving of large investment banks and politicians and central bankers. I don’t want to get into conspiracy theories; I think it’s just people’s self-interest.

Forbes: How about a stupidity theory?

Mauldin: Some of it was stupid, but some of it was just greed. Nonetheless, we had a crisis. The banking system froze up. We went to the edge of the abyss. We looked over and it was a long way down. And I believe central banks appropriately provided liquidity. That was their function, and I would argue that almost the sole true function of a central bank is to be there when the stuff hits the fan.

Forbes: To be what Bagehot called the lender of last resort.

Mauldin: Yes, the lender of last resort. That being said, they never took the patient off morphine. At your and my age, we’ve had the unpleasant experience of caring for friends who are in the hospital. And in today’s world, my mother has a hip operation, and they have her up and walking the next day.

They just opened up her hip, put a new hip in. One of my good friends, the same thing – the next day he’s up and walking. Forget this morphine stuff. Forget lying around in a hospital bed like we used to have to do. Well, the central banks are still operating with 1900s medicine, so they just kept the patient on morphine.

And now the patient is addicted. The problem is, when you want to end that addiction, whether it’s alcohol or drugs or quantitative easing, withdrawal is not going to be pretty. But the Fed’s hope is that somehow or other, “We can get the economy going. We can create animal spirits,” and that people won’t notice when they start withdrawing a trillion dollars a year of monetary easing out of the global system.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – please click here.

© 2013 Mauldin Economics. All Rights Reserved.
Thoughts from the Frontline is a free weekly economic e-letter by best-selling author and renowned financial expert, John Mauldin. You can learn more and get your free subscription by visiting www.MauldinEconomics.com.

Please write to subscribers@mauldineconomics.com to inform us of any reproductions, including when and where copy will be reproduced. You must keep the letter intact, from introduction to disclaimers. If you would like to quote brief portions only, please reference www.MauldinEconomics.com.

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Thoughts From the Frontline and MauldinEconomics.com is not an offering for any investment. It represents only the opinions of John Mauldin and those that he interviews. Any views expressed are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony of, or associated with, Mauldin’s other firms. John Mauldin is the Chairman of Mauldin Economics, LLC. He also is the President and registered representative of Millennium Wave Advisors, LLC (MWA) which is an investment advisory firm registered with multiple states, President and registered representative of Millennium Wave Securities, LLC, (MWS) member FINRA and SIPC, through which securities may be offered. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB) and NFA Member. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. This message may contain information that is confidential or privileged and is intended only for the individual or entity named above and does not constitute an offer for or advice about any alternative investment product. Such advice can only be made when accompanied by a prospectus or similar offering document. Past performance is not indicative of future performance. Please make sure to review important disclosures at the end of each article. Mauldin companies may have a marketing relationship with products and services mentioned in this letter for a fee.

Note: Joining The Mauldin Circle is not an offering for any investment. It represents only the opinions of John Mauldin and Millennium Wave Investments. It is intended solely for investors who have registered with Millennium Wave Investments and its partners at http://www.MauldinCircle.com (formerly AccreditedInvestor.ws) or directly related websites. The Mauldin Circle may send out material that is provided on a confidential basis, and subscribers to the Mauldin Circle are not to send this letter to anyone other than their professional investment counselors. Investors should discuss any investment with their personal investment counsel. John Mauldin is the President of Millennium Wave Advisors, LLC (MWA), which is an investment advisory firm registered with multiple states. John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS), an FINRA registered broker-dealer. MWS is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Millennium Wave Investments cooperates in the consulting on and marketing of private and non-private investment offerings with other independent firms such as Altegris Investments; Capital Management Group; Absolute Return Partners, LLP; Fynn Capital; Nicola Wealth Management; and Plexus Asset Management. Investment offerings recommended by Mauldin may pay a portion of their fees to these independent firms, who will share 1/3 of those fees with MWS and thus with Mauldin. Any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any CTA, fund, or program mentioned here or elsewhere. Before seeking any advisor’s services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Since these firms and Mauldin receive fees from the funds they recommend/market, they only recommend/market products with which they have been able to negotiate fee arrangements.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop. You are advised to discuss with your financial advisers your investment options and whether any investment is suitable for your specific needs prior to making any investments.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs may or may not have investments in any funds cited above as well as economic interest. John Mauldin can be reached at 800-829-7273.

Outside the Box: Cool Tech for Your Workouts

 

I know that what you’ll encounter in today’s Outside the Box is not macroeconomics. But we all have to live in the real world, and our health is as real as it gets. So this is just one guy telling his friends about something he found that has helped make his world a lot better. 

My friend and colleague Pat Cox is always finding something new and different. When Pat first introduced me to this idea, I thought he was being a little over the top. But I happened to be in Palo Alto the following week and met with the scientists Pat mentioned and saw their results. Then I got a beta unit and used it for the first time on my last birthday last year. 

I am in reasonable shape for my 64 years. I can do 50 pushups relatively easily and then go on to other parts of the gym, but I could never get past 40 for the second set and then even less if I attempted a third set. I would hit maybe 8 machines and exercises as part of one full upper-body set. The first time I used the AVAcore device you’re going to read about, I did three sets of everything, including 3×50 pushups over about 75 minutes, then went home and told the kids – who expressed a certain amount of skepticism. I immediately dropped and did another 39. All in less than two hours. It was a good birthday. 

And I was not sore the next day, which was even stranger. But let Pat explain the science. It all makes sense. I have talked with and seen interviews with lots of real athletes who swear by this. This is for real, but as Pat emphasizes, it is not Miracle-Grow. It will do nothing for you if you don’t work out, and baby workouts won’t cut it, either. But if you train seriously – and you should –this is the coolest thing ever (pardon the pun). It will increase your stamina and workout effectiveness.

This is really the first time the device has been offered to a general public audience. And yes, in one year it will be a different and better model and likely cost less. That’s the way of the world. So you can keep your current workout if you like, or you can do much better workouts, starting today. And you’ll amaze your friends. This is a rather cool thing to take to the gym.

Your keeping cool and pounding reps analyst,

John Mauldin, Editor
Outside the Box
subscribers@mauldineconomics.com

Cool Tech for Your Workouts

By Patrick Cox

Two Stanford University biologists have discovered a way to dramatically increase the benefits of exercise. I’ve used this technology for the last year and, like many other early users, have seen remarkable improvements in strength, endurance, and muscle mass. In fact, my results are better than they were thirty years ago when I was in my thirties.

I understand, by the way, that this sounds like the claims made in spam e-mails. Fortunately, you don’t have to take my word for it. Multiple third-party studies from important academic institutions have verified that the device, about the size of a coffee maker, delivers benefits that are superior to those associated with moderate doses of anabolic steroids – with none of the negative side effects.

Moreover, use of this biotechnology is spreading rapidly through the world of professional athletics. Though these organizations are not quick to publicize competitive advantages, we know that the San Francisco 49ers, the Seattle Seahawks, and some US Olympic training facilities use it. Internationally, at least one major soccer team is employing the device, but they haven’t said so publicly. The same is true in professional MMA and basketball.

If I have to convince you that exercise should be a priority in your life, you’re probably not the person I want to talk to. Nevertheless, I’ll point out that research has shown that cardiovascular and strength training can increase your life expectancy by preventing or reversing many serious health risks. These include arthritis, osteoporosis, obesity, loss of muscle mass (sarcopenia), age-related loss of function, diabetes, and cardiovascular and other chronic diseases. Exercise improves sleep, mood, metabolism, appearance, and creativity. Investors who do not recognize the economic value of their own health and longevity are not truly serious investors.

I understand, however, that it can be hard to find time for fitness. It can also be frustrating when results are slow in coming and the aftermath of exercise includes joint pain and muscle soreness. This is particularly true for those of us who are older, and the older you are the more true it becomes.

Until I started using the device a year ago, I felt I was only slowing my descent into age-related frailty. It was a fight I took seriously, but slow failure is not fun. Since integrating this technology into my workouts, however, I’ve put on serious muscle mass while increasing flexibility, strength, and endurance.

You’re not going to see me on stage in a bikini bottom any time soon, but now I’m having serious fun and feeling better than I have in many, many years. I look forward to every workout and start planning the next one as soon I’ve finished the last. In the interest of full disclosure, I’m also engaged in a program of nutritional supplementation that includes clinically validated but little-known products. I don’t have the space to get into that area today, however.

So, please allow me to give you the big scientific picture so you understand how this device radically improves the results of exercise. I should emphasize that I’m not speaking for the inventors of this technology. Some of what I say about cellular processes probably falls into the realm of speculation, but it is my best attempt to explain why this technology is so important and why it works as well as it does.

Cool Science

The story begins with two esteemed Stanford biologists, Drs. Craig Heller and Dennis Grahn, the world’s leading authorities in the field of mammalian thermoregulation. Thermoregulation, the ability to moderate body temperature, is the key to steroid-like exercise gains, as I’ll explain shortly.

Grahn and Heller are not minor actors in the area of biological research. Grahn is a senior research scientist in the Biological Sciences Department at Stanford University who has authored numerous important papers. Heller is past chairman of the Biological Sciences Department at Stanford and former chairman of the Defense Advanced Research Projects Agency (DARPA). He has coauthored a leading biology text and numerous research papers. I could go on, but I need to get to thermoregulation.

Heller and Grahn have studied hibernating mammals for decades, puzzling out the means by which animals maintain core body temperatures in both freezing cold and intense heat. Using modern electronics, including remote sensors and infrared photography, they solved a medical mystery that goes back to the time when researchers began dissecting corpses in ancient Egypt and Greece.

Specifically, I’m referring to the masses of densely packed veins found in the palms of your hands as well as the soles of your feet and cheeks. These veins are capable of expanding many times to carry large quantities of blood.

These are the retia venosa, and they present an evolutionary puzzle. Why, after all, would we have veins that bleed so profusely, if cut, near the surface of the skin, located where we are most likely to be injured? Ask any chef who has sliced a palm on a mandoline or a swimmer who has lacerated the arch of the foot on a sharp seashell.

Heller and Grahn solved the puzzle by observing bears and other well-insulated hibernating animals. Infrared photography of bears, who are covered in layers of fat and thick fur, revealed heat being vented from the pads in their paws as well as their noses. Humans are not furred animals, but we share the same characteristic of heat dissipation through our extremities.

Further research revealed that all mammals, including humans, have an alternative circulatory system that kicks in when core body temperature rises. Arterial blood is rerouted away from the normal capillary system that handles oxygen and nutrition delivery. Instead, blood moves into the arteriovenous anastomoses (AVA).

Seriously, this is so cool. When your body heats up, blood is routed away from the other tissues in your limbs and into the specialized AVA, where it travels directly to the retia venosa in your extremities. The veins of the retia venosa swell to many times their normal size to enable venting of excess heat. As you radiate heat, cooled blood then flows directly back to the heart and is used to protect the vulnerable brain, heart, and other organs of your core from overheating.

Meet the Wall

This is a marvelous system, of course. Unfortunately, this cooling system has its limits. Vigorous exercise can overwhelm your thermoregulatory system. When this happens, very bad things can happen, starting with heat stroke. However, your body, has several defense mechanisms to stop the overproduction of heat that can cause permanent damage to your brain and other organs.

One safety mechanism resides right in the brain, which tells you to stop exerting yourself. Exertion becomes extremely unpleasant. You may try to exert yourself at maximum force, but your brain won’t send the signals needed to do it. You can still move your muscles, but with much less force.

On the cellular level, important changes are also taking place in muscle cells. As blood is routed away from limbs to protect the core, the normal flow of nutrients and oxygen is cut off. Heat and waste materials, such as lactic acid, build up. The mitochondria that convert food into usable biological energy (adenosine triphosphate) stop functioning, so cells run out of power.

While all these responses to overheating may seem dire, they are actually extremely important safety mechanisms. If you work out seriously, you’ve undoubtedly “hit the wall.” The wall is your body’s way of stopping the heat production that could seriously damage the organs of your core.

What’s good for your core, however, can be hard on muscle and connective tissues, which are second-class citizens in the hierarchy of your body’s priorities. While critical organs are being protected, muscle and connective tissues “slow cook” until core temperature and normal circulation are restored.

Delayed-onset muscle soreness is one result of this heat buildup, but it’s by no means the most serious. Exercise provokes adaptation and strengthening, of course, but too much can create enough heat to cause serious cellular damage. If you hit the wall often and hard enough, overtraining can erase the health benefits of working out. Serious overtraining can cripple the immune system and lead to illness and death.

As a result, we have to walk the line between too little and too much exercise. One way to shift the balance toward muscle growth is through the use of anabolic steroids, which promote protein synthesis and recovery. Steroids, however, entail risks.

A better solution would be to rapidly cool the core during and after exercise. Normal circulation would then be restored to muscle and connective tissues. Excess heat would be cleared out within minutes and mitochondrial energy production would resume.

Cellular repair and adaptive strengthening would therefore be accelerated. The flow of oxygen and nutrients would return to muscle and connective tissues while waste gases and other products would be cleared. In short, adaptive strengthening would be maximized while the damage done by exercise, as well as the associated pain, would be minimized. The capacity to exercise would go up and recovery would be much more rapid. The gains from exercise would therefore be significantly greater.

This is not just theory; it is clinically validated reality. The story of how it came to pass is, in my opinion, fascinating.

Beat the Wall with AVAcore CoreControl

Once Heller and Grahn understood how the body deals with excess heat, they began to wonder if they could give it a hand. And they succeeded.

First, they figured out that they could drain heat and accelerate core cooling using cold moving water. Construction workers, by the way, already knew this. If overcome by heat, some know to put their palms under cold running tap water until they feel better.

Heller and Grahn, through exhaustive research, learned that they could do this optimally by putting the palm of one hand in contact with cold water at precisely the right temperature range. For convenience sake, they learned to move the cold water through a kind of soft plastic network of tubes called a perfusion pad. The big breakthrough, though, was discovering that a slight vacuum caused the veins in the retia venosa to expand and give up heat much, much faster.

Initially, they concentrated on the many medical uses that their technology opened up. By accident, however, they discovered that post-exercise recovery was radically improved, making workouts far more productive. So, while continuing to work on medical applications, they decided to make their technology available to people interested in maximizing the outcome of physical exercise.

The device has two parts. One contains ice water, a pump, and the microchip that controls water temperature and vacuum. The other portion is a kind of vacuum glove that seals around one hand. In it, water at the optimal temperature passes through the perfusion pad in contact with the palm.

This device, called AVAcore CoreControl, can restore core temperature in just a few minutes for individuals who are heated due to exercise. Typically, it can take hours after intense exercise for normal temperature to be restored.

In practical terms, this means that the cellular damage done by exercise is minimized while recovery is accelerated dramatically. This applies both to resistance and cardiovascular training. Results of resistance training, according to various studies, are comparable to the use of 600 mg of testosterone enanthate weekly, which is significant.

Unlike with steroids, however, the benefits of thermoregulatory augmentation accrue to aerobic and endurance training as well as strength training. Though it’s not practical to run with the device at this time, it can be used on a treadmill, elliptical, or other stationary cardio machine.

Moreover, gains that come with use of the device can be maintained through normal exercise even if you stop using it. Personally, I think that the advantages of this device are particularly important for older people, because thermoregulatory abilities decline with age. As I said earlier, my current progress is better than it was when I was half my current age of 62.

Though studies have not been done yet to prove it, I believe the most important benefit to older people will be proven to be that the device protects and allows the strengthening of connective tissues. I’m doing exercises now that I couldn’t do a year ago because of joint problems.

I feel like I should share some of what I’ve learned about optimizing the use of this technology after a year of regular usage, but this article is already long. Maybe I’ll discuss supersets and other techniques on my own website, TransTechDigest.com, for those who do buy the AVAcore CoreControl.

I could easily go on for another ten thousand words, as I’m completely obsessed with this breakthrough and enormously grateful to Heller and Grahn. I believe thermoregulatory augmentation is the most important advancement in fitness technology since the ancient Greeks pioneered progressive training.

I’m also enthusiastic because this entirely unexpected breakthrough demonstrates a central premise of my work, that the most important impact of computer technology is its ability to unlock and exploit the secrets of a much older and more sophisticated system: human biology.

Regardless, I ought to make it clear that this is a relatively new technology and the device is, in a sense, at the beta testing stage. It’s a little bit kludgey right now and will undoubtedly be improved in years to come, shrinking in size and improving in ease of use. I would not wait, however, if you want to improve your level of fitness.

If you are already serious about exercise, the AVAcore CoreControl device could help you recover quicker from your workouts and derive more impressive gains from your current fitness routine.

AVAcore’s CoreControl device sells for $995. If you are interested in obtaining a CoreControl device for yourself or a family member, you may learn more and place your order here. If you want the device delivered in time for the upcoming holiday, you should place your order by noon on Thursday, December 19, and be sure to select the 3-day shipping option.

In the interest of full disclosure, you should know that Mauldin Economics will receive a referral fee if you purchase a CoreControl device. But as I mentioned earlier, I use the CoreControl device myself to aid in workout recovery. John uses the device as well and has reported gains similar to those I described. We are both serious about fitness and love AVAcore’s technology.

I reiterate, however, that CoreControl is meant for you only if you already have a rigorous exercise routine in place. If you are more casual about exercise, this is probably not for you. But if you are serious, this product could help you reach the next level of health and fitness.

Here’s the link to the company’s website.

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PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER. Alternative investment performance can be volatile. An investor could lose all or a substantial amount of his or her investment. Often, alternative investment fund and account managers have total trading authority over their funds or accounts; the use of a single advisor applying generally similar trading programs could mean lack of diversification and, consequently, higher risk. There is often no secondary market for an investor’s interest in alternative investments, and none is expected to develop.

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