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Archive for January 2014

Archive for January, 2014

Outside the Box: Hoisington Investment Management: Quarterly Review and Outlook Fourth Quarter 2013

 

Last week Greg Weldon made the case for rising interest rates on US treasuries. This week Lacy Hunt offers us the case for a continued low-interest-rate environment for long-term treasuries. This is one of the most fascinating tugs-of-war in the investment world today. I’ve made the argument that we are in a deflationary deleveraging world for quite some time to come, or at least until the velocity of money turns around. Lacy makes that point, too, and offers some insights into the velocity of money. This is a fascinating Outside the Box, and I won’t spoil it by stealing any more of Lacy’s thunder.

I write from a sunny, if cold, Dallas. The thermostat has been a topic of conversation in my apartment lately, and not just because we need to keep turning it up. By now, the entire world knows that Google bought the thermostat company Nest for $3.2 billion, a good 50% more than the valuation Nest was trying to raise money on just a month earlier. I was rather surprised at the price, but I was also surprised that Google paid $1.65 billion for YouTube. Now, six years later, the YouTube franchise produced almost $6 billion in revenues last year. Clearly, the founders of Google saw something that much of the world did not see at the time. My suspicion is that Nest will end up ranking in the same category of return on investment for Google.

I have installed the cool new Nest thermostats in my new apartment. Having bought and installed thermostats on my own for various homes in the past, I was thoroughly surprised at the value of the Nest thermostat. Just a few years ago it would’ve cost some three to four times more to buy the same functionality that the Nest thermostat has. And this little toy does so much more. It actually adjusts itself to my personal habits and preferences and allows me to change everything from my iPad when I go to bed in the evening or get up in the morning, with a thoroughly programmable slate of settings. It even senses when I come close to it. It is just one element in what will soon be the Internet of Things that Cisco CEO John Chambers says will rapidly come to be worth $20 trillion.

I’m enjoying all the new technology that we’ve installed in the apartment, and we’ve designed and wired it to be able to adapt to what we think will be the direction of further change. I’m just hoping I don’t have to buy antivirus software for my oven.

Have a great week.

Your thinking about mortgage interest rates analyst,

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

 

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Hoisington Investment Management – Quarterly Review and Outlook – Fourth Quarter 2013

In The Theory of Interest, Irving Fisher, who Nobel Laureate Milton Friedman called America’s greatest economist, created the Fisher equation, which states the nominal bond yield is equal to the real yield plus expected inflation. It serves as the pillar of macroeconomics and as the foundational relationship of the bond market. It has been reconfirmed many times by scholarly examination and by the sheer force of historical experience. Examining periods of both low and high inflation offers insight into how each variable in the Fisher equation affects the outcome.

From 1871 to 1948, a period of relatively low inflation, the Treasury bond yield averaged 2.9%, with the inflation rate 1.0% and the real yield 1.9%. From 1948 to 1989, a period of higher inflation, the Treasury bond yield increased to 6.0%, inflation jumped to 4.3% on average, but the real yield remained close to historical levels at 1.7% (Chart 1). In more recent times, the inflation rate has changed, but the real rate has remained close to historical averages. The significant point is that while average inflation and bond yields were volatile, the average real yield was far more stable. Over these longer stretches the average real yield was never far from the post 1871 average of 2.2%. Thus, over long periods of time, bond yields fluctuated in response to rising and falling inflation. However, the real bond yield steadily reverted to its mean indicating that inflation was the driving force in determining the bond yield over time.

Inflation

A host of different factors caused inflation to vary in the aforementioned periods, but two points of significance are identifiable. First, the seventy-year plus span between 1871 and 1948 (excluding the World War years) was an extended global market era. It began about the time of uninterrupted transcontinental railroad travel and the completion of the Suez Canal and resulted in a period of rapidly expanding global trade. By 1871, 10% of U.S. railroad traffic carried goods that were traded globally. This era produced increasing returns to scale and minimized price pressures. Second, the 1871-1948 period encompassed two episodes of high indebtedness: the 1870s and then the 1920s until the mid-to-late 1940s. Both severely destabilized economic activity and produced minimal inflation, which in turn led to bond yields that eventually reached slightly less than 2%.

From 1871 to 1948, there were two, twenty-year periods when the total return on long- term Treasury bonds exceeded the total return on the S&P 500: one from the 1870s to the 1890s and another from 1928 to 1948. Additionally, the traditional vibrancy in demographic trends in the United States ended during the 1930s as both the birth rate and total increase in population slowed dramatically.

The period from 1948 to 1989 differs markedly. By 1948, a global market did not exist, and the excessive indebtedness of the 1920-1930s had been eliminated. In the late 1940s, the Iron and Bamboo Curtains imposed by Russia and China removed roughly 50% of the world’s population from global trade, reducing economies of scale. During the war years, from 1933 to 1948, the U.S. ratio of public and private debt to GDP dropped from 295% to 139%, as the personal saving rate jumped from below zero to 28% (Chart 2). With normal and sustainable debt levels the U.S. entered the post-war boom, a period of rapidly rising prosperity that produced greater returns in the S&P 500 than on long-term Treasury bonds. Additionally, the abysmal demographics of the 1930s gave way to the post-war baby boom as households became more positive about their economic prospects.

Today, conditions resemble the 1871-1948 period. Global trade is once again less inhibited and public and private debt is high and rising. The saving rate is also greatly depressed. In this modern era of high indebtedness, there have been long periods of negative risk premium which have lasted over a decade. Demographics have also soured. The birth rate in 2013 fell to the lowest level on record, and the population increase was the slowest since the depression era year of 1937. Thus, fundamental conditions are now conducive for an inflation rate averaging 1% or less. Based on the Fisher equation, long-term bond yields should be comfortable trading at 3% or lower.

The global inflation rate is influenced by many factors, but the current bout of low inflation and the insufficiency of demand are both symptoms of extreme over-indebtedness. Weakness in prices is evident in various price indices. Over the twelve months ending in November, the price of goods in the CPI actually decreased 0.5%, while the more accurately measured durable and nondurable components of the U.S. personal consumption deflator fell by 2.0% and 0.6%, respectively. Prices of imported goods fell 1.5% over the same period; excluding oil the decline was nearly as large. Facing weak domestic demand, foreign producers cut prices on goods headed toward the U.S. market, and this forced domestic producers to match those lower prices.

A lack of pricing power is likely to continue in 2014. First, the global economy continues to incur more indebtedness. Both public and private debt in the major economies of the world continue to move further above the levels that create a sustained negative impact on economic activity. Second, monetary conditions moved in the wrong direction last year, partially as a result of misguided policy efforts at quantitative manipulation of reserves. Third, although the sequester of government expenditures will be less in 2014 than in 2013, fiscal policy in the broadest sense is not supportive of economic growth.

Indebtedness

Academic research has shown that a public and private debt to GDP ratio above the range of 260-275% has a depressing impact on economic growth. In 2000 the U.S. debt level exceeded this range. Since then, the bond yield has averaged 4.6%, with inflation 2.1% and the real yield 2.5%. By comparing growth and debt figures prior to 2000 with those afterward, the magnitude of the problem and likelihood of its persistence can be assessed. From 1871 to 1999, private and public debt averaged less than 165% of GDP (well below the 260-275% critical level), and the trend growth in real GDP was 3.8%. From 2000 through 2013, growth has faltered to just 1.9%. Based on the latest 2013 figures, total private and public debt amounted to $58.2 trillion or 344% of GDP (Chart 3). If the debt to GDP ratio were currently the same as the average from 1871 to 1999, total debt should only amount to $30.5 trillion, or almost half of the existing level. The debt to GDP ratio declined since peaking in 2009 but not sufficiently to re-enter the normal range. Moreover, the ratio resumed its upward trend in 2013. Thus, the U.S. appears to be following the Japanese example of trying to cure an indebtedness problem by accumulating more debt.

Scholarly research conducted in the U.S. and Europe over the past three years indicates that existing levels of government debt relative to GDP have reached the point that historically have produced a deleterious effect on economic growth. In the past this effect has lasted two decades or longer. As termed by European researchers, the current levels have reached the “non-linear zone”. This means that the negative effects on growth are likely to intensify as this debt ratio moves higher. Ignoring this research is ill advised, especially since the debt levels are advancing. Although the U.S. budget deficit was smaller last year, the more critical debt ratio continued to rise.

According to the Organization for Economic Cooperation and Development (OECD), General U.S. Government Gross Financial Liabilities as a percent of GDP reached 104.1% in 2013, the highest level since the early 1950s (Table 1). (Gross, rather than net, government debt is the appropriate measure; netting out the government debt held in other government accounts is not appropriate since the social insurance trusts have far greater liabilities than they have government securities to fund those future commitments.) By the end of 2015 the OECD projects this figure to jump to 106.5%. Over the next twenty-five years the Congressional Budget Office projects government debt to GDP to move dramatically higher.

Since European fiscal policies mirror those in the U.S., it is not surprising that growth prospects there remain dismal. According to the OECD, General Government Gross Financial Liabilities in the Euro area reached 106.4% of GDP in 2013, up from 95.6% in 2011, an even faster rise than in the United States (Table 1). New research shows that the world average of total public debt, expressed as a percent of global GDP, is approximating its highest level since 1826 (IMF Working Paper WP/13/266, “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten”, December 2013, by Carmen M. Reinhart and Kenneth S. Rogoff). Private debt to GDP in the Euro currency zone and the UK (and interestingly, in Japan) are all higher than in the U.S. and even further above the levels that research has identified as being detrimental to growth.

Monetary Conditions

As discussed in our last quarterly letter, three academic papers presented at the Jackson Hole conference determined that the present approach of quantitative easing by the Federal Reserve has actually slowed economic activity. Three considerations – real interest rates, the money multiplier and the velocity of money – indicate that monetary policy is working against economic growth.

First, monetary policy works primarily through price effects. The level of real interest rates determines the price of credit. In 2013, long-term Treasury bond yields rose 100 basis points, or 1.0%. The inflation rate, measured by the year-over-year change in the Fed’s targeted core personal consumption expenditure deflator, dropped 50 basis points. This pushed the real yield on the thirty-year bond to nearly 3% at the close of 2013. Thus, real yields currently carry a significant premium to the long-term average. The effects of this rising price of credit are visible in the high frequency housing data. Pending and existing home sales in November were below year ago levels. Mortgage applications for home purchases in December were at their lowest level in more than a decade.

Second, the money multiplier, which reflects the conversion of bank reserves into deposits (money) by the banking system, fell to a new 100 year low of less than 3 in late December 2013. This is an indication that the Fed’s Large Scale Asset Purchases (LSAP) are not currently producing real, tangible economic effects and are not likely to in the future. Since 1913, $1 of high-powered money has, on average, resulted in an increase of $8.20 of M2 (Chart 4). The current multiplier constitutes an unprecedented historical gap. To begin the process of accelerating economic growth from a monetary perspective, an increase in the multiplier would be necessary. The best indicator of whether this process is working would be the expansion of bank credit, which includes bank investments and bank loans. Unfortunately, the expansion of total bank credit is only 2.0% higher than a year ago, and bank loans have expanded by only 1.9%. In spite of the Fed’s massive LSAP, M2 expanded at a slightly slower pace in the latest twelve months than it did in 2012.

Third, the even more important velocity of money (V) rejects the argument that monetary policies are gaining traction. Velocity, or the speed at which money turns over, links M2 to the level of nominal economic activity. With the money supply expanding at 5.6% in the latest year, it would be reasonable to expect the same growth rate in nominal GDP if V were stable. Unfortunately, since 1997 velocity has been falling, and in the last twelve months it has dropped by 3% to 1.57, the lowest level in six decades (Chart 4). While velocity is influenced by a myriad of factors, the rate of change of financial innovation and lending for productive purposes affect its direction. If debt generates an income stream that repays principal and interest and creates other activities, it will tend to expand economic activity and cause V to rise. Student, auto and other loans for consumption (which represent the bulk of the increase in consumer credit in 2013) do not meet the necessary criteria, so debt is merely an acceleration of future consumption. This will tend to inhibit the borrower’s ability to increase consumption in the future. Further, new regulations on our financial industries are discouraging financial innovation, and this will bring further downward pressure on velocity. In 2014, if velocity continues to erode at a 3% pace and money supply continues to grow around 6%, it is reasonable to anticipate that nominal GDP will expand at about a 3% growth rate.

Fiscal Issues

Based on scholarly research, only half of the negative economic impact emanating from the $275 billion 2013 tax increase has been registered. Due to the recognition and implementation lags, the remaining drag on growth from the tax increase will occur this year and again in 2015. Carrying a negative multiplier of 2 to 3, this impact far outweighs the sequester (which is expected to be slightly less in 2014 than in 2013) since the multiplier for government expenditures is zero, if not slightly negative.

An important fiscal policy event for 2014 is the Affordable Care Act (ACA). Healthcare is the largest U.S. industry, comprising 17.2% of the economy in 2012. This is more than twice as large as residential construction, oil and gas exploration and the automotive sectors combined. The scope and scale of ACA may divert energy and activity away from more productive endeavors. The ACA’s employer mandate was waived in 2013, as were similar obligations of labor unions and others, but these waivers expire this year. Firms may have to cut some full time employees to part time, reduce total employment or cut benefits since they lack pricing power to cover these costs. As such, this will place the burden of adjustment on consumers. On January 1, health insurance premiums that target small businesses and individuals were raised. These groups create jobs and are vital for growth, thus even though the amount of the increase is small, this is still a net drag for economic growth. While the ACA is an unprecedented event for which no historical point of comparison exists, history does confirm that substantial increases in government regulation are not a springboard for innovation, the lifeblood of economic activity.

The slow nominal growth rate anticipated for 2014 should continue to put downward pressure on the inflation rate as the insufficiency of demand continues to create highly competitive markets. With slower inflation, lower long-term interest rates are a probable outcome.

Van R. Hoisington
Lacy H. Hunt, Ph.D.

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Things That Make You Go Hmmm: Behold, Politics

 

Gibraltar is a British Overseas Territory.Description: ibraltar.psd

It has an area of 2.6 square miles and juts from the southern tip of the Iberian Peninsula, overlooking the entrance to the Mediterranean Sea. Roughly 30,000 people live in the territory, whose sole distinguishing feature is the very large rock which runs along the eastern edge of the territory and culminates in a dramatic promontory in the northeastern corner.

That’s it there, on the right … see?

Gibraltar was captured by an Anglo-Dutch force in 1704 during the War of the Spanish Succession, in which European countries fought each other over who had the right to succeed King Charles II as ruler of Spain.

Charles (or Carlos) had died without heirs, bringing to its final extinction the mighty House of Habsburg, which had dominated European royalty for three centuries. In his will, Charles had designated his 16-year-old grandnephew Philip, Duke of Anjou, as his successor.

Philip was the grandson of the reigning French king, Louis XIV, the famous “Sun King”; and the prospect of an early 18th-century Franco-Spanish alliance at the heart of Europe was unnerving to others, who saw it as potentially destabilizing the delicate balance of power; and so, as Europeans tended to do in the days before they got around to creating the EU, they opted to fight a war.

This war turned out to be quite the bar brawl, spilling out of Spain and into Germany, the Netherlands, and, somehow, America, as the French and the English fought each other in Florida, New England, Newfoundland (huh?), and Carolina.

(Thankfully, the prospect of an Hollande/Rajoy alliance at the heart of today’s Europe would provoke nothing more than uncontrollable laughter, so Europe is far safer now; but then it was a different world.)

Anyhoo, as part of the Treaty of Utrecht, which ended the Spanish War of Succession in 1713, Spain got a French king after all (Philip V), but he was required to relinquish all future claims by his family on the French throne; various French princelings were forced to give up all present and future claims to the Spanish throne; Savoy was given Sicily; Charles VI of Austria received the Spanish Netherlands, Naples, Sardinia, and most of Milan; Portugal was handed a chunk of the Amazon rainforest … and Great Britain got Gibraltar.

Big whoop!

Personally, if I’d been negotiating the deal, I’d have stuck it out for Naples, Sardinia, and Milan, but … whatever. Gibraltar was better than nothing. Probably.

Funnily enough, as the years have passed, the Spanish have from time to time reasserted their claims to the rocky promontory that juts out from mainland Spain, 80-odd miles southwest of another town annexed (albeitUNofficially) by the British — Marbella. And who can blame them?

Gibraltar is to Spain as Cape Cod is to Massachusetts or Baja is to California — only with more monkeys.

Referenda proposing a return to Spanish sovereignty were held in Gibraltar in 1967 and 2002, and one would have to say that the results could certainly be classified as “conclusive.”

The 1967 referendum on whether to pass under Spanish Sovereignty or remain part of Great Britain left little room for doubt:

Choice

Votes

%

British Sovereignty

12,138

99.64

Spanish Sovereignty

44

0.36

Invalid/Blank Votes

55

-

Total

12,237

100

Registered Voters/Turnout

12,672

95.67

Thirty-five years later, the 2002 referendum, which asked “Do you approve of the principle that Britain and Spain should share sovereignty over Gibraltar?” was equally one-sided:

Choice

Votes

%

No

17,900

98.48

Yes

187

1.03

Valid Votes

18,087

99.51

Invalid/Blank Votes

89

0.49

Total

18,176

100

Voter Turnout

 

87.9

Electorate

 

20,678

Whatever your view on the Gibraltar issue (assuming you can be bothered to have one), it’s pretty hard to argue with 98.48% of the voters in a (supposed) democracy; but with things in Spain being quite tight and Catalonia looking to become a new Gibraltar all of its own, the Rajoy government clearly felt that a little distraction was in order; and so “tensions” in the Strait have escalated in recent months, with Spanish-imposed delays at border crossings that would make Chris Christie’s staff salivate (no need for subterfuge HERE). And, of course, in response quite by coincidence, there have been the requisite “naval exercises” conducted by the British Royal Navy off the coast of “The Rock.”

In early January, however, after the mood had darkened considerably over waiting times to cross the border between the Territory and the Mainland having stretched to four hours (Fort Lee residents, the people of Gibraltar feel your pain), another amazing coincidence occurred when certain diplomatic documents relating to discussions on Gibraltar were declassified by the British Foreign Office. Within these documents detailing exchanges between King Juan Carlos of Spain and the then-British Ambassador to Madrid, Sir Richard Parsons (no relation to Nicholas), was a revelation:

(UK Daily Telegraph): King Juan Carlos of Spain told Britain that Spain “did not really want” Gibraltar back as it would lead to claims from Morocco for Spanish territories in North Africa, newly declassified documents from the 1980s released by the Foreign Office reveal.

The King of Spain admitted privately in a meeting with the then British ambassador to Madrid, Sir Richard Parsons, that it was “not in Spain’s interest to recover Gibraltar in the near future.”

If it did so, “King Hassan would immediately reactivate the Moroccan claim to Ceuta and Melilla,” the monarch, who celebrated his 76th birthday on Sunday, reportedly said during the meeting in Madrid in July 1983.

Fascinating stuff, but that’s not the passage that contains the revelation.

This is:

In a confidential dispatch from Madrid to Geoffrey Howe, the then Foreign Secretary, Ambassador Parsons wrote: “The King emphasised, as he had done with me before, that that requirement was to take some step over Gibraltar which would keep public opinion quiet for the time being.

“It should be clearly understood in private by both governments that in fact Spain did not really seek an early solution to the sovereignty problem.

“If [Spain] recovered Gibraltar, King Hassan of Morocco would immediately activate his claim to Ceuta and Melilla.

“The two foreign ministers should reach a private understanding between each other, differentiating between their actual aim and the methods used to propitiate public opinion on both sides.”

Did you spot it? No?

Well here it is again in slow motion:

“T h e t w o f o r e i g n m i n i s t e r s s h o u l d r e a c h a p r i v a t e 
u n d e r s t a n d i n g b e t w e e n e a c h o t h e r, d i f f e r e n t i a t i n g 
b e t w e e n t h e i r a c t u a l a i m a n d t h e m e t h o d s u s e d t o 
p r o p i t i a t e p u b l i c o p i n i o n o n b o t h s i d e s.”

… and here’s the super-slo-mo close-up frame (if you have 3D glasses, put them on now):

“… P R O P I T I A T E P U B L I C O P I N I O N …”

Let’s go to the dictionary:

pro·pi·ti·ate transitive verb prō-pi-shē-āt :
to make (someone) pleased or less angry by giving or saying something desired

Behold, politics.

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.

140125-01

Thoughts from the Frontline: Forecast 2014: The CAPEs of Hope

 

“Sooner or later everyone sits down to a banquet of consequences.”

– Robert Louis Stevenson

South Africa’s Cape of Good Hope is one of the most dangerous stretches of coastline anywhere in the world, where the warm Agulhas Current (also called the Mozambique Current), rushing down from the Indian Ocean, meets the cold Benguela Current, pushing up from Antarctica. The difference in water temperatures alone is a recipe for legendary storms, but the two opposing ocean currents just so happen to converge where the African Continental Shelf drops off into a deep abyss.

So not only do warm and cold pressure systems converge to create raging tempests, but the underwater topography – together with surging waves from the Indian and Atlantic Oceans and fierce winds from the west – frequently gives rise to rogue waves over 80 feet tall, capable of sinking even the largest supertankers and container ships.

Just imagine how terrifying it must have been for the first maritime explorers to brave such dark and dangerous waters. The mind truly boggles at the courage and daring it took.

In a day and age when superstition abounded, unknown and unmapped places were often said to hide the most terrifying beasts of myth and legend; but rounding the Cape must have been a particularly terrifying experience for any uneducated crew. Portuguese legend warned that the long-imprisoned Titan Adamaster, who was said to have been cast into the stone of Capetown’s Table Mountain, would never allow a captain and crew to pass the Cape without a fight.

Bartholomew Dias is the first European known to have braved the Cape, in 1488 (four years before Columbus stumbled on the Americas in 1492). Sent by Portuguese King John II to find an ocean route to India, Dias was more than 1,000 miles south of the edge of any known map when a storm blew his ship away from the coastline and out to sea. Little is known of his actual voyage, since the records were later destroyed in a fire, but historians believe Dias must somehow have had knowledge of the southeasterly winds that could blow him around the Cape and against the powerful Agulhas Current (the second fastest ocean current in the world) without crashing him against the rocky coastline. Although Dias survived the storm, successfully rounded the Cape, and unequivocally proved the Indian Ocean could be reached by sailing around the southern tip of Africa, he had not planned for such a long and treacherous journey. With supplies running low and the threat of mutiny in the air, Dias was forced to turn back to Portugal – braving the “Cape of Storms” once more on the way home.

But our story continues (building toward the inevitable, if tenuous, economic connection!). The next great Portuguese explorer to round the recently renamed “Cape of Good Hope” (given that positive moniker by Portuguese King John II, who wanted to encourage sailors to risk the voyage – he was one of the original spin doctors) was Vasco da Gama, who consulted closely with Dias in planning the long, hard voyage from Lisbon to India. With Adamaster’s pardon, da Gama successfully sailed around the Cape on the westerly South Atlantic winds Dias had discovered on his first voyage and finally reached Calicut, India, in 1497. Although he eventually died in India, da Gama had finally opened the trade route that European merchants had desperately sought.

Dias was not so lucky. Illustrating the soon to be learned 50-50 odds of challenging the Cape of Storms, Dias did not survive his second voyage. After voyaging to Brazil, the intrepid explorer crossed the South Atlantic Ocean on a follow-up expedition to India – and sailed right into a terrible storm just off the same Cape that had almost claimed his life a decade earlier. Four ships disappeared beneath the waves, and Adamaster had evened the score.

In the years that followed, more than two million Dutch settlers attempted to round the Cape of Good Hope, and more than one million of them fell victim to the high waves, violent storms, and nearly impossible navigating conditions. Naturally, such cataclysmic death and destruction gave rise to another dark myth: the Flying Dutchman.

Now, leaving both historical and supernatural tales aside, let’s turn to another CAPE that is deserving of exploration – and that may be signaling danger. As we will see in the pages ahead, buy-and-hold investors are clearly sailing in dangerous waters, where the strong, cold current of deleveraging converges with the warm, fast rush of quantitative easing. Not only does this clash of forces create the potential for epic storms and fateful accidents, it dramatically increases the chances for sudden loss as rogue waves crash unwary investment vehicles against the underwater demographic reef!

Yes, the equity markets are an increasingly treacherous environment, but investors have an opportunity to diversify away from historically expensive equity markets into other asset classes that respond differently to changing economic conditions, and into other countries that may experience very different economic outcomes in the years ahead.

(Please note that this letter will print rather long as there are more than the usual number of charts.)

The Second Most Expensive Stock Market in the World

Last week’s letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE). Unlike the more common trailing 12-month P/E ratio, Shiller’s CAPE smooths out the earnings series and helps us avoid what could be false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past 10 years. Historically, this range has peaked and given way to major market declines at around 29x on average (26x excluding the dot-com bubble), and it has usually bottomed in the mid-single digits. Except for relatively brief windows during the late 1920s, the late 1990s, and the mid-2000s, Shiller’s CAPE ratio has never been as expensive as it is today (see chart below).

As you can see, the S&P 500′s high and rising CAPE ratio signals that US stocks are sailing into a well-proven danger zone. Also note that if we get a repeat of the stock market prior to 2007, the market can stay at this elevated range long enough to make investors complacent.

Not only does today’s CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week. Today’s CAPE is just slightly less expensive than the 27x level seen at the October 2007 market peak and modestly below the level seen before the stock market crash in 1929. Although we are nowhere near the all-time “stupid” valuation peak of 43x in March 2000, a powerful narrative drove the markets to clearly unsustainable levels 15 years ago and a powerful narrative is driving markets today. Then it was the myth of dotcom and new tech, and now it is the tale of QE and the Fed.

Unfortunately, the outlook for US stocks only looks more daunting when we examine CAPE ratios for foreign equity markets. Mebane Faber, chief investment officer of Cambria Investments and author of The Ivy Portfolio (2009) and Shareholder Yield (2013), regularly posts international CAPE updates to his research blog, The Idea Farm (www.theideafarm.com). Meb was kind enough to let me reprint his year-end 2013 update here.

A quick look reveals that the S&P 500 is the second most expensive stock market in the world today on both an absolute and a relative basis, second only to that of tiny Sri Lanka.

Expanding on recent valuations, Meb’s work highlights that the relationship between CAPE valuation and subsequent returns is still very much intact. This next table compares the relative returns of the most expensive and cheapest markets. Study it carefully.

On average, the cheapest 10 markets as 2013 opened returned over 21% last year, while the most expensive 10 markets lost more than 5%. This is just one year, but we would expect to see the same basic relationship over the course of the next decade, if history is a reliable guide. I want to draw your attention to a fascinating observation: look at the outliers.

Russian stocks lost almost 1% in 2013, despite showing the fourth lowest CAPE at the beginning of the year. That’s not a huge surprise. Valuations tell us a lot about long-term potential returns but not much about short-term timing. Momentum works until it doesn’t.

US stocks tell quite a different story. They returned over 30% last year, despite starting 2013 with the sixth highest CAPE valuation. Rather than reversing course in the face of sluggish earnings growth, CAPE multiples expanded from 21.1x to 25.4x. By comparison, every market that started 2013 with more expensive CAPEs than the US’s saw notable reversals of fortune, especially the top three: Peru’s CAPE fell from 33.7x to 19.7x; Colombia’s fell from 33.5x to 23.9x; and Indonesia’s fell from 24.7x to 20.1x.

The impressive thing about US stocks is not simply that positive sentiment and Fed liquidity continued to drive valuations higher, but that the market rallied as much as it did with very modest earnings in the face of historically dangerous valuations. I have said it before, and I will say it again: Sentiment, rather than fundamentals, is driving the US stock market, and sentiment can quickly reverse.

Since we have no idea when the inevitable correction will come, we must expect it at any time. Shiller’s CAPE can keep rising longer than any of us expect in the United States, but no one should be surprised if it corrects next week, next month, or next year. My friend, all-star analyst, and Business Insider Editor-In-Chief Henry Blodget makes a compelling point: Anyone who thinks we need a ‘catalyst’ for a market crash should brush up on their history… There was no ‘catalyst’ in 1929. Or 1966. Or 1987. Or 2000. Or 2008…”

So let’s take Henry’s advice and brush up on our history…

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.

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Thoughts from the Frontline: Forecast 2014: The CAPEs of Hope

 

“Sooner or later everyone sits down to a banquet of consequences.”

– Robert Louis Stevenson

South Africa’s Cape of Good Hope is one of the most dangerous stretches of coastline anywhere in the world, where the warm Agulhas Current (also called the Mozambique Current), rushing down from the Indian Ocean, meets the cold Benguela Current, pushing up from Antarctica. The difference in water temperatures alone is a recipe for legendary storms, but the two opposing ocean currents just so happen to converge where the African Continental Shelf drops off into a deep abyss.

So not only do warm and cold pressure systems converge to create raging tempests, but the underwater topography – together with surging waves from the Indian and Atlantic Oceans and fierce winds from the west – frequently gives rise to rogue waves over 80 feet tall, capable of sinking even the largest supertankers and container ships.

Just imagine how terrifying it must have been for the first maritime explorers to brave such dark and dangerous waters. The mind truly boggles at the courage and daring it took.

In a day and age when superstition abounded, unknown and unmapped places were often said to hide the most terrifying beasts of myth and legend; but rounding the Cape must have been a particularly terrifying experience for any uneducated crew. Portuguese legend warned that the long-imprisoned Titan Adamaster, who was said to have been cast into the stone of Capetown’s Table Mountain, would never allow a captain and crew to pass the Cape without a fight.

Bartholomew Dias is the first European known to have braved the Cape, in 1488 (four years before Columbus stumbled on the Americas in 1492). Sent by Portuguese King John II to find an ocean route to India, Dias was more than 1,000 miles south of the edge of any known map when a storm blew his ship away from the coastline and out to sea. Little is known of his actual voyage, since the records were later destroyed in a fire, but historians believe Dias must somehow have had knowledge of the southeasterly winds that could blow him around the Cape and against the powerful Agulhas Current (the second fastest ocean current in the world) without crashing him against the rocky coastline. Although Dias survived the storm, successfully rounded the Cape, and unequivocally proved the Indian Ocean could be reached by sailing around the southern tip of Africa, he had not planned for such a long and treacherous journey. With supplies running low and the threat of mutiny in the air, Dias was forced to turn back to Portugal – braving the “Cape of Storms” once more on the way home.

But our story continues (building toward the inevitable, if tenuous, economic connection!). The next great Portuguese explorer to round the recently renamed “Cape of Good Hope” (given that positive moniker by Portuguese King John II, who wanted to encourage sailors to risk the voyage – he was one of the original spin doctors) was Vasco da Gama, who consulted closely with Dias in planning the long, hard voyage from Lisbon to India. With Adamaster’s pardon, da Gama successfully sailed around the Cape on the westerly South Atlantic winds Dias had discovered on his first voyage and finally reached Calicut, India, in 1497. Although he eventually died in India, da Gama had finally opened the trade route that European merchants had desperately sought.

Dias was not so lucky. Illustrating the soon to be learned 50-50 odds of challenging the Cape of Storms, Dias did not survive his second voyage. After voyaging to Brazil, the intrepid explorer crossed the South Atlantic Ocean on a follow-up expedition to India – and sailed right into a terrible storm just off the same Cape that had almost claimed his life a decade earlier. Four ships disappeared beneath the waves, and Adamaster had evened the score.

In the years that followed, more than two million Dutch settlers attempted to round the Cape of Good Hope, and more than one million of them fell victim to the high waves, violent storms, and nearly impossible navigating conditions. Naturally, such cataclysmic death and destruction gave rise to another dark myth: the Flying Dutchman.

Now, leaving both historical and supernatural tales aside, let’s turn to another CAPE that is deserving of exploration – and that may be signaling danger. As we will see in the pages ahead, buy-and-hold investors are clearly sailing in dangerous waters, where the strong, cold current of deleveraging converges with the warm, fast rush of quantitative easing. Not only does this clash of forces create the potential for epic storms and fateful accidents, it dramatically increases the chances for sudden loss as rogue waves crash unwary investment vehicles against the underwater demographic reef!

Yes, the equity markets are an increasingly treacherous environment, but investors have an opportunity to diversify away from historically expensive equity markets into other asset classes that respond differently to changing economic conditions, and into other countries that may experience very different economic outcomes in the years ahead.

(Please note that this letter will print rather long as there are more than the usual number of charts.)

The Second Most Expensive Stock Market in the World

Last week’s letter focused on my 2014 outlook for the US stock market and highlighted an important, but controversial, measure for long-term valuations: Robert Shiller’s cyclically adjusted price-to-earnings ratio (CAPE). Unlike the more common trailing 12-month P/E ratio, Shiller’s CAPE smooths out the earnings series and helps us avoid what could be false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past 10 years. Historically, this range has peaked and given way to major market declines at around 29x on average (26x excluding the dot-com bubble), and it has usually bottomed in the mid-single digits. Except for relatively brief windows during the late 1920s, the late 1990s, and the mid-2000s, Shiller’s CAPE ratio has never been as expensive as it is today (see chart below).

As you can see, the S&P 500′s high and rising CAPE ratio signals that US stocks are sailing into a well-proven danger zone. Also note that if we get a repeat of the stock market prior to 2007, the market can stay at this elevated range long enough to make investors complacent.

Not only does today’s CAPE of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years coupled with sluggish earnings growth suggests that this market is also seriously overbought, as I pointed out last week and as we are seeing play out this week. Today’s CAPE is just slightly less expensive than the 27x level seen at the October 2007 market peak and modestly below the level seen before the stock market crash in 1929. Although we are nowhere near the all-time “stupid” valuation peak of 43x in March 2000, a powerful narrative drove the markets to clearly unsustainable levels 15 years ago and a powerful narrative is driving markets today. Then it was the myth of dotcom and new tech, and now it is the tale of QE and the Fed.

Unfortunately, the outlook for US stocks only looks more daunting when we examine CAPE ratios for foreign equity markets. Mebane Faber, chief investment officer of Cambria Investments and author of The Ivy Portfolio (2009) and Shareholder Yield (2013), regularly posts international CAPE updates to his research blog, The Idea Farm (www.theideafarm.com). Meb was kind enough to let me reprint his year-end 2013 update here.

A quick look reveals that the S&P 500 is the second most expensive stock market in the world today on both an absolute and a relative basis, second only to that of tiny Sri Lanka.

Expanding on recent valuations, Meb’s work highlights that the relationship between CAPE valuation and subsequent returns is still very much intact. This next table compares the relative returns of the most expensive and cheapest markets. Study it carefully.

On average, the cheapest 10 markets as 2013 opened returned over 21% last year, while the most expensive 10 markets lost more than 5%. This is just one year, but we would expect to see the same basic relationship over the course of the next decade, if history is a reliable guide. I want to draw your attention to a fascinating observation: look at the outliers.

Russian stocks lost almost 1% in 2013, despite showing the fourth lowest CAPE at the beginning of the year. That’s not a huge surprise. Valuations tell us a lot about long-term potential returns but not much about short-term timing. Momentum works until it doesn’t.

US stocks tell quite a different story. They returned over 30% last year, despite starting 2013 with the sixth highest CAPE valuation. Rather than reversing course in the face of sluggish earnings growth, CAPE multiples expanded from 21.1x to 25.4x. By comparison, every market that started 2013 with more expensive CAPEs than the US’s saw notable reversals of fortune, especially the top three: Peru’s CAPE fell from 33.7x to 19.7x; Columbia’s fell from 33.5x to 23.9x; and Indonesia’s fell from 24.7x to 20.1x.

The impressive thing about US stocks is not simply that positive sentiment and Fed liquidity continued to drive valuations higher, but that the market rallied as much as it did with very modest earnings in the face of historically dangerous valuations. I have said it before, and I will say it again: Sentiment, rather than fundamentals, is driving the US stock market, and sentiment can quickly reverse.

Since we have no idea when the inevitable correction will come, we must expect it at any time. Shiller’s CAPE can keep rising longer than any of us expect in the United States, but no one should be surprised if it corrects next week, next month, or next year. My friend, all-star analyst, and Business Insider Editor-In-Chief Henry Blodget makes a compelling point: Anyone who thinks we need a ‘catalyst’ for a market crash should brush up on their history… There was no ‘catalyst’ in 1929. Or 1966. Or 1987. Or 2000. Or 2008…”

So let’s take Henry’s advice and brush up on our history…

Who’s Got Your Risk?

Average 60/40-type investors unknowingly concentrate over 90% of their portfolio risk in stocks and typically allocate over 80% of their stock portfolio to their home market. Consequently, most US-based investors are incredibly exposed to US equities and could suffer life-altering losses in the event of 1929- or 1987-style stock market crash. No one believed such an event was possible back then or in 2000 or 2006.

As you can see in chart above, large losses are exponentially more damaging than small losses. It takes only an 11% return to recover from a 10% drawdown and a 25% return to recover from a 20% drawdown. These kinds of losses are manageable for disciplined, long-term investors; but recovery from larger losses is far more demanding. For example, it takes a 100% return just to recover from a 50% drawdown and a 300% return to recover from a 75% loss. The numbers can get out of hand in a hurry, and most investors have no idea how much of their future depends on the health of just one market, within just one asset class.

With the average investor’s total lack of diversification in mind, I want to spend a few minutes exploring a seeming contradiction in the markets. This week I was in Canada at three CFA forecast dinners and heard my fellow speakers generally forecast much higher interest rates for the US bond market in particular and the world in general. And everyone was bullish. (The consensus forecast for the S&P 500 from the college student contingent at the CFA dinner in Regina was 2300. You have to admire youthful exuberance!)

Look at the chart below. Note that even with the recent rise in 10-year bond yields, those yields are still historically low, punishing savers and distorting comparable stock market valuations.

Yet, even as low interest rates drive a reach for yield in the US and other developed markets, commodities and emerging markets may be signaling a global slowdown. In fact, most of the predictions for global growth this year make heavy assumptions that the developed markets will pick up the pace.

The question on everybody’s mind is, how much of the rise in market valuations has been due to the expansion of central bank balance sheets in the developed world? Rather than seeing inflation in the prices of things we buy, are we seeing inflation in assets? (And more on inflation in a minute.)

Greg Weldon highlighted the problem extremely well in last week’s Outside the Box. If you haven’t read it, you should. Among other things, he points out that the Federal Reserve’s holdings of US treasuries have been rising dramatically while foreign holdings have gone flat. The central banks of the world are not aggressively selling US treasuries, but they are either directly saying or clearly demonstrating that their appetite to increase their holdings of US treasuries is sated.

Greg asked the question, “As the Federal Reserve begins to taper, who will buy the almost $4 trillion of US treasuries that will have to be sold this year?” Much of it will be simply rolled over, of course, but there will still be $500 billion at a minimum (depending on the extra losses from Obamacare, which are beginning to mount) of new money that will have to be found. Greg thinks the natural direction for interest rates is up, and almost everyone seems to agree.

The problem is that interest rates generally have a very tight relationship with inflation. I get that measuring inflation is subjective, but by almost any measure inflation is extraordinarily low given the amount of money that central banks have injected into the economy. We are in a deflationary, deleveraging world where the bias to inflation is down. From one perspective, it is only the massive amount of central bank printing that has been able to give us even the modest inflation we have today. And by the Federal Reserve’s preferred inflation model, inflation is basically zero, as the chart below shows.

Even if you use the more standard CPI inflation, the year-over-year increase has fallen to 1.5%; and given that the direction of gasoline prices is probably down, the bias for the future is even lower.

For interest rates to rise much from here, either inflation needs to pick up, or there must be a disconnect between the normal relationship between inflation and interest rates. This is just one of the reasons that analysts like Lacy Hunt continue to believe that the longer-term bias for interest rates is down.

So, an actual forecast? With the caveat that I don’t have a real clue but am just trying to make an educated guess? Unless there is something that spikes the price of energy, inflation will stay low, and I think that’s going to be an anchor on the rise in interest rates. Which means that yields will stay down, and the reach for yield that has been so evident in the markets for the past few years will continue to be a dominant factor. That means credit spreads will tighten even further, though that still wouldn’t take them outside historical boundaries.

And those factors give the longer-term direction of the market an upward bias – after we have a correction sometime this year. Are we in the midst of that correction now? Possibly.

Thirty years ago one of my mentors gave me a rule: Mr. Market is a vicious sadist. He will do whatever it takes to create the greatest amount of pain for the largest number of investors. The way that might happen this time around is that we could see a few real corrections, with the market climbing back to ever-new highs after each one, and finally luring in everyone who will be fool enough to reach for that last bit of yield, before there is a really breathtaking correction. I wrote 14 years ago, at the beginning of what I predicted would be a secular bear market, that there are typically three major corrections before we get down to low valuations. We have had two this time around, and I think Mr. Market is setting us up for a third somewhere down the line. At that point valuations all over the world will drop, and it will be time to start talking about a long-term secular bull market.

For now, if you want to play the markets, you might want to look outside of the United States for some potential and pay attention to those markets that are already at low relative valuations. Remember that all markets are going to go down in the next true bear market, but some will go down less than others. Diversification and hedging are the order of the day.

We need to be paying attention to the European bank stress tests, how China deals with its burgeoning bank debt crisis, how the market responds to the actions of the French government to deal with its budget deficit.

But most of all, we need to stay laser-focused on whether tapering by the Fed will have an effect on emerging markets or on US interest rates. This could be the trigger for some very nasty market action. Ambrose Evans-Pritchard, reporting from the World Economic Forum in Davos, had a piece on this topic just yesterday.

We have never been in a situation where the central bank that controls the world’s reserve currency has injected trillions of dollars into the system and then decided (and undecided and then redecided) to reduce those injections. Has the world grown addicted to its QE fix? Or will withdrawal be a nonevent, as many are predicting? I truly hope that the research which suggests that quantitative easing had no real positive additive effect on the markets means that the oh-so-gradual tapering of QE won’t really be noticed.

The simple answer is that no one knows. We are in completely unknown territory, with the FOMC conducting experimental surgery on our economic body without benefit of anesthesia. At the very least, the Fed’s new direction has the potential to increase volatility globally.

At the end of the day I agree with my friend Ben Hunt, who is quite concerned that the narrative surrounding the Federal Reserve could change in the course of tapering. The Fed has been given the lion’s share of the credit for the positive economic results we’ve had coming out of the Great Recession. What happens when that story – what Ben calls the Fed’s narrative – changes? He sent me this note yesterday:

For 20+ years there has been a coherent growth story around Emerging Markets (EM), where the label “Emerging Market” had real meaning within a common knowledge perspective. Today … not so much. Today the story is that it was easy money from the Fed that drove global growth, EM or otherwise. Today the story is that Emerging Markets are just the levered beneficiaries or victims of Fed monetary policy, no different than anyone else….

I’m not asking whether the growth rate in this Emerging Market country or that EM country will meet expectations, or whether the currency in this EM country or that EM country will come under more or less pressure. I’m asking if the WHY of EM growth and currency valuation has changed. The WHY is the dominant Narrative of a market, the set of tectonic plates on which investment terra firma rests. When any WHY is questioned and challenged – as it certainly is in the case of EM markets today – you get a tremor. But if the WHY changes you get an earthquake.

What are the investments that such an earthquake would challenge? You don’t want to be short the yen if this earthquake hits. You don’t want to be long growth or anything that’s geared to global growth, like energy or commodities. You don’t want to be overweight equities and underweight bonds. You don’t want to be overweight Europe. There … did I cover one of your favorite investment themes? Bet I did. You can run from EM’s with US equities, but with S&P 500 earnings driven by non-US revenues, you cannot hide. If you think that your dividend-paying large-cap US equities are immune to what happens in China and Brazil and Turkey … well, good luck with that. My point is not to sell everything and run for the hills. My point is that your risk antennae should be quivering, too.

What Ben is describing is what will happen in the next major bear market. Almost no one thinks that will happen this year. Do you worry when other people are worried? Is the fact that people are seemingly not worried a reason to be concerned? As valuations around the world move up, investors should become more cautious, not less.

I started this letter talking about the Cape of Good Hope, one of the most treacherous stretches of ocean on Earth. And then I managed to segue more or less gracefully (I hope!) into a discussion of CAPE valuations. I don’t think that people who are enthusiastic about this market understand they are getting ready to sail around the investment equivalent of the Cape of Good Hope. Hope, as we well know, is not an investment strategy. The next leg of this journey will require all the planning, preparation, and caution that you can muster. Don’t look now, but the Titan Adamaster is a pussycat compared to Mr. Market.

Join Me in San Diego

Before I close today, let me invite you to join me in San Diego, May 13-16, for my annual Strategic Investment Conference, cohosted with my partners Altegris Investments. Also joining us (so far) will be Niall Ferguson, Kyle Bass, Ian Bremmer, David Rosenberg, Dr. Lacy Hunt, Dylan Grice, David Rosenberg, David Zervos, Rich Yamarone, my Code Red coauthor Jonathan Tepper, Jeff Gundlach, and Paul McCulley, with a few more surprise names waiting to confirm. Nothing but headliners, one after the other.

When I first broached the idea of our conference to Jon Sundt, the founder of cosponsor Altegris, the one rule I had was that I wanted the conference to be one I would want to attend. The usual conference boasts a few headliners, and then the sponsors fill out the lineup. I wanted to do a conference where no speaker could buy his way onto the platform. That means we often lose money on the conference (hard as that may be to imagine, at the price, I acknowledge); however, the purpose is not to make money but to learn with – and maybe have some fun with – great people. We do put on a great show, and my partners make sure it is run well. But the best part will be your fellow attendees. A lot of long-term friendships are forged at this conference. You can learn more and sign up at http://www.altegris.com/sic.

Home Again, Los Angeles, Miami, and Argentina

I arrived home yesterday after a rather tiring four-day, three-city tour of Western Canada. But now I look at the calendar and find that I may be home for nearly four weeks! I can’t remember the last time I was home for four weeks running. Something will probably come up, but until it does I intend to be far more regular with the gym and yoga and to reestablish something that resembles a routine in my life.

At the end of the month I go to Los Angeles and then cross the country to Miami. It looks like I may fit in another quick trip here or there, but I want to invite you to join me in the middle of March for an experience of a lifetime in Argentina’s emerging wine country. A couple of years ago I was invited to visit La Estancia de Cafayate, a unique lifestyle and sporting estate in the up-and-coming wine-producing town of Cafayate in Northwest Argentina. I enjoyed the place so much that I returned again the following year, and I am doing so again March 17-22 in order to participate in the annual Harvest Celebration there.

As a Mauldin Economics subscriber, you are cordially invited to join in the fun in the sun, play some golf, hang out at the world-class spa (an hour-long, fabulous massage works out to about $20), enjoy wine tastings in the town’s many small bodegas, rub elbows with interesting folks at gala dinners and social events, ride horses, tour the area, and generally soak in the rich culture of the Argentine outback. Given the somewhat chaotic nature of Argentina today, the country is on sale, and everything is cheap. It is a fabulous place to go for those seeking a “value vacation.” And Cafayate is in one of the most beautiful settings anywhere in the world. The drive through the canyon (Quebrada del Rio de las Conchas) to get there is simply breathtaking.

In addition, as icing on the cake, there will be a half-day conference featuring yours truly; Bill Bonner, the chairman of Agora Financial; Doug Casey, the original international man; Claudio Maulhardt, a top-performing emerging markets fund manager; Frank Trotter, president of EverBank Direct; and Dr. Ted Harrison, a life extension expert.

The cost of the event is just $350, a real bargain. Which probably explains why the Harvest Celebration at La Estancia de Cafayate always sells out fast – you’ll want to write for more information today. To learn more, drop a line to Chris Leverich, grapevine@LaEst.com.

And Final Thoughts on the Employment Participation Rate

On a final final note, I just picked up an odd factoid from Derek Burleton, vice-president and deputy chief economist of TD Bank Financial Group.

They did an analysis of the precipitously falling US employment participation rate. If Canada had the same participation rate as the US, their unemployment level would be in the 2% range. Now, as I travel around Canada (and with the trip to Regina, Saskatchewan, I have now been in all of the border provinces) I generally don’t see much of a difference in the “feel” of the place as compared to the US, aside from the normal regional quirks you experience anywhere in the Western world. In other words, it mostly feels like home, and other than the weather, it seems like an all-around great place to live.

For there to be such a significant difference in our labor participation rates tells me that something is happening in the US that is not just a seasonal factor or something that will go away when the economy finally returns to a normal growth trajectory somewhere in the future. I am concerned that the difference is systemic in nature, and that makes me uncomfortable. It doesn’t bode well for the return of animal spirits and growth.

And on that somber note, I will hit the send button. Have a great week.

Your off to the gym again analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

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The United States: Are the Seeds Already Sown for the Next Macro-Market Deflation Crisis?

 

Greg Weldon has long been my favorite slicer and dicer of data – his charts and insights on charts really help me keep my eyes peeled. But in order to get across to us the drastic state of the economy as we plunge headlong into 2014 – a year that we all know will be pivotal – Greg has felt it necessary to resort to a rather trenchant metaphor from the year just past. Yes, says Greg, the economy is … Breaking Bad.

But – listen up now – bad is now good. At least temporarily.

Good, because bad macroeconomic data means an ongoing (if slightly tapering) supply of monetary steroids (Greg’s term) will be forthcoming from our pushers, the central banks of the developed world.

Greg reminds us that the “Breaking Bad Era” actually got underway decades ago. He traces its history back to pre-WWII manipulation of the bullion market; to the historic post-WWII Bretton Woods agreement that gave the US currency “seigniorage,” thus setting it up to become the world’s reserve currency; and right on through to the closing of the gold window by Richard Nixon in 1971.

Since then, the US economy has been dependent on steady – and of course ever-growing – doses of monetary steroids, with only one brief drug-free stint in the Paul Volcker Rehabilitation Center in the 1980s.

And of course the Greenspan Fed did try to do the tighten-up from time to time; but each attempt brought greater pain during withdrawal … and the ever-compassionate Dr. Greenspan took pity on us and increased our monetary prescription.

Now, Greg really socks it to us (and we haven’t even gotten to those charts yet … but we will):

Who, even a short ten years ago, would have ever thought that the most popular shows on US television would be about hero-serial-killers and methamphetamine ‘cooks’?? We could extrapolate to suggest that this reflects the intensifying socio-economic impact of the secular trend related to the polarization of wealth, the expanding production-output efficiency generated by technology, the rise in the level of poverty in the US, and the increased social unrest evidenced by ever more incidents of seemingly random, premeditated violence.

The story line in the award-winning US television show Breaking Bad is ‘Milton-esque’, in that it explores the internal war between good and evil as manifest within the lead character, a high school chemistry teacher who contracts brain cancer. In need of money to pay bills that his health insurance will not cover, the teacher turns to the nefarious underworld of ‘cooking’ crystal-meth.

Greed leads to violence, which in turn leads to chaos and intensifying desperation. Ultimately, things spin out of control, as the teacher-turned-meth-cook finds it impossible to maintain a balance between family values and the ruthlessness of his business.

Therein lies the analogy, as the global situation finally reached the desperation point and threatened to spiral out of control in 2008-09 … when withdrawal from Fed monetary tightening led to organ failure in the housing market, which nearly spilled over into the banking system, [leaving] the US economy perilously close to ‘death’.

We are tempted to say that the US has been in and out of a coma ever since, in the sense that “real” reflation remains flat-lined. 

You get the picture.

But now Greg wants us to dig even deeper. Yes, the Fed has “saved” the banking system – for now. And yes, the Fed has refloated the US consumer – on the bloated back of the stock market. (“Note,” says Greg, “the exceptionally ‘tight’ positive-correlation between the Fed’s Balance Sheet, the US S&P 500 stock index, and US Household Net Worth” – great chart follows.)

But in doing all this saving of the economy from itself, Greg wants to argue, the Fed has already sown the seeds of the next macro-market deflationary wave. So let’s give Greg the floor and let him paint the Big Bad Picture for 2014. And be sure to catch his special offer for Outside the Box readers, at the end.

I write this note from Vancouver where I will shortly be speaking to the local CFA organization before traveling on to Edmonton and Regina to speak for their respective CFA groups. I came in to Vancouver early yesterday so that I could finally get the opportunity to meet Frank Giustra, one of the more storied and colorful names in the natural resources field. We have many mutual friends who had been suggesting we get together. The son of an immigrant miner, he is one of those wonderful rags to riches stories that you see from time to time.

Frank hosted a small dinner at his home. Randomly, there was a natural resources conference going on in Vancouver the same day, so Frank was able to get decades-long friend Frank Holmes of US Global to come along, as well as my business partner Olivier Garret, energy maven and speculator Marin Katusa, and a few others. It was one of those special nights where the conversation flowed vibrantly from one topic to the next. Of course we talked about natural resources, but also about robotics and the still-approaching Singularity, the future of work, and the nature of progress – etc. For those who aren’t familiar with Frank, he made most of his money investing in natural resources, was also a founder of the movie production giant Lionsgate, and is a running buddy of Bill Clinton’s. So naturally the talk turned to politics and movies. (Turns out Frank just purchased half the rights to Blade Runner, which may be my pick for all-time best science fiction movie. I am ready for an updated remake!)

Vancouver is one of the most beautiful cities I get to visit. The weather has been spectacular, although I’m told it will turn cold just about as soon as I head east to Edmonton and Regina.

(Wow! I just got word that my old friend Ross Beatty is in town and would like to get together. It’s been a long time. I first met him in the ’80s when he was trying to figure out how to get a little silver out of the ground. I understand that he’s made a few billion here or there in the meantime, mining all sorts of minerals and creating lots of wealth for his investors. Ross Beatty was always and still is a winner. It will be fun to catch up.)

You have a great week and stay warm.

You’re looking for his Under Armor gear analyst,

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

 

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Fourteen-For-Fourteen

Fourteen Macro-Market Trading Themes to Watch For During 2014

A Preview of Our Number-One Theme: The United States

The United States: Are the Seeds Already Sown for the Next Macro-Market Deflation Crisis?

We recently finished our 2014 outlook piece entitled “Fourteen-For-Fourteen”, with fourteen separate macro-market ‘trading themes’, all of which offer numerous specific ways in which to participate in a broad and diversified batch of global markets. Our coverage extends from stock indexes, individual equities, ETFs and ETNS, foreign exchange, fixed-income, precious and industrial metals, energy, and agricultural commodities, sectors we discuss every day in our Weldon LIVE research publication.

I have teamed up with my golf buddy John Mauldin to offer a slice (no pun intended) of our first, and perhaps most important, macro-market trading-theme for 2014, as it relates to US Federal Reserve policy, the US consumer, the US stock market, and US Bonds.

(Details on how to get our “Fourteen-For-Fourteen“, at a special, discounted, Outside the Box price, can be found at the end of our preview.)

We begin with a headline that caught my eye the other morning, culled from Bloomberg …

… “India’s SENSEX rose 1.8 percent today, the most in three weeks, after an unexpected drop in factory output spurred optimism that the central bank will not raise interest rates.”

We might call this the ‘Breaking Bad Era’.

Bad is now good.

Good, because bad macro-data means … a continued flow of monetary steroids from Central Banks.

Indeed, whether it be India, the UK, Japan, the EU, or the US, bad economic data is celebrated, as is so grossly evidenced by the reaction seen on television, amid stock market exuberance and the resultant extension in net worth/wealth reflation.

Indeed, just like any addict, the global markets, not to mention the underlying global macro-economy, have come to RELY ON a steady dose of monetary steroids, without which withdrawal kicks in, muscle atrophy intensifies, and eventually organ failure ensues.

We see this already, within the US labor market … atrophy without a steady, if not ever increasing, dose of monetary “roids”.

Our regular readers know that we have been all over this ‘theme’ for years.

In my book “Gold Trading Boot Camp” (Nov-2006) I examined the then-intensifying trend towards a blow-out in the massive credit bubble in US Housing facilitated by the Fed’s response to the 1997-98 global crisis, and the 2000-01 tech-bubble-bursting crash. I laid out the scenarios in which the Federal Reserve would need to ride their monetary white-horse to the rescue, to avert a full-blown credit crash and debt deflation …

… by conducting outright purchases of US Treasury securities.

Even as late as 2006, anyone opining such a blasphemous thought was considered a monetary heretic. 

Now the history books are being ‘re-written’, while the un-written mandate of the US Federal Reserve and other global Central Banks  has subtly-yet-significantly shifted, exactly as we said it would way back in the nineties, from preventing a repeat of the 1970′s inflation, to circumventing a full-blown debt deflation and macro-economic depression.

We said quite blatantly, two decades ago, that … “someday the Fed will pursue inflation.”

Blasphemy !!! Pure monetary heresy !!!

Now it’s called the “new normal”.

But, as we laid-out in “Gold Trading Boot Camp”, what we now call the ‘Breaking Bad Era’ began decades ago.

We traced the history back to pre-WWII manipulation of the bullion market, the historic post-WWII Bretton Woods agreement that gave the US currency ‘seigniorage’, thus setting it up to become the ‘world’s reserve currency’, right through to the closing of the Gold window by US President Richard Nixon in August of 1971, the spark that truly started this ‘fire’.

The US macro-market has been taking monetary steroids since 1971, with a brief stint spent ‘drug free’, while residing in the Paul Volcker rehab center.

Each successive tightening brings greater pain during withdrawal, which then drives Central Bankers to increase the monetary dosage, to the point where the once unthinkable has occurred, and the Assets Held Outright by the Fed will balloon to more than $4 trillion, most of which is held in US government debt.

Indeed, consider this … who, even a short ten-years ago, would have ever thought that the most popular shows on US television would be about hero-serial-killers and methamphetamine ‘cooks’ ?? We could extrapolate to suggest that this reflects the intensifying socio-economic impact of the secular trend related to the polarization of wealth, the expanding production-output efficiency generated by technology, the rise in the level of poverty in the US, and the increased social unrest evidenced by evermore incidents of seemingly random, pre-meditated violence.

The story line in the award-winning US television show “Breaking Bad” is ‘Milton-esque’, in that it explores the internal war between good and evil as manifest within the lead character, a high school chemistry teacher who contracts brain cancer. In need of money to pay bills that his health insurance will not cover, the teacher turns to the nefarious underworld of ‘cooking’ crystal-meth.

Greed leads to violence, which in turn leads to chaos and intensifying desperation. Ultimately, things spin out of control, as the teacher-turned-meth-cook finds it impossible to maintain a balance between family values, and the ruthlessness of his business.

Therein lies the analogy, as the global situation finally reached the desperation point, and threatened to spiral out of control in 2008-09 … when withdrawal from Fed monetary tightening led to organ failure in the housing market, which nearly spilled over into the banking system, putting the US economy perilously close to ‘death’.

We are tempted to say that the US has been in and out of a coma ever since, in the sense that “real” reflation remains flat-lined. 

Yet, there have been some bright spots, some limb movements and facial expressions emanating specifically from the US consumer, and from corporate America as it relates to streamlined efficiency and increased competitiveness.

The Fed successfully ‘saved’ the banking system, for now.

The Fed successfully kept the US consumer afloat.

Moreover, the Fed has facilitated an unprecedented reflation in US Net Worth. But, this reflation comes in PAPER wealth, NOT wage-income, which is still glaringly lacking.

Witness the chart below plotting the path of US Household Net Worth, which has spiked to a new all-time high, with a near-$22 trillion expansion from the 2009 secular crisis low.

But in so doing, we could argue that the Fed has already sown the seeds for the next macro-market deflationary wave.

We can directly connect the dots.

It all starts with Fed purchases of government debt …

… which has led to the reflation in the US equity market …

… almost single-handedly generating a huge expansion in US Net Worth.

From there we can continue to draw a straight-line to the fact that the strongest improvement within the underlying macro-economy has been seen specifically in sentiment-derived numbers …

… which leads us directly to the virtually unnoticed renewed blow-out in US consumer credit…

… which has ‘funded’ the robust recovery in retail sales and US final household demand.

And finally, it is an easy link to the upside outperformance and leadership exhibited in the stock market since the advent of QE, by the Consumer Discretionary sector.

Note the exceptionally ‘tight’ positive-correlation between the Fed’s Balance Sheet, the US S+P 500 stock index, and US Household Net Worth, as evidenced in the overlay chart below. Indeed, since the advent of QE-III the movements of the US stock market and the Fed’s Balance Sheet have become almost identical.

With US Households ‘feeling’ STRONG thanks to massive injections of monetary steroids, and a renewed feeling of invincibility among stock market investors, consumers are flexing their muscles by borrowing significant amounts of ‘cash’.

We offer hard-core data as evidence. As seen in the chart below, we can identify more months of double-digit (as in more than $10 billion) growth in the Fed’s own measure of Consumer Credit over the last three-years, than during ANY other period in the post-WWII timeline.

Note further, that the 5-Year Average of monthly borrowing has almost returned to the pre-2007 crisis highs.

In essence, we can very comfortably argue that the Fed has facilitated another credit-fueled recovery, wherein the US consumer is, again, borrowing aggressively against a collateral base that is ‘defined’ by paper wealth, rather than ‘real’ income growth.

The stock market has replaced the housing market as that collateral base against which the US consumer is now borrowing hand-over-fist.

Yes, there are differences, the ”breadth’ of this ‘reflation’ is not the same as it was with the mortgage market debacle. Banks are (allegedly) not involved, with bank lending growth remaining less than overtly reflationary.

But the similarities are intriguing, if not somewhat frightening, as US households place massive bets, again, that the stock market is in a Nirvana-like, perma-bull market, and that ‘tapering’ is not a threat …

… just like US households placed massive bets that housing prices were incapable of deflating.

Not only that, but tapering has a major impact on the US bond market, with buyers having become increasingly scarce, against which the tide of supply does NOT recede for several years, if even then.

A rise in interest rates that has a negative impact on the US stock market would require another dose of monetary steroids, because the implications of a deflation in stocks would be too significant for the underlying macro-economy to handle.

To simplify, the unwritten mandate of the Fed is now singular; to prevent the stock market from failing.

The greater fear stems from thoughts that the macro-market dynamic has been internally ravaged by years of steroid abuse, and anything less than an increase in ‘roid’ dosage from the Fed may lose its effectiveness in fighting macro-muscle atrophy.

We could say we see evidence of this already, in the expanding and recently developed divergences exhibited within the overlay chart on display below.

Notice how Gold led the charge into QE-II, peaked first, and rolled over first, breaking down, and plunging amid disinvestment and a rotation out of safety, and into risk assets.

Next it was Home Prices, peaking, and most recently … breaking down.

We could add Emerging Market stock indexes, Emerging Market Bond prices, Emerging Market currencies … and … the CRB Index … all of which have followed Gold to the downside, in a GLARING example of the ‘internal atrophy’ taking place, as per the global market’s narrowing response to Fed QE.

Subsequently, we theorize that there is significant risk associated with tapering, particularly when tapering turns into ‘tapping out’, when the Fed reaches the point where they are no longer buying-to-accumulate any assets. There is risk that ‘extends’ to the stock market, for its tight, reliant relationship with the Fed’s Balance Sheet (our detailed “Fourteen-For-Fourteen” digs deeper into this dynamic, with specific ‘predictions’ for the path of the S+P 500 in 2014, based on the pace of tapering).

But more pointedly the risk emanates from the potential impact on US Treasury Bond and Note yields, as a result of an eventual ‘tap out’ by the Fed.

We find it most interesting to observe the overlay chart below in which we plot the Fed’s Assets Held Outright (black line) versus Custody Holdings (foreign official holdings of US Treasury securities, red line). We first focus on the rise in the Fed’s Balance sheet associated with QE-III, during which time bond and note yields in the US have risen.

Secondly, and most importantly, we shine the spotlight on the peak in Custody Holdings, and the DECLINE in 2013. For sure, it is NOT a coincidence that foreign officialdom turned NET SELLERS of US Treasuries in May, precisely on the back of Fed Chair Ben Bernanke’s first mention of ‘taper’.

Demand from foreign officialdom is flat, at best.

The US ‘public’ is not buying bonds.

The US ‘public’ has followed the lead of the Pied Piper Ben Bernanke, the monetary maestro, who has carried the day on his back with some spectacular flute playing, calming the masses, resurrecting confidence, and facilitating a rotation out of safety (bonds, gold) and back into risk assets, stocks specifically.

So, from where will the marginal buyer of US Treasury bonds appear ??

No doubt, there is NO dearth of supply.

We examine the ‘schedule’ of ‘Treasury Obligations’ seen below.

Need we say more ??

A tsunami of Treasury supply, no matter how you slice-and-dice it.

And the Fed is potentially, probably, pulling the plug on a half-trillion a year in ‘support’??

Moreover, that ‘support’ which is to be removed represents pure monetization, actual evaporation of debt (for all intents and purposes).

Tapering to a ‘tap-out’ also means more supply in ‘perpetual roll-over’.

Over the next five-years, that is virtually $2.5 trillion.

When we add the new debt, needed to finance this year’s (fiscal) deficit, well the numbers start to add up very quickly. Yes, seeing the annual US deficit ‘shrink’ (laughter) by half, from $1 trillion, to something closer to $500 billion, could be labeled ‘improvement’. But, just five years ago the current deficits would have been record breaking, and still represent a significant, on-going, supply side issue.

So, who is the ‘marginal’ buyer of US debt ?? Who will help maintain ‘equilibrium’ to where Treasury yields will not rise ??

From a simple supply-demand dynamic, the risk-reward skew is to the upside in bond yields.

Of course things are never simple.

Especially in the Breaking Bad Era, where BAD is GOOD !!!

Evidence last week’s US payroll data … and the hundreds of thousands of chronically unemployed who simply fell out of the ‘equation’. This alone speaks volumes to the dysfunction in the US labor market.

But still, even during any initial ‘positive’ reaction to the ‘negative’ news, we might offer a thought: any macro-economic deflation that is deep enough to sway the Fed, will also have an impact on the fiscal side of this dual-headed coin … most probably towards increased bond supply.

Yet still, some might hypothesize that there is a major difference now, than during the housing-credit-deflation induced event of 2008-09, the banking system was saved, and is now solid.

As evidenced, of course, in this new era … by rising bank share prices.

For sure, banks are more ‘liquid’.

No debate.

Thanks to the Fed, and the Fed only, as is clear upon a survey of the overlay chart below revealing the link in Bank Balance Sheets, a distinctively direct link … to the Fed’s Balance Sheet.

And while bullish for the bank shares, this dynamic is not ‘positive’.

Indeed, only in the ‘Breaking Bad Era’ could this be construed as ‘positive’. But it is not positive, not when it means banks sit on their own mountain of ‘cash’ (aka, US Treasury securities), instead of lending that money.

Moreover, with huge holdings of US Treasuries, In the advent of another deflationary wave banks could well turn net sellers of government debt.

In other words, do not look to US financial institutions to plug any hole that might develop in the US bond market.

Another, less obvious reason that we say the rise in ‘cash’ held by banks is not ‘positive’, has to do with what is happening in the background with Bank Balance Sheets. The level of cash-securities held by US Commercial Banks, about $2.7 trillion, is peanuts compared to the level of risk banks are carrying in terms of ‘Derivative Holdings’.

In fact, as we try to comprehend the figures shown in the chart below, extracted from the FDIC’s Quarterly Banking Profile’s breakdown of Commercial Bank Balance Sheets … we are continually shocked.

Shocked to think that during this period of Fed largesse, during this period where the banks are allegedly healing as they do dispose of some non-performing assets … the risk is rising again, and rising rapidly.

Most troubling is the fact that the vast majority of the rise in, and the total of, Derivative holdings, roughly $225 trillion, yes trillion, are labeled as Derivatives Held for “Trading Purposes”, as opposed to being held for “Hedging Purposes’.

Indeed, it appears that risk and leverage in the banking system is still alive and well. No wonder the biggest banks, who hold the lion’s share of the derivative risk, now carry the moniker of ‘too big to fail.

They are called that because they are, literally … “too big” … specifically as it applies to their holdings of Derivatives for Trading Purposes (again, pegged at $225 trillion).

The simple fact that in the twelve-months ending June-2013 (data release lagged by the FDIC, one reason it goes largely unnoticed), Bank holdings of Derivative contracts linked to ‘trading’(aka profit generation) rose by more than $11 trillion …

… which dwarfs the expansion in Bank cash holdings …

… dwarfs the expansion in Bank Deposits …

… and, even more ‘tellingly’, dwarfs the expansion in the Fed’s Balance Sheet, over that same period, by about ten-to-one.

And most acutely frightening is the fact that the expansion in derivative exposure is most focused in Fixed-Income derivatives, by far, as seen below ($188.3 trillion, yes, trillion, in Fixed-Income contracts alone).

Clearly, the Fed is walking a tightrope.

Again, in our view, the risk-reward skew in the US Treasury market, for 2014, is tilted towards rising yields, which points us in the direction of strategies that accept that premise.

In our “Fourteen-For-Fourteen” we offer an even more detailed look at the US Treasury market specifically, from a technical perspective, and a strategic perspective.

We also take a closer look at the US consumer, household net worth, retail sales, and even gasoline prices, as factors that will play into the US based theme during 2014.

And that, is just our first of fourteen major macro-market themes for 2014, which encompass more than 200 pages of charts, graphs, and data slides covering both fundamental and technical analysis.

It is with a heartfelt thank-you that I nod in the direction of my colleague and conference-golf buddy John Mauldin; the man behind the curtain, Ed D’Agostino; the gang at Mauldin Economics; and my Kiawah Island golf buddy Grant Williams, for their willingness to participate with us in offering this preview of our 2014 Outlook.

Our fourteen market themes for 2014 include careful examinations of the monetary policy challenges faced by multiple Central Banks’ and the potential impact on the bond, FX and stock markets (including Exchange Traded Funds).

We also highlight some very specific currency challenges in some key regions especially as it relates to devaluations and competitive depreciation, and how that will impact the global markets. And, we shine the spotlight on a few very specific metals and energy opportunities with some compelling market charts and inter-market analysis.

Finally, we offer a few commodity plays in line with their underlying supply-demand fundamentals, including focus on the parallel opportunities within the commodity ETN universe.

All fourteen themes have been produced as separate chapters in video form (and come with a printable pdf version), all of which include detailed market charts and audio commentary.

ACT NOW to get all Fourteen Macro Themes at a special discounted rate (over 15% off) for readers of John Mauldin’s Outside the Box.

SEND $249.99 to weldon.macro.research@gmail.com via www.paypal.com

Or email eileen@weldononline.com and get special access now.

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© 2013 Mauldin Economics. All Rights Reserved.
Outside the Box 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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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.

140118-00

Thoughts from the Frontline: Forecast 2014: “Mark Twain!”

 

Piloting on the Mississippi River was not work to me; it was play — delightful play, vigorous play, adventurous play – and I loved it…

– Mark Twain

In the 1850s, flat-bottom paddlewheel steamboats coursed up and down the mighty Mississippi, opening up the Midwest to trade and travel. But it was treacherous travel. The current was constantly shifting the sandbars underneath the placid, smoothly rolling surface of the river. What was sufficient depth one week on a stretch of the river might become a treacherous sandbar the next, upon which a steamboat could run aground, perhaps even breaching the hull and sinking the ship. To prevent such a catastrophe, a crewman would throw a long rope with a lead weight at the end as far in front of the boat as possible (and thus the crewman was called the leadman). The rope was usually twenty-five fathoms long and was marked at increments of two, three, five, seven, ten, fifteen, seventeen and twenty fathoms. A fathom was originally the distance between a man’s outstretched hands, but since this could be quite imprecise, it evolved to be six feet.

The leadsman would usually stand on a platform, called “the chains,” which projected from the ship over the water, and “sound” from there. A typical sound would be expressed as “By the mark 7,” or whatever the depth was. In modern English language, it is interesting to note that the expression “deep six,” refers to this old method of measuring water. On the Mississippi River in the 1850s, the leadsmen also used old-fashioned words for some of the numbers; for example instead of “two” they would say “twain”. Thus when the depth was two fathoms, they would call “by the mark twain!” (bymarktwain.com)

And thus a young Samuel Clemens, apprentice Mississippi riverboat pilot, would take the “soundings” and from time to time would sing out the depth of two fathoms as “By the mark twain!” We think that is how he found his pen name. In Life on the Mississippi, Mark Twain describes sounding: “Often there is a deal of fun and excitement about sounding, especially if it is a glorious summer day, or a blustering night. But in winter the cold and the peril take most of the fun out of it.”

The pilot would much prefer to hear the sweet sing-song call of “no bottom,” as that meant there was no danger of running aground. “Mark twain,” or 12 feet, was getting rather shallow for some of the larger vessels and so sounded a note of caution.

On their surface today the markets seem as smooth and flowing as Old Man River, but are there sandbars lurking in the depths? Will the journey this year be as fast and easy as in the last five? Can we plunge on into the night, relishing the call of “No bottom” that we are hearing from the bulls? Or is that a cry of “Mark twain!” telling us to be cautious?

Perhaps we should take our own soundings from the data to see what might lie up ahead. This week, in the third part of my 2014 forecast, we’ll look in particular at the US markets as a proxy for markets in general. (This letter will print a little longer as there are lots of charts.)

But first, I am pleased to announce that my friend former House Speaker Newt Gingrich will be at my conference this May 13-16 in San Diego, joining (so far) Niall Ferguson, Kyle Bass, Ian Bremmer, David Rosenberg, Dr. Lacy Hunt, Dylan Grice, David Rosenberg, David Zervos, Rich Yamarone, Code Red coauthor Jonathan Tepper, Jeff Gundlach, Paul McCulley, and a few more surprises waiting to confirm. Nothing but headliners, one after the other.

When I first broached the idea of our conference with Jon Sundt, the founder of cosponsor Altegris, the one rule I had was that I wanted the conference to be one I would want to attend. The usual conference boasts a few headliners, and then the sponsors fill out the lineup. I wanted to do a conference where no speaker could buy his way onto the platform. That means we often lose money on the conference (hard as that may be to imagine, at the price, I acknowledge); however, the purpose is not to make money but to learn with – and maybe have some fun with – great people. We do put on a great show, and my partners make sure it is run well. But the best part will be your fellow attendees. A lot of long-term friendships are forged at this conference. You can learn more and sign up at http://www.altegris.com/sic.

It’s All About the Earnings

For over a dozen years I have regularly compared notes on S&P 500 earnings with my friend Ed Easterling. For Ed, the subject borders on an obsession. I am, of course, far more reserved in my enthusiasm. We have co-authored numerous articles, and Ed never fails to call to my attention anything unusual that happens on the earnings front. He is the ultimate data wonk, and I say that in an affectionate way. Ed has what I think is one of the best data research sites anywhere at www.crestmontresearch.com. So this week I read his latest email, about the uptick in the forecast earnings of the S&P 500, with considerable interest.

As they do at this time of year, S&P posted an update to their 2014 EPS (earnings per share) forecast. For newbies, “as-reported” earnings are earnings as reported to the tax authorities, and we can more or less think of them as real earnings. “Operating earnings,” on the other hand, are what companies like you to pay attention to. They exclude one-time charges and other things that companies find inconvenient. I call operating earnings “EBIH earnings” – earnings before interest and hype.

S&P conveniently gathers forecasted earnings data from numerous analysts and amalgamates it in one big spreadsheet along with the history of actual earnings. You can access their spreadsheet here. The data we will be looking at will come from the first tab, but there is also a lot of data commentary from Howard Silverblatt, the longtime curator and maven of all things earnings.

The forecast for 2014 as-reported earnings was $106 in late December. Now it’s $119.70 – up 13% from the previous forecast just two weeks ago and up 20% versus the 2013 estimate of $99.42. Since 2013 has concluded, that number will be revised only slightly. Silverblatt says the revised figure is based upon an improved outlook rather than something technical like an accounting change.

The table below is a screenshot from the Excel spreadsheet. Note that, depending on which set of earnings you want to use (and Ed and I prefer to use as-reported as opposed to operating earnings), if the forecasters are right, then the P/E ratio at the end of 2014 will be in the neighborhood of 15, less than the long-term average and down considerably from today’s. This can only be described as a bullish number.

Ed notes in a quick email, which spurred a long telephone conversation, that “The 2015 forecast is still a month or so away – yet just imagine the bull stampede if it comes in +15%. That’ll would take the figure to $138 and a forward “next year” P/E of only 13 when the trailing 20-year Shiller P/E10 is 25.4.”

I would have ended that sentence with an exclamation point (!), but Ed is more even-tempered in his writing. Still, a price-to-earnings ratio of 13, published on the official S&P website for all the world to see, would have the bulls salivating. It would even have me close to “pounding-the-table-bullish,” as a true P/E of 13 is quite favorable for the long term (say, ten years). So should we take the forward-looking view? If that P/E ratio of 13 based on today’s price of the S&P 500 turns out to be the reality, another 30% year is well within the scope of possibilities and might likely be considered the most probable outcome.

And the markets seem to think that will be the case. Lately, it seems every week (and sometimes every day) brings a new all-time high. For fans of Mad magazine, it’s an Alfred E. Newman world: “What? Me worry?” Volatility is back at pre-crisis lows, as the chart below illustrates.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but take heed: prices do not always reflect reality, and analysts’ expectations consistently tend to overstate actual earnings, as you can see in the following graph from a 2010 McKinsey on Finance Study, Equity analysts: Still too bullish. When that graph gets updated next year, we will see that nothing has changed.

For the record, I was citing similar research back in 2003 in my book Bull’s Eye Investing. In fact, there was a whole chapter on the topic of analysts’ estimates. They also tend to be too bearish at market bottoms. Basically, analysts tend to forecast for the near future more of what has happened in the recent past. At turning points they really miss the boat.

If we look at recent years in light of long-term valuations and market behavior, we see that the combination of high and rising valuations, low and suppressed volatility, and a relatively weak trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

The S&P 500 Index returned 32% excluding dividends from January 1, 2012, through January 17, 2014. Over that time frame, real earnings grew by less than 8%…

… while the trailing 12-month price-to-earnings multiple has expanded by nearly 30%, from 12.8x to 17.3x.

That means most of the recent gains in US equity markets have been driven by multiple expansion, in spite of sluggish real earnings growth. Despite an improvement in the real earnings trend since I dug into US stock market valuations, multiple expansion, and earnings last August, the disproportionate amount of gains attributable to multiple expansion versus gains attributable to earnings is a clear sign that sentiment, rather than fundamentals, may be the dominant force driving the markets higher.

Of course, the simple trailing 12-month price-to-earnings ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500′s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, Dr. Robert Shiller’s “cyclically adjusted price-to-earnings ratio” (commonly known as the “Shiller P/E” or “CAPE”) is far more useful for calculating a reasonable range of expected returns going forward.

As I wrote back in August 2013 when the prevailing Shiller P/E sat near 24, this approach won’t help you much with short-term market timing; but current valuations have historically proven extremely useful in forecasting long-term returns. In his book Irrational Exuberance (2005), Dr. Shiller shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

As you can see in in the graph above, compared to the more common trailing 12-month P/E ratio, the Shiller P/E metric essentially smooths out the series and helps us avoid false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past ten years. Historically, this ratio has peaked and given way to major market declines at around 29x on average (or 26x excluding the dot-com bubble), and it has bottomed in the mid-single digits.

Not only does today’s Shiller P/E of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years, coupled with sluggish earnings growth, suggests that this market is also seriously overbought. Today’s markets are just slightly less expensive than the 27x level seen at the October 2007 market peak and are only modestly below the levels seen before the stock market crash in 1929. Although we are nowhere near the all-time “stupid” peak of 43x reached in March 2000, a powerful narrative drove the markets to clearly unsustainable levels then, and a powerful narrative is driving markets today. In many ways, faith in the Federal Reserve today is roughly equivalent to faith in the words dot com in 1999.

While it may be impossible to accurately predict when this policy-driven market will break, history suggests it would be very reasonable for the secular bear to eventually bottom at a P/E multiple between 5x and 10x, opening up one of the rare wealth-creation opportunities to deploy capital at truly cheap prices.

Sometimes we have to wade through what may seem like deceptively dry technical details to sort out compelling conclusions, but I hope you’ll focus on the main idea: We are not talking about the potential for a modest 20% to 30% drawdown in the US stock market. If the historical relationship between Shiller’s P/E and consequent returns is any indication, we are talking about the potential for a 50%+ peak-to-trough drawdown and ten-year average annual returns as bad as -6.1%, according to the chart below from Cliff Asness at AQR. Such a result would fall in line with somewhat similar deleveraging periods such as the United States experienced in the 1930s and Japan has experienced since 1989. There is no way to sugarcoat it: too much equity risk can be unproductive and even destructive in this kind of economic environment.

But where there is danger there is also opportunity. I believe this is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios.

On that front, keep a lookout for a special report that we will release in the next week to share five critical steps you can take to defend your portfolio from economic disasters, bankrupt governments (or governments that are testing their borrowing limits), and increasingly desperate governments. It will be a free report for all Thoughts from the Frontline readers, and we hope you will share it with everyone you know.

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.

Thoughts from the Frontline: Forecast 2014: “Mark Twain!”

 

Piloting on the Mississippi River was not work to me; it was play — delightful play, vigorous play, adventurous play – and I loved it…

– Mark Twain

In the 1850s, flat-bottom paddlewheel steamboats coursed up and down the mighty Mississippi, opening up the Midwest to trade and travel. But it was treacherous travel. The current was constantly shifting the sandbars underneath the placid, smoothly rolling surface of the river. What was sufficient depth one week on a stretch of the river might become a treacherous sandbar the next, upon which a steamboat could run aground, perhaps even breaching the hull and sinking the ship. To prevent such a catastrophe, a crewman would throw a long rope with a lead weight at the end as far in front of the boat as possible (and thus the crewman was called the leadman). The rope was usually twenty-five fathoms long and was marked at increments of two, three, five, seven, ten, fifteen, seventeen and twenty fathoms. A fathom was originally the distance between a man’s outstretched hands, but since this could be quite imprecise, it evolved to be six feet.

The leadsman would usually stand on a platform, called “the chains,” which projected from the ship over the water, and “sound” from there. A typical sound would be expressed as “By the mark 7,” or whatever the depth was. In modern English language, it is interesting to note that the expression “deep six,” refers to this old method of measuring water. On the Mississippi River in the 1850s, the leadsmen also used old-fashioned words for some of the numbers; for example instead of “two” they would say “twain”. Thus when the depth was two fathoms, they would call “by the mark twain!” (bymarktwain.com)

And thus a young Samuel Clemens, apprentice Mississippi riverboat pilot, would take the “soundings” and from time to time would sing out the depth of two fathoms as “By the mark twain!” We think that is how he found his pen name. In Life on the Mississippi, Mark Twain describes sounding: “Often there is a deal of fun and excitement about sounding, especially if it is a glorious summer day, or a blustering night. But in winter the cold and the peril take most of the fun out of it.”

The pilot would much prefer to hear the sweet sing-song call of “no bottom,” as that meant there was no danger of running aground. “Mark twain,” or 12 feet, was getting rather shallow for some of the larger vessels and so sounded a note of caution.

On their surface today the markets seem as smooth and flowing as Old Man River, but are there sandbars lurking in the depths? Will the journey this year be as fast and easy as in the last five? Can we plunge on into the night, relishing the call of “No bottom” that we are hearing from the bulls? Or is that a cry of “Mark twain!” telling us to be cautious?

Perhaps we should take our own soundings from the data to see what might lie up ahead. This week, in the third part of my 2014 forecast, we’ll look in particular at the US markets as a proxy for markets in general. (This letter will print a little longer as there are lots of charts.)

But first, I am pleased to announce that my friend former House Speaker Newt Gingrich will be at my conference this May 13-16 in San Diego, joining (so far) Niall Ferguson, Kyle Bass, Ian Bremmer, David Rosenberg, Dr. Lacy Hunt, Dylan Grice, David Rosenberg, David Zervos, Rich Yamarone, Code Red coauthor Jonathan Tepper, Jeff Gundlach, Paul McCulley, and a few more surprises waiting to confirm. Nothing but headliners, one after the other.

When I first broached the idea of our conference with Jon Sundt, the founder of cosponsor Altegris, the one rule I had was that I wanted the conference to be one I would want to attend. The usual conference boasts a few headliners, and then the sponsors fill out the lineup. I wanted to do a conference where no speaker could buy his way onto the platform. That means we often lose money on the conference (hard as that may be to imagine, at the price, I acknowledge); however, the purpose is not to make money but to learn with – and maybe have some fun with – great people. We do put on a great show, and my partners make sure it is run well. But the best part will be your fellow attendees. A lot of long-term friendships are forged at this conference. You can learn more and sign up at http://www.altegris.com/sic.

It’s All About the Earnings

For over a dozen years I have regularly compared notes on S&P 500 earnings with my friend Ed Easterling. For Ed, the subject borders on an obsession. I am, of course, far more reserved in my enthusiasm. We have co-authored numerous articles, and Ed never fails to call to my attention anything unusual that happens on the earnings front. He is the ultimate data wonk, and I say that in an affectionate way. Ed has what I think is one of the best data research sites anywhere at www.crestmontresearch.com. So this week I read his latest email, about the uptick in the forecast earnings of the S&P 500, with considerable interest.

As they do at this time of year, S&P posted an update to their 2014 EPS (earnings per share) forecast. For newbies, “as-reported” earnings are earnings as reported to the tax authorities, and we can more or less think of them as real earnings. “Operating earnings,” on the other hand, are what companies like you to pay attention to. They exclude one-time charges and other things that companies find inconvenient. I call operating earnings “EBIH earnings” – earnings before interest and hype.

S&P conveniently gathers forecasted earnings data from numerous analysts and amalgamates it in one big spreadsheet along with the history of actual earnings. You can access their spreadsheet here. The data we will be looking at will come from the first tab, but there is also a lot of data commentary from Howard Silverblatt, the longtime curator and maven of all things earnings.

The forecast for 2014 as-reported earnings was $106 in late December. Now it’s $119.70 – up 13% from the previous forecast just two weeks ago and up 20% versus the 2013 estimate of $99.42. Since 2013 has concluded, that number will be revised only slightly. Silverblatt says the revised figure is based upon an improved outlook rather than something technical like an accounting change.

The table below is a screenshot from the Excel spreadsheet. Note that, depending on which set of earnings you want to use (and Ed and I prefer to use as-reported as opposed to operating earnings), if the forecasters are right, then the P/E ratio at the end of 2014 will be in the neighborhood of 15, less than the long-term average and down considerably from today’s. This can only be described as a bullish number.

Ed notes in a quick email, which spurred a long telephone conversation, that “The 2015 forecast is still a month or so away – yet just imagine the bull stampede if it comes in +15%. That’ll would take the figure to $138 and a forward “next year” P/E of only 13 when the trailing 20-year Shiller P/E10 is 25.4.”

I would have ended that sentence with an exclamation point (!), but Ed is more even-tempered in his writing. Still, a price-to-earnings ratio of 13, published on the official S&P website for all the world to see, would have the bulls salivating. It would even have me close to “pounding-the-table-bullish,” as a true P/E of 13 is quite favorable for the long term (say, ten years). So should we take the forward-looking view? If that P/E ratio of 13 based on today’s price of the S&P 500 turns out to be the reality, another 30% year is well within the scope of possibilities and might likely be considered the most probable outcome.

And the markets seem to think that will be the case. Lately, it seems every week (and sometimes every day) brings a new all-time high. For fans of Mad magazine, it’s an Alfred E. Newman world: “What? Me worry?” Volatility is back at pre-crisis lows, as the chart below illustrates.

This kind of news would normally point to prosperity across the real economy and call for a celebration – but take heed: prices do not always reflect reality, and analysts’ expectations consistently tend to overstate actual earnings, as you can see in the following graph from a 2010 McKinsey on Finance Study, Equity analysts: Still too bullish. When that graph gets updated next year, we will see that nothing has changed.

For the record, I was citing similar research back in 2003 in my book Bull’s Eye Investing. In fact, there was a whole chapter on the topic of analysts’ estimates. They also tend to be too bearish at market bottoms. Basically, analysts tend to forecast for the near future more of what has happened in the recent past. At turning points they really miss the boat.

If we look at recent years in light of long-term valuations and market behavior, we see that the combination of high and rising valuations, low and suppressed volatility, and a relatively weak trend in real earnings growth is a proven recipe for poor long-term returns and market instability.

The S&P 500 Index returned 32% excluding dividends from January 1, 2012, through January 17, 2014. Over that time frame, real earnings grew by less than 8%…

… while the trailing 12-month price-to-earnings multiple has expanded by nearly 30%, from 12.8x to 17.3x.

That means most of the recent gains in US equity markets have been driven by multiple expansion, in spite of sluggish real earnings growth. Despite an improvement in the real earnings trend since I dug into US stock market valuations, multiple expansion, and earnings last August, the disproportionate amount of gains attributable to multiple expansion versus gains attributable to earnings is a clear sign that sentiment, rather than fundamentals, may be the dominant force driving the markets higher.

Of course, the simple trailing 12-month price-to-earnings ratio can be misleading at critical turning points if you are trying to handicap the potential for long-term returns. For example, the collapse in real earnings during the global financial crisis sent the S&P 500′s trailing P/E multiple through the roof by March 2009. So, while trailing P/E is a useful tool for understanding what has already happened in the market, Dr. Robert Shiller’s “cyclically adjusted price-to-earnings ratio” (commonly known as the “Shiller P/E” or “CAPE”) is far more useful for calculating a reasonable range of expected returns going forward.

As I wrote back in August 2013 when the prevailing Shiller P/E sat near 24, this approach won’t help you much with short-term market timing; but current valuations have historically proven extremely useful in forecasting long-term returns. In his book Irrational Exuberance (2005), Dr. Shiller shows how this approach “confirms that long-term investors – investors who commit their money to an investment for ten full years – did do well when prices were low relative to earnings at the beginning of the ten years. Long-term investors would be well-advised, individually, to lower their exposure to the stock market when it is high … and to get into the market when it is low.”

As you can see in in the graph above, compared to the more common trailing 12-month P/E ratio, the Shiller P/E metric essentially smooths out the series and helps us avoid false signals by dividing the market’s current price by the average inflation-adjusted earnings of the past ten years. Historically, this ratio has peaked and given way to major market declines at around 29x on average (or 26x excluding the dot-com bubble), and it has bottomed in the mid-single digits.

Not only does today’s Shiller P/E of 25.4x suggest a seriously overvalued market, but the rapid multiple expansion of the last few years, coupled with sluggish earnings growth, suggests that this market is also seriously overbought. Today’s markets are just slightly less expensive than the 27x level seen at the October 2007 market peak and are only modestly below the levels seen before the stock market crash in 1929. Although we are nowhere near the all-time “stupid” peak of 43x reached in March 2000, a powerful narrative drove the markets to clearly unsustainable levels then, and a powerful narrative is driving markets today. In many ways, faith in the Federal Reserve today is roughly equivalent to faith in the words dot com in 1999.

While it may be impossible to accurately predict when this policy-driven market will break, history suggests it would be very reasonable for the secular bear to eventually bottom at a P/E multiple between 5x and 10x, opening up one of the rare wealth-creation opportunities to deploy capital at truly cheap prices.

Sometimes we have to wade through what may seem like deceptively dry technical details to sort out compelling conclusions, but I hope you’ll focus on the main idea: We are not talking about the potential for a modest 20% to 30% drawdown in the US stock market. If the historical relationship between Shiller’s P/E and consequent returns is any indication, we are talking about the potential for a 50%+ peak-to-trough drawdown and ten-year average annual returns as bad as -6.1%, according to the chart below from Cliff Asness at AQR. Such a result would fall in line with somewhat similar deleveraging periods such as the United States experienced in the 1930s and Japan has experienced since 1989. There is no way to sugarcoat it: too much equity risk can be unproductive and even destructive in this kind of economic environment.

But where there is danger there is also opportunity. I believe this is a terrific time to take some profits and diversify away from the growth-oriented risk factors that dominate most investors’ portfolios.

On that front, keep a lookout for a special report that we will release in the next week to share five critical steps you can take to defend your portfolio from economic disasters, bankrupt governments (or governments that are testing their borrowing limits), and increasingly desperate governments. It will be a free report for all Thoughts from the Frontline readers, and we hope you will share it with everyone you know.

The Trouble with Earnings

Let’s be clear: earnings growth of 8% last year in a nominal GDP growth world of 4% is rather outstanding. Good on management in general to capture profits from something other than simple global growth. But how long can earnings in general continue to grow faster than the general economy? Understand, that is quite possible for an individual business, and it’s why stock picking is an important part of the investment process. But research shows that the long-term trend is clearly that earnings of the broad corporate business world are highly correlated with GDP growth. How could it be otherwise? Again, not for individual businesses, but for the aggregate of all businesses.

Profits are at an all-time high, as this chart from the FRED database of the St. Louis Fed illustrates. This series is mean-reverting. There is nothing that says profits cannot go higher, but the visual suggestion is that we are closer to a reversal than a breakout.

Why is this so? Part of the reason is that labor is getting less of the pie. The following chart from my friends at Research Affiliates (headed by Rob Arnott) shows that the longer-term correlation with labor costs is at a point where a correction is due, which does not bode well for longer-term profit growth.

Over the last year, this topic has been a large part of the conversation that I have had with Rob, one of the more thoughtful people I dialogue with. This recent post summarizes some of that conversation:

The macroeconomic cause of today’s profits bubble can be understood as a quarter century of politically facilitated globalization. During the 50 years following WWII, we lived in an open global developed economy containing less than one billion people in Europe, North America, Australia, Japan, Korea, Taiwan, and a handful of others. Some countries were growing faster, some slower, but the technological level and population growth rates were not very different across the predominant countries within this relatively open global economy. The shares of income to labor and capital varied cyclically but tended to revert toward long-term averages.

Beginning in the 1990s, we experienced a seismic shift in our global political economy. Approximately three billion people began to join this open global economy: about one billion each in China and India and another billion or so in Russia, Eastern Europe, South America, and Southeast Asia. Average wages, level of technology, and amount of accumulated capital in the countries of the aspiring three billion lagged far behind those enjoyed by the one billion in the developed world. Imitation and appropriation is far easier than innovation and invention, so catching up has been rapid for those nations willing to make even modest concessions to the aspirations of their citizenry. For the past quarter century, the capital and technology accumulated by the old equilibrium advanced global economy has been suddenly shared across a labor force and populace that quadrupled.

This tectonic shift in our global political economy produced some winners and some losers. Incomes of many of the three billion newly joined rose quickly. Global poverty rates have plummeted. Meanwhile, wages in the old advanced-economy countries stalled, at least partly in response to competition from the lower wages welcomed by workers in developing countries.

Profits grew to a much larger share of output and an unprecedented percentage of wages and salaries [see chart above]. To be sure, if we adjust wages to include the value of benefit programs and entitlements, we aren’t quite at all-time highs in profits-to-total compensation ratios. But, even here, we’re darned close to unprecedented records. In both cases, the five- and ten-year averages are at new highs. These longer-term trends are fueling popular unrest.

What Would Yellen Do?

The Fed is clearly looking at labor and employment. We will delve into this topic (once again) in a future letter; but before we close, this post from my friend Dan Greenhaus, Chief Global Strategist at BTIG, will give us a view on the latest JOLTS (Jobs Opening and Labor Turnover) data. (The word on the street is that incoming Fed Chair Janet Yellen does not look simply at the unemployment number.)

What matters right now is the chart below, a chart to which [it] surely pays [to pay] attention. The chart plots the unemployment rate along the horizontal access and the aforementioned number of job openings along the vertical axis. The chart details the two-variable relationship as the economy entered and then exited recession.

Slowly but surely, the economy is moving back towards a “normalized” state in which job openings are increasing while the unemployment rate is decreasing. Before the recession, four million job openings was associated with an unemployment rate of roughly 5.0%. Today, the same number of job openings is associated with an unemployment rate of 6.7% while just a few months ago, nearly four million job openings was associated with an unemployment rate of 7.8%.

This normalization is good news and is further evidence that the labor market is healing. Janet Yellen is surely paying attention.

Forecast 2014: “Mark Twain!”

The surface of the market waters looks smooth, but the data above suggest caution as we proceed. Perhaps slowing the engine and taking more frequent soundings (or putting in closer stops!) might be in order. The cry should be “Mark twain!” Let’s steam ahead but take more frequent readings and know that a course correction may soon be necessary.

And just so you know that you should take any forecast from me with multiple grains of salt, I am going to close this letter without having touched on the rest of the world markets. I know that only three weeks ago I said the annual forecast “issue” would be three issues, and now I see it will be at least four. Apparently, I am not very good at forecasting even the few things I should be in nominal control of. The legal types might like me to say something like “Often wrong, but seldom in doubt.”

Argentina, Vancouver, Edmonton, Regina, and Home

This letter sees a change in a relationship I have enjoyed for several years. As some of you know, my letter is translated into Chinese, and I have had the pleasure of working with a capable young translator with the exotic-sounding name of Shadow Wong. It has been a true delight, and I will miss our banter and her cheery attitude. She is in a transition, so I will have a new translator as of next week – but she will be missed. I thank her for her perseverance and tolerance over the years, and I commend her for the consistent excellence of her work.

I have decided to spend some R&R time back in one of my favorite places in the world, Cafayate, Argentina. Some of my friends and partners have built a true world-class resort and development in a lovely mountain valley in northern Argentina. The only way to get there is through a magnificent canyon that stretches for miles. You arrive at a picturesque little village with lots of cool venues, all the amenities of a great resort, and a beautiful settings among mountains that change their colors and moods all day as the sun moves. I am going at the end of March, if you want to join in. The development has some 30 countries represented among its residents and has attracted a bunch of conservative libertarian types, which makes for great conversation. You can see a few pictures at www.lec.com.ar. Drop me a note if you want to know more.

I am on the plane back from Tampa as I finish this note. I spent the afternoon meeting with scientists and researchers at the Rosskamp Institute there. My associate Patrick Cox arranged the meeting. What I heard and the research I saw makes me truly optimistic about the potential for a cure for Alzheimer’s in maybe less than ten years. And they were doing lots of other work as well. Later that evening Pat and I and an associate compared notes on what we are learning about the coming changes. I like being around Pat because he makes my normally very optimistic view of the future seem not just sanguine but very realistic – and over the years his optimism has proven correct. The pace of change is just accelerating. I hesitate to share some of what we are learning as it just sounds so science-fictionish, but the world of tech is advancing on a thousand fronts. Keeping up with it all is difficult, but Pat and his team have launched a new, free tech digest and website at www.mauldineconomics.com/tech/tech-digest. Subscribe and join us as we explore the Human Transformation Revolution.

I am off on a tour of Vancouver, Edmonton, and Regina starting Monday and then back Friday to enjoy life at home for a few weeks, although I may make a quick trip to DC and NYC for some meetings.

I am settling into my new place. It has turned out even better than I had hoped, and not just the look and feel. It has become the magnet for my kids that I had wanted to create. It is a very comfortable place for us all to gather, share meals, and just hang out. We designed it with that in mind, and to watch it happen feels very good. Worth the hassle and the money. In family terms, it is a great investment. And at the end of the day, creating family togetherness is one of the true ways that we can create value, and that’s one trend that does not ever have to revert to the mean.

I had fun researching the Mark Twain reference, and I let Google lead me down a few memory lanes. Not the most productive use of time, perhaps, but enjoyable. Have a great week.

Your buying arctic weather gear analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

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Outside the Box: The Demographic Cliff and the Spending Wave

 

For today’s Outside the Box, my longtime friend Harry Dent is letting us have a look at chapter 1 of his latest (and I would say his greatest) book, The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019. Harry’s grasp of the impact of demographics on economies and investments is unexcelled and unambiguous. We all know that demographics really matter, but Harry has looked deeper and harder and understood better than any of us.

One of the key insights Harry brings to us is the concept of the Spending Wave. In other words, it’s not just when you and the rest of your generation were born that matters, it’s when you spend. At what age does your spending peak for housing or for child rearing or travel? Harry and his team have developed really good numbers on all of this, and from that data they have been able to consistently predict major macroeconomic trends. Harry summarizes the recent decades and the coming ones like this:

The demographic climaxes in average peak spending led to the rising boom from 1983 to 2007, then the slowdown in 2008 that will carry on until 2020 until trends bottom out and 2023 before trends turn up again. These numbers won’t predict stock crashes and swings in the markets in between, but the big picture is undeniable.

There is a lot more to Harry’s thesis than we can fit in an Outside the Box – chapter 1 alone runs 35 pages, and I can only bring you the first 10 here. So to help you bring Harry’s work into immediate focus – and because I always like to compare notes with Harry – I recently asked him to sit down with me and talk over what we can expect to see in 2014. Some interesting ideas emerged at the intersection among demographics, debt, and deflation – three of the “Killer D’s” that were my topic in last week’s Thoughts from the Frontline – and we also looked at potential great trades for the coming year.

Our conversation, moderated by Mauldin Economics publisher Ed D’Agostino, is available right here.

I write this note from the airport lounge in Riyadh, Saudi Arabia, at the beginning of a long 24 hours to get back to Dallas. Riyadh was a fascinating exclamation point on my foray into the Middle East. When visiting a new country or region, I try to arrive with as few expectations as possible … and then absorb.

I have to say that my hosts, the MASIC group, treated me as well and as with as much genuine hospitality as anyone has done in any of the 60+ countries I have visited over the years. Sometimes that can be person-specific, and certainly the family that owns MASIC spent a lot of personal time taking care of me and the other speakers; but I also observed here how people in general are treated, and I found myself appreciating a tradition of hospitality that I had heard a lot about but never had the opportunity to experience first-hand.

Oddly enough – and I have to admit this observation was a bit outside the scope of my expectations – I found a good deal of similarity between a nation with a “country” Bedouin cultural heritage and the cowboy culture and mythos I grew up with in West Texas. The differences are also apparent and were somewhat jarring at times, but somehow the overall sense of the people was strangely familiar. These are people who, once they are your friends, treat you with a deeply felt sense of honor and acceptance. Where I grew up in Texas, the meaning and value of a handshake was drummed into me at an early age. I think a handshake might have value here as well. Just my impression.

I have a great fascination with Japan and the Japanese culture, but I am not sure I will ever understand it very well, except perhaps in an intellectual sort of way. Here, I got the sense that the gulf of personal understanding was not as wide. Big differences in style, yes. But then the world thinks all Texans wear cowboy hats and boots.

The MASIC group that invited me is an old Saudi business that has grown quite large, yet the family is clearly quite involved and is dealing with many of the very same issues that large family firms in the US confront. And is dealing with them more openly than many.

I’m afraid I often learn a lot more from the people I meet on these trips than I impart to them. On this occasion I laughed a lot more than usual – and had some quite serious conversations as well.

The entire Middle East is in the midst of great change, in a world that is changing even faster. I am forcibly reminded on trips like these that the world is simply unprepared for the rapidity and scale of change that is going to happen over the next 20 years. The jobs we will have in 20 years will be quite different from the ones we have today. Think 1850 to 1950 in the US – but compressed into one lifetime.

And yet I was asked some of the right questions during my stay here, which is more than I experience on many trips. All too often, we humans we want to figure out how to protect ourselves from unwanted change rather than trying to make the change work for us.

British Airways is calling my flight, so it is time to hit the send button. Among other little problems, their seat ate my brand new iPad on the trip out here, so my plan to sit and read on the return flight to London has gone by the wayside. Sigh. I look forward to being on American from London and having wifi for nine hours. Maybe I can catch up a little with my email inbox.

I will write this week’s letter from Tampa, as I have to make a quick trip there to meet with some medical research teams, along with my friend and colleague Patrick Cox. There are fascinating discoveries being made, and I have an opportunity to talk with a newly forming group that is working on the types of changes we all want. What a fascinating world I have stumbled into, where I seem to have a front-row seat to watch all sorts of stupendous changes unfold. Have a great week.

Your once again running to the gate analyst,

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

 

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The Demographic Cliff Around the World

By Harry Dent
(An excerpt from chapter 1 of The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019)

One simple indicator warned of the crashes in Japan from late 1989 forward and in the United States in 2008. It’s called the Spending Wave.

The wave is not a function of stock valuations, but of consumer spending patterns over the course of their life cycle. It’s about the predictable things people do as they age.

Demographics tell us a typical household spends the most money when the head of the household is age forty‐six—when, on average, the parents see their kids leaving the nest. Reading these numbers is no different from life insurance actuaries predicting when the average person will die and, based on that, making projections decades ahead.

Essential to understanding broad economic trends is the recognition that new generations of consumers enter the workforce around age twenty and spend more money as they raise their families, buy houses and cars, borrow, and so on. You may peak at a different age, likely in your early fifties if you are more affluent and went to school longer (as your kids probably did or will, too). The demographic climaxes in average peak spending led to the rising boom from 1983 to 2007, then the slowdown in 2008 that will carry on until 2020 until trends bottom out and 2023 before trends turn up again. These numbers won’t predict stock crashes and swings in the markets in between, but the big picture is undeniable.

In 1989, stocks in Japan peaked dramatically at 38,957 on the Nikkei. A major real estate peak followed in 1991. Despite unprecedented monetary stimulus since 1997 (there’s that QE—quantitative easing—again), more than two decades later stocks remained down 80 percent in late 2012. Likewise, twenty‐two years later, real estate is still down 60 percent from the peak, and commercial real estate by even more. Real estate has never bounced back significantly, even though, from 1999 forward, a new— but significantly smaller—generation began to reach the right age to buy houses.

Did you know that almost all of the money spent on housing occurs between ages twenty‐seven and forty‐one? In Our Power to Predict in 1989, I predicted Japan would see a twelve‐to‐fourteen‐year downturn, while the United States and Europe would see their strongest decade in history. Only demographic indicators could anticipate such a powerful shift in the global economy.

After two lost decades in a coma economy, in early 2013 the Japanese government announced that it would implement the most aggressive stimulus program in history to turn things around. Stocks advanced dramatically in response into mid‐2013, but we can’t know for how long, given that the advance is based on a desperate monetary policy meant to fight dire debt ratios and demographic trends. Since Japan’s first demographic slowdown was over in 2003, why wasn’t the last decade more prosperous?

The world’s economists simply have not come to terms with not only what happens when the largest generation in history reaches its spending peak, but also what it means when that generation is followed by a smaller one. We need to consider hard questions, such as what happens when Japan, most of the countries in Europe, the North American countries, and even China face shrinking workforces and reduced population growth. And what happens as more people retire than are entering the workforce? How does that affect economic growth and commercial real estate? What happens when more homes go onto the market as people die than there are younger buyers to buy them? Such a situation has not occurred before in modern history, and it will have a powerful effect on economics. We’ve seen it already in Japan, which I will cover in chapter 2.

The Best Leading Indicator

The best indicator? People do predictable things as they age. That’s it in a nutshell. So, let’s look at how demographics drive economic trends, from the macro to the micro, in modern middle‐class economies.

Only since 1980 have we had clear and detailed annual surveys from the U.S. government on how consumers spend, borrow, and invest over their life cycle, down to very small sectors (remember my reference to potato chips? Sales of those peak at age forty‐two for the average household). But with great volumes of such data, it is possible to forecast the most fundamental economic trends.

Consider that the Consumer Expenditure Survey (CE) from the U.S. Bureau of Labor Statistics measures more than six hundred categories of spending by age—and spending really changes in different areas according to age. The average family borrows the most when the parents are age forty-one, typically the time of their largest home purchase. They spend the most at age forty‐six, although more affluent households reach that peak later, between age fifty‐one (top 10 percent) and fifty‐three to fifty‐four (top 1 percent). People save the most at age fifty‐four and have the highest net worth at age sixty‐four (and later for more affluent households). Predictably, as we live longer these peaks slowly move up in age. The Bob Hope generation, born in increasing numbers from around 1897 to 1924, reached their spending peak at age forty‐four in 1968, meaning their boom was a forty-four‐year lag on the birth index from 1942 to 1968.

The average person enters the workforce at age twenty, an average of those who complete their education with a high school degree at age eighteen and those who graduate from college at age twenty‐two. Typical Baby Boom couples got married at age twenty‐six (though that age is rising, presently hovering around twenty‐seven‐plus). That’s when apartment rentals peak, too, and the average kid arrives when his or her parents are ages twenty‐eight to twenty‐nine. That stimulates the first home purchase at about age thirty‐one—as soon as people can afford it! As the kids first become teenagers, parents buy their largest house, between ages thirty‐seven and forty‐one. (Why? Parents and kids both need more space in this difficult period of adolescence. You want the kids to be way over there and you way over here—and the kids agree!) We continue to furnish our houses, and thus spending on furniture overall peaks around age forty‐six, which, again, is also the peak in spending for the average household.

A sample of some key areas of consumer spending out of the broad survey. Does this resemble your life pattern? If not, it’s likely because you are more affluent and peak a bit later in these areas.

In the downward phase of spending, some sectors continue to grow and peak. College tuition peaks around age fifty‐one. Automobiles are the last major durable good to peak (that’s around age fifty‐three), as parents buy their best luxury car after the kids have left the nest and they don’t need a boring minivan anymore. Some get fancy sports cars. Some get big pickup trucks. These are in fact the sectors doing the best in 2013 before they peak after 2014. But then their vehicles last much longer as they have nowhere to drive without the kids, so car spending plummets thereafter.

Savings rise most from age forty‐six to fifty‐four and continue to grow, though more slowly, toward a net worth that peaks at age sixty‐four, one year after the average person retires at age sixty‐three. Spending on hospitals and doctors peaks between age fifty‐eight and sixty. Vacation and retirement home purchases peak around age sixty‐five. People travel more from age forty‐six to sixty, after their kids leave the nest, but then they begin to find it too stressful. They finally choose to just go on cruise ships and be stuffed with food and booze with no jet lag or customs hassles. That peaks around age seventy. Then there are the peak years for prescription drugs (age seventy‐seven) and nursing homes (age eighty‐four).

I have highlighted only some key areas: the data can tell you much more, such as when consumers spend the most on camping equipment, babysitting, or life insurance.

The peak in overall spending in Figure 1‐2 is at age forty‐six and revolves around kids’ getting out of school and the need for spending dropping for parents so that they can both enjoy life more and save for retirement. Spending on furniture peaks here as well. But note that there is a plateau between age thirty‐nine, when home buying starts to peak, and age fifty-three, when auto spending peaks. Then spending drops like a rock all the way into death! This is a big deal that governments, businesses, and investors are not anticipating as the massive Baby Boom generation ages in one country after the next.

If you want to reduce middle-class economies down to one important factor, this is it: consumer spending by age. Most economists assume consumers are more like a constant and that business and government swings drive our economy. In fact, consumers are 70 percent of the GDP, and business investment only expands if consumer spending is growing and the government taxes businesses and consumers for its revenues; hence, it follows consumer spending indirectly as well.

The difference in spending patterns between a nineteen‐year‐old, a forty‐six‐year‐old, and a seventy‐five‐year‐old is huge. How much did you earn and spend yourself at age eighteen or nineteen? How much did you earn and spend when you bought your largest house and then furnished it in the years to follow? How much do seventy‐five‐year‐olds spend . . . and do they borrow money? Consumers are anything but a constant when generational cycles are shifting the age concentrations significantly—especially the unusually large generations like the Baby Boomers. Note that some individual spending sectors can be very volatile, such as in acquiring items like motorcycles, which are largely purchased during the male midlife crisis years between forty‐five and forty‐nine, or RVs (recreational vehicles) that are largely bought between age fifty‐three and sixty.

In the big picture, what makes this consumer spending cycle so powerful is the fact that people are born (and immigrate) in clear generational waves. These are the two ways that you become a worker and consumer in a country like the United States—workers represent “supply” of goods and the same people as consumers represent “demand.” Hence, new generations drive both as they age into their peak spending years—and that’s precisely what causes a broad boom in our economy, which happened from 1942 to 1968 and from 1983 to 2007.

A century ago, immigration was the largest driver in the U.S. economy. New arrivals were the biggest factor in what I call the Henry Ford generation, which powered the economic boom that bubbled into the Roaring Twenties. More recently, we have for two decades predicted that immigration will fall sharply again from 2008 forward, when declining spending by Baby Boomers was also pushing us toward the next great depression between 2008 and 2023. We’ve seen that happening, with the drop‐off from Mexico especially apparent. Along with declining births since 2007, U.S. population is simply not going to grow as fast as economists forecast by extrapolating past trends.

In the recent immigration surge from the 1970s into the 2000s, which peaked in 1991, the immigrants added more to the Baby Boom generation (born from 1934 to 1961) than to the Echo Boom (born from 1976 to 2007) to follow. The highest numbers of immigrants arrive around age twenty‐three (what is called the mode in statistics), with the average age at thirty. The new arrival usually enters the workforce and starts producing and consuming. Hence, immigration has an immediate impact on the economy, unlike new births (the latter arrivals require eighteen to twenty‐two years to enter the workforce and become productive).

Looking back to the late 1800s, you can see that immigration is anything but constant. There were two major peaks in immigration: the first in 1907 with a major drop-off after 1914; the second was around 1991 with a major drop-off beginning after 2008. Note that immigration dropped to near zero in the 1930s after the greatest surge in American history.

When my outlandish forecasts back in the late 1980s for a Dow of 10,000 by 2000 started to look a bit too conservative, I realized that I wasn’t adjusting for immigrants, which I did in 1996. I developed a bell curve for the age of immigrants over decades of data using a computer model to determine when immigrants were actually born on average so I could add them to the birth index as if they were born here. And at Dent Research we make our own future forecasts for immigration taking into account the business cycle instead of the normal straight‐line projections of economists.

Note how much larger the Baby Boom was than the Bob Hope generation before it. The Echo Boom hit similar levels of births at its peak in 2007. But the last is a smaller wave as a generation, and from 2008 into the early 2020s, births are going to tend to fall more than rise due to a bad economy, just as they did in the 1930s and the 1970s. Note that it’s also necessary to adjust the birth index for immigrants to get the total size of each generation. When legal and illegal immigration during the Baby Boom generation is added, the Baby Boom towers higher still.

We found that, when adjusted for immigrants, the Echo Boom generation never reaches the growth numbers of the Baby Boom generation. Hence, it is the first generation to be smaller than the one before it. This pattern is consistent throughout the developed world, with the exception of Australia and the Scandinavian countries. Many European and East Asian countries have no Echo Boom generation at all.

Not everyone recognizes the subtleties of this. In print and broadcast journalism—a May 2013 article in Barron’s, for example, and on air at CNBC—we’re told that the millennial or Echo Boom generation is larger than the Baby Boom generation. By habit, I cringe when I hear broad statements concerning demographics (too often the speaker hasn’t done in‐depth research and reaches wrong conclusions). In this case, the statement is partly true, partly not.

The easy part—and the one that economists usually get right about demographics—is that the populations of most developed countries are aging and that rising entitlement burdens will fall on the younger generations. How will the lower spending and earnings levels of a smaller generation affect the economy? Take a good look at the Japanese economy, which went into a coma after Japan fell off the Demographic Cliff between 1989 and 1996: Japan has had zero inflation and GDP growth for the last two decades (see chapter 2).

Taking a close look at the data, it’s clear that the Echo Boom generation does exceed the Baby Boom generation in sheer numbers. In the United States, the birth rate for the Echo Boom group started at a higher level, and its rising birth span of thirty‐two years (1976–2007) was longer than that of the Baby Boom group, at twenty‐eight years (1934–61), as Figure 1‐6 shows. Baby Boomers total 108.5 million adjusted for immigration, compared with 138.4 million Echo Boomers. But the more important point from my research: the peak immigration‐adjusted births of the Baby Boom generation are still substantially higher and have a bigger overall wave.

The key to demographic trends and forecasting is reading the wave—namely, the rising wave of births and growth—and distinguishing the relative size of the acceleration of each generation. The Baby Boom is like a ten-foot-tall wave coming onto the beach, whereas the Echo Boom is a five-foot-tall wave. A surfer can instantly tell you the difference! Although the Echo Boom wave is wider in its scope, the Baby Boom wave is taller and greater in magnitude and peak numbers.

In the next boom, from about 2023 forward, the number of households needed to keep the economy going by spending and borrowing money, buying homes, investing, and other economic activity simply will not grow as fast or to the same levels. Yes, many (but not all) developed countries will experience a boom driven by demographics about a decade from now, but it will not be as strong as that precipitated by the rising spending and borrowing of the Baby Boomers.

Growth is more likely to come as a result of technological advances, especially those that will increase longevity and working years, which could help compensate for the lower number of workers. Such areas as biotechnology, robotics, nanotechnology, and new energy sources that are cleaner will be the drivers, but it will be a long time before they affect the economy broadly, because it takes decades for new innovations to gain momentum. For example, the automobile was invented in 1886, but only began to move into the mainstream U.S. economy from 1914 to 1928.

Harry Dent’s new book, The Demographic Cliff: How to Survive and Prosper During the Great Deflation of 2014-2019, is available here.

And here again is the conversation between Harry Dent and John Mauldin, moderated by Ed D’Agostino.

Chart_1_1401123

Thoughts from the Frontline: Forecast 2014: The Killer D’s

 

It seems I’m in a constant dialogue about the markets and the economy everywhere I go. Comes with the territory. Everyone wants to have some idea of what the future holds and how they can shape their own personal version of the future within the Big Picture. This weekly letter is a large part of that dialogue, and it’s one that I get to share directly with you. Last week we started a conversation looking at what I think is the most positive and dynamic aspect of our collective future: The Human Transformation Revolution. By that term I mean the age of accelerating change in all manner of technologies and services that is unfolding before us. It is truly exhilarating to contemplate. Combine that revolution with the growing demand for a middle-class lifestyle in the emerging world, and you get a powerful engine for growth. In a simpler world we could just focus on those positives and ignore the fumbling of governments and central banks. Alas, the world is too complex for that.

We’ll continue our three-part 2014 forecast series this week by looking at the significant economic macrotrends that have to be understood, as always, as the context for any short-term forecast. These are the forces that are going to inexorably shift and shape our portfolios and businesses. Each of the nine macrotrends I’ll mention deserves its own book (and I’ve written books about two of them and numerous letters on most of them), but we’ll pause to gaze briefly at each as we scan the horizon.

The Killer D’s

The first five of our nine macro-forces can be called the Killer D’s: Demographics, Deficit, Debt, Deleveraging, and Deflation. And while I will talk about them separately, I am really talking threads that are part of a tapestry. At times it will be difficult to say where one thread ends and the others begin.

Demographics – An Upside Down World

One of the most basic human drives is the desire to live longer. And there is a school of economics that points out that increased human lifespans is one of the most basic and positive outcomes of economic growth. I occasionally get into an intense conversation in which someone decries the costs of the older generation refusing to shuffle off this mortal coil. Typically, this discussion ensues after I have commented that we are all going to live much longer lives than we once expected due to the biotechnological revolution. Their protests sometimes make me smile and suggest that if they are really worried about the situation, they can volunteer to die early. So far I haven’t had any takers.

Most people would agree that growth of the economy is good. It is the driver of our financial returns. But older people spend less money and produce far less than younger, more active generations do. Until recently this dynamic has not been a problem, because there were far more young people in the world than there were old. But the balance has been shifting for the last few decades, especially in Japan and Europe.

An aging population is almost by definition deflationary. We can see the results in Japan. An aging, conservative population spends less. An interesting story in the European Wall Street Journal this week discusses the significant amount of cash that aging Japanese horde. In Japan there is almost three times as much cash in circulation, per person, as there is in the US. Though Japan is a country where you can buy a soft drink by swiping your cell phone over a vending machine data pad, the amount of cash in circulation is rising every year, and there are actually proposals to tax cash so as to force it back into circulation.

A skeptic might note that 38% of Japanese transactions are in cash and as such might be difficult to tax. But I’m sure that Japanese businesses report all of their cash income and pay their full share of taxes, unlike their American and European counterparts.

Sidebar: It is sometimes difficult for those of us in the West to understand Japanese culture. This was made glaringly obvious to me recently when I watched the movie 47 Ronin. In the West we may think of Sparta or the Alamo when we think of legends involving heroic sacrifice. The Japanese think of the 47 Ronin. From Wikipedia:

The revenge of the Forty-seven Ronin (四十七士 Shi-jū-shichi-shi, forty-seven samurai) took place in Japan at the start of the 18th century. One noted Japanese scholar described the tale, the most famous example of the samurai code of honor, bushidō, as the country’s “national legend.”

The story tells of a group of samurai who were left leaderless (becoming ronin) after their daimyo (feudal lord) Asano Naganori was compelled to commit seppuku (ritual suicide) for assaulting a court official named Kira Yoshinaka, whose title was Kōzuke no suke. The ronin avenged their master’s honor by killing Kira, after waiting and planning for almost two years. In turn, the ronin were themselves obliged to commit seppuku for committing the crime of murder. With much embellishment, this true story was popularized in Japanese culture as emblematic of the loyalty, sacrifice, persistence, and honor that people should preserve in their daily lives. The popularity of the tale grew during the Meiji era of Japanese history, in which Japan underwent rapid modernization, and the legend became subsumed within discourses of national heritage and identity.

The point of my sidebar (aside from talking about cool guys with swords) is that, while Japan may be tottering, the strong social fabric of the country, woven from qualities like loyalty, sacrifice, and diligence, should keep us from being too quick to write Japan off.

“Old Europe” is not far behind Japan when it comes to demographic challenges, and the United States sees its population growing only because of immigration. Russia’s population figures do not bode well for a country that wants to view itself as a superpower. Even Iran is no longer producing children at replacement rates. At 1.2 children per woman, Korea’s birth rates are even lower than Japan’s. Indeed, they are the lowest in the World Bank database.

A basic equation says that growth of GDP is equal to the rate of productivity growth times the rate of population growth. When you break it down, it is really the working-age population that matters. If one part of the equation, the size of the working-age population, is flat or falling, productivity must rise even faster to offset it. Frankly, developed nations are simply not seeing the rise in productivity that is needed.

As a practical matter, when you are evaluating a business as a potential investment, you need to understand whether its success is tied to the growth rate of the economy and the population it serves.

In our book Endgame Jonathan Tepper and I went to great lengths to describe the coming crisis in sovereign debt, especially in Europe – which shortly began to play itself out. In the most simple terms, there can come a point when a sovereign government runs up against its ability to borrow money at reasonable rates. That point is different for every country. When a country reaches the Bang! moment, the market simply starts demanding higher rates, which sooner or later become unsustainable. Right up until the fateful moment, everyone says there is no problem and that the government in question will be able to control the situation.

If you or I have a debt issue, the solution is very simple: balance our family budget. But it is manifestly more difficult, politically and otherwise, for a major developed country to balance its budget than it is for your average household to do so. There are no easy answers. Cutting spending is a short-term drag on the economy and is unpopular with those who lose their government funding. Raising taxes is both a short-term and a long-term drag on the economy.

The best way to get out of debt is to simply hold spending nominally flat and eventually grow your way out of the deficit, as the United States did in the 1990s. Who knew that 15 years later we would be nostalgic for Clinton and Gingrich? But governments almost never take that course, and eventually there is a crisis. As we will see in a moment, Japan elected to deal with its deficit and debt issues by monetizing the debt. Meanwhile, in Europe, the ECB had to step in to save Italy and Spain; Greece, Ireland, and Portugal were forced into serious austerities; and Cyprus was just plain kicked over the side of the boat.

There is currently a lull in the level of concern about government debt, but given that most developed countries have not yet gotten their houses in order, this is a temporary condition. Debt will rear its ugly head again in the not-too-distant future. This year? Next year? 2016? Always we pray the prayer of St. Augustine: “Lord, make me chaste, but not today.”

Deleveraging and Deflation – They Are Just No Fun

At some point, when you have accumulated too much debt, you just have to deal with it. My associate Worth Wray forwarded the following chart to me today. There is no better explanation as to why the current recovery is the weakest in recent history. Deleveraging is a b*tch. It is absolutely no fun. Looking at this chart, I find it rather remarkable and somewhat encouraging that the US has done as well as it has the past few years.

As I’ve outlined at length in other letters and in Code Red, central banks can print far more money than any of us can imagine during periods of deleveraging and deflation. For the record, I said the same thing back in 2010 when certain hysterical types were predicting hyperinflation and the end of the dollar due to the quantitative easing of the Federal Reserve. I remain actively opposed to the current level of quantitative easing, not because I’m worried about hyperinflation but for other reasons I have discussed in past letters. As long as the velocity of money keeps falling, central banks will be able to print more money than we would have thought possible in the ’70s or ’80s. And seemingly they can get away with it – in the short term. Of course, payback is a b*tch. When the velocity of money begins to rise again for whatever unknown reason, central banks had better have their ducks in a row!

Deflationary conditions make debt worse. If you borrow money at a fixed rate, a little inflation – or even a lot of inflation – helps a great deal. To think that even conservative Republican leaders don’t get that is naïve. Certainly it is understood in Japan, which is why the success of Abenomics is dependent upon producing inflation. More on that below.

For governments, there is more than one way to deleverage. You can default on your payments, like Greece. We’re going to see a lot more of that in the next five years – count on it. Or you can get your central bank to monetize the debt, as Japan is doing. Or get the central bank to convert your debt into 40-year bonds, as Ireland did. (Brilliant move, by the way, for tiny Ireland – you have to stand back and applaud the audacity. I wonder how much good Irish whiskey it took to get the ECB to agree to that deal?)

Inflation is falling almost everywhere today, even as central banks are as accommodative as they have ever been. Deflation is the default condition in a deleveraging world. It can even create an economic singularity.

Singularity was originally just a mathematical term for a point at which an equation has no solution. Then, in astrophysics, it was proven that a large-enough collapsing star would become a black hole so dense that its own gravity would cause a singularity in the fabric of space-time, a point where many standard physics equations suddenly have no solution.

Beyond the “event horizon” of the black hole, the physics models no longer work. In terms of general relativity, an event horizon is a boundary in space-time beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational force becomes so large that nothing can escape.

Deflation and collapsing debt can create their own sort of black hole, an economic singularity. At that point, the economic models that we have grown comfortable with no longer work. As we approach a potential event horizon in a deflationary/deleveraging world, it can be a meaningless (and extremely frustrating) exercise to try to picture a future that is a simple extension of past economic reality. Any short-term forecast (less than one or two years) has to bear that fact in mind.

We Are in a Code Red World

We need to understand that there has been a complete bureaucratic and academic capture of central banks. They are all run by neo-Keynesians. (Yes, I know there are some central bankers who disavow the prevailing paradigm, but they don’t have the votes.) The default response of any present-day central banker faced with a crisis will be massive liquidity injections. We can argue with the tide, but we need to recognize that it is coming in.

When there is a recession and interest rates are at or close to the zero bound, there will be massive quantitative easing and other, even more creative injections of liquidity into the system. That is a reality we have learned to count on and to factor into our projections of future economic possibilities. But as to what set of econometric equations we should employ in coming up with accurate, dependable projections, no one, least of all central bankers, has a clue. We are in unknown territory, on an economic Star Trek, with Captain Bernanke about to turn the helm over to Captain Yellen, going where no reserve-currency-printing central bank has gone before. This is not Argentina or Zimbabwe we are talking about. The Federal Reserve is setting its course based on economic theories created by people whose models are demonstrably terrible.

Will we have an outright recession in the US this year? I currently think that is unlikely unless there is some kind of external shock. But short-term interest rates will stay artificially low due to financial repression by the Fed, and there will be an increased risk of further monetary creativity from a Yellen-led Fed going forward. Stay tuned.

China, Europe, and Japan – Crises in Waiting

We have been waiting for over a decade for a hard landing in China. When you go to Asia it is the number one topic you are questioned about. How long can the Chinese continue to forestall the sort of correction that has needed to take place in every other developed economy in the world?

China is undergoing its most serious policy changes of the last 30 years. The new leadership appears to be taking an aggressive stance toward correcting the problems of excess leverage and bank debt that are obvious to anyone who pays attention. The correction will not be easy, and it will be quite costly, but they may in fact have the ability to skate through without the major depression that typically accompanies a massive bank restructuring. What the unintended consequences are remains to be seen.

China must be watched. It is a major world power in the midst of restructuring. It is in the process of growing old before it grows rich, something no other country of its size and importance has ever done. At the same time that it is dealing with its banking issues, it is trying to shift to become a consumer economy rather than a cheap-labor economy. Like Singapore, it wants to move up the intellectual-capital chain. Singapore has made important transitions multiple times and is a model to be admired. But China is some 250 times larger than Singapore. And its government institutions, especially at the lower levels, are corrupt and inefficient. There is an apparent recognition by the current new leadership that this is a situation that must change, too.

Japan May Be a Moose in Search of a Windshield

I have written about Japan on numerous occasions. My classic line is that Japan is a bug in search of a windshield. We devoted chapters to Japan in Code Red. Upon reflection, I think that referring to Japan as a bug might give the wrong impression. We all know what happens to a bug upon impact. It might be more appropriate to think of Japan as a moose. Ask a Canadian what happens when you hit a moose late at night at high speed. While the collision is not good for the moose, the car and driver are not unaffected.

Japan has opted to monetize its debt. Given their situation, I would do the same. They have no good choices, only potentially disastrous ones. From their standpoint, monetization makes the most sense. The yen is going to drop inexorably in value over the coming decade, unless they decide to choose disaster B (massive deflation or default), which seems unlikely at the moment.

For all intents and purposes, Japan is firing the first missile in what will be a major currency war over the next five to seven years. We have seen such a situation only twice in the past century, and neither of those contests ended well for any of the participants.

For the record, and for the sake of full disclosure, shorting the government of Japan is my biggest single investment. That position is going to get much bigger in the next few months, as I am finally able to hedge my new mortgage. I fully intend to let Abe-san and Kuroda-san to pay for half of my new apartment.

I will have a very personal vested interest in paying attention to the political situation in Japan. I will keep you updated if I change my mind!

The world has never experienced a major nation like Japan monetizing a significant portion of its debt. Weimar Germany, by contrast, was a defeated nation, did not print a reserve currency, and was not accorded the status that Japan has today. Further, Japanese industry brings its A game to the international competitive markets. Biggest head-to-head competitor with Japan? It’s not Korea but Germany. And neither country will be happy when the yen is 150 to the dollar. It will be interesting to see the reactions around the world when it is 200 to the dollar. Stay tuned.

And then there is Europe. Again, I have written extensively about the debacle (another D) that is Europe. It is going to cost multiple trillions of euros for them to deal with their situation. Essentially, they either have to break up or mutualize their debts. They have to decide whether there will be a fiscal union as well as a monetary union. While I think they will make the hard decision and elect to remain as a monetary union, that course is not a given. The pain that will come from the required austerity in France and other countries is not to be sneezed at. The various nations of Europe will have to give up a measure of independence in their budgetary process in order to get Germany to agree to the mutualization of debt and unleash the hounds of the ECB.

The greatest impediment to getting such an agreement may not be in Germany; it may be in France. If Marine Le Pen is the answer, then the French are asking the wrong question. Her policies may have some appeal for the French, but they are ultimately disastrous for the European Union. National Socialism is not an answer that has worked well in Europe.

The following cool note on the Germany and its relations with France and the rest of the Eurozone comes from Quartz.com:

Germany is justifiably proud of its many world-class products, and bristles when others criticize its export-driven economic model—as US Treasury secretary Jack Lew did yesterday. Critics like Lew contend that the country needs to focus its attention on boosting domestic spending rather than fine-tuning its export machine, in order to benefit its trading partners, particularly less well-off members of the euro zone.

On the very day of Lew’s rebuke, new data on German foreign trade provided grist for his critique: November exports rose for the fourth consecutive month and imports unexpectedly plunged. But dig into the details and the picture is much more complicated. In the first 11 months of 2013, Germany’s trade surplus with the rest of the euro zone was only €1 billion ($1.4 billion); its surplus with non-EU counties was more than €140 billion over the same period.

If German exporters can generate profits by selling goods far from Europe, they may have less incentive to compete with local European suppliers on their home turf. They also gain the financial firepower to spend more at home in Germany, including on imports produced by its hard-up euro zone neighbors.

Diving into country-by-country trade details complicates the picture even more. It also becomes clear why you hear little criticism of German exports in Amsterdam, while Paris seems positively obsessed. Germany ran a trade deficit of more than €15 billion with the Netherlands in the first 10 months of 2013 (the latest data available), while Germany’s trade surplus with France was worth more than €30 billion.

The key goods that Germany trades with other euro zone members are varied, as the chart below shows. It is easy to say that Germany should export less and invest more, but on the ground the policies dealing with exports of aircraft to France will have little impact on vaccines sold to the Netherlands, just as efforts to promote more imports of olive oil from Italy are quite distinct from the trade in cars made in Spain. These and countless other examples make sweeping calls for Germany to “rebalance” its economy more difficult to achieve in practice than on paper.

There are no easy solutions for Europe. France has to balance its budget or lose access to the markets, just as Italy and Spain did. This will be the moment of truth for the European Union. I think it probably happens in 2015 or possibly in late 2014. (Although, for the record, I’m almost always early with my predictions. At least I usually get the direction right, and in this case I think the direction is clearly that France is going to have to make difficult decisions in the next few quarters. This is not a country that has made difficult decisions easily in the past, nor is it in a mood to do so today.

If you want to see an intriguing and rather blunt article that is provoking furious reaction in France, then I invite you to read the fascinating piece by Janine di Giovanni in Newsweek, entitled the “The Fall of France.” This was followed almost immediately by an article in the same magazine entitled “Fall of France II: How a Cockerel Nation Became an Ostrich,” which elicited even further outrage in the French press. Given that Ms. Giovanni lives in Paris, I wonder whether she will be the recipient of many invitations to lunch in the coming months. Give her a call if you are in Paris; she may need friends.

These articles will give you background to understand how fully difficult it is going to be to turn the French ship around. The majority of the French simply do not want to change the direction in which they are sailing, although they might prefer another captain with another banner. The bond markets have subsidized their wishes a for very long time. I think we are fast approaching the Endgame for Europe.

This has been a very brief inventory of the headwinds for economic growth in the next few years. It counterbalances the rather joyous view of the future that I outlined last week. I get the incongruity. How could one be so excited about the future on the one hand and so dismal on the other? That is the main thought conundrum of my life. That and trying to figure out my kids. I’ve completely given up trying to understand women.

We will turn to the third part of the 2014 forecast next week.

Some Thoughts from Dubai

I finish this letter in my hotel room at the Park Hyatt in Dubai. I visited Abu Dhabi yesterday and drove home in the evening to the towering vision of Dubai. Everyone has always told me you have to see it to understand it, but I really didn’t grasp what they meant until I got here. When you try to comprehend the enormity of what they have built in the last 20 – and really in the last 10 – years, it is overwhelming.

I get Singapore. Singapore is just as impressive, but it is at the center of one of the most important shipping lanes in the world. I can understand the economics and grasp what Lee Kuan Yew did to wrest his nation from the throes of poverty and turn it into the dynamo that it is today. He is one of the most intriguing personalities of the 20th century.

But I am simply staggered by Dubai and Abu Dhabi. This is the ultimate Field of Dreams, built by men who must have a vision that is beyond extraordinary. It is not just about oil, as Dubai has nowhere near the wealth of Abu Dhabi. Oil wealth alone is not enough to ensure the enterprise and generate the vision that I see manifested here. The oil wealth of this region is legendary; and yet across the Straits lies a country with far more oil wealth and cultural heritage, and yet it languishes.

The city landscape of Dubai reminds me of the science fiction book covers that we saw 15 to 20 years ago. Today, as I walk out of my hotel room and look across the bay, the towering spires and surreal architecture of science fiction have come to life. There is development everywhere. While some of the office buildings are obviously “see-through,” the local home market seems to be booming, particularly since the Arab Spring.

I had to make a trip to the local shopping mall. The shops and restaurants were all familiar to someone from the West, yet the cultural diversity was amazing. I must have heard every major language spoken. I’ve been to 60 countries, and nowhere have I seen the amalgamation of people that I’ve encountered here – not in London or even New York. Cosmopolitan, clean, and seemingly prosperous, this is a city to be admired. I will admit to not getting the economics of building on such a massive scale in the middle of the desert, but then I’m a country boy from Texas.

As if to punctuate my trip, as I was writing this note I began to hear very loud booms outside my ground-floor room. After a second, I recognized the sounds of fireworks. (Hey, I’m in the Middle East, so you know what I thought of first).

I walked out of my room to the sidewalk beside the yacht docks and witnessed what was perhaps the most impressive display of fireworks I’ve ever seen in my life – and I make a point of going to watch fireworks. I truly enjoy them. I guess it’s the little kid in me. In the distance you could see multiple fireworks displays going off everywhere you turned. I was lucky in that from my vantage point the main fireworks were almost overhead. Until the culmination of the show, that is, when they began coming even closer. I am hard-pressed to describe the experience; but for you science fiction fans, it was almost as though the gaping maw of one of the great worms in Frank Herbert’s Dune was descending ever closer with each burst of flame. I stood in awe, waiting to be engulfed, until it all magically ended.

What could have possibly provoked such artistic excess? What great event did all this signify? I walked down the way to the restaurant and asked some of the staff about it. “Oh,” they replied, “This is a celebration of National Shopping Week.”

And with that I will close, as I need to get some sleep so that I can explore little bit more of Dubai before I head to Riyadh tomorrow. I will let you know next week what I see and learn there. In the meantime, have a great week.

Your still not all that jaded analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Chart_1_140112

Thoughts from the Frontline: Forecast 2014: The Killer D’s

 

It seems I’m in a constant dialogue about the markets and the economy everywhere I go. Comes with the territory. Everyone wants to have some idea of what the future holds and how they can shape their own personal version of the future within the Big Picture. This weekly letter is a large part of that dialogue, and it’s one that I get to share directly with you. Last week we started a conversation looking at what I think is the most positive and dynamic aspect of our collective future: The Human Transformation Revolution. By that term I mean the age of accelerating change in all manner of technologies and services that is unfolding before us. It is truly exhilarating to contemplate. Combine that revolution with the growing demand for a middle-class lifestyle in the emerging world, and you get a powerful engine for growth. In a simpler world we could just focus on those positives and ignore the fumbling of governments and central banks. Alas, the world is too complex for that.

We’ll continue our three-part 2014 forecast series this week by looking at the significant economic macrotrends that have to be understood, as always, as the context for any short-term forecast. These are the forces that are going to inexorably shift and shape our portfolios and businesses. Each of the nine macrotrends I’ll mention deserves its own book (and I’ve written books about two of them and numerous letters on most of them), but we’ll pause to gaze briefly at each as we scan the horizon.

The Killer D’s

The first five of our nine macro-forces can be called the Killer D’s: Demographics, Deficit, Debt, Deleveraging, and Deflation. And while I will talk about them separately, I am really talking threads that are part of a tapestry. At times it will be difficult to say where one thread ends and the others begin.

Demographics – An Upside Down World

One of the most basic human drives is the desire to live longer. And there is a school of economics that points out that increased human lifespans is one of the most basic and positive outcomes of economic growth. I occasionally get into an intense conversation in which someone decries the costs of the older generation refusing to shuffle off this mortal coil. Typically, this discussion ensues after I have commented that we are all going to live much longer lives than we once expected due to the biotechnological revolution. Their protests sometimes make me smile and suggest that if they are really worried about the situation, they can volunteer to die early. So far I haven’t had any takers.

Most people would agree that growth of the economy is good. It is the driver of our financial returns. But older people spend less money and produce far less than younger, more active generations do. Until recently this dynamic has not been a problem, because there were far more young people in the world than there were old. But the balance has been shifting for the last few decades, especially in Japan and Europe.

An aging population is almost by definition deflationary. We can see the results in Japan. An aging, conservative population spends less. An interesting story in the European Wall Street Journal this week discusses the significant amount of cash that aging Japanese horde. In Japan there is almost three times as much cash in circulation, per person, as there is in the US. Though Japan is a country where you can buy a soft drink by swiping your cell phone over a vending machine data pad, the amount of cash in circulation is rising every year, and there are actually proposals to tax cash so as to force it back into circulation.

A skeptic might note that 38% of Japanese transactions are in cash and as such might be difficult to tax. But I’m sure that Japanese businesses report all of their cash income and pay their full share of taxes, unlike their American and European counterparts.

Sidebar: It is sometimes difficult for those of us in the West to understand Japanese culture. This was made glaringly obvious to me recently when I watched the movie 47 Ronin. In the West we may think of Sparta or the Alamo when we think of legends involving heroic sacrifice. The Japanese think of the 47 Ronin. From Wikipedia:

The revenge of the Forty-seven Ronin (四十七士 Shi-jū-shichi-shi, forty-seven samurai) took place in Japan at the start of the 18th century. One noted Japanese scholar described the tale, the most famous example of the samurai code of honor, bushidō, as the country’s “national legend.”

The story tells of a group of samurai who were left leaderless (becoming ronin) after their daimyo (feudal lord) Asano Naganori was compelled to commit seppuku (ritual suicide) for assaulting a court official named Kira Yoshinaka, whose title was Kōzuke no suke. The ronin avenged their master’s honor by killing Kira, after waiting and planning for almost two years. In turn, the ronin were themselves obliged to commit seppuku for committing the crime of murder. With much embellishment, this true story was popularized in Japanese culture as emblematic of the loyalty, sacrifice, persistence, and honor that people should preserve in their daily lives. The popularity of the tale grew during the Meiji era of Japanese history, in which Japan underwent rapid modernization, and the legend became subsumed within discourses of national heritage and identity.

The point of my sidebar (aside from talking about cool guys with swords) is that, while Japan may be tottering, the strong social fabric of the country, woven from qualities like loyalty, sacrifice, and diligence, should keep us from being too quick to write Japan off.

“Old Europe” is not far behind Japan when it comes to demographic challenges, and the United States sees its population growing only because of immigration. Russia’s population figures do not bode well for a country that wants to view itself as a superpower. Even Iran is no longer producing children at replacement rates. At 1.2 children per woman, Korea’s birth rates are even lower than Japan’s. Indeed, they are the lowest in the World Bank database.

A basic equation says that growth of GDP is equal to the rate of productivity growth times the rate of population growth. When you break it down, it is really the working-age population that matters. If one part of the equation, the size of the working-age population, is flat or falling, productivity must rise even faster to offset it. Frankly, developed nations are simply not seeing the rise in productivity that is needed.

As a practical matter, when you are evaluating a business as a potential investment, you need to understand whether its success is tied to the growth rate of the economy and the population it serves.

In our book Endgame Jonathan Tepper and I went to great lengths to describe the coming crisis in sovereign debt, especially in Europe – which shortly began to play itself out. In the most simple terms, there can come a point when a sovereign government runs up against its ability to borrow money at reasonable rates. That point is different for every country. When a country reaches the Bang! moment, the market simply starts demanding higher rates, which sooner or later become unsustainable. Right up until the fateful moment, everyone says there is no problem and that the government in question will be able to control the situation.

If you or I have a debt issue, the solution is very simple: balance our family budget. But it is manifestly more difficult, politically and otherwise, for a major developed country to balance its budget than it is for your average household to do so. There are no easy answers. Cutting spending is a short-term drag on the economy and is unpopular with those who lose their government funding. Raising taxes is both a short-term and a long-term drag on the economy.

The best way to get out of debt is to simply hold spending nominally flat and eventually grow your way out of the deficit, as the United States did in the 1990s. Who knew that 15 years later we would be nostalgic for Clinton and Gingrich? But governments almost never take that course, and eventually there is a crisis. As we will see in a moment, Japan elected to deal with its deficit and debt issues by monetizing the debt. Meanwhile, in Europe, the ECB had to step in to save Italy and Spain; Greece, Ireland, and Portugal were forced into serious austerities; and Cyprus was just plain kicked over the side of the boat.

There is currently a lull in the level of concern about government debt, but given that most developed countries have not yet gotten their houses in order, this is a temporary condition. Debt will rear its ugly head again in the not-too-distant future. This year? Next year? 2016? Always we pray the prayer of St. Augustine: “Lord, make me chaste, but not today.”

Deleveraging and Deflation – They Are Just No Fun

At some point, when you have accumulated too much debt, you just have to deal with it. My associate Worth Wray forwarded the following chart to me today. There is no better explanation as to why the current recovery is the weakest in recent history. Deleveraging is a b*tch. It is absolutely no fun. Looking at this chart, I find it rather remarkable and somewhat encouraging that the US has done as well as it has the past few years.

As I’ve outlined at length in other letters and in Code Red, central banks can print far more money than any of us can imagine during periods of deleveraging and deflation. For the record, I said the same thing back in 2010 when certain hysterical types were predicting hyperinflation and the end of the dollar due to the quantitative easing of the Federal Reserve. I remain actively opposed to the current level of quantitative easing, not because I’m worried about hyperinflation but for other reasons I have discussed in past letters. As long as the velocity of money keeps falling, central banks will be able to print more money than we would have thought possible in the ’70s or ’80s. And seemingly they can get away with it – in the short term. Of course, payback is a b*tch. When the velocity of money begins to rise again for whatever unknown reason, central banks had better have their ducks in a row!

Deflationary conditions make debt worse. If you borrow money at a fixed rate, a little inflation – or even a lot of inflation – helps a great deal. To think that even conservative Republican leaders don’t get that is naïve. Certainly it is understood in Japan, which is why the success of Abenomics is dependent upon producing inflation. More on that below.

For governments, there is more than one way to deleverage. You can default on your payments, like Greece. We’re going to see a lot more of that in the next five years – count on it. Or you can get your central bank to monetize the debt, as Japan is doing. Or get the central bank to convert your debt into 40-year bonds, as Ireland did. (Brilliant move, by the way, for tiny Ireland – you have to stand back and applaud the audacity. I wonder how much good Irish whiskey it took to get the ECB to agree to that deal?)

Inflation is falling almost everywhere today, even as central banks are as accommodative as they have ever been. Deflation is the default condition in a deleveraging world. It can even create an economic singularity.

Singularity was originally just a mathematical term for a point at which an equation has no solution. Then, in astrophysics, it was proven that a large-enough collapsing star would become a black hole so dense that its own gravity would cause a singularity in the fabric of space-time, a point where many standard physics equations suddenly have no solution.

Beyond the “event horizon” of the black hole, the physics models no longer work. In terms of general relativity, an event horizon is a boundary in space-time beyond which events cannot affect an outside observer. In a black hole it is “the point of no return,” i.e., the point at which the gravitational force becomes so large that nothing can escape.

Deflation and collapsing debt can create their own sort of black hole, an economic singularity. At that point, the economic models that we have grown comfortable with no longer work. As we approach a potential event horizon in a deflationary/deleveraging world, it can be a meaningless (and extremely frustrating) exercise to try to picture a future that is a simple extension of past economic reality. Any short-term forecast (less than one or two years) has to bear that fact in mind.

We Are in a Code Red World

We need to understand that there has been a complete bureaucratic and academic capture of central banks. They are all run by neo-Keynesians. (Yes, I know there are some central bankers who disavow the prevailing paradigm, but they don’t have the votes.) The default response of any present-day central banker faced with a crisis will be massive liquidity injections. We can argue with the tide, but we need to recognize that it is coming in.

When there is a recession and interest rates are at or close to the zero bound, there will be massive quantitative easing and other, even more creative injections of liquidity into the system. That is a reality we have learned to count on and to factor into our projections of future economic possibilities. But as to what set of econometric equations we should employ in coming up with accurate, dependable projections, no one, least of all central bankers, has a clue. We are in unknown territory, on an economic Star Trek, with Captain Bernanke about to turn the helm over to Captain Yellen, going where no reserve-currency-printing central bank has gone before. This is not Argentina or Zimbabwe we are talking about. The Federal Reserve is setting its course based on economic theories created by people whose models are demonstrably terrible.

Will we have an outright recession in the US this year? I currently think that is unlikely unless there is some kind of external shock. But short-term interest rates will stay artificially low due to financial repression by the Fed, and there will be an increased risk of further monetary creativity from a Yellen-led Fed going forward. Stay tuned.

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.
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