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Archive for May 2014

Archive for May, 2014

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Things That Make You Go Hmmm: The Underpants Gnomes

 

This week’s TTMYGH will be a little shorter than usual (“Thank heavens!” I hear you cry) owing to my presence at the Strategic Investment Conference 2014 this past week and the travel time to and fro.

Due to the hectic schedule and the fact that there were so many interesting people in attendance, I had planned to spend my week dragging as much knowledge as I possibly could out of those who made the trip to San Diego rather than committing finger to keyboard; but a chance encounter with a delightful young lady initiated an engaging conversation which, in turn, led to my discovery of the Underpants Gnomes.

Those of you who have ever attended an event such as the SIC know full well how such conversations arise. Those of you who haven’t will likely think I’ve taken another step towards the light (and will wonder just what sort of a dialogue we engaged in), but allow me to elaborate.

I will spare the name of the young lady in question to protect her modesty, but if she happens to be reading this back home in Bath, my thanks for the inspiration — even though I find myself awake at 3 AM rather worriedly thinking about underpants.

On December 16th, 1998, Comedy Central broadcast the seventeenth episode of the second season of South Park. In the episode, written by Trey Parker and Matt Stone, Harbucks (a franchise coffee shop chain with no similarity to any real-life company) planned to enter the South Park coffee market, thus threatening the local business owners.

Through a rather convoluted series of developments, the boys (Stan, Kenny, Kyle, and Cartman), are tasked with writing a school report on the threat that corporatism poses to small businesses. The report mobilizes the South Park community to take action against the insurgent corporate behemoth.

In true South Park style, what starts off as an attack on the culture of greed surrounding corporate interests ends up taking a pot-shot at the work ethic and merchandise quality of the small business owner.

Somewhat surprisingly, the TV critic (and sometime Austrian economist) Paul Cantor referred to this particular episode as “the most fully developed defense of capitalism ever” — which simultaneously speaks volumes regarding both the South Park writers and all those who have at one point or another defended capitalism.

(If you’d like to watch the full episode, you can find it HERE. Ain’t the internet grand?)

So… those Underpants Gnomes.

In the middle of the episode, Stan, Kyle, Kenny, and Cartman finally manage to lay eyes upon a pack of mysterious gnomes and ask them if they know anything about business. The gnomes assure the boys that they do and lead them into the cave where the gnomes stash their contraband underpants.

Once there, the gnomes lay out their business plan… a thing of beauty and simplicity that has been emulated by many companies in the age of the Internet of Things (a phrase whose constant occurrence in recent years has never failed to get my hackles up, but one that has, amazingly, been in existence since the early 1990s).

Surprisingly enough, many investors seem to have bought into things that even Eric Cartman could see through. Ah well, there’s no helping some folks.

Behold, the Underpants Gnomes’ business plan in all its majesty:

 

Now, in the real world, during the first internet boom (which peaked the year after this episode of South Park aired), the business model of the Underpants Gnomes was commonplace, as scores of companies flooded the marketplace, sustained purely by the promise of future profits that would somehow magically appear.

It was the corporate embodiment of George Costanza’s “yada, yada, yada”: “First we build a company… yada, yada, yada… we make billions.”

Of course, most of these companies went the way of the dodo; but remarkably, a mere 14 years after the bursting of the original internet bubble, there are signs of what Yogi Berra so beautifully referred to as “déjà vu all over again” — signs which some real heavyweight financial minds have recently highlighted:

(Seattle Times): Venture capital rising to levels not seen since 2001. Companies with no profits going public. Billions of dollars being paid for startups.

These and other signs that the tech boom may be taking an irrational turn are leading some notable investors to utter the dreaded word “bubble,” waking up the ghosts of an era many in Silicon Valley would prefer to keep buried.

Has Silicon Valley once again lost its collective mind?

Hedge-fund manager David Einhorn thinks so.

“There is a clear consensus that we are witnessing our second tech bubble in 15 years,” he warned in a note to his clients in late April. “What is uncertain is how much further the bubble can expand, and what might pop it.”

Of course, as we saw in 1998/9, there are plenty of people who believe in fairy tales, and they are happy to explain why THIS time is different:

Venture capitalists and entrepreneurs insist the Silicon Valley tech economy is not in bubble territory. Yes, they misjudged just how fast the Internet would change the world a decade ago and let things get a little bit out of hand.

But this time, they say, the revolution of mobile and cloud services justifies big, bold bets. And most of the companies going public are profitable, with real businesses that are transforming the way we live.

To some tech insiders, the region’s economy is in a “Goldilocks” moment. Not too hot. Not too cold. Enough of a boom to be just right.

Seriously?… Goldilocks? Again with that?

As you can see from the chart above, the Social Media ETF (SOCL) has fallen in almost a straight line since it peaked on Feb 19, 2014. Quite coincidentally, that was the day when $19 billion was paid for Whatsapp’s 450 million users.

The day that rationality returns to investing in technology stocks will be the day that we see some high-flyers (which had previously been given a pass on their poor performance because the promise of a bright tomorrow was just SO compelling) fall to earth in a hurry.

However, so as not to call out any specific companies, I am going to take the South Park approach and lay out a hypothetical fable about one such giant, high-flying corporate darling which has been embraced for its willingness to follow the Underpants Gnomes’ ingenious business plan.

The company has designs on becoming absolutely essential to all of mankind; and at that point, it has promised, it will figure out how to make a profit from the massive turnover that comes with ubiquity.

Let’s call this company… Spamazon.

(I should point out that Spamazon is an entirely fictional company. I offer no recommendation whatsoever, implied or otherwise, to either buy or sell the imaginary shares of this completely made-up entity.)

Spamazon was founded in 1994 in the mythical town of Beattle by an ex-investment banker and Harvard graduate named Jim Beeswax, a man with a passion and talent for engineering who had seen the internet wave swelling and wanted to ride it to the shore, where riches and fame awaited.

Click here 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.

Thoughts from the Frontline: A Bubble In Complacency

Thoughts from the Frontline: A Bubble In Complacency

 

Notes from SIC 2014

I and many others are still trying to digest the massive amount of useful and original information that was offered at last week’s Strategic Investment Conference. In this week’s letter I want to recap some of what I learned but do so in a little different manner. I find it quite instructive to listen to and read what other people have to say about their takeaways from the conference. I have come across several very good summaries and reviews that I am going to excerpt rather liberally, along with sharing some of my own thoughts.

Nearly everyone noted that there was somewhat of a divide in the opinions as to whether things in the US and global economies are getting better or getting worse. Upon reflection, I think that John Nicola (my Canadian partner of the eponymous wealth management firm, who sent me his comments, which I will use freely below) had it right. If we all examine a glass that is filled up to the mid-level, some of us will describe it is half-full, and others will describe it as half-empty. And of course there is plenty of data to back up either the optimistic or the pessimistic position.

The simple fact is that we are in what I call a Muddle Through Economy. Things aren’t terrible, but they are not great, either. We’ve come through a devastating Great Recession caused by a crisis in the financial sector. It is quite typical for the effects of such a crisis to linger for a decade or more. So compared to where we were at the bottom of the Great Recession, the glass is half-full. But compared to the expectations we have for economic recovery and the resumption of vibrant growth, half-full seems like an exaggeration. And for many people, the glass is simply empty, while for others it is spilling over.

Steve Moore sent me a graph demonstrating that net new jobs since the onset of the Great Recession have come, in large measure, from the energy sector. Those are generally high-paying jobs, but the rest of the country and many industries have not done so well. According to a new report from the National Employment Law Project, the quality of the jobs that have been created since the end of the last recession does not match the quality of the jobs that were lost during that recession:

  • Lower-wage industries constituted 22 percent of recession losses, but 44 percent of recovery growth.
  • Mid-wage industries constituted 37 percent of recession losses, but only 26 percent of recovery growth.
  • Higher-wage industries constituted 41 percent of recession losses, and 30 percent of recovery growth.

Yes, unemployment is down, but so is labor participation, and the simple fact is that outside of the petroleum sector new jobs are not being created to anyone’s satisfaction. In my presentation at the conference I showed a chart that illustrates the fact that we are losing businesses faster than we are creating new ones – an unprecedented statistic. This is a glass not only half-empty but leaking:

Richard Lehmann and Marty Fridson attended the conference and wrote an exceptionally well-done review in Forbes. (I was honored that they attended.) They started with the optimistic note that my good friend David Rosenberg offered as the very first speaker at the conference:

David Rosenberg, chief economist and strategist at Gluskin Sheff, sees reduced unemployment as a positive sign for the economy, despite objections that the decline in the unemployment rate reflects an unusually low participation rate. For one thing, says Rosenberg, the number of discouraged workers is down by 40% from the peak. At the margin, he adds, people are choosing to stay out of the work force in response to government incentives to remain idle.

The number of people collecting disability benefits, using food stamps, or collecting welfare payments is at a record high. Three-quarters of the reduction in the participation rate, says Rosenberg, is attributable to demographics, as the number of Baby Boomers reaching age 65 is rising dramatically.

Rosenberg further notes that unfilled job openings are at a five-year high. The U.S. government is granting fewer visas, college students are graduating without marketable skills, and the skills of many workers who have been laid off for long periods have become outdated. If all of the current openings could be filled, unemployment would drop to 4%.

The bottom line for Rosenberg is that the current recovery/expansion is in the fourth inning. Business cycles never die from old age, he maintains. He puts the probability of recession in 2015 at close to zero….

Richard Yamarone, senior economist at Bloomberg Economics, takes a less sanguine view on unemployment than David Rosenberg. He argues that the type of jobs being created makes a difference. Currently, job creation is skewed toward low-skill, low-income categories. To circumvent the Affordable Care Act’s requirement to provide health care to full-time employees, retailing, health care and food service employers are cutting workers’ hours. Consequently, new jobs are being created for people who now have to hold multiple part-time jobs, but that does not constitute a genuine increase in employment or GNP.

Yamarone’s view of the labor market leads to a comparatively bearish outlook on the economy. Since GDP began to be reported in 1947, he points out, the U.S. economy has slid into recession every time GDP growth has fallen to 2%, a level below which it currently stands.

Yamarone also reports unfavorable readings in four of five special data series that he has found to be accurate indicators of the economy—dining out, casino gambling, jewelry and watches, cosmetics and perfumes, and women’s dresses….

Lacy Hunt, executive vice president of Hoisington Investment Management, contends that the Fed’s strategy for boosting the economy is not working. Little wealth effect (the tendency of people to step up their spending when their wealth increases) has been observed. Hunt explains that the monetary policy cannot influence the economy unless the market rate of interest (represented by the Baa corporate bond yield) is below the natural rate of interest (the nominal rate of GDP growth). That has not been the case at any point during the recovery. Until it is, Hunt contends, consumers will have no incentive to take on debt to finance spending and economic growth will consequently remain sluggish.

Lacy believes all major developed countries are going to have deal with their “Minsky moments,” because not enough of their overall debt is productive. When all debt (government, corporate, and personal) is added up, it equals 350% of GDP in the US and 440% in developed countries on average. Lacy kept emphasizing his conviction that any number over 275% results in limited growth and eventual deflation.

David Zervos expects the Fed to keep interest rates low until it gets either inflation or solid economic growth. In fact, the private sector has been growing at more than 3% annually since 2010. His view is that savers will continue to be punished, because the interest rates they receive will remain artificially low. Gary Shilling was decidedly more upbeat and felt solid economic growth is at hand. (Nicola)

I noted an interesting theme in several speeches. Millennials, Jeff Gundlach noted, are different. They are less acquisitive. Neil Howe also talked about this and noted that we are in the middle of a “Fourth Turning,” which is a typically an isolationist period. He also notes that Millennials (1981-1994) like to rent (not just homes but cars, recreational property, clothing  etc.) They have less stress, often live at home with their parents, and are looking for meaningful work where they can be mentored. Ian Bremmer echoed Neil’s theme and stated that one of the important geopolitical trends at play is that the US is becoming more isolationist.

And Ian, who is a geopolitical analyst with the Eurasia Group and an NYU professor, also noted that the huge increase in US oil and gas production means much less dependence on Mideast oil and suggests that the US will eventually become a net energy exporter. As a result the US will not want to get entangled in the Middle East, and this reluctance will increase the risks in that region. Regarding the Ukraine situation, Ian feels the US made a mistake in trying to put sanctions on Russia that it couldn’t back up (a sentiment echoed by several speakers). He also expects Israel and the US to make a deal with Iran in the next twelve months – and if they do, Iran will bring 1.5 million additional barrels of oil to world markets. The big winner of the Ukraine crisis? Ian argued very cogently that it’s China. Ian continues to impress me every time I hear him or talk with him.

Jeffrey Gundlach was quite negative on US housing but positive on multifamily rental real estate, because rentals increase as home ownership drops. Home ownership has dropped from 69% of households to 65%. One well-known US investor, Sam Zell, expects it to drop to 55%. A 1% drop means 1.2 million additional households are looking for rental accommodations. Another speaker had mentioned that over 1 million millennials are living with their parents, which is a major factor in the reduction of household formation. Jeffrey does not like the risks associated with high-yield bonds but does like emerging-market debt and mortgages on a risk-adjusted basis. He expects the US to see deflation before inflation makes a comeback. (Nicola, et al.)

Grant Williams made a comment during a discussion about global markets that I thought was excellent. There is a bubble, he asserted, in complacency. He is very concerned with shadow banking in China (currently 60% of GDP) and with unaffordable housing. Many investors in wealth management products (WMPs) will lose a lot of money unless government bails them out. Overall there is a credit bubble in China. Japan is even worse at almost 250% of GDP for government debt alone. Grant feels Abenonmics is not working and that little structural reform is occurring. Notwithstanding that, Japanese 10-year bond rates dropped from almost 1% to 0.6% in the last year. Kyle Bass stated that he thinks Japanese 10-year rates will rise to 2.5%.

There was a very consistent theme in a number of presentations: no one is sanguine about China. The comments ranged from quite concerned to worried to very alarmed. (Next week this letter will focus on China.) There was not much that was positive to be said about Europe and Japan. Thoughts on the emerging markets varied a great deal and at the end of the day were very specific to particular markets.

John Nicola offered this summary to his clients:

As you can see, there are definitely two camps but also some common themes. Let me wrap up with our own thoughts on what we learned and how it might change our investment strategies.

There are still many headwinds to getting inflation to rise. One of the main issues is considerable slack in global labor markets. With emerging markets looking to improve their own standards of living, this spare capacity will likely be with us for many years. Overall it should continue to provide deflationary pressure on wages.

For a large part of the twentieth century the developed world experienced real growth of 3%+ per year. Many countries now have flat or declining populations, and all of them are aging. Looking forward, the developed world would be doing well if it were to realize real growth of 2% annually. Global growth will be driven by developing nations.

The impact of shale oil and gas is a game changer for the US both politically and economically. When this is combined with the US having the best demographic profile of any developed nation, it becomes an important part of any portfolio.

Long-term interest rates have been in a relatively narrow range for the last couple of years, and this may continue for some time even as QE is reduced or eliminated.  Even when rates rise they may not get to the “real” return levels of the past when long-term government bonds earned between 2-3% after inflation. At some point rates will rise, and we need to design portfolios to prepare for that. But the increases may take longer than many forecasters expect and be more muted as well.

Now let’s turn to a blog by Chris Bailey, who gave his readers ten take-away thoughts from the second day of the conference. I thought his wrap-up was well-done and somewhat different from the views mentioned above.

1. Trust within the economic system was a sub-theme with Dylan Grice noting on the regressive/divisive nature of QE that Central Banks “can only cheat … because people trust” and that a yield statistic should be considered a trust indicator … but that the risk with QE was that “if you weaken the currency, you weaken society, you weaken trust.”

2. Talking about yields… Lacy Hunt noted that we have not seen the spread between corporate bonds and nominal GDP be negative for over 30 years … but there was a real risk that it would happen this year. He noted this was reflective of a world with declining money velocity and a nominal GDP number “not enough or top-line growth.”

3. Geo-political troubles and challenges in the world were well captured by Newt Gingrich who noted from a US perspective that the world is “much harder, denser than thought… we are more limited than we think we are … our opponents get to play too.” Neil Howe noted that “the fourth turning” (which runs until c. the mid 2020s) generally sees a rise in isolationism. Dylan Grice showed some upturns in capital controls/protectionism (from a very low level) were occurring.

4. Debt levels around the world were a constant theme. Lacy Hunt noted that above a (combined) 275% public/private debt level “bad things happen” (guess where almost all large economies are…). Paul McCulley said that a sovereign country like the United States could not have a public debt crisis because it retained the capability to print… although clearly this could lead to other issues.

5. The role of government was much debated. John Mauldin said that one of his biggest questions was “can governments destroy … quicker than humans can create.” Newt Gingrich divided everyone in both government and corporate life between pioneers, prison guards, champions and prisoners. Dylan Grice noted he is preferring companies in sectors with less government intervention capability.

6. Neil Howe noted many attitude links between the 1930s and this decade covering pessimism, worries about inequality, distrust in the elites, retreat from globalism, a new desire for community and declining personal risk-taking.

7. Still there is hope. George Gilder said that “creativity always comes as a surprise” whilst John Mauldin talked about the need to evolve yourself into a future-looking homo rationalis with the scope for positive trends across mobile internet, automation, internet of things, robotics, renewals and advanced materials (amongst others) building an exponentially more attractive future.

8. Attractive future themes and traits across all sectors were are those that speak digitally, virtually, from a mobile perspective or personally as per Newt Gingrich. Stephen Moore talked about the importance of “more oil and gas in North Dakota than in Saudi Arabia” and noted ex-oil/gas employment growth had been negative.

9. Whether there a rising capital shortage was a question posed by Dylan Grice, and in such a world “gold is capital” and a focus on high-ROCE companies makes sense.

10. “Millennial[s] come of age in the crisis” – and as new consumers. Neil Howe noted less risk-taking and independence plus a greater friends/social orientation has implications for most sectors from autos (fewer drivers) to housing (more multi-generational houses, less need for large personal space) to advertising strategies (“quantified self,” “blanding of culture”).

And Martin Fridson and Richard Lehmann concluded with the following:

To make sure we did not go away too happy, the conference wrapped up with Ian Bremmer, Anatole Kaletsky and Niall Ferguson giving a world geopolitical outlook that focused on the risks and uncertainties we still face. This nuanced much of the positive outlook given earlier in the conference by John Mauldin, Pat Cox, George Gilder and Newt Gingrich.

No, the conference was not the World Economic Forum, but at times, it felt like that was where we were. And then, for those who don’t ski, San Diego in May is way nicer than Davos in January.

This does not even take into account the fabulous and powerful presentation by Pat Cox, which took us back into the history of alchemy and showed that almost every major breakthrough in medicine and healthcare was initially opposed by the establishment and ignored by other doctors. Newt Gingrich’s argument about how the “prison guards of the past” are slowing the advances of healthcare and new life-saving medicines re-emphasized that point. George Gilder presented his ideas on a new model for economic theory (which I am enamored with). We extended the conference by one-half day to allow for a few more speakers, and I worked hard to pull together a wider set of topics and views.

Each year we ask ourselves how we can make the conference any better, and each year we seem to do so. But this year set a very high bar for next year’s event, which by the way will be a little earlier in the year and once again in San Diego, April 28 – May 1. Set your calendar. You can buy a set of the 2014 audio CDs and/or MP3 files and listen to the speeches at your leisure by going to this link.

Trequanda, Rome, Nantucket, New York, and Maine

I leave this Thursday evening for Italy. We will spend the first night in Rome, where, randomly, my very good friend Steve Cucchiara (of Windhaven Fund fame) will also find himself, and we will take our kids to dinner that evening. Then we’re off the next day for two weeks at the little hilltop village of Trequanda, where some friends will drop by for a few days and use the villa as a base to explore or work from. I will be starting to work on my next book. Seriously.

Then I will again be in Rome June 14-17, where I will be joined by Christian Menegatti from Roubini Global Economics. We plan to spend time with various businessmen, investors, central bankers, and politicians to get a better understanding of what is really unfolding in Italy. We are actively looking for people to visit and especially for business associations with whom we can meet. Drop me a note if you’re interested.

Drugs, Prostitution, and Smuggling

I was recently sent this note by Cliff Draughn, who will be joining me for a few days in Trequanda. File this under “you can’t make this up.” This shows the extremes to which politicians in Europe will go to “adjust” their accounting to meet treaty requirements. Greece used Goldman Sachs, but now Italy will look to hookers and drugs. This is just too juicy, and I will have fun discussing it in Italy.

Drugs, prostitution and smuggling (ie Hookers & Blow) will be part of Italy’s GDP as of 2014, and prior-year figures will be adjusted to reflect the change in methodology, the Istat national statistics office said today. The revision was made to comply with European Union rules, it said.

Prime Minister Matteo Renzi, 39, is committed to narrowing Italy’s deficit to 2.6 percent of GDP this year, a task that’s easier if output is boosted by portions of the underground economy that previously went uncounted. Four recessions in the last 13 years left Italy’s GDP at 1.56 trillion euros ($2.13 trillion) last year, 2 percent lower than in 2001 after adjusting for inflation.

The punch line: “Even if the impact is hard to quantify, it’s obvious it will have a positive impact on GDP,” said Giuseppe Di Taranto, economist and professor of financial history at Rome’s Luiss University. “Therefore Renzi will have a greater margin this year to spend” without breaching the deficit limit, he said.

It will be interesting to see how much they think drugs and sex will add to the economy, and whether they publish the basis for their accounting. I suppose that next they will try to account for the rest of the massive underground economy in Italy. They are also quantifying other elements such as research and development costs and arms sales in the effort to increase nominal GDP. I wonder whether France will consider including the value added by the mistresses of politicians? Just asking…

Have a great Memorial Day weekend. I hope that a few of my kids show up. And then it’s off to Italy. Ivo the Gardener will be cooking at least twice. Last time he came and made pasta and everything to go with it. I swear that his is the best lasagna ever. And we’ll enjoy other cooks and some fabulous restaurants. Of all the food in the world, countryside Italian is my favorite cuisine. Hard to find it anywhere else as good as it is in Tuscany. Ciao until next week…

Your ready for my daily caprese fix analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Thoughts from the Frontline: A Bubble In Complacency

Thoughts from the Frontline: A Bubble In Complacency

 

Notes from SIC 2014

I and many others are still trying to digest the massive amount of useful and original information that was offered at last week’s Strategic Investment Conference. In this week’s letter I want to recap some of what I learned but do so in a little different manner. I find it quite instructive to listen to and read what other people have to say about their takeaways from the conference. I have come across several very good summaries and reviews that I am going to excerpt rather liberally, along with sharing some of my own thoughts.

Nearly everyone noted that there was somewhat of a divide in the opinions as to whether things in the US and global economies are getting better or getting worse. Upon reflection, I think that John Nicola (my Canadian partner of the eponymous wealth management firm, who sent me his comments, which I will use freely below) had it right. If we all examine a glass that is filled up to the mid-level, some of us will describe it is half-full, and others will describe it as half-empty. And of course there is plenty of data to back up either the optimistic or the pessimistic position.

The simple fact is that we are in what I call a Muddle Through Economy. Things aren’t terrible, but they are not great, either. We’ve come through a devastating Great Recession caused by a crisis in the financial sector. It is quite typical for the effects of such a crisis to linger for a decade or more. So compared to where we were at the bottom of the Great Recession, the glass is half-full. But compared to the expectations we have for economic recovery and the resumption of vibrant growth, half-full seems like an exaggeration. And for many people, the glass is simply empty, while for others it is spilling over.

Steve Moore sent me a graph demonstrating that net new jobs since the onset of the Great Recession have come, in large measure, from the energy sector. Those are generally high-paying jobs, but the rest of the country and many industries have not done so well. According to a new report from the National Employment Law Project, the quality of the jobs that have been created since the end of the last recession does not match the quality of the jobs that were lost during that recession:

  • Lower-wage industries constituted 22 percent of recession losses, but 44 percent of recovery growth.
  • Mid-wage industries constituted 37 percent of recession losses, but only 26 percent of recovery growth.
  • Higher-wage industries constituted 41 percent of recession losses, and 30 percent of recovery growth.

Yes, unemployment is down, but so is labor participation, and the simple fact is that outside of the petroleum sector new jobs are not being created to anyone’s satisfaction. In my presentation at the conference I showed a chart that illustrates the fact that we are losing businesses faster than we are creating new ones – an unprecedented statistic. This is a glass not only half-empty but leaking:

Richard Lehmann and Marty Fridson attended the conference and wrote an exceptionally well-done review in Forbes. (I was honored that they attended.) They started with the optimistic note that my good friend David Rosenberg offered as the very first speaker at the conference:

David Rosenberg, chief economist and strategist at Gluskin Sheff, sees reduced unemployment as a positive sign for the economy, despite objections that the decline in the unemployment rate reflects an unusually low participation rate. For one thing, says Rosenberg, the number of discouraged workers is down by 40% from the peak. At the margin, he adds, people are choosing to stay out of the work force in response to government incentives to remain idle.

The number of people collecting disability benefits, using food stamps, or collecting welfare payments is at a record high. Three-quarters of the reduction in the participation rate, says Rosenberg, is attributable to demographics, as the number of Baby Boomers reaching age 65 is rising dramatically.

Rosenberg further notes that unfilled job openings are at a five-year high. The U.S. government is granting fewer visas, college students are graduating without marketable skills, and the skills of many workers who have been laid off for long periods have become outdated. If all of the current openings could be filled, unemployment would drop to 4%.

The bottom line for Rosenberg is that the current recovery/expansion is in the fourth inning. Business cycles never die from old age, he maintains. He puts the probability of recession in 2015 at close to zero….

Richard Yamarone, senior economist at Bloomberg Economics, takes a less sanguine view on unemployment than David Rosenberg. He argues that the type of jobs being created makes a difference. Currently, job creation is skewed toward low-skill, low-income categories. To circumvent the Affordable Care Act’s requirement to provide health care to full-time employees, retailing, health care and food service employers are cutting workers’ hours. Consequently, new jobs are being created for people who now have to hold multiple part-time jobs, but that does not constitute a genuine increase in employment or GNP.

Yamarone’s view of the labor market leads to a comparatively bearish outlook on the economy. Since GDP began to be reported in 1947, he points out, the U.S. economy has slid into recession every time GDP growth has fallen to 2%, a level below which it currently stands.

Yamarone also reports unfavorable readings in four of five special data series that he has found to be accurate indicators of the economy—dining out, casino gambling, jewelry and watches, cosmetics and perfumes, and women’s dresses….

Lacy Hunt, executive vice president of Hoisington Investment Management, contends that the Fed’s strategy for boosting the economy is not working. Little wealth effect (the tendency of people to step up their spending when their wealth increases) has been observed. Hunt explains that the monetary policy cannot influence the economy unless the market rate of interest (represented by the Baa corporate bond yield) is below the natural rate of interest (the nominal rate of GDP growth). That has not been the case at any point during the recovery. Until it is, Hunt contends, consumers will have no incentive to take on debt to finance spending and economic growth will consequently remain sluggish.

Lacy believes all major developed countries are going to have deal with their “Minsky moments,” because not enough of their overall debt is productive. When all debt (government, corporate, and personal) is added up, it equals 350% of GDP in the US and 440% in developed countries on average. Lacy kept emphasizing his conviction that any number over 275% results in limited growth and eventual deflation.

David Zervos expects the Fed to keep interest rates low until it gets either inflation or solid economic growth. In fact, the private sector has been growing at more than 3% annually since 2010. His view is that savers will continue to be punished, because the interest rates they receive will remain artificially low. Gary Shilling was decidedly more upbeat and felt solid economic growth is at hand. (Nicola)

I noted an interesting theme in several speeches. Millennials, Jeff Gundlach noted, are different. They are less acquisitive. Neil Howe also talked about this and noted that we are in the middle of a “Fourth Turning,” which is a typically an isolationist period. He also notes that Millennials (1981-1994) like to rent (not just homes but cars, recreational property, clothing, etc.) They have less stress, often live at home with their parents, and are looking for meaningful work where they can be mentored. Ian Bremmer echoed Neil’s theme and stated that one of the important geopolitical trends at play is that the US is becoming more isolationist.

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.

Important Disclosures

Outside the Box: Gave & Gave … and Hay

 

My good friend David Hay, Chief Investment Officer at Evergreen Capital Management in Bellevue, WA, has saved me the trouble of writing an introduction to the two pieces you’re about to read, which are by Charles and Louis Gave, a father-son duo who are no strangers to the readers of Outside the Box and my Over My Shoulder. For the first time in many years, due to other commitments, neither father nor son was able to speak at our just-concluded Strategic Investment Conference (though their Gavekal partner Anatole Kaletsky did play a prominent role in the conference); so David, who is also their business partner, thought we should make up for their absence by directing readers’ attention to two very significant pieces they recently penned.

I am back in Dallas trying to absorb what I learned at the conference. There were a very wide range and an overwhelming number of new and newly conjoined ideas. I hope to be able to get into a few of the more prominent themes in this week’s Thoughts from the Frontline. Every year we say it can’t get any better, and every year it seems to. And those who have attended for many years have been emphatic in saying that this year’s conference was the best ever. They wonder, along with me, how we can possibly make it better next year. We’ll have to see. I have a few ideas, and I expect to solicit a few more.

This year’s theme was “Investing in an Age of Transformation.” I have been thinking a lot about the changes we have seen over the last 40+ years of my adult life and what I can expect from the next 40 (hopefully), although we are going to need to see some cool new transformative biotech to make that next 40 of mine possible.

I have been collecting a lot of reading material on cool biotech to review while I’m in Tuscany. I leave next Thursday night for about two weeks in Trequanda, and then I’ll be in Rome for a few days, where I hope to meet with businesspeople and other thought leaders who can help with some insights into Italy and Europe. I’ll be there with Christian Menegatti of Roubini Global Economics, and we’ll be taking meetings together, mostly. Drop me a note if you would like to meet or make an introduction.

And now I’ll turn the floor over to David to introduce Charles’s and Louis’s latest and greatest.

Your still happily reeling from the conference analyst,

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

 

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Gave & Gave … and Hay

By David Hay
Evergreen Virtual Advisor, May 16, 2014

“The whole aim of practical politics is to keep the populace alarmed (and hence clamorous to be led to safety), by menacing it with an endless series of hobgoblins, all of them imaginary.”

– H.L. Mencken

If it’s May, it must be Mauldin. As avid EVA readers are aware, this is the time of year for the annual Mauldin/Altegris Strategic Investment Conference (SIC). Consequently, several Evergreen team members and I are in San Diego (I know, tough duty). It’s an exciting time as the always-stimulating SIC has helped us develop some crucial long-term insights over the years. Consistent with our custom, we will be recapping the most compelling ideas and themes that we attain at the conference in upcoming EVAs.

This year’s slate of speakers is once again impressive, with giants of the investment world such as Jeff Gundlach, David Rosenberg, Kyle Bass, and, our partner Anatole Kaletsky. Additionally, my close friend Grant Williams will be presenting his maiden oration at this prestigious confab. My only disappointment is that, unlike last year, our other senior partners, Louis and Charles Gave, will not be speaking as originally planned.

Accordingly, I thought I’d dedicate this edition of our monthly “Guest EVA” to a pair of essays Louis and Charles recently authored. (Some of you undoubtedly read Louis’ piece in our recent Daily, but it’s worth reviewing!) As you will see, Louis is addressing the theme I’ve written about in our last two EVAs: The shockingly low level of interest rates in most of the world (which is turning out to be a very hot topic at this year’s SIC). Contrary to what almost all pundits expected at the start of the year, these yields have dipped even lower in nearly every developed country.

Louis gives several concise reasons why the era of yields-gone-missing might not end anytime soon. (As an aside, my view is that ultra-low yields may continue to persist for much longer than expected by the investment community at large, at least for creditworthy issuers. However, I continue to believe that there is a 2008-like reckoning coming for weaker borrowers, where financing rates are nonsensically low and lending terms are also irrationally easy.)

Charles’ essay relates to a book you may have read about, Capital in the Twenty-First Century, by French economist Thomas Piketty. It recently hit number one on the Amazon best-seller list and, reportedly, numerous senior US government officials are captivated by its central message of aggressive wealth redistribution.

Now, you may think that “French economist” is synonymous with socialist, if not Marxist. To be sure, many of Piketty’s proposals would warm the cockles of old Karl’s heart, such as an 80% tax on incomes over $500,000 and an annual 10% wealth tax for large fortunes (e.g., for someone with a $10,000,000 net worth, making $1,000,000 per year, they would actually pay out almost twice as much as they earn!). Yet, Charles is also a French economist and, as you will see, he vehemently disagrees with several of Mr. Piketty’s core themes.

Some EVA readers may recall that I have long believed a wealth tax is inevitable in the so-called “rich” countries whose governments (ex-Canada) are increasingly impoverished. Moreover, I feel that if properly structured (i.e., low rates and nearly zero loopholes), a US wealth tax, combined with much lower personal and corporate income tax rates (again, with the elimination of almost all deductions), would likely catalyze a growth boom and a restoration of our national balance sheet.

As indicated by the runaway success of Mr. Piketty’s book, there is intense interest in the wealth tax issue among the intelligentsia. Those of a more practical bent, who realize the growth-killing impact of his proposed confiscatory tax rates, especially on income, might want to start offering alternatives. Devoid of a more pragmatic solution, the Pikettys of the world may capture the minds of the planet’s politicians and the hearts of their voters.

Why Are Bond Yields So Low?

Louis-Vincent Gave

As long as men continue to age, they will probably complain that “things were better in their day” and that “the world is going to hell in a hand-basket”. Ignore for a moment that the proportion of undernourished people fell from 23% of the developing world in 1990-92 to under 15% in 2010-2012, that more than two billion people gained access to improved sources of drinking water in the past decade, and that never in history have so many people across the globe lived so comfortably—as far as financial markets are concerned, the ‘old-timers’ may have a point.

Indeed, anyone who started their financial career in the late 1990s has had to deal with the Asian Crisis, the Russian default and Long Term Capital Management failure, the Technology, Media, Telecom (TMT) bubble and collapse, the subprime bust and global financial crisis, the eurozone crisis and the past 12 months’ bond market taper tantrum and emerging market wobbles. In other words, there have been plenty of opportunities to catch the volatility on the wrong side. And these recurrent punches in the gut (combined with the recent violent rotation from growth stocks to value stocks or the fall in the renminbi), may explain why so many investors continue to seek the shelter of the long-dated treasuries, bunds and Japanese Government Bonds, despite these instruments’ apparent lack of value. Simply put, after almost two decades of repeated financial crises, investors today
do not have their forebears’ tolerance for pain. And so the old timers may be right: today’s young people are wimps, for both theoretical and practical reasons:

• An inherent level of systemic risk? Most people intuitively feel Karl Popper’s observation that: “In an economic system, if the goal of the authorities is to reduce some particular risks, then the sum of all these suppressed risks will reappear one day through a massive increase in the systemic risk and this will happen because the future is unknowable”. In other words, suppress risk somewhere and it comes back with a vengeance to bite you on the derriere at some later date. Look at 2008 as an example: we cut up credit-issuing risk into tiny parcels and distributed it across the system through securitization, only to see the banks take on a lot more leverage and ultimately sink their balance sheets on instruments they failed to understand. Hyman Minsky summed up this inherent contradiction well when he stated that “stability breeds instability”. In other words, the more stable a thing is, the temptation rises to pile on leverage, which makes that “something” more unstable on the back end.

• The notion of Anti-Fragile: the above brings us to the Nassim Taleb notion of “anti-fragile”: just as a parent who overly cocoons a child prepares that offspring poorly to function in the wider world, so policy-makers intent on cushioning the private sector from every shock in the economic cycle are doing the overall system a massive disservice. By preventing the build-up of immunity, or the ability to thrive in crises (i.e., anti-fragility), policymakers sow the seed for a greater crisis down the road (hence the repeated cycle of crises).

• Lay the blame on zero interest-rate policy (ZIRP): following on the above, not only does ZIRP allow the survival of zombie companies (which drags down the returns for everyone) but it most certainly affects investors’ behavior. Firstly, by encouraging banks to play the yield curve and buy long bonds, rather than go out and lend. Secondly, because almost all investors hold part of their assets in equities and part in cash or fixed incomes. And in a world in which fixed income instruments yield close to nothing, the tolerance for pain in other asset classes probably diminishes all the more. Indeed, if an investor is guaranteed a 7% coupon on his fixed income portfolio, then a mild sell-off in equity markets can be easily dismissed. But drop the yield on the bond portfolio to 2.5% and all of a sudden, the slightest drop in equity markets risks pushing the overall returns of the total portfolio into the red… Unless, of course, one holds much more fixed income instruments than equities. Paradoxically, that growing population cohort which seeks a guaranteed level of annual income faces the perverse reality that low bond yields force an even greater allocation of their savings into bonds! And this quandary is further amplified by the last point.

• The changing structure of savings: a generation ago, employees of large corporations would typically be enrolled in that company’s “defined benefits” pension plan. This meant that most salary-men, at least in the US, could look forward to a fixed monthly sum upon retirement, regardless of a) how long they lived for and b) what the market did. At that time, the overall behavior of financial markets was the concern of the pension fund’s managers who, if they were wise, could average up in bear markets and take some gains off the table when markets got hot; in other words, stomach the volatility of financial markets (back-stopped by their companies’ long-term earning power) for the long-term benefit of their plan holders. But today, following the evolution of most pension plans away from “defined benefits” to “defined contribution”, the average pensioner’s relationship to his pension has been turned on its head. Today, the average saver receives a monthly statement explaining how much he has saved; and any dip in that amount triggers sentiments of panic and fears that a looming retirement may not be well provided for. Combine that fear with rises in healthcare and college costs (two costs that older folks have to worry about) that, over the past decade, have typically continued to outstrip inflation and any dip in the market is more likely to trigger a sentiment of panic, and rapid shift into bonds, than a willingness to ‘buy on the dip’.

Putting it all together, it seems hard to find one factor that explains the low level of yields. In our view, the ageing of our societies, ZIRP and the low level of rates, the shift from defined benefits to defined contributions, the activism of policy-makers (who, by attempting to cushion the volatility of the economic cycle more often than not end up increasing the volatility of financial markets down the road)… have all had a hand in keeping interest rates low. And if that is the case, then it will probably take a marked change in some of the above factors to trigger a significant rise in bond yields?

The Problem with Piketty

Charles Gave

Thomas Sowell coined a marvelous phrase to describe the well-intentioned social engineers who always know what needs to be done to improve the wellbeing of the downtrodden. He called them “the anointed” and explained how their reasoning always evolves in the same three stages:

1.) They identify a problem, which may or may not exist. But whether it is real or not, they always insist the problem is caused by market failures.

2.) They propose a solution, which inevitably involves a greater role for the State—and for themselves as its high priests (high priests do not work, except within the Temple).

3.) When their solution fails (as it invariably does), they don’t re-examine their thinking, but just complain that it has been implemented with insufficient vigor. Needless to say, they put forward a new and improved plan they insist will work better next time…

Thomas Piketty is one of France’s great (self-)anointed. Like the rest of his cohort, he eagerly supported François Hollande in the run-up to the 2012 presidential election. Once voted in, the great man started to follow Piketty’s advice, and massively raised taxes on capital. Naturally the policy failed miserably, so Piketty has published a book which explains—predictably—that his recommendations only failed because they were not applied on a worldwide basis. Apparently this book has now become a best seller.

The extraordinary thing is that Piketty’s analysis is based on a massive logical error. His thesis runs as follows: if R is the rate of return on invested capital and if G is the growth rate of the economy, since R>G, profits will grow faster than GDP, and the rich will get richer and the poor poorer. This is GIGO (garbage in, garbage out) at its most egregious. Piketty confuses the return on invested capital, or ROIC, with the growth rate of corporate profits, a mistake so basic it is scarcely believable.

Let me explain with an example. I happen to be a shareholder in an industrial bakery in the south west of France. It has a return on invested capital of 20%, but we cannot reinvest the profits in the company at 20%. If we were to reinvest the profits by putting more capital to work, the profits would not change at all, because nobody in the region is going to buy more bread and productivity gains there are non-existent. In other words, the marginal return of one more unit of capital put to work is zero. So instead of reinvesting in the bakery, we distribute the profits among the shareholders and they invest them elsewhere as they see fit. In short, our bakery has a high ROIC but no profit growth.

At the other extreme, a company expanding rapidly according to a “stack ’em high, sell ’em cheap” model might well show a low ROIC but very fast profit growth. Every company in the world can be “mapped” according to these two criteria: ROIC, and the growth rate of corporate profits.

Over the long term, the growth rate of corporate profits cannot be higher than the growth rate of GDP. That’s simply because if it was, after a while corporate profits would rise to reach 100% of GDP, which we all know is silly. Historically, the ratio of domestic profit to GDP has been a mean-reverting variable.

In reality, all Piketty has done is to rehash the great Marxist theory about the “unavoidable impoverishment” of the working classes, recasting it as a theory in which the capitalist class gets richer and richer over time, and everyone else poorer and poorer. We only need to look at the history of the last 150 years, or of the last 20—in which two billion people have escaped poverty—to see how valid this theory has proved to be.

Still, it was fine for Marx to confuse the ROIC and the growth rate of corporate profits, because he worked in the days before William Jevons, Eugen Böhm-Bawerk, Knut Wicksell, Joseph Schumpeter and Alfred Marshall, who between them developed the notion of the marginal return on one more unit of capital. Alas, one cannot make the same excuse for Piketty, who is writing more than 100 years after this discovery.

The next question, then, is: why has his book become a best seller? The answer was provided a long time ago by the early 20th Century Italian economist Vilfredo Pareto, who argued that to the governing and chattering classes a theory can be:

1.) true and useful
2.) false and useful
3.) true and useless
4.) false and useless

Here a “useful” theory is one that increases the power of the anointed, not one that benefits the population at large. Theories that fall into the “false and useful” category are grasped especially fiercely by the anointed precisely because they help them to consolidate their political power. Keynesianism is a prime example.

Which brings us to Schumpeter. In Capitalism, Socialism and Democracy he made a fabulous remark which throws more light on the matter. He explained that the rise in living standards allowed by capitalism through the process of creative destruction was going to drive a huge rise in the educational level of the population. The educated but uncompetitive would grow to hate the capitalist system, under which their merits were not recognized, and would try to seize control of educational and cultural institutions in order to teach the youth that markets do not work.

Much the same idea was expressed by the Italian Marxist Antonio Gramsci. If these fellows were to take control of the cultural and educational world, then 30 years later the political system would fall into their hands like a ripe fruit. Then they would be able to use the democratic process to destroy the free market, having first brain-washed the electorate.

Don’t get me wrong, I am absolutely in favor of education. But I am against a centralized educational system, easily controlled by the anointed.

This leaves open a question: why do intellectuals hate free markets? Because, as French sociologist Raymond Boudon explained, in a free market they would be paid at their real value.

Their success in controlling not ideas, which are uncontrollable, but the teaching of ideas, continued Schumpeter, would inevitably lead to a shift from a democratic, market-based system, to tyranny and poverty.

This is exactly what is happening in the old world today. An over-educated, self-anointed elite is fighting tooth and nail to defy market forces and preserve its position in the educational and cultural system. Piketty, as one of this elite, is being feted accordingly. Nothing new there.

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Thoughts from the Frontline: Special Updates from the Strategic Investment Conference: Day 3

 

By Worth Wray

Good morning from 30,000 feet, somewhere over the great American West!

I admit to being a little overwhelmed as I write to you on my way home from the Strategic Investment Conference. After three days with two dozen of the finest investors, economists, and political scientists anywhere in the English-speaking world, it is going to take me weeks to think through the real-world implications of all I have learned.

While I will have to rely on my overloaded memory and late-night notes to reflect on the dozens of one-on-one conversations I had, I am so thankful to the folks at Mauldin Economics and Altegris for recording the sessions themselves, which will let me replay the experience over and over in the coming weeks. (You can do so, too, by ordering the SIC MP3/CD Audio Set at our discounted pre-event price. It’s available here.)

Much to my surprise, after two days of mind-blowing presentations and provocative conversations about debt overhangs, monetary policy, technological transformation, and the growing bubble in investor complacency, the conference ended on its strongest note yet!

Early in the day, GaveKal Research co-founder (and Europe’s preeminent financial journalist) Anatole Kaletsky shared a handful of variant perceptions that challenged my thinking and shattered my often self-deceptive sense of certainty. Contrary to the optimistic and technologically promising view of the future shared by John Mauldin, George Gilder, Newt Gingrich, and Jack Rivkin, Anatole suggested that the jury is still out on the future path of productivity growth. The still open question about productivity (which Anatole says may take 15 years to answer) has enormous implications not only for the climax and resolution of the global debt drama but also for the very structure of the global economy in the years ahead.

Looking to the shorter term, Anatole echoed a wise but too-often-overlooked comment from Gluskin Sheff Chief Economist & Strategist David Rosenberg on day 1 of the conference. Markets move as economic activity, liquidity conditions, and valuations get better or worse at the margin… and at the margin, Anatole suggests, the great and powerful headwinds on everyone’s minds may be slowly turning into tailwinds.

He laid out a powerful and actionable view of the future that I seriously need to consider in the coming weeks, starting with this question: Is the US stock market (an asset class that tends to dominate traditional investment portfolios) at the end of a five-year cyclical rebound and due for a correction…

… or are US stocks finally breaking out in a structural upswing after 14 years in a secular bear market purgatory?

While I remain concerned about the corrosive effects of dogmatic and irresponsible central bank policy – not to mention historically elevated valuations in the face of negative real interest rates – Anatole has learned to look past emotion and ask the uncomfortable questions. These are the moments when my brain goes into overdrive, and I feel absolutely alive.  

What many people do not realize about Anatole is that he draws not only on the wisdom gained from a long career but also on an unparalleled personal network of legendary investors like George Soros, Stan Druckenmiller, and Kyle Bass… to name just a few.

The day ended with a lively debate, featuring an eye-opening range of competing views, that extended our conversation from questions about global markets and economies to geopolitics. While Harvard Professor Niall Ferguson expressed worries about the global dangers of US isolationism, the degeneration of American culture, and the troubling trajectory of government debt in the face of a dysfunctional political system, Eurasia Group President Ian Bremmer argued that US ambiguity is far more dangerous than isolationism.  Hamstrung by a lack of support from the American people to enforce hollow threats over “red lines” in Syria and the Ukraine, the Obama administration has not actually said what it wants in the world… leaving US allies and enemies to assume the worst (a point that Anatole shared with great vigor).

I wish I could outline their entire conversation for you – ranging from the future of the Eurozone and the rising risk of Russian imperialism to the enormous risks of Chinese reforms – but it is time to hit the send button.

I am leaving the Golden State with more questions than answers… but then again, that’s the mark of a great conference! Hope you can join us next year, and feel free to drop me a line anytime on Twitter at @WorthWray.


Worth Wray
Chief Strategist, Mauldin Companies

Thoughts from the Frontline: Special Updates from the Strategic Investment Conference: Day 1

 

By Worth Wray

Good morning from sunny San Diego, California!

As the sun rises on the second day of the Strategic Investment Conference, I am absolutely blown away. John and Altegris put on an amazing show, and this is simply unlike any investment conference I have ever attended.

Let me explain…

In my experience, these industry events are usually more about networking than content. I go to investment conferences in hopes of expanding my thinking and challenging my preconceived ideas about the world… but all too often I find myself sitting in half-empty auditoriums listening to rock-star economists who are resting comfortably on their laurels rather than bringing their A-games.

At your average conference, over the course of several days and several dozen presentations, I usually expect to hear only a handful of truly original ideas… but not here. Here, I can hardly keep up.

Instead of skipping sessions to explore the resort or lounge by the pool, here everyone stays in the room. It’s so refreshing to see 650 people guarding their seats, hanging on every word, and drinking from a fire hose of transformational ideas.

Day 1 started off with the king of modern-day economists, David Rosenberg, who goes on ruffling a lot of feathers. Rather than obsessing over whether the state of the global economy is good or bad, Dave challenged us to see beyond the deflationary headwinds and focus on how things are changing at the margin. Markets move as things get better or worse; and at the margin, Dave argues, inflation pressures are building. I know this sounds odd to a lot of us who are still worried about deflation; but Dave notes that out of 140MM workers in the large, insulated US economy, roughly 40MM higher-skilled workers have the bargaining power to push wages higher and turn the inflationary dial… even as low- and medium-skilled workers see their wages decline.

Next up, we had an epic debate between Bloomberg Senior Economist Rich Yamarone and Jefferies Chief Market Strategist, David Zervos. Rich is worried that after six years of fragile growth, the US economy is prone to recession and skating on very line ice. He argues that the middle class is getting hollowed out, because no positive wage pressure can be exerted by the vast majority of Americans. More people are being forced to take multiple jobs to make ends meet, in part because the Affordable Care Act is changing the way businesses employ nonessential workers.

With his thumb on the pulse of the real economy through his Orange Book research, Yamarone gives us his top five real-world indicators, which tell a story very different from the official macro data. Meanwhile, in high spirits and with a powerful faith in central banks, Zervos exhorts us to be lovers, not haters. Deflation cannot take hold, he asserts, as long as the Federal Reserve is pouring money into the system. Today, sitting in low-volatility cash is more dangerous than being in higher-volatility stocks, he argues. David laid out two choices and encouraged the crowd to pick a path.

Then we moved on to a comprehensive look at the global economy as the always brilliant Grant Williams and Jonathan Tepper took the stage to share their ideas about China, Japan, Europe, and other markets. Jonathan argued that low volatility and tight European credit spreads are not necessarily signs of lasting recovery but rather the sort of irrational calm that always comes before a crisis. Expanding on Jonathan’s point, Grant warned that if and when this bubble of complacency pops, the impact will shake the world. And then he explained how sudden shifts in confidence in China and Japan could tip off the next global panic.Patrick Cox, who writes Mauldin Economics’ Transformational Technology Alert, ran(!) us through a jaw-dropping, hugely inspiring PowerPoint show and commentary, one of the highlights of which was his prediction that the US energy boom will enable the widespread adoption of robotics here, which will reverse 40+ years of manufacturing outsourcing.

We heard from several other excellent speakers during the day, including Gary Shilling, and Vice Admiral Robert Harward… a great American who once commanded the Navy SEALS and who gave us all hope that with the support of the greatest warriors in human history, America’s best days lie ahead.

There’s lots more I could share with you about yesterday’s developments, but it’s time to hit the send button. John Mauldin is about to take the stage with one of the most powerful presentations I have ever seen, and I don’t want to miss a second. We have been working on this speech for more than six weeks, and I am inspired by his ability to find hope in the midst of debt-related worries and to look into and through the macro chaos to give us a profoundly positive vision of the future.

Thankfully, I have not had to take copious notes, because there’s no way the pace of this event would allow me to keep up with all the information coming at me.  To fill in the blanks, I’ll be able to refer to the recordings of all the authorized presentations from the event when my MP3/CD Audio Set arrives in a few weeks.  If you couldn’t make it to SIC but want to tune in to the insights shared by 20 of the world’s top independent thinkers, you can order the audio set here today at our discounted pre-event price. Based on what I’ve already experienced at the conference, I can tell you the SIC Audio Set will be loaded with invaluable information and worth every penny.

Thanks again for your support, and I hope you can join us next year!


Worth Wray
Chief Strategist, Mauldin Companies

Thoughts from the Frontline: Special Updates from the Strategic Investment Conference: Day 2

 

By Worth Wray

Hello again from the Strategic Investment Conference in San Diego, California!

John Mauldin took the stage on day 2 with a powerful message: while the human brain struggles to anticipate exponential change, our economic future quite literally depends on a race between two accelerating curves – debt and innovation.

Just as exponential growth in government debt starts to destabilize the global economy – with enormous and growing risks to growth and productivity in Japan, the United States, Europe, China, and even many of the emerging markets – John believes the constant doubling of computing power since the late 1950s has brought us to the point where our technological capabilities are taking exponentially larger leaps every year. That constantly accelerating computing power is enabling innovation so profound and disruptive that it looks and feels like magic.

The question John asks is, “Can the private sector innovate and create wealth faster than governments and central banks can destroy it?” We are optimistic that the human race will continue its march forward in the coming decades, but bad policy can stifle innovation and hurt us economically. Ultimately, John’s question will need to be answered on a country-by-country basis… and the distinguished speakers who followed John today gave us a lot of additional food for thought as we contemplate the path ahead.

Former Speaker of the US House of Representatives Newt Gingrich asserted that the pioneers of the future (the dreamers, innovators, and entrepreneurs) will eventually break out past the prison guards of the past (irresponsible and overprotective governments, central bankers, and special interests). Ultimately the rising tide of productivity growth will allow our economic future to transcend past experience, but those gains will be unevenly distributed during the transition – continuing to fuel a political shift from right to left.

We heard a similar view from former President Reagan’s most-quoted living author, George Gilder, who argued that the study of economics must evolve and embrace the lessons of information theory, as he outlined in his 2013 book Knowledge and Power: The Information Theory of Capitalism and How It is Revolutionizing Our World. Mr. Gilder draws a brilliant insight from the way information like phone conversations, emails, and video is transmitted. The electromagnetic spectrum, he argues, is a completely predictable carrier, governed by speed of light. The information it carries, on the other hand, is highly unpredictable. It takes a low-entropy, no-surprises carrier to reliably transmit high-entropy, surprising content. If the carrier itself were to introduce a lot of noise into the signal, our communications would be a jumble.

These ideas from the fields of physics and information theory have extremely important implications for public policy in an age of accelerating technological transformation. In order for innovation to thrive, productivity to surge, and living standards to dramatically rise over the coming decades, we need “low-entropy” legal, regulatory, tax, and monetary policy, and stable institutions to implement it. Too much noisy interference from governments and central banks that distorts market incentives and increases the hassles of doing business can stifle innovation and discourage entrepreneurship. That’s why it is so critical for governments around the world to understand the technological transformation in progress and to actively pursue the reforms their economies will desperately need to participate in the new global economy.

That’s a worrying dynamic if we pay attention to the Heritage Foundation’s Stephen Moore, who harps on the distortions in public policy, or if we consider Hoisington Management’s Dr. Lacy Hunt, who explained to us today that, in aggregate and contrary to popular belief, total debt-to-GDP across the world’s major economies has INCREASED by nearly 35% in the years since 2008. And even more importantly, the new debt has been taken on disproportionately by the real problem economies: Japan, the Eurozone, and China.

With a powerful grasp of an enormous body of academic research (and armed with some hard-hitting discoveries of his own), Dr. Hunt warns that debt deflation – not inflation – is the biggest near-term risk. While inflationists like to chant Milton Friedman’s famous mantra “Inflation is always and everywhere a monetary phenomenon,” Lacy pulled back the curtain on Friedman’s lesser-known research and explained that the famous characterization of inflation ultimately depends on stable or rising monetary velocity… sans sufficient monetary velocity, inflation does not materialize. I really need to think through Dr. Hunt’s research to a greater extent and plan to spend a lot of time reviewing the conference recordings in the coming weeks. (You can do so, too, by ordering the SIC MP3/CD Audio Set at our discounted pre-event price. It’s available here.)

Dylan Grice largely concurred with Dr. Hunt. In his thoughtful outlook for a breakdown in international monetary cooperation, instigated by Japan’s dangerous move toward tit-for-tat central banking, Dylan warned that the world’s central banks are drifting into a dangerous prisoner’s dilemma.

In one of those wonderful moments that happen only at a conference of this quality, Dylan mentioned in conversation later in the day that a Minsky-like inflationary moment can absolutely happen if velocity (rather than interest rates) skyrockets. Paul McCulley had already claimed, in his lunchtime address, that major governments with control over their own printing presses do not have Minsky Moments, but he later had to concede that Dylan could be right in the event of a major policy error.

In the coming weeks, John and I are going to rest up a bit, then revisit the conference, dig into the research, reorganize and expand on our thoughts, and bring you some provocative new ideas.

Once again it is time to hit the send button. Ian Bremmer is walking us through his geopolitical outlook at the moment, and the crowd is hanging on every word. I don’t want to miss it!

Have a great day, and I’ll send you another recap tomorrow.


Worth Wray
Chief Strategist, Mauldin Companies

Outside the Box: EM Carry Trade Looks Vulnerable

 

Last year, post-taper tantrum, the story was all collapsing BRIC walls and emerging-market doom. This year the so-called “fragile five” – Brazil, India, Indonesia, Turkey, and South Africa – the countries that were most vulnerable last year, are looking downright robust. Since their January lows, the Turkish lira has climbed 13%, the Brazilian real 10%, the South African rand 8%, and the Indonesian rupiah and Indian rupee 6% each. In the last two months, the MSCI Emerging Markets Index is up 7% in US dollar terms, a whole lot better than the 1% the developed markets have logged.

But not so fast, says Joyce Poon, Gavekal Asia Research Director (and for my money the best of the young generation of analysts working the Asia markets). “The trouble,” says Joyce, “is that this rally has been driven primarily by investors’ growing enthusiasm for carry trades in an environment of declining global volatility. Experience teaches this is an engine which can all too suddenly be thrown into reverse.”

Joyce’s concern was echoed in a tweet just yesterday from Global Macro Investor’s Raoul Pal – who we are delighted to have joining us at the SIC conference this week, by the way. He tweeted:

And before we move on, I just have to share with you a marvelous bit of whimsy concocted a couple days ago by my associate Worth Wray (who always seems to be two steps ahead of the game in sensing these macro trends). As I mentioned over the weekend, you’ll be hearing from Worth every day during the conference, as he and I summarize all the goings on for you in a special Thoughts from the Frontline series. But first this:

And that is the name of that tune.

I am in San Diego, and my Strategic Investment Conference has started. They tell me they are setting the room for over 650 attendees. Old friends and new gather, economic junkies and those who are trying for the first time to figure things out. (It seems we have more young people every year, or it might be that I keep getting older and the standard of “young” keeps rising along with the markets.)

And late at night a few resilient souls gather in my room, debating the topics of the day. David Rosenberg, polite but never shy, weighs in with his bullish calls, while Darth Vader (aka Bloomberg Chief Economist Rich Yamarone) waves the yellow flag. Wait, who is that flapping her arms and hooting? It is Joan McCullough, that rarely seen, beautifully plumed bird who has graced us with her presence. And she schools both David and Rich with a dose of real world. And sets the tone for the next hour’s debate.

Maybe 15 people, free thinkers all (or maybe some of us are free of thought?), weigh in as the conversation morphs and finds its own path. Gods, I live for these nights! I am such an unrepentant idea and information addict. And for the next three days be the fastest game in town will be right here – it will be like drinking new ideas and views from a fire hose.

I confess to being nervous about my speech on Thursday, something that doesn’t happen often any more. I have spent more time on this one than on any speech I have ever done, and may have overthought it. Too much in my head trying to get out; too much for 40 minutes. Kind of like trying to get your 100,000-year-old human brain to truly understand exponential change. It feels like too much is rushing to the front of the brain, all begging to be set free. The rehearsals have not gone well, at least in my opinion.

And perhaps that is due in part to the fact that I have seen the presentations of some of the other speakers. Patrick Cox is doing a 260-slide PowerPoint deck in 40 minutes. Seriously. And it’s captivating. And Grant Williams truly makes his Apple whatever-it-is software literally sing and dance. At least I don’t follow them or Kyle Bass or Newt, although Dylan Grice will blow the place out before I get my shot. Rosie (David Rosenberg), my lead-off hitter, steps up to the plate in 8 hours, at 8 am, and then it never slows down. Until Saturday, maybe… I kicked everyone out of the room at 11, came in, checked email, and finished this note. And Rosie, who I firmly believe is the first true android, will get his daily out tomorrow morning.

You have a great week, and if you do the Twitter thing, shoot me a note as to what you want me to ask the speakers. You can see the list here (click on the Speakers tab). Worth and I will be writing notes every day about what we are hearing and thinking and sending them your way as shorter editions of Thoughts from the Frontline.

Your thinking about Investing in an Age of Transformation analyst,

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

 

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EM Carry Trade Looks Vulnerable

By Joyce Poon, Gavekal Asia Research Director

Over the last two months, emerging markets have delivered a handsome rally, with the MSCI emerging markets index recording a 7% return in US dollar terms, compared with just 1% for the developed markets. The trouble is that this rally has been driven primarily by investors’ growing enthusiasm for carry trades in an environment of declining global volatility. Experience teaches this is an engine which can all too suddenly be thrown into reverse.

The defining feature of the current run-up in emerging markets is that the greater the sell-off a country suffered last year, the stronger the rally it has enjoyed this year. As a result, the so-called “fragile five”—Brazil, India, Indonesia, Turkey, and South Africa—the markets most reliant on foreign capital and so most vulnerable during last year’s taper tantrum, are no longer looking quite so fragile. Since their lows in January, the Turkish lira has surged 13%, the Brazilian real 10%, the South African rand 8% and the Indonesian rupiah and Indian rupee 6% each.

It hasn’t taken long for the rebound to flow through to stock markets. In local currency terms, an investor with an equally-weighted allocation to each of the fragile five’s equity markets will already have seen his portfolio regain its previous high reached in May 2013 (see chart below).

As investors, we like equity rallies to be propelled by fundamental factors, like earnings re-ratings or growth surprises. But there is little behind this rally to suggest any sustainable economic healing. Sure, there are pockets of earnings re-ratings because of last year’s currency depreciation, but we see little in terms of broad-based economic surprises. According to the Citi Eco Surprise Index, economic data in the emerging market has largely surprised on the downside so far this year. Most forward-looking indicators, especially in Asia, are signaling no prospect of any decisive upturn in the growth outlook. What’s more, the prevailing direction of economic and monetary policies is hardly investor-friendly. Credit moderation remains the order of the day in China, while policy settings have been on hold among many of the other major emerging markets in the run-up to national elections. And with food prices turning up, monetary easing is now off the table for emerging market central bankers.

That leaves the search for carry as the principal engine of the current rally. The markets which sold off most violently last year, and which have rebounded most strongly over the last couple of months, are those offering the most attractive yields. As volatility in global financial markets fell this year, and lingering fears of emerging market contagion evaporated, the lack of yield on cash prompted investors to turn once again to the high yielding emerging market currencies and fixed income markets which took such a beating last year.

The widespread return of calm which has underpinned the revival of the emerging market carry trade is marked, and even ominous. Unless you are trading the renminbi or the Russian market, volatility levels in major equity markets, currency pairs, CDS spreads and basis swaps are once again approaching, if not already below, the lows seen last April. Even Chinese CDSs are at year-to-date lows, despite the worries over China’s growth trajectory, while volatility in the Brent crude market has fallen even as geopolitical uncertainty has mounted. While low volatility is nothing new in the era of financial repression, it still signals a remarkable rebound in confidence given expectations that the Fed will halt its balance sheet expansion within a few months.

On this premise, the moment that volatility returns, the emerging markets will be extremely vulnerable to investor repositioning. Quite what the trigger might be is impossible to say. But history teaches us that volatility rarely stays this low for long.

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Thoughts from the Frontline: Are Valuations Really Too High?

 

The older I get and the more I research and study, the more convinced I become that one of the more important traits of a good investor or businessman is not simply to come up with the right answer but to be able to ask the right question. The questions we ask often reveal the biases in our thinking, and we are all prone to what behavioral psychologists call confirmation bias: we tend to look for (and thus to see, and to ask about) things that confirm our current thinking.

I try to spend a significant part of my time researching and thinking about things that will tell me why my current belief system is wrong, testing my opinions against the ideas of others, some of whom are genuine outliers.

I have done quite a number of media interviews and question-and-answer sessions with audiences in the past few months, and one question keeps coming up: “Are valuations too high?” In this week’s letter we’re going to try to look at the various answers (orthodox and not) one could come up with to answer that basic question, and then we’ll look at market conditions in general. This letter may print a little longer as there are going to be a lot of charts.

I am back in Dallas today, getting ready to leave Monday for San Diego and my Strategic Investment Conference. I’m really excited about the array of speakers we have this year. We’re going to share the conference with you in a different way this year. My associate Worth Wray and I are going to do a brief summary of the speakers’ presentations every day and send that out as a short Thoughts from the Frontline for four days running. Plus, for those who are interested in my more immediate reactions, I suggest you follow me on Twitter. There are still a few spots available at the conference, as we have expanded the venue, and if you would like to see who is speaking or maybe decide to show up at the last minute (which you should), just follow this link. Now let’s jump into the letter.

Take It to the Limit

First, let’s examine three ways to look at stock market valuations for the S&P 500. The first is the Shiller P/E ratio, which is a ten-year smoothed curve that in theory takes away some of the volatility caused by recessions. If this metric is your standard, I think you would conclude that stocks are expensive and getting close to the danger zone, if not already in it. Only by the standards of the 2000 tech bubble and the year 1929 do you find higher normalized P/E ratios.

But if you look at the 12-month trailing P/E ratio, you could easily conclude that stocks are moderately expensive but not yet in bubble territory.

And yet again, if you look at the 12-month forward P/E ratio, it might be easy to conclude that stocks are fairly, even cheaply priced.  

In a Perfect World

Earnings are projected to grow rather significantly. Let’s visit our old friend the S&P 500 Earnings and Estimate Report, produced by Howard Silverblatt (it’s a treasure trove of data, and it opens in Excel here.

I copied and pasted below just the material relevant for our purposes. Basically, you can see that using the consensus estimate for as-reported earnings would result in a relatively low price-to-earnings ratio of 13.5 at today’s S&P 500 price. If you think valuations will be higher than 13.5 at the end of 2015, then you probably want to be a buyer of stocks. (Again, you data junkies can see far more data in the full report.)

But this interpretation begs a question: How much of 2013 equity returns were due to actual earnings growth and how much were due to people’s being willing to pay more for a dollar’s worth of earnings? Good question. It turns out that the bulk of market growth in 2013 came from multiple expansion in the US, Europe, and United Kingdom. Apparently, we think (at least those who are investing in the stock market think) that the good times are going to continue to roll.

The chart above shows the breakdown of 2013 return drivers in global markets, but this next chart, from my friend Rob Arnott, shows that roughly 30% of large-cap US equity (S&P 500) returns over the last 30 years have come from multiple expansion; and recently, rising P/E has accounted for the vast majority of stock returns in the face of flat earnings.

The Future of Earnings

What kind of returns can we expect from today’s valuations? There are two ways we can look at it. One way is by looking at expected returns from current valuations, which is how Jeremy Grantham of GMO regularly does it. The following chart shows his projections for the average annual real return over the next seven years.

If you go back to the very first chart we looked at, which showed the Shiller P/E ratio for the S&P 500, you can see that it is quite high. If you break returns down to 10-year periods for the last 86 years and rank those returns from the highest to the lowest in 10 groups, you find out that, reasonably enough, if you start out at a low price-to-earnings ratio, your returns for the next 10 years are likely to be quite high. If you start from where we are today, though, the same methodology suggests that your returns might be anywhere from -4.4% to +8.3%, or less than 1% on average, not exactly a projection likely to warm an investor’s heart.

I was talking with my good friend Ed Easterling of Crestmont Research, as I often do when I’m thinking about stock market valuations – he’s one of the most thoughtful analysts I know. We were looking at some charts on his always-useful Crestmont Research website, and he offered to modify one of the reports for this letter. You can see the updated version at Crestmont P/E Report.  Here’s what he wrote to accompany the table below:

The outlook may be uncertain, but that does not make it unpredictable. The current secular bear could remain in hibernation. The inflation rate could remain low and stable, thereby sustaining P/E in the range of 20 to 25. The current secular bear could succumb to a period of higher inflation or deflation, thereby P/E declines to levels associated with the end of typical secular bears (at or below 10). Alternatively, P/E might begin to migrate along its secular bear course, only to arrive near its historical average around 15. The outlook may be uncertain, yet we can assess the range of potential outcomes using these three scenarios.

Consistent with a foggy crystal ball, the horizon is likewise variable. Some people may want to see the impact of a fast path (say, 5 years), while others may take a somewhat longer view of a decade or more.

The result is a forecast providing a matrix of outlooks based upon your assumptions. Pick your time, pick your ending P/E, and add in dividend yield for the expected total return from the stock market. Figure 7 shows that secular bear markets are periods of below-average returns. The magnitude of the annualized return (or loss) depends upon the investor’s time period. Most notably, however, is that none of the scenarios provide average or above-average returns. As history has shown, average or above-average returns cannot occur from levels of relatively high valuation without the multiple expansion of a rising P/E. From today’s lofty levels, bubble conditions would be required… and that’s not a reasonable assumption for any investor’s portfolio.

Figure 7. Crestmont Research Outlook (S&P 500 Total Return)

AS OF: MAR 31, 2014

TOTAL ANNUALIZED RETURN FOR S&P 500

 

(nominal returns)

 

 

 

 

 

P/E Ratio (P/E10)

 

YEARS

10

15

22.5

 

5

-10.4%

-3.0%

5.0%

 

7

-5.8%

-0.3%

5.5%

 

10

-2.2%

1.8%

5.9%

 

20

2.3%

4.3%

6.4%

 

 

 

 

Notes 1-5: see footnotes in Figure 1; also, includes dividend yield of 2%

 

Copyright 2008-2014, Crestmont Research (www.CrestmontResearch.com)

How Did We Get Here?

I think we have to admit that quantitative easing on the scale that it has been practiced by the Federal Reserve for the past few years has had a great deal to do with the rise in the prices of stocks. We’re not seeing the massive inflation that was predicted with the swelling of the money supply, except in asset prices, as the chart below shows.

The tapering by the Fed is well underway and will be completed sometime this fall. It would not surprise me if they come to October and just go ahead and take off the final $5 billion along with the expected $10 billion reduction. It would seem pretty pointless to maintain just a $5 billion QE program. (Thanks to Josh Ayers at Paradarch Advisors for the following chart.)

It’s Not Only Stock Market Valuations

Bonds are beginning to get a little stretched as well. This note from MarketWatch pretty much tells the story:

If it’s not happening immediately, when will it happen? Valuations are getting pretty high, prompting junk bond guru Martin Fridson to say the asset class is in a state of “extreme overvaluation.” Credit is in such high demand right now that it’s prompting big name investors like DoubleLine Capital’s Jeffrey Gundlach to declare that the asset class is too crowded.

Citi credit strategist Matt King, who is out with an extensive report this week about the current state of the credit market, has this chart to show:

It will be interesting to see what Jeff Gundlach says at our Strategic Investment Conference this week. As well as David Rosenberg, Lacy Hunt, Gary Shilling, and others who will always opine on the bond market. As I mentioned at the beginning, we will be sending you updates from the conference, and you really should follow me on Twitter.

San Diego, Italy, and Nantucket

I leave Monday morning for San Diego to prepare for the conference (co-sponsored with Altegris) and to spend a day with my partners planning and shooting videos. I have really been anticipating this conference, not only because of the speakers but because this is the place where I catch up with so many friends and meet new ones. This really is just about my favorite week of the year. While we may have trouble finding value in the stock market, I always find that time with my friends is about the most valuable time I can spend. Right now, my daughter Tiffani is scheduled to come, as well as most of my staff. Tiffani has not been to the last few conferences, and she is looking forward to catching up as well.

I’ve been working on my presentation for about eight weeks now. The theme for the conference is “Investing in an Age of Transformation,” and I want to try to really focus our attention on the large trends in the world, both economic and technological, that are going to have rather massive implications for our investment portfolios.

Following the conference, I’ll be home for a few weeks before I take off for a working vacation in a little town in Tuscany called Trequanda. I will also be in Rome June 14-17, where I will be joined by Christian Menegatti from Roubini Global Economics. We plan to spend time with various businessmen, investors, central bankers, and politicians to get a better understanding of what is really unfolding in Italy. We are actively looking for people to visit and especially for business associations with whom we can meet. Drop me a note if you’re interested.

Then I’m home for another month before I have a speaking engagement in Nantucket, Massachusetts, in the middle of July. And of course the first Friday of August will find me in Grand Lake Stream, Maine, where I will once again be trying to outfish my youngest son on our annual fishing trip to “Camp Kotok.”

I am often asked how I can travel so much. I admit that from time to time it can be a bit physically wearing, but I have come to the conclusion that it’s early mornings and insufficient sleep that is the main culprit in travel weariness. I find that if I get enough sleep and can find a gym, then I seem to be okay. I guess it’s just important to stay away from those early-morning meetings if you’re going to be out late the night before.

It is time to hit the send button. The gym is calling. Have a great week!

Your just trying to keep up analyst,

John Mauldin, Editor
subscribers@mauldineconomics.com

 

Thoughts from the Frontline: Are Valuations Really Too High?

 

The older I get and the more I research and study, the more convinced I become that one of the more important traits of a good investor or businessman is not simply to come up with the right answer but to be able to ask the right question. The questions we ask often reveal the biases in our thinking, and we are all prone to what behavioral psychologists call confirmation bias: we tend to look for (and thus to see, and to ask about) things that confirm our current thinking.

I try to spend a significant part of my time researching and thinking about things that will tell me why my current belief system is wrong, testing my opinions against the ideas of others, some of whom are genuine outliers.

I have done quite a number of media interviews and question-and-answer sessions with audiences in the past few months, and one question keeps coming up: “Are valuations too high?” In this week’s letter we’re going to try to look at the various answers (orthodox and not) one could come up with to answer that basic question, and then we’ll look at market conditions in general. This letter may print a little longer as there are going to be a lot of charts.

I am back in Dallas today, getting ready to leave Monday for San Diego and my Strategic Investment Conference. I’m really excited about the array of speakers we have this year. We’re going to share the conference with you in a different way this year. My associate Worth Wray and I are going to do a brief summary of the speakers’ presentations every day and send that out as a short Thoughts from the Frontline for four days running. Plus, for those who are interested in my more immediate reactions, I suggest you follow me on Twitter. There are still a few spots available at the conference, as we have expanded the venue, and if you would like to see who is speaking or maybe decide to show up at the last minute (which you should), just follow this link. Now let’s jump into the letter.

Take It to the Limit

First, let’s examine three ways to look at stock market valuations for the S&P 500. The first is the Shiller P/E ratio, which is a ten-year smoothed curve that in theory takes away some of the volatility caused by recessions. If this metric is your standard, I think you would conclude that stocks are expensive and getting close to the danger zone, if not already in it. Only by the standards of the 2000 tech bubble and the year 1929 do you find higher normalized P/E ratios.

But if you look at the 12-month trailing P/E ratio, you could easily conclude that stocks are moderately expensive but not yet in bubble territory.

And yet again, if you look at the 12-month forward P/E ratio, it might be easy to conclude that stocks are fairly, even cheaply priced.  

In a Perfect World

Earnings are projected to grow rather significantly. Let’s visit our old friend the S&P 500 Earnings and Estimate Report, produced by Howard Silverblatt (it’s a treasure trove of data, and it opens in Excel here.

I copied and pasted below just the material relevant for our purposes. Basically, you can see that using the consensus estimate for as-reported earnings would result in a relatively low price-to-earnings ratio of 13.5 at today’s S&P 500 price. If you think valuations will be higher than 13.5 at the end of 2015, then you probably want to be a buyer of stocks. (Again, you data junkies can see far more data in the full report.)

But this interpretation begs a question: How much of 2013 equity returns were due to actual earnings growth and how much were due to people’s being willing to pay more for a dollar’s worth of earnings? Good question. It turns out that the bulk of market growth in 2013 came from multiple expansion in the US, Europe, and United Kingdom. Apparently, we think (at least those who are investing in the stock market think) that the good times are going to continue to roll.

The chart above shows the breakdown of 2013 return drivers in global markets, but this next chart, from my friend Rob Arnott, shows that roughly 30% of large-cap US equity (S&P 500) returns over the last 30 years have come from multiple expansion; and recently, rising P/E has accounted for the vast majority of stock returns in the face of flat earnings.

The Future of Earnings

What kind of returns can we expect from today’s valuations? There are two ways we can look at it. One way is by looking at expected returns from current valuations, which is how Jeremy Grantham of GMO regularly does it. The following chart shows his projections for the average annual real return over the next seven years.

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.